We’ve been on the ‘new normal’ kick for a while now. Maybe it’s time for a break?
Your punditry team was chatting the other day (actually we do that a lot, but that is one of the most useful parts of the job) and we got off on the topic of turnover. Have you ever wondered why it is that value investors tend to have a fairly long time horizon while growth investors seem to be much more focused on the near term? It would seem that value investors ought to be the ones with the fairly short time frame. Value, if you do it even remotely right, ought to be the approach that would compel you to buy and sell, buy and sell as one investment after another became cheap and then was recognized as being undervalued and bid up. By the same token, true growth companies should work for perhaps decades before the growth fades and they become more pedestrian. So, which group has it wrong? The value investors who wait and wait until even their worst ideas work out? Or the growth folks, who demand instant satisfaction? We think it is mostly the growth folks. Too many ‘growth’ investors are in fact only momentum investors.
So, while the value investors seem to have the time frame pretty well in hand, it is the growth investors who are needlessly churning their portfolios. Every academic study we’ve ever seen argues that high turnover is hard on investment performance. One wonders what would happen if a growth investor adopted the decade standard for their investments? If someone would have bought Google at the offering back in 2004, they are up some 400% despite the last couple of year’s declines. That beats the heck out of the roundly zero for the S&P 500. Since 1968, McDonalds is ahead by some 150 fold versus the mere 25 fold for the market. Don’t even ask about Wal-Mart. Great growth stocks are the gift that keeps on giving.
Sure, most growth stories turn out to be just that, stories. For every Microsoft, there are a dozen Computer Associates, each Hewlett-Packard has many more Ataris. But, with a little good luck a little discipline would work to reduce the number of errors. Besides, if you hold stocks for decades, you can afford to take your time and seek out only the strongest stories that have staying power. You might only need a couple of buy ideas a year and maybe only a couple of sells.
Once again, the entire marketplace seems to have gotten it backwards. Value players ought to be the ones with rapid fire turnover of maybe 25% or so a year and growth guys ought to be down around 10%. But no, growth funds’ turnover is closer to 180%, and value is about 80%. Another one to scratch our collective heads over.
In other news. There are other things going on in the world. This weekend, we saw elections in Germany. (This segment was penned over the weekend before the results of the German elections were announced, so it ought to sound pretty silly by the time we know what happened.) While the campaign was coming to an end, Chancellor Angela Merkel was in Pittsburgh, Pennsylvania attending the Group of Twenty economic summit. Merkel is sort of like a watered-down, German version of Margaret Thatcher, the British Prime Minister who turned that sad nation around back in the 80’s. Merkel is watered-down because she it unwilling to radically change the German social and economic structure, and also because Germany was never the basket case that Britain had become.
Merkel was facing her former coalition partner, Frank-Walter Steinmeier at the top of the ticket, but that isn’t really the way it works there. The chancellor isn’t like the president over here. Actually, Germany has a president too, but he is largely ceremonial in nature. The chancellor is really more akin to the prime minister in Britain. The party that wins the most seats in the parliament (the Bundestag in Germany) is asked to form a government and the head of the party generally pencil’s themself in as chancellor.
The odds are that Merkel’s Christian Democratic Union (kind of like the Republicans) would be the leading vote getters in the election and would probably win about 35% of the votes and also about 35% of the seats in the Bundestag. Steinmeier’s Social Democratic Party (kind of like Britain’s Labor Party) would likely come in second at maybe 25%. Then the Free Democrats (pro-business) would likely win 15%, the Greens (environmentalists) maybe 10%, the Left party (an amalgam of old communists, socialists and anarchists) would likely win about 10%. The regional parties and various other fringe parties would win whatever is left-over. Merkel’s job is to fashion a coalition out of this mess. She would rather team up with the Free Democrats and her regional sister party the Christian Social Union from Bavaria. This will happen if they manage to get 50% of the votes in the Bundestag between them. Odds were good that they would fail. If that’s the case, Merkel will probably try to re-forge the current grand coalition with the SDP. (By the time you read this, one or the other may already be a fait accompli.)
The problem for Merkel is that the way they vote in Germany favors the smaller parties as they have proportional representation, so if you win a decent share of the vote in one district, you might get a seat even if you don’t really win any. Every time they have an election there are a lot of people who get more votes than the next guy, but still don’t get to serve because of this proportional representation thing. Each voter gets two votes, one for an individual parliamentarian and one for their party of choice. This is why parties with only a few percent of the absolute vote continue to exist. It is sort of like electoral Robin Hood, taking from the rich to give to the poor vote getters.
We are reminded once again of the uniqueness of America’s accidental two-party system. Here, we punish third parties and fourth parties and so forth. There are two independents in the Senate, one of whom was originally elected as a Republican (Jeffords) and the other was originally a Democrat (Lieberman – but the Democratic Party essentially threw him out). Both of these folks caucus with the Democrats.
But, the American system confuses most people around the world. In most nations the greens and labor don’t see eye to eye on most things. Labor is in favor of development so long as it doesn’t enrich anyone and increases employment. Greens abhor development, especially if anyone makes any money on the deal. The two would seldom work together except to join a coalition to oppose a conservative party. But, in the Democratic Party they sit there side by side, seething under their breath and dreaming of the day they can split up. What we tend to have are these two, semi-permanent coalitions.
It is difficult for us to imagine, but we are the odd ones out when it comes to politics. Most of the rest of the world is either a single party state or has so many parties it is almost comical. We have two. Funny, huh?
So, Merkel is trying to put together what looks a lot like the Republican coalition in Germany but she might have to invite in the blandest of the Democrats. Good luck with that.
Economic News (we’ve discontinued the Good News section since most of the economic news seems to be good news these days)
In Fed news, they again left short rates at essentially zero. We can’t fathom why, but they did. The argument they make is that the recovery will be fairly tepid at least at first and they want to avert any slippage back into no growth. Something tells me that zero interest rates aren’t keeping anyone from anything, so tepid growth is due to some other factor. What zero interest rates are doing is setting us up for the next series of bubbles. We don’t see what difference 1.5% short rates would make. If you’re not going to buy a refrigerator at zero, you’re still not going to buy it at 1.5%. But if you need a new refrigerator, you’re not going to let 1.5% get in the way, either.
Leading Indicators rose again, making this five months in a row. Half of the individual series in the index rose on the month and two more were unchanged. It isn’t unusual for only a couple of series to jerk this index around as many of them are quite volatile on their own. The coincident index, which is created to monitor economic series that seems to coincide with economic growth, was unchanged in August, but was revised to a small gain in July. Our guess is that the economy turned in July.
The Federal Housing Finance Administration home price index rose by 0.3% in August. This index follows homes sold using FHA or VA financing or homes whose mortgage is insured by Freddie Mac or Fannie Mae. Thus it covers only ‘qualifying’ mortgages, under the caps on mortgages allowed by the mortgage giants. So, this index is dominated by homes not in major metropolitan areas. The Case-Shiller index is out this week and covers the largest cities.
In probably the surprise economic report of the week, existing home sales fell. It was widely expected that home sales would rise modestly due to the rapidly approaching end of first-time buyer incentives and improving availability of financing. But, it didn’t happen that way. Evidently, the gain in July sated much of the pent-up demand by these potential buyers. Also, the inventory of unsold homes fell to ‘only’ 8.5 months supply. That is the biggest improvement in several years. However, it seems that a lot of homes just went off the market rather than being sold.
New home sales rose a piddly 0.7% in August. Were it not for a downward revision of July’s data, sales would have been down. New homes are selling at an annual rate of just 429,000, which is below the rate one year ago. Prices for new homes also slipped to a recessionary low. Prices dropped 9.5% from July to August to a median price of $195,200. Given the small number of homes sold, the change was attributed to a mix shift with far more smaller homes sold than typical while fewer large homes sold. The first-time buyer tax credit has spurred sales of lower-priced homes.
New homes completed hit a record low in August at 110,000 at an annual rate (records go back to 1963). Builders are loath to complete a home because once it is completed, the construction financing comes due and permanent financing must be sought. Since they are unlikely to get permanent financing to pay-off the construction loan, they don’t finish the house.
Durable goods orders fell by 2.4% largely due to lower aircraft orders. Economists had been trend-lining a rise of 0.3% but were disappointed. Demand for aircraft fell 42.2% from the month before. Aircraft orders can be very volatile as they are dominated by huge orders that come in intermittently. Excluding transportation orders, other durable goods rose 0.9%.
Consumer sentiment rose to 73.5 in September from 65.7 in August according to the University of Michigan survey. This improvement echoes the gain registered in early September. Almost every element of consumer sentiment improved from last month.
The past several weeks have seen a return of ‘M&A Monday.’ Each Monday sees some new merger deal announced. There is always a good rationale for these deals even though they seldom actually work. Most mergers are an exercise in futility. Company A that is either desperate to grow and can’t summon any internal growth looks around for a product or something that would help it regain its youthful vigor. Company B needs massive amounts of financial help to get their new product/service off the ground and to a scale that is profitable. That seems like a match made in heaven. Oddly, these deals are few. Usually it is the company with more money than good sense, buying the company that beat them to market with the newest whiz-bang thing. Either way, most deals don’t work because the buyer pays too much, or the seller isn’t what they are chalked-up to be or maybe both. But, deals are back in the news.
Is this a reason to celebrate? In a way it is. The answer likely isn’t that the economy is healthy again, or the market is back on an even keel. No, the reason is that the credit markets are functioning again. There is enough money back in circulation to make these deals possible again. When you need to borrow $5 or $10 billion to get a deal done, that was impossible just a couple of months ago. Now, there is a market for the debt and some banks are willing to help get a deal like this done. As the credit markets get healthier, there will be less need for the Fed to help support everything. As the Fed steps back, the free market should step in. At least let’s all hope that’s the way it works.
Stocks fell last week for the second week in a row. The selling seemed to be concentrated in some of the areas that have done the best recently. Financials were down a lot, many materials sectors were lower (energy among them), industrial companies seemed to be mostly down. The areas that held up relatively well were consumer staples and healthcare. Surprise! Now that the recovery seems to be on, the cyclicals may be about over.
Much of the selling was concentrated in the small caps, which fell about one-third faster than the large caps. It will take a lot of that to get the small to large relative performance back where we think it ought to be, but it could happen. Once again we underestimated the power of group think about an investment concept that has no real foundation in logic or history. Small has beaten large during the early parts of economic recoveries, but not all the time and not by a whole lot. That we should all suddenly fall in love with small caps only due to the idea that the recovery would reward us is absurd, but if we all believed it, we made it happen. Oh well, we live and learn.
Foreign stocks also fell last week. The declines were fairly modest. What is strange is that the emerging markets fell less than developed ones. Declines were concentrated in Europe and that makes sense. The German elections were big news and the angst about the G-20 meeting could be seen as an excuse. The emerging markets were supported by Brazil, India and Singapore while most of Latin America fell and China proper was down. Maybe it was just one of those rare weeks when people were all about making sound decisions for a change. No, only kidding.
Bond markets around the globe and up and down the quality spectrum were generally higher last week. The nice talk out of the G-20 helped with that. There was no real plan to resolve the huge liquidity overhang in the global financial markets. The ‘exit strategy’ which is so desperately needed, but so hugely feared was put-off for another day. With no strategy to fret about and no time table to monitor, the bondos were all about looking at the glass half full and not about to be poured on their heads.
Real estate was upended after the last couple of glorious weeks. Since the mini-low back in July, real estate securities had advanced about 50% until last week. That relief rally may now be over, but a more sanguine outlook for commercial real estate is far from established. All the horrible headlines about this or that specific problem have brought the issue into the spotlight. But, the change in the underlying value of the properties has probably over discounted the future environment. We’ve collectively taken the worst case scenario of a couple years ago and recast it as the most likely scenario today. It is not. There will be issues over coming months and years with real estate in specific markets and with specific developers and REITs. But on the whole, the industry has taken its lumps and is valued fairly attractively versus the prospects.
Commodities had another mixed week, with energy retreating on most fronts, with precious metals backing away from recent gains, and with industrial metals dropping from recovery highs. Most ag commodities also declined with corn a notable exception. The whole commodities rally this year is likely a case of buy on the rumor (of economic recovery) and sell on the news (of economic recovery).
Have a really great week.
Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.