Despite the harassment, I decided to take the risk and share another except from Hussman Funds Weekly Market Comment.  We’ll explore this one in detail as there is a lot of meat here.  Be forewarned – this turned out to be quite a lengthy post.  So here is a quick summary of the material to follow:

1. Denial
2. Deja Vu All Over Again
3. Europe’s Banks
4. The Fallacy of Forward Earnings
5. Bad Estimates
6. Setting the Record Straight
7. Bottom Line – Too Much Leverage

Denial

 “Last week, the financial markets mounted a striking shift back to the “risk-on” trade, as investor concerns about a recession were abandoned, and Wall Street came to believe that Europe will easily contain its banking problems. Accordingly, downside protection was largely discarded (as reflected by a plunge in the CBOE volatility index), price-volume action reflected eager short-covering, and investor interest shifted strongly away from defensive sectors to speculative ones. For defensive investors, it was admittedly a difficult week, as the markets suddenly became convinced that no defense was needed, and treated defensive investments accordingly.

“From my perspective, Wall Street’s “relief” about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI’s own (and historically reliable) set of indicators, “We’ve entered a vicious cycle, and it’s too late: a recession can’t be averted.” Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.”

Here is a picture of the most recent picture from ECRI.  The interview with Lakshman Achuthan Hussman refers to is available here. We think an important point lost on the consensus is the frequency of recessions.  John Mauldin has discussed this at length as well.  The bottom line is that during an extended deleveraging process, economic volatility is higher than “normal” which means recessions are more frequent than “normal” when you are dragging along at “stall speed.” More frequent recessions, more volatile economic growth . . . higher risk premiums, lower equity prices.  We’d also recommend taking a moment to read this interview, available at GuruFocus, with Fairfax CEO, Prem Watsa to get a feel for the possibilities here.  “That second leg can be vicious, and we might well be entering that second stage.”

Deja Vu All Over Again

“The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a “denial” phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high”

In addition to the economic similarities, here’s a look at the current set-up is from a technical standpoint, compliments of The Chart Store:

Source: thechartstore.com

 Europe’s Banks

“At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis.”

Here’s a great illustration of the extent of Europe’s problems in one concise chart.  Per the folks at Credit Writedowns, “The size of the largest four banking institutions in France, for example, represents over 300 percent of the country’s GDP.”

The Fallacy of Forward Earnings

 “While many Wall Street analysts continue to view stocks as cheap on the basis of forward operating earnings (which reflect expectations of a continued economic expansion and the maintenance of record profit margins indefinitely), the use of forward P/E multiples is a valid shorthand for discounted cash flow valuation only when profit margins reflect a level that is actually likely to be sustained over several decades. Even then, the benchmarks typically applied to forward operating earnings are actually based on historical norms for price-to-trailing net earnings.”

Here’s one of the problems with “forward earnings” in a nutshell.  We will discuss the second momentarily.  For now, suffice it to say that profits are extremely high and have always reverted to trend historically.  Perhaps this time is different, but it never has been, so we’d caution those betting it is.  In fact, if indeed this time is different, we’d suggest that the major trend change ahead is best signaled by the Occupy Wall Street movement.  The largest driver of profit margins today is clearly employment – meaning there is very little of it.  The share of profits making its way to corporate balance sheets rather than their employees has been increasing for a generation.  The result is record income inequality at home and abroad.  This is precisely why we have America’s next generation unemployed and sitting outside the Financial District as if it were Tahrir Square.  Again, my bet is that if indeed “this time is different,” the difference will not be in favor of profit margins, as the pendulum is likely to swing back towards labor over time. I suspect that income inequality across the globe does not end well for any of us. This is definitely something worth monitoring.

Bad Estimates

 “Investors should recognize that P/E multiples are simply a crude shorthand for legitimate valuation calculations (specifically, the careful discounting of a whole stream of future cash expected to be delivered into investor’s hands over time). P/E multiples subsume a whole set of assumptions regarding the entire future path of growth rates, profit margins, return on invested capital, and other factors. The common practice of valuing the stock market based on “forward operating earnings times arbitrary P/E multiple” is not only misguided – it’s an utterly disappointing display of Wall Street’s willingness to dumb-down the investment process. As investors have discovered through more than a decade of zero returns, the constant abandonment of intellectual effort comes at a cost over the long-term.”

The second issue with forward earnings multiples is simply that they are WRONG.  The chart below, initially posted at The Big Picture shows S&P operating earnings (red line) and their 12-month forward forecasts shifted ahead one year. Bottom line according to James Bianco, “If the economy goes into recession, earnings forecasts are not 10% to 12% too high. Instead they might be 20% to 40% too high. In other words, if the economy goes into recession, the earnings forecasts are horribly wrong.”

Source: Bianco Research

The second chart shows the difference between the forecasts and actual releases. The shaded areas highlight official recessions. Bianco notes, “Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession. During the 1990/1991 recession, top-down forecasters (strategists) were too optimistic by 10%. Bottom-up forecasters (adding up the 500 company forecasts) were too optimistic by 25%. During the 2000/2001 recession, top-down forecasters were too optimistic by 25%. Bottom-up forecasters were too optimistic by 23%. During the 2007/2009 “Great Recession”, top-down forecasters were too optimistic by 39.6%. Bottom-up forecasters were too optimistic by 40%. Also notice the difference between the top-down and bottom-up forecasts. Current strategists are getting significantly worse at predicting earnings than their 1980s and 1990s counterparts.”

Source: Bianco Research

Consensus expectations, particularly bottom-up, are still wildly optimistic.  Bulls continue to point to “excellent” company fundamentals to support their thesis, completely missing the fact that they are staring in the rear view mirror.  Top down forecasts are less rosy but are yet to bake in recession which I think is a given at this point.  Equity analysts rarely lower estimates, recommendations, etc. based on in-house forecasts. They wait until they are told by management, which by definition, is too late.  Company fundamentals still appeared “excellent” in H1-08 as well.  Until they didn’t. By the time management admits the economy has turned, we are typically closer to the recovery.  According to research performed by Ned Davis, the S&P has actually declined historically when earnings expectations have been this lofty.  The time to get bullish is only once consensus has baked in the drop in forward earnings.  Not before.

Setting the Record Straight

One last point on valuation that drives me mad.  This one is almost as popular as forward earnings. Take a look at the illustration below. If you can determine any relationship between the “earnings yield” on stocks and interest rates, please give me a call.  Because outside of the brief period in history that an illusion of a relationship appeared – which happens to coincide with the time period that most investment managers in the business today have operated – there is no relationship between expected returns on stocks and expected returns on bonds. The consensus would also have you believe that as interest rates and inflation come down, PE’s should go up.  Ask the folks in Japan how this has worked out for them.  The fact is, today’s models worked great in an environment of increasing leverage.  No one has thought to look at how they would perform as that leverage is unwound.  The impact on economic growth, financial asset prices, inflation, etc. is profound and few have yet to grasp this change.

Source: GMO

Consider a few simple examples to help illustrate why this is utter nonsense. First, suppose I am willing to sell you a quart of milk for $10 but offer you a gallon for $30.  Does that mean the gallon is cheap or that it is a good buy at today’s price?  If you answered yes, and you are a long-only investor, good luck. Alternatively, suppose you can buy a dollar today for 50 cents. Tomorrow, you pay two dollars for that same dollar. Is the level of the ten year treasury, or any interest rate for that matter, a significant determinant of how those investments work out for you? If you answered no, you are on your way to separating fact from fiction. Now please press mute on your remote control the next time you hear anyone comparing the yields on stocks to interest rates on bonds. Chances are anything else they have to say is not worth listening to.

Bottom Line – Too Much Leverage

 “This is a good opportunity for investors to review their tolerance for significant losses. My impression is that this may be the best opportunity to reduce risk that investors are likely to see for a while.

“As of last week, the Market Climate in stocks remains negative, but has deteriorated significantly from the more benign negative levels that we’ve seen in recent weeks. Generally speaking, the worst market plunges tend to feature three things – overvaluation, negative market action, and a short-term overbought condition.”

A quick look at just how overbought this market is in the short term.  As a general rule, overbought conditions should be sold in bear markets. In case you were wondering, this is a bear market.

Source: thechartstore.com

“You rarely see the three together, because establishing that sort of condition requires a strong rally against both overvaluation and negative internals. That’s about where we are, though we can’t rule out a modest extension for a bit – mostly because advisory bearishness is reasonably elevated as of last week. That said, the drop in the CBOE volatility index late last week suggests an abandonment of bearish views, and more generally, just as early shifts toward advisory bullishness at the beginning of bull markets are often accurate and followed by further gains, early shifts toward advisory bearishness at the beginning of bear markets are also often accurate and followed by further losses. Overall, market conditions remain negative . . . “

Contrary to popular belief, the market is NOT cheap here. There are pockets of value if you look hard enough.  But broadly speaking most major stock averages are not cheap. The chart below shows the S&P 500 trading at over 20x normalized earnings, relative to a long-term average closer to 16x. The current multiple is not that far off from where the market traded in the mid-60s prior to a bear market that lasted for almost two decades. You can feel comfortable hitting the mute button on your remote control whenever you hear someone claim that the next ten years look good for stocks, based solely on the fact that the last ten years were poor.  Will they ever learn?

While many of our indicators are pointing to excessive pessimism, which may well be supportive of further rally, it is worth noting that AAII’s measure of Bullish Sentiment has rebounded sharply back to levels last seen in July, when all was still well in the world.

Putting it all together, the immediate future is not so bright for the buy-and-hold type today.  While there are certainly values to be found in the large, multinational franchises that historically traded at premiums to the market, I am also growing concerned that this is more of a consensus belief today. Groupthink is dangerous. When everyone crowds into the same trade, the crowd is rarely right. One of the factors which made the 2008 crash so devastating was the forced liquidation driven by excessive leverage in the system. Once the crowd started selling, they all sold. We run from one side of the boat to the other, and back again. As they say, financial memory is notoriously short.  But even we are surprised by speculators’ willingness to jump back on the leverage train after being so badly burned three short years ago.  The amount of leverage in the system today is back at dangerous levels – it is declining, but prior market bottoms did not occur until these debts were entirely wiped out. I just hope this doesn’t mean that owners of risk assets and retirement plans get wiped out for the third time in ten years.  Be careful out there.

“At the point our nation recognizes that the pattern of repeated bubbles, crashes, and misallocation of capital is not solved by the Fed but is instead caused by the Fed, it will become clearer that the best path to economic recovery is to shift attention toward debt restructuring, real investment, useful infrastructure, and the creativity and work ethic of real human beings. Until then, we will have an economy built on speculation and paper, stacked into a flimsy house of cards.”

-  John Hussman, Weekly Market Comment

Dr. Hussman’s full comments are definitely worth a read this week as he puts to rest a number of questions regarding an imminent downturn, the Greek race toward default, the probability of recession and those “sticky” profit margins.  You can access his weekly comments here.  After reading them this morning, I opened a package on my desk which contained additional reading material for the week – our friend Francois Trahan’s new book, The Era of Uncertainty.    The dedication alone assures it will be a practical resource rather than Wall Street gurgle.  It reads, “To Ben Bernanke . . . thanks for the material.”

I’m sure we’ll have more to share on this one as I make my way through it.

“Thinking about fundamental risk also reduces the “black swan” element of investing. Nassim Taleb defines a black swan as a highly improbable event with three principle characteristics: 1) it is unpredictable; 2) it has a massive impact; and 3) ex post explanations are concocted that make the event appear less random and more predictable than it was.

“It should be noted that some black swans are a matter of perspective. Rather than genuine black swans, most financial implosions are the result of “predictable surprises” . . . Like black swans, predictable surprises have three characteristics: 1) at least some people are aware of the problem; 2) the problem gets worse over time; and 3) eventually the problem explodes into a crisis, much to the shock of most.

“The nature of predictable surprises is that while uncertainty surrounds the details of the impending disaster, there is little uncertainty that a large disaster awaits.”

China’s debt-fueled speculative bubble is likely to be yet another victim in a long list of predictable surprises.  As we discussed in a Cautionary Fable last year, forecasting the timing of such trend changes is always a challenging (and frustrating) exercise.  But just because the timing is questionable doesn’t mean the risks should be ignored.  More often than not, investors are rightly focused on the odds that circumstances turn negative.  But every so often, it is much more important to consider the consequences of these low probability events.  With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial, yet insurance to hedge against such a risk is almost free.

Consider that China’s local government debt load has increased by 36 times in nominal terms and five times relative to GDP since 1997.  In just the last three years, total liabilities of local governments have mushroomed from 17% to 27% of GDP based upon the State Council’s Audit Report. With more than 80% of those borrowings going to infrastructure, it’s difficult to imagine that the return on investment for each additional project has not declined.  Aggravating this debt load, about one quarter of it is promised with land sale revenue, making today’s real estate bubble even more detrimental to the command economy.  Defaults are already happening, even with economic growth rates hovering near 10%.  According to Reuters, China’s regulators plan to shift 2-3 TRILLION yuan off local government balance sheets – a massive bailout that is multiples of TARP relative to China’s GDP.  With monetary conditions in China now tighter than the 2007-2008 peak and a global economy much more fragile today, we wonder how fast this number will increase once slowing credit actually stalls economic growth.  Consider that in 1999, after borrowing and binging through the 80s and 90s, the NPL ratio of the Big 4 Banks was a massive 39% or roughly 20% of China’s GDP from 1988 to 1993.  For China, this was a huge sum of money, equivalent to 25% of foreign reserves at the time.  Contrast that with the banks current “reported” NPLs near 1% . . . and consider that Fitch reports bad loans could rise to 15% to 30% of assets.

Consequently, we think a small investment today can serve as an effective hedge on a much larger portfolio, in case the global economy’s locomotive hits a speed bump along the way.  That being said, we are much more comfortable taking larger positions when we can say with confidence, “This is going to happen.”  I’m not sure I can say that with confidence about a yuan devaluation, but I can say that the odds are currently much higher than what Mr. Market is offering today. Aussie housing is one of those “near certainties,” with or without a Chinese hard landing.  And it appears that the risk in the Australian property market has elevated sharply over the past year.  Part of this may be attributable to the slow-down in China.  Part of it may be attributable to the Australian banks’ reliance on European financing. Or it may simply be bursting under its own weight, with a little help from the RBA and higher rates. Whatever the cause, the evidence is right in front of anyone who cares to look.

Gold Coast beachfront values have plunged by as much as 50 percent since the peak of the boom in 2008, states The Australian Newspaper Online. We are beginning to see signs of the “blame game” emerging even as we are very early into the expected decline in property prices – check out the collapse of Ray White Broadbeach. Despite claims of a “housing shortage” which is typical of just about every housing bubble, Real Estate Institute of WA president Alan Bourke said that there were now thousands more properties on the market than needed to meet demand. Meanwhile, real estate agents are cutting their sales commissions to compete for fewer buyers – some below one percent. Major banks have warned that loan arrears have increased, real estate data shows house prices in affluent suburbs have fallen more than the overall market and new loans have dropped sharply. High-income earners are also experiencing mortgage problems but nobody is talking about it – they are financially overstretched and quietly making lifestyle changes, deleveraging and selling investments to reduce loans and other debt, and avoiding unwanted public attention they would have if they had to foreclose on their mortgage.

Coming back to China, the 1880s – 1890s boom provides an interesting parallel.    In 1890, more than half of Australia’s exports went to Britain, with wool making up the majority.  This concentration of exports was a critical vulnerability then, as it is now.  Today, Australia’s exports are again dominated by commodities (iron ore) and its future is almost entirely tied to its largest customer, China.  That said, the magnitude of the housing boom in the 1880s is dwarfed by what we’ve seen in the past two decades – where prices have more than doubled in real terms versus a gain of a third the first time around.

Then, the withdrawal of foreign capital served as a catalyst for recession, credit crunch and price declines.  Today, Australian banks find themselves in an eerily similar position – almost entirely reliant on foreign funding (chart below from RBA), which Moody’s recently cited as they downgraded the major banks.  “With the domestic economy increasingly biased to the commodity sector, terms of trade that are exceptionally favorable by historical standards, and high asset prices, there is a potential for confidence shocks to impact the bank’s access to funding.”  We believe slowing Chinese demand will be a catalyst for an abrupt reversal in Australia’s terms of trade, likely followed by a collapsing currency, vanishing foreign capital and significant stress on the banking system.  Aussie bank CDS look very cheap relative to global peers.  The sovereign looks even cheaper when one considers the potential cost of a bank bail-out.

Disclosure: At the time of publication, the author was short the Chinese Yuan, Australian Dollar, various Australian financials and long Australian interest rates via traditional and derivative investment vehicles, although positions may change at any time.

Fundamentals are beginning to matter again. High quality franchises with high and consistent returns on capital are cheap and poised to perform well looking forward.  Low quality small cap stocks are beginning to act how they “should.”  They went straight up for two years not because fundamentals were necessarily better, but because investors realized they weren’t going out of business.  Now that solvency is “assured” and the stocks are priced as ongoing businesses, fundamentals should begin to matter again. You can buy MSFT today at under 10x earnings or gamble on Constant Contact at over 300x trailing earnings.  Not much of a decision in our humble opinion.

This should continue for years and is very productive for long short managers. We sure hope he’s right!  According to John, Julian believes that investing is the exact opposite of baseball. The only way to make money in baseball is to make it to the majors. In other words, even the best player in the minor leagues makes next to nothing.  He says that in investing, you want to be “the best player in the worst league.”  Take gold, as an example.  “All smart people know gold makes no sense at all.  It has no cash flows so it cannot be valued.  I guess we would fall into the “not so smart category.” But Tiger has identified a manager that they consider to be the best in the (bad) industry.  While “gold bugs make money every 20 years,” John tells us that this particular manager has compounded at 60% net of fees for the past decade.  Wow!

We spent quite a bit of time discussing how Tiger identifies talent.  According to John, Julian has seeded about 46 managers over the years, with 40 of them tremendously successful.  A batting average that’s not too shabby, even for baseball.  While most of us come in every day with our “to do” list, checking off boxes until tasks are completed, John explains that Julian’s genius is in his madness.  He doesn’t wear a watch. He doesn’t have a “to do” list. He leaves his mind open and goes wherever the day takes him.  John claims that every bright investor has narcissistic tendencies, but Tiger believes there are three traits that every good manager has in common: 1) you have to be unbelievably smart; 2) you’ve got to be very honest (both traditionally and intellectually), and; 3) you’ve got to be incredibly competitive. Every investor goes through difficult periods. That competitive fire provides the top investors with the will to win. Interestingly, Tiger has developed a test that judges character, honesty, etc. After managers have interviewed with Julian, they sit for this test and results are mapped against the results of other great investors in the world.

By their estimates, if you add up all the assets under management that have “touched” Julian in some way, these managers would comprise roughly $500 billion of the $2 trillion hedge fund industry.  There is no question that Julian Robertson was an early pioneer, but these numbers might qualify him for “Godfather” status.  The book More Money Than God, explores and quantifies Julian’s ability to add alpha over his career.  I look forward to giving it a read.  The game has certainly gotten more difficult over the past three decades but as John explains, there’s always going to be bad stocks. If you’re smart enough and prepared to do the work, there are always ideas to uncover. But you have to do it in a way where you’re liquid enough to manage the risks. While many investors worry about “crowding” in the hedge fund space, I found it very interesting that the correlation between Tiger Funds over the past twelve months is 0.12 despite concerns around “group think” within Tiger.  The data certainly does not supports the thesis.  With most “traditional” asset classes priced to deliver returns, far below expectations and far short of what is required, the “hedge fund” space should continue to grow in the years ahead. Most pensions aren’t at 10-12% in terms of allocation . . . they are at 1-2% invested in hedge funds.

For what it’s worth, Julian’s personal portfolio today is 300%+ gross and -5% net as he is very concerned about a number of trends in the world. I’m sure we share many of his concerns, but we aren’t brave enough to run 300% gross!!  We’ll leave that for “The Godfather.”

High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.

One of the most important things we can do is take note of other investors’ attitudes and behavior regarding risk. Fear, worry, skepticism and risk aversion are the things that keep the market at equilibrium and prospective returns fair. When investors fear loss appropriately, too-risky deals can’t get done, and risky investments are required to offer high prospective returns and generous risk premiums. (And when fear reaches extreme levels during crises, the capital markets turn too stingy, asset prices sink too low, and potential returns become excessive.)

But when investors don’t fear sufficiently – when they’re risk tolerant rather than risk averse – they let down their guard, surrender their discipline, accept rosy projections, enter into unwise deals, and settle for too little in the way of prospective returns and risk premiums.

There’s nothing more risky than a widespread belief that there’s no risk . . . and, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

I recite all of this because I have no doubt that investors are making substantial movement back in the same direction . . . In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.

There may be corners of the market where elevated popularity and enthusiastic buying have caused prices to move beyond reason . . . But for the most part, I think investors are taking the least risk they can while assembling portfolios that they think can achieve their needed returns or actuarial assumptions.

In general, I would describe most security prices as falling somewhere between fair and full. Not necessarily bubbly, but also not cheap.

If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.

Today, pension funds and endowments simply can’t achieve their goal of nominal returns in the vicinity of eight percent if they keep much money in Treasuries or high grade bonds, and they may not even expect public equities to be much help. They’ve moved into high yield bonds, private equity and hedge funds . . . not because they want to, but because they feel they have to. They just can’t settle for the returns available on more traditional investments. Thus their risk taking is in large part involuntary and perhaps unenthusiastic.

Those of us who calibrate our behavior based on what others are doing should increase watchfulness and, as Buffett suggests, apply rising amounts of prudence.

Prudent Behavior in a Low-Return World

• Go to cash – not a real alternative for most investors.
• Ignore the lowness of absolute returns and pursue the best relative returns.
• Forget that elevated prices might imply a correction, and buy for the long run.
• Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.
• Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.

Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”

In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility. I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:

• the so-so U.S. recovery;
• the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;
• the economic impact of deleveraging and austerity;
• the over-indebtedness of peripheral eurozone countries;
• the possibility of rekindled inflation and rising interest rates;
• the uncertain outlook for the dollar, euro and sterling; and
• the instability in the Middle East and resulting uncertainty over the price of oil.

With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right.

We have a hard time finding anything to disagree with in Mark’s most recent letter and look forward to reading his most recent book.

How Quickly They Forget 05-25-11

This market has now doubled from “the lows” reached in March 2009.  Unnervingly, there have been only two other times when the market has rallied so sharply over this time period.  Neither of them occurred during raging bull markets.  In fact, both of them occurred during the Secular Bear Market of 1929 to 1942.  Over this period, normalized valuations (as measured by CAPE) fell from a peak of 32.6 to a trough of 5.6.  While there were occasionally powerful rallies throughout this cycle as evidenced below, investors were well served waiting for lower valuations and/or extreme oversold conditions before dipping their toes in the water.

We find ourselves in a similarly uncomfortable position today, with the markets extremely overbought (below) and still, stubbornly extremely overvalued.  In the current Secular Bear Market which began at the turn of the millennium, normalized valuations reached 43.8 – more than 10 points better than the peak of 1929.  Even today, after a ten year bear market in stocks, normalized valuations still stand above 24x CAPE, a level significantly higher than any other market peak outside of 1929 and 2000.  Coincidentally, today’s Monster Rally (shown below), has taken us back to a similar level of overvaluation reached after the Monster Rally of 1937 (22x CAPE).

The prognosis for forward returns does not look particularly appealing.  As shown below, the market’s performance after past Monster Rallies of this magnitude has been decidedly negative 4, 8, 12, 26 and 52 weeks later. It is impossible to know exactly when the fuel will run out of Junk Ben’s Rally, but history has not been kind to those holding on for the last few percent of speculative blow-offs.  Be careful out there.

Source: Thechartstore.com

Source: Thechartstore.com

In a sense, the financial crises marked a critical inflection point: either the world would rebalance to more sustainable sources of growth, or, on the back of stimulus, continue to pursue the logically flawed policies of asset and credit-driven growth—the very same policies which led to the crisis in the first place. It is now clear that the path of political least resistance was chosen. As a result, the global economy has become more imbalanced with 45% of growth derived from countries running fiscal deficits of greater than 10%. Additionally, central bankers around the globe are now targeting asset prices in order to drive consumption while the emerging economies in Asia have fallen back into the illusory comfort of export-led growth. With China, Japan and Germany—the world’s 2nd, 3rd and 4th largest economies—running perennial trade surpluses, the burden of global demand is placed squarely on the already over-indebted countries of the west, specifically, the US and Britain.

Although the world today remains highly imbalanced, we are also careful not to underestimate the will of policymakers, or ignore the adept management and profitability of many high-quality companies over the near term. We would not at all be surprised by a further increase in equity prices.

Nonetheless, similar to banks in 2007, governments today rely more on access to capital markets to fund themselves than any time in history. Many countries in Europe are effectively insolvent, yet have avoided default as a result of recent liquidity (either provided by markets or from bailout vehicles and supranational entities). Liquidity, however, largely results from confidence. As confidence erodes, sovereign defaults will become more likely.

Finally, the fiscal deflation necessary to cover both the on-and-off-balance sheet liabilities around the world is politically impossible, which, combined with a hyper-expansionary Federal Reserve, provides a positive backdrop for gold, as well as other sound currencies. Although we may tactically alter our position size given the wild swings in sentiment that accompany it, gold is likely to remain a core position for the medium term.

Shorting Congress – Commentary & Strategy (January 2011)

The Broyhill Letter (Q4-10)

Last year in commenting on the inability of the overwhelming majority of investment managers to achieve performance superior to that of pure chance, I ascribed it primarily to the product of: “(1) group decisions – my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is “safe” and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

This year in the material which went out in November, I specifically called your attention to a new Ground Rule reading, “We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each – no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn’t work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight.” It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have .05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn’t. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.

There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation.

Anyone owning such numbers of securities after presumably studying their investment merit (and I don’t care how prestigious their labels) is following what I call the Noah School of Investing – two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles. (I only made it through plane geometry, but with one exception, I have carefully screened out the mathematicians from our Partnership.) Of course, the fact that someone else is behaving illogically in owning one hundred securities doesn’t prove our case. While they may be wrong in overdiversifying, we have to affirmatively reason through a proper diversification policy in terms of our objectives.

The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of “results,” I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater.

You have already seen some examples of this. Our margin versus the Dow has ranged from 2.4 percentage points in 1958 to 33.0 points in 1965. If you check this against the deviations of the funds listed on page three, you will find our variations have a much wider amplitude. I could have operated in such a manner as to reduce our amplitude, but I would also have reduced our overall performance somewhat although it still would have substantially exceeded that of the investment companies. Looking back, and continuing to think this problem through, I feel that if anything, I should have concentrated slightly more than I have in the past. Hence, the new Ground Rule and this long-winded explanation.

Again let me state that this is somewhat unconventional reasoning (this doesn’t make it right or wrong – it does mean you have to do your own thinking on it), and you may well have a different opinion – if you do, the Partnership is not the place for you. We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity. We probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time. They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year-to-year variation in results). In selecting the limit to which I will go in anyone investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.

We presently have two situations in the over 25% category – one a controlled company, and the other a large company where we will never take an active part. It is worth pointing out that our performance in 1965 was overwhelmingly the product of five investment situations. The 1965 gains (in some cases there were also gains applicable to the same holding in prior years) from these situations ranged from about $800,000 to about $3 1/2 million. If you should take the overall performance of our five smallest general investments in 1965, the results are lackluster (I chose a very charitable adjective).

Interestingly enough, the literature of investment management is virtually devoid of material relative to deductive calculation of optimal diversification. All texts counsel “adequate” diversification, but the ones who quantify “adequate” virtually never explain how they arrive at their conclusion. Hence, for our summation on overdiversification, we turn to that eminent academician Billy Rose, who says, “You’ve got a harem of seventy girls; you don’t get to know any of them very well.”

Warren E. Buffett, 1966 Annual Letter to Limited Partners

With expectations still elevated, any unexpected developments should serve as a catalyst for a sell-off.  We can imagine plenty of triggers, ranging from Chinese Inflation and the European Debt Crisis to US Housing Deflation and Currency Wars.  As we discussed in our last Broyhill Letter, an abrupt decline that cleared overbought levels and  injected renewed fear into the psyche of speculators might provide a better base for the typical Third Year Boom. We can’t rule out the possibility that investors will continue to speculate on the hope of ever larger deficits and ever increasing liquidity, but history is chock-full of examples where free money ended in financial ruin.  Take for example, Ireland or Greece.  Bailouts don’t change the level of debt that debtors owe; they just shift the creditors around. In our view, the risk profile of the equity market is extremely negative here as a growing number of worrying divergences point to sharply lower prices ahead.  Dollar strength, emerging market underperformance, widespread complacency, rising interest rates and spiking credit spreads are just a few.

TIS MIR 01.05.10

Signs of Exuberance Abound according to our favorite Dave, who warns that:

• The VIX index, at 17.5x, is back to where it was last April. Remember what happened next.
• Investors Intelligence bullish sentiment is back to where it was at the all-time market highs of October 2007.
• The non-commercial accounts on the CME have recently opened up a considerable net speculative long position in equities, particularly the QQQ’s (Nasdaq stocks).
• Market leadership is narrowing, as Bob Farrell has been busy pointing out.
• The number of short-selling positions slid 2.2% in the first half of December on the NYSE; and by 2.8% on the Nasdaq. The bears are running scared.
• As Kelly Evans asserted last week, the AAII investor sentiment poll has been above its historical norm now for 17 weeks running ? the longest stretch in six years.
• Since July, margin debt has exploded by 16% to $274 billion, the most since September 2008 when people still thought we were in a soft landing.
• Equity mutual funds and ETF’s took in $24 billion in December (TrimTabs data). As an aside, the last time we saw retail inflows like this inequities was last March … just ahead of a 17% correction.

Risk assets have become extremely correlated and the market is clearly exhibiting a herding behavior that has historically been associated with a very negative skew of returns.  Additionally, the 100 basis point spike in interest rates has created an extremely hostile environment for stocks, particularly when combined with a market that is overbought, overloved, overvalued and overdue for an abrupt decline. Stay sober in your thinking and resist the temptation to drink from the funnel of excess liquidity.  There will be better times to invest.

Source: Hedgeye Risk Management