February 2010 

"May you live in interesting times."

Chinese Proverb (maybe)

I headed back into the rabbit hole this week, pouring though articles, documents and charts to try to figure out what is really going on in the markets and economy.  The deeper I got, the more questions I had.

What we are seeing in this market rally is the most unusual I have ever seen, a sentiment echoed by the founder of Trim Tabs Research, which is used by approximatey 20-25% of all hedge funds. 

Trim Tabs recent reports and reports over the second half of 2009 indicate that insider selling is at multi-year highs.  The ratio of corporate insiders selling versus buying their company's stock has reached as high as 60:1 in several weeks and commonly has been between 30:1 to 50:1.  Typical ratios are usually around 3:1 to 15:1.  While insiders can get it wrong too, and there is reason to believe they are taking some income they didn't receive in 2008 as expected, these ratios are huge. 

Another interesting point that Vincent Deluard (a Trim Tabs analyst) makes, is that middle class investors haven't been investing in equities either, rather they are pouring into bonds with what they do invest- although retirement plan inflows during the first quarter of the year are likely providing some short term equity market support.  The insiders and middle class investor are rarely on the same side.  With neither group buying into equities, who then is buying? 

The first group is pension funds, investment banks and other institutional investors.  They are likely buying in order to try to capture gains after a devastating run from mid 2007 to early 2009.  The second group of buyers is an unknown.  Near the end of trading on many days, according to several market participants on the floors (including Biderman), there appears to be regular buyers of stock that isn't accounted for through SEC filings.  This could imply many things.  It could be traders at hedge funds completing trades, offshore buyers, various types of funds, insiders buying from illegal tax-haven accounts set up offshore as part of a dodge on future higher taxes  (it's happened) or even government sponsored buying- not necessarily the U.S. Government.  Nobody really knows who the late day buyers are. What we do know, is that the late day buying has been a major support for the markets.

What We Have Learned, What We Know and What It Might Mean

The Fed just mentioned that they would soon be raising the discount rate.  In March, the Fed and Treasury are also scheduled to start withdrawing liquidity support from mortgage security markets as well.  This is likely the very early stages of Fed tightening that will be slow in coming in any particular strength.

We know that about 20% of American mortgages out of 50 million loans, have mortgages with balances higher than the value of the homes and that there is a wave of ARM resets this year and next.  Currently there are about six million non-performing mortgage loans, the number could top out around 12 million between this year and next.  We also have seen large banks accelerate their acceptance of short sales on homes.  That is a clear sign to me that the banks are finally throwing in the towel and taking what they can get.  So, it appears we might finally see the bottom in residential real estate over the next two years, though that might entail another 20% or so slide in many home prices.

Unemployment officially is about 10%, however, according to independent studies is really about 20%. 

Interestingly, and hopefully, unemployment appears to have peaked, though this could be a head fake.  We do know that the second half of the stimulus money is due to be spent over the next year or so.  If the first half of the stimulus actually did stem the deterioration of the economy, and a raft of information supports the idea that it did, it stands to reason that spending the second half could stimulate the economy to legitimate growth.  It is vitally important that the U.S. economy grow again and support employment, because as inflation rears its ugly head due to international growth and emerging commodity scarcity, we will need growth to maintain our standard of living.

As we can see, the cost of living has increased over time as the dollar has declined in value.  Presuming further decline in the value of the dollar over time- despite some short term moves up- due to increased U.S. Government debt and strengthening economies around the world, the United States is likely to see significantly increased inflation this decade.

A Trade Turned Buy and Hold

Above and in previous letters, we have identified some strong deflationary pressures, for example mortgage debt and unemployment, which are but a few of the pressures which are likely to persist for a couple more years.  We also have identified some inflationary pressures, i.e. U.S. debt expansion through this decade and international growth through the century, which will no doubt manifest as actual inflation someday.

What I have prepared for is, what I believe, a strong possibility of volatility and corrections in various markets over the next couple years.  If those corrections come, and hopefully do not turn into crashes, we plan to buy assets from our shopping list when those assets are on sale- our general approach all of the time- with the idea of holding those purchases for an extended period to try to take advantage of developing longer term trends.  I am not unique to this idea of investing, however, it is clearly not the generally accepted approach of trade and/or over-diversify.  After an aggressive spring and summer in 2009, we will continue to nickle and dime until the clouds clear and we can see the sun again.  If I am wrong to be so cautious, we will be trading extra safety for potentially slight underperformance to the equity markets short run if the markets continue to run up.  If I am right in this approach (this approach is usually right, except for in rapidly moving bull markets) not only are we taking less risk, but we will also be lining up for an opportunity at outsize gains into the mid and longer terms.

I am very bullish on the longer term as I believe that ultimately the United States will adopt highly improved energy and healthcare policies, which are the linchpins to growth and improving the national balance sheet in my opinion.  I am hoping that government over the next few years can get their part right so that business can do what business does and make the longer term not be so far away. 

Your thinking out loud advisor.

Kirk Spano

This newsletter contains forward looking statements that may not come true.  Past performance does not guarantee future results.  This letter is intended for informational purposes only, and reflects only my thoughts and opinions in general, and do not constitute individual advice.  Opinions expressed may change without prior notice.