Looking Back
2014 marked the end of Quantitative Easing in the United States and the beginning of QE in Europe. The effects of QE are clear to see. Through multiple iterations since March 2009, QE has been the primary driver of higher equity prices. Janet Yellen’s actions to eliminate QE has been interpreted by the market as a sign of a growing economy that no longer needs to be stimulated. Last year also embarrassed anyone who was bearish on bonds.
The taper tantrum of 2013 faded and the most hated asset class in the world provided astounding returns. 30 year Treasury bonds produced a 30% total return as yields fell from 3.90% to 2.75%. Shorter maturity bonds and municipal bonds also rallied in 2014. For commodities everything flipped from positive to negative in August. Following comments by Mario Draghi foretelling the use of QE in Europe, the Euro plunged and the dollar rallied.
Euro/US Dollar
This rapid decline in the Euro was accompanied by a similar rally in the US Dollar which in turn knocked down commodity prices to multi-year lows.
A New Year
To be successful in 2015, investors need to discern the right moment to break from the herd and forge ahead even if they are in the minority. Despite an exhaustive array of metrics that show the stock market is overvalued, investors have been convinced that they have no alternatives.
Shiller P/E Ratio
Expensive markets can stay expensive or get even more expensive. The art is in identifying the catalyst for reality to reassert itself. The warning signs are beginning to develop.
VXX – Ipath S&P 500 Volatility
Credit spreads between lower rated, junk bonds and high quality bonds are showing signs of decoupling.
10 year US Treasury price index versus JNK
The divergence that started in July portends more problems for risk based assets. The bond market is telling a different story than the stock market. In the long run, they both can’t be right. Either the stock market is accurately reflect a robust economic recovery that will lead the Federal Reserve to raise rates in 2015 (the conventional view) or the bond markets relentless push to lower yields is signaling that the end of QE is the beginning of an economic slowdown that isn’t on stock investor’s radar.
SPX-S&P 500 versus JNK-Junk Bonds
Closing in on the 6th year anniversary of this bull market run has prompted investors to ponder the timing of its demise. In the current Central Bank-controlled environment, the tendency is for expensive markets to get more expensive. Some investors act like a bear market is years away (and they may very well be correct). Europe is planning for their own version of QE because of anemic growth and they are tired of the US exporting our deflation to their economy. That gives investors a reasonable excuse to rule out European equity markets. China and the emerging markets are growing faster than anywhere else on the planet but they have their own credit problems and growth while good is slowing down. The US with its strong dollar and bulletproof stock market is the “cleanest dirty shirt” for growth investors to consider. This feedback cycle sucks more capital into its vortex as investors become convinced that they can ride the bull to the end and exit with their gains intact. History has shown that reality never works out this way.
The first leg down draws investors even deeper into the trap with shouts of “Buy the Dip!” Unfortunately the cash for said purchases is coming more and more from borrowings:
The second leg down normally happens violently without immediate or obvious provocation. As this phase of a market reversal many investors react with denial even while other investors are being forced to sell to cover the aforementioned margin debt. With the bear market trap fully set, investors get flushed down 30, 40 even 50% before they know what happened.
The only way to survive a bear market is to be under-invested when it hits. Which is to say, investors have to be under invested in equities before the bull market ends. In the old days we called this “selling high”. This is a sacrilegious act today.
Preparing for a bear market means selling winners and buying something less appealing, something that hasn’t been a winner. In professional vernacular we call this negative correlation.
Putting your money into someone else’s losers offers little immediate comfort to the buyer. You probably aren’t going to realize gains quickly. You won’t be able to brag to your buddies about owning the hot IPO. In fact you would likely face severe ridicule if you talked up your book of beaten down contrarian plays to an investor who was sitting on a book of recent stock market winners. You’ll have to be patient, confident in the knowledge that you understand value and how to avoid risk.
This is the life of a contrarian investor and integral to understanding the methodology employed by LeConte. We are deeply contrarian. This means we sell when an investment reaches fair value. We don’t wait around to see if a buyer is willing to overpay us. We tend to leave money on the table when investors are willing to overpay. Since we buy when prices are down we have a tendency to buy early and have the discipline to buy more in the likely event that the price goes lower.
Our contrarian/value-based analysis was designed to take advantage of the fear surrounding the Taper Tantrum in 2013. In 2014 we began accumulating emerging markets exposure and gold. In the past 24 months we have methodically reduced our U.S. stock exposure to less than 50% of our equity allocation. In our bond portfolios we reduced our exposure to high yield bonds and added inflation protected Treasury bonds. In each instance we moved away from what we believed was an expensive asset class into a cheaper one. We’ll have to be patient and wait to see if the rest of the market will realize the value that we see in these positions. We are confident these steps will help us be prepared for the next bear market.
Whenever it arrives…
Hoy Grimm
Managing Partner
