April 15, 2009
2009 Q2 Newsletter
| People are always curious about why our portfolios look the way they do. We thought we would use this newsletter to walk you through the decision making process here at Excelcia when we construct our portfolios in the context of our current economic outlook. Usually it refers to the positions that show recent negative returns since the portfolios would have performed even better if we did not have Holding X or Y. This letter will cover the Macroeconomic trends we see so that we can overlay that to an outlook on the financial markets then finally apply that to a tradable portfolio to match our clients’ needs.
Macro Trends
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Excelcia believes that the Macroeconomic trends have actually improved in the last few weeks so we are gaining confidence that we have passed the panic stage of this downturn. We feel that the rate of decline is decreasing so financial markets are better able to cope with the changes and to be clear, improving trends does not imply that things are getting better. At this point Excelcia is planning for the economy to look vastly different from today. As such we are expecting the Secular Trends (18-36 Months) to include higher unemployment, increased savings rates, more regulation, higher taxes and continued deleveraging. Most of these Secular and Cyclical trends start with consumer retrenchment. What this basically means is that a lot of people have started to cut back on nonessential purchases, as a result February retail sales were down 8.4% from a year ago1. The major impact here has been the cutback in auto sales. In March we saw a slight up tick to a seasonally adjusted annual rate of 6.9 million units from the low in February of 6.4 million units. This is considerably down from the 2005 high of 16.9 million units sold2. As the consumer continues to cut back |
we should see discretionary retail sales at substantially lower levels than at the peaks just a few years ago.
This is actually great news for the long-term fundamental strength of the US, but it will cause short-term pain. These savings will more than likely be used to pay down debt instead of adding to investment capital so it will require manufacturers and retail stores to adjust to the new sales volume equilibriums. The adjustment definitely involves downsizing across the board adding to the unemployment rate that has hit 8.5% nationally3. (See Chart #1) When taking a look at the Cyclical Trends which reflect our outlook 3-12 Months from today, things actually look much brighter. The massive government interventions around the globe have helped to address one of the core issues - distress in the banking sector. In our last newsletter, we already believed that the panic had subsided and that the healing would begin, but in late February and early March, there was a new fear going around that the US government would nationalize some of the banks. This brought about significant fear in the credit markets since the market |
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participants had modeled their investment decisions on the premise that the bank’s creditors would be saved even if equity holders were diluted to practically zero. Nationalization would most likely involve creditors taking losses and that was not what they signed up for. The administration finally made it clear in March that they had no plans to nationalize the banks and they would proceed to inject capital as necessary. As long as the administration remains true to their word then our belief is that the banking sector will stabilize even in the context of continued foreclosures in both the residential and commercial sectors. One of the new programs that we are very excited about is the TALF (Term Asset-Backed Securities Loan Facility). It is a public-private investment program that will have tax payer dollars investing side by side with private capital. These funds will be allowed to take advantage of non-recourse debt to leverage their purchases of different kinds of asset-backed loans. We believe this will make the potential investment returns very attractive to private capital and should help raise the prices of these securities. This will help the banks by flushing these toxic assets from their balance | sheets as well as being a backdoor approach to recapitalizing these banks4. As the banks are able to get their capital ratios to healthier levels, then we can expect that lending markets across the board will start to open up and spreads should begin to narrow.
These are the macroeconomic forecasts that we are using to search for investment opportunities. We try to find solutions that should fare well in these scenarios. Markets are forward looking so we always try to understand the expectations that are built into the prices of securities to determine whether they are above or below our expectations. Within our overall market outlook we also break it down between a Secular outlook and Cyclical outlook. We continue to believe that we are in a secular bear market, but as we covered in the last newsletter, the cyclical rallies can be very powerful and last a considerable amount of time. Market Trends
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We always like to start with an overall valuation for the markets to get an idea of potential upside or downside returns. This calculation is done on the S&P 500 index. Earnings peaked back in 2006 with total earnings being $87.725. and at the time the market was trading at 1418.3. This comes out to a Price/Earnings ratio of 16.2 (1418.3/87.72) or an earnings yield of 6.2% (87.72/1418.3). If you compare this to the 10-year Treasury bond yield of 4.71%5. then you get a risk premium of about 1.5% (S&P Earnings Yield – 10yr Treasury Yield). If we look at the most dire forecasts for S&P earnings from Nouriel Roubini (aka Dr. Doom), he projects 2009 earnings to come in at $406. We will use double the risk premium from 2006 so 3% over prevailing 10-year rates which are currently at 2.85% means a S&P earnings yield of 5.85% or a P/E ratio of 17. So if we multiply $40 by 17 then we get 680, which is pretty close to the S&P low of 666.79. Keep in mind that the $40 includes the write-down’s from the financial sector so |
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taking out these non-cash losses our projections put fair value of the S&P closer to 900. As you can see the rate on the 10yr Treasury can have a substantial impact on stock prices so this is something that we track very closely. Having the markets trade down to what we believe to be the cyclical worst-case scenario makes us believe that the panic selling should be over. As long as Washington does not deviate from the ground rules they have laid out so far then the March lows should prove to be the cyclical low. That is why we believe that there is strength behind this current rally. Just as we have a downside projection for the S&P we also have an upside projection. With the limited growth potential and increasing risk premiums in the marketplace we also do not believe that stocks will prove to be a great investment over the next 3 years. We look to exploit this rally then look outside stock market returns to achieve growth in the portfolios over the next few years. Portfolio Construction This brings us to how we put all this research to work for our clients. Each of them have hired us |
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| to design a portfolio that is based on the risk profile and investment objective that they believe will help get them to their goals. The number one priority for us in this process is the risk-management process. We look to protect against the improbable but extremely devastating events (Tail Risk) that can adversely affect the portfolios and then look for opportunities with the highest probability of success for the level of risk taken.
Right now the improbable yet potentially devastating outcomes include Treasury yields increasing substantially, policy shift from status quo and capital flight out of the United States. Treasury yields and capital flight would probably go hand-in-hand and this would cause a devaluation of the dollar. The most likely outcome of this scenario would be higher inflation and a spike in gold. We are hedging this tail risk with exposures to Gold and TIPs (Treasury Inflation-Protected Securities). TIPs get adjusted to the CPI so any adverse movements in the dollar and inflation should reward TIPs investors. Gold is used to hedge against a loss of confidence in the US and recently it has rallied | considerably so the position has been pared down (for now). The next step is to stay nimble and be able to adjust to market conditions as necessary. We have switched to using an index fund giving us the ability to buy and sell without short-term trading restrictions. Currently on the fixed income side we agree with Bill Gross and Mohamed El-Erian of PIMCO that returns should come in stages. Investors should return to risky asset classes in where the government intervention is focused. So we will look to ride on the government’s coattails. Currently the focus is on bringing mortgage rates down so Fannie, Freddie and Ginnie agency-backed mortgage securities are a major part of the portfolios. The next step should be consumer loans such as auto loans then finally to corporate debts. The future portfolios are a work in progress, we are working on unique allocations to achieve expected returns on par with equity exposures with more protection then common equity. Asset classes that are being modeled and considered at this point include Preferred Stock, |
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| Convertible bonds and High-Yield Debt. We would like to be in the highest part of the capital stack that will still give us potential reward when we exit this recession. An example of this structure would be to invest $100 by being 70% Long High-Yield Debt (Junk Bonds) which are currently paying 15%5. and then 30% Short and equity index. This would give us positive carry on the position while hedging against downside moves in the market.
It seems the world is going through major changes as each day passes. Here at Excelcia we believe that it is imperative to continuously adapt to the policies and developments in the markets. There is a tremendous amount of data that we must sift through to determine how to best allocate our clients capital. We feel it is important to walk our clients through the process of research, analysis and the implementation into the holdings they see on their statements. Hopefully you found this helpful in understanding our process and how it is utilized for the benefit of our clients. If you find yourselves discussing the economy and have questions please do not hesitate to call us. If you are interested in learning more about Excelcia and how we can help you accomplish your financial goals please sign up for a complimentary consultation at the top of this newsletter.
Thank You, |
Information presented is general and for information purposes only. The information does not take into account your individual circumstances, financial situation, or needs, nor does it present a personalized recommendation for any investor. Investment strategies presented may not be suitable for all investors. Although information has been obtained from and is based upon sources Excelcia Financial Group believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. All opinions and estimates constitute Excelcia Financial Group’s judgment as of the date of the report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. |
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