Blackthorn Q3 2013 Quarterly Letter
Posted on Friday, October 11th, 2013
If you have read much of what I write (and I won’t hold you accountable if you don’t) you probably would have surmised by now that we are entering into what is my favorite time of the year. At least as far as investing goes. It doesn’t get more exciting then rounding the corner and sliding headfirst into the October through December time period when it comes to investing. Historically, October has presented some of THE most exciting and harrowing time periods across the last 100 years and for someone who is constantly looking to buy new securities at fire sale prices those times can be like Christmas morning.
This September the “Taper Caper” came and went and we saw bond prices head higher. The FOMC put on hold any talk of lessening their purchase of securities in the open market and that had the effect of lowering rates across the yield curve. The FOMC while looking for a way out of supporting the market may not have liked the fact that the 10 Year US Treasury seemed inclined to head north of 3% which would put a crimp in their plans and the burgeoning real estate market. While the FOMC realizes that it is going to have to taper it’s buying at some point it seemed to feel that the economy was not quite ready to stand on its own. The path to “Tapering” may be quite difficult as we have surmised for some time. After all it is far easier to buy securities then to sell them.
The Federal Reserve may have found itself in a bit of a pickle. In June the Bank of International Settlements insisted that the Federal Reserve may already have gone too far in its bond purchasing when they stated that. …central banks cannot do more without compounding the risks they have already created. – Bank of International Settlements (BIS) June 2013
“…the path of tapering is going to be tough because every time the market thinks they are going to taper, yields will likely rise and conditions will tighten” – Deutsche Bank
The fact that the FOMC wants to keep rates down but needs to get out of the bond buying game means that a type of rate pegging may be on tap. The Fed, when trying to extricate itself from its bond buying position, may need to jawbone rates or even purchase bonds when rates go too high in an effort to affect a soft landing. As rates rise in anticipation of any Fed tapering of their easy money policies then the Fed is less likely to take their foot off of the gas pedal. That is the conundrum that the Fed faces.
The battle the Fed is fighting may be won in getting the handoff correct. The Financial Crisis was about the private sector deleveraging and the government taking the ball. The government picked up the ball that the private sector had dropped and filled the role of lender. It is now time to try and hand that ball back. We may see an air pocket between the time the government tries to hand the ball back and the private sector begins to run with the ball.
This handoff may create spasms of volatility in the marketplace. Those spasms of volatility will present opportunities for prepared investors. The US economy is in a great position to rebound with broad access to clean water, abundant affordable energy, recapitalized banks and an educated workforce although that recovery may be bumpy at times.
All of this talk about tapering and interest rates leads us to a discussion on the role of bonds in our portfolio. Bonds can still give us a decent return if we concentrate on duration. According to “Bond King” Bill Gross of PIMCO, he believes (and we concur) that the Fed can’t raise rates in a levered economy and that interest rates are going to stay low for a long long time.
If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time. Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that.
The reason to place your bet on the “don’t come” 2016 line is what we have just experienced over the past few months. We have seen a 3% Treasury yield and a 4½% 30-year mortgage rate and the economy peeked its head out its hole like a groundhog on its special day and decided to go back inside for another metaphorical six weeks. No spring or summer in sight at those yields. The U.S. (and global economy) may have to get used to financially repressive – and therefore low policy rates – for decades to come. – Bill Gross PIMCO
Emerging markets may be one place to sidestep as the FOMC details further asset purchase wind down and, in fact, may show the first signs of any oncoming crisis. The Fed’s easy money policy has found a home in emerging markets as investors seek higher returns. Any restriction of those easy money policies will have that money recoiling from those same emerging markets. This past quarter saw great volatility in stock markets from India to Thailand to the Philippines.
Ray Dalio, founder of $145 billion hedge-fund firm Bridgewater Associates, believes that the next major financial crisis may come from an emerging-market country; said India is the most likely candidate to trigger such a crisis. The country is most vulnerable because it relies too much on outside capital to finance its budget deficit. China and Russia, by contrast, are relatively insulated. -Bloomberg
As for the ongoing case for equities, valuations may be a bit stretched in light of the current economic environment. Witness some notable commentary from the Legends of Investing Category in recent weeks.
Not a lot of bargains. -Carl Icahn
The stock market “doesn’t look so cheap, “The whole thing about keeping interest rates low, people put money into stocks because they want the yield, or they’re gambling, or they’re getting nothing on their cash. That really adds to the speculative environment. A bit of a bubble. And at some point you have to pay the piper. –Meryl Witmer
The stock market is more or less fairly priced now. – Warren Buffett
The outright purchases of securities by the Federal Reserve have bolstered (and quite possibly inflated) bond and equity prices. As an investor we continually ask ourselves are asset prices undervalued, overvalued or just about right? Our job as investors is to sell when prices are high and investors are eager to take on risk. We also seek to buy when others are fear filled and reticent to take on risk as we seek to buy assets for less than they are worth. That is our margin of safety.
Remember, central banks don’t create growth. They only pull demand forward much as they have pulled market returns forward. Does it make sense that the market is at all time highs if the economy is so weak that the Fed cannot withdraw? The Fed has pulled market returns forward by pushing investors into riskier assets. Markets will have to reprice at some point.
Many market participants have 1987 on their minds. (1987 is a year which is never far from investors minds.) That year much like 2013 started sharply to the upside rising over 20%. The Federal Reserve recently published a report comparing leveraged ETF’s to portfolio insurance. It was portfolio insurance that was blamed for taking the market down 22.6% on Black Monday in 1987. In recalling 1987 we must remind you to remember that there are no problems, only opportunities.
We have felt over the past month the Congressional Budget Debate would only be just the warm-up to the debt ceiling negotiations. Jeremy Klein is a very astute analyst at FBW Securities that we are lucky enough to have access to. His market calls over the last two years have been quite prescient. Here is what he had to say on the negotiations.
If the House and the President cannot reach an agreement on an issue much less contentious than the upcoming debt ceiling debate, investors will reasonably conclude that a technical sovereign default is not only possible, but also likely later in October. This scenario has the potential to roil the capital markets especially in light of a central bank lacking ammunition to kick start growth after five challenging years. Such an event would usher in volatility last seen in the latter half of 2011 while earnings estimates, already woefully optimistic given flat revenues, would quickly ratchet lower such that a secular tailspin will arrive for stocks far sooner than I anticipated. –Klein FBW 9/30/13
Seemingly ALL investors expect that the current budget/debt ceiling crisis will be dragged out but solved at the last minute. The only question remaining for those investors is how high will the eventual bounce in the market be? 3%? 5%? Or even 10%!? When all investors agree as to an outcome then that outcome becomes less likely. So, we shall continue to maintain cash as a call option to deploy if lower valuations come calling. We will also maintain some bond exposure due to the possibility of deflation which is hedged with a holding of senior loan funds which will give us some upside exposure if rates turn higher.
The stock market has now completed two round trips in the last 13 years and if we look at P/E ratios from the last decade investors are now paying less per $1 of earnings today than they were in 2000. Although the market has gone relatively nowhere in the last decade it has gotten cheaper on a relative basis. As much of a bubble that may or may not have been created by the Federal Reserve the stock market is a better bargain today than it was in 2000. Any major sell off from here may turn out to be a great buying opportunity when we look back 10 or 20 years from now.
Going forward we will continue to monitor bond yields. While the stock market tends to gyrate wildly bonds have a steadier hand and bonds may tip the thinking of investors long before stocks. The critical level is the 3% on the US Treasury 10 year. The 2.8-2.9% level is also important because stocks have started to struggle above those bond yields. A soaring 10 year is a huge headwind for the housing market and a breach of the 3% level could be quite damaging to the economy and investors.
We have nothing but the highest respect for investing legend Howard Marks. Here is what he had to say on the current investing environment in his commentary earlier this year titled Middle Ground.
…when there’s nothing clever to do, the mistake lies in trying to be clever. Today it seems the best we can do is invest prudently in the coming months, avoiding aggressiveness and remembering to apply caution.
We look forward to the opportunities presented by Mr. Market or maybe more precisely Congress in the coming weeks and months. We also look forward to hearing from you as we round the corner on 2013.
A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference. – Robert Rubin
Blackthorn Asset Management LLC
5845 Ettington Drive
Suwanee, Georgia 30024
678-696-1087
Terry@BlackthornAsset.com
Disclosure:Blackthorn is an investment adviser registered in the state of Georgia. Blackthorn is primarily engaged in providing discretionary investment advisory services for high net worth individuals.
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