Wednesday, December 23, 2009

Investing Outlook and Strategy for 2010

Here is an article from the FT confirming that large hedge funds are betting on inflation. Obviously, there is nothing earth shattering in this article since Robertson has been touting his “steepner trade” since Jan 2008 and Paulson is the largest holder of the GLD (in addition to marketing a new gold focused fund), but thought it was interesting to point out how funds are positioning themselves to make money in 2010.

In reflecting on the market bottom that we hit in March 2009, if you had told me that the high yield index would be up 55% this year, leveraged bank loans up a similar amount, the Nasdaq up 40+%, the S&P up 60% from its March lows, gold at $1100 (having crossed $1200 along the way), I would have thought it nuts to see the 10-year at only 3.7% (and around 3% for much of this rally!). This goes to show you the incredible effectiveness of the monetary experiment initiated by the Fed. Essentially, quantitative easing (primarily through the Fed’s $300 billion treasury purchase program and $1.25bn agency-backed mortgage program), has kept the back end of the curve fairly low, even with a powerful rally in risky assets. One can chastise the Fed for its involvement in the financial system and dispute the long-term merits of such action, but in no way can one debate how successful it has been in the short-term. The ponzi-esque nature of the Fed’s actions are legendary (i.e. buying unwanted assets in the open market to keep their yields low and allow the treasury to fund our fiscal deficits at rock bottom rates), but even Madoff’s investors felt great in the beginning years. However, based on the recent rise in the long end of the curve it’s unclear that our creditors will remain as committed to us as Madoff’s unwitting investors were to him.

Rapped up in this “inflation” trade is actually a very bullish view on the economy. Assuming the Fed keeps rates negligible for some time, which is my own personal opinion (hardly differentiated, but certainly confirmed by Bernake’s extensive work on the failings of the Fed during the Great Depression), we could see a fairly powerful rally in the stock market for the early part of 2009. As forceful as the rebound has been off the March lows, the individual investor has remained almost entirely on the sidelines. This is confirmed by the persistent negative fund flows into equity mutual funds. March represented a capitalization of sorts on the downside; the pervasive skepticism that has greeted the current rally is hardly reflective of market tops.

I routinely like to call a bunch of friends in the industry to take a very informal poll of their mood and that of their firms. I like to say that everyone was a micro bottoms up investor in 2004-early 2007 and ignored (except John Paulson and a few other astute investors) the macro clouds hanging over the global economy in 2005/2006. Well in October 2008 to March 2009, everyone all of a sudden became a “macro investor.” Concerns over the systemic risk of the banking system, the Fed’s irresponsible involvement in the financial markets, and the death of capitalism dominated the conversation. Such “boring” things as single digit PE multiples off of cyclically depressed earnings and free cash margins in the double digits (for even unlevered companies) all of sudden became irrelevant in the context of the impending doom of the financial system.

As we emerged from the depths of the March lows, massive amounts of skepticism greeted the market rally. People conceded that asset prices were extremely cheap, regretted that they hadn’t bought more, but also doubted the sustainability of the rally. The “green shoots” sprouting in the economy (i.e. house price stabilizing in California, inventory liquidations abating at most large companies, credit worthy borrowers accessing cheap credit) were either ignored or outright dismissed by those seeking confirmation of their bearish bias.

As I stand here now in December 2009, I can sense a clear shift in the mood of my fellow investors. Skepticism is melting away as people are simply tired of being bearish. The macroeconomic concerns that dominated the conversation over the last twelve months are being replaced by “M&A is back”, “companies still look reasonably priced on historical metrics”, “which companies stand to benefit from China growing 10% next year.” In short, all the discussion topics that would have served investors well in March; ones that I found so hard to engage people in less than a year ago, are only now beginning to resurface.

While the individual investor still remains on the sidelines, the hedge fund community has clearly embraced this rally. Until the former joins the party, I think we could see a continued rally in the market, perhaps materially so. Improving economic data that will most surely surface in the early part of 2009 will only confirm this increasingly bullish disposition. However, as an unrepentant contrarian, I think investors should not so easily dismiss the “macroeconomic” views they so diligently added to their investing toolkit at the bottom of the market. An improving economy will have the perverse effect of encouraging the Fed to extricate itself from the economy. This is particularly the case as it relates to housing, which I have repeatedly pointed out since starting this blog, has been on an improving trend for much of 2009 (do in no small part to the strong hand of our government).

The Fed’s decision on whether or not to extend the $1.25 trillion mortgage-backed security market (set to expire at the end of Q1) will serve as the seminal data point on the sustainability of the market rally. Should they let this program expire, the impact on mortgage rates, housing, and the banking system will be immediate. The reverberations of this in the overall economy could take a few quarters, but under such a scenario I think 2010 could end up disappointing a lot of investors as we exit the year. On the flip side, should the Fed maintain its overall accommodative stance by keeping rates low and extending many of its liquidity programs, we could see a sustained rally for some time. At some point, the reckoning will have to come, but I doubt it will happen in 2010. If 2009 has taught me anything, it’s to never doubt the short-term impact of a massive Fed-induced monetary experiment.

Bernake and Co. unleashed every weapon in their arsenal to prevent another Great Depression. As long as they continue their fight, and Bernake’s academic background leaves little doubt that he remains committed for the long haul, it remains pointless to fight the Fed. The ramifications of sustained monetary stimulus will be inflation, which underpins the short treasuries/long gold thesis dominating the investing strategies of many hedge funds going into 2010. I remain in this camp, though I concede I derive little comfort from the growing consensus forming around this thesis. A sharp reversal in Fed policy will warrant a reassessment of this investing strategy, though I think investors will be well-served by maintaining a strong bias to equities and gold as we enter 2010.

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