Strategists Panel
Speakers: Milton Ezrati, Lord Abbett & Co.; Jonathan Golub, CFA®, UBS; Moderator: Michael Santoli, Barron’s
ME: If you can get the Tea Party and the Occupy people together, we’re good. We built social security for the boomers.
11:00 JG: What’s the win for the Republican party? Embrace young people and say you’re on our side because the 60+ is the enemy. You’re paying for grandma’s retirement, vote Republican. If they could capture that, it would be a game changer.
ME: They’ve done the cuts in the past to people not paying attention (cuts for social security for young people in 1980s).
JG: We get pleasure from national parks, prisons, highway systems, judges — but closing the national endowment for the arts is just a basis point. So people think taking down national defence is good. That’s going to be harder than we think. But if you don’t take down entitlement spending down, you don’t have anything to talk about.
MS: One thing about US is we live where 1,000s show up in the capitol to say we want less debt. But then we provide the implications — reduced Medicare, higher retirement age — everyone thinks it’s waste and abuse in the government. It’s not.
10:56 ME: After 2008, Americans did readjust. Savings rates went up. $640 billion a year now. If you asked me 5 years ago, I’d have been skeptical. So they have done it. The big issue — the government. The corporate sector and household sector have cleaned up their act. We have to wait for November.
MS: Readjusting expectations — is America capable of that re: retirement?
JG: Whenever you have an economic recovery, we go to Nordstroms. If things get bad, we (the rich) trade down to Macy’s. Not that poor guy can’t go. Same things with Whole Foods versus other markets. Higher-end hotels, restaurants. Dollar stores will unwind. In very difficult times, consumer companies manage costs well. Media: movie prices gone up, even though attendance down. So they’ve done a great job of managing costs and pricing. There’s discipline now.
10:53 MS: Media? Retail? Do you carve it that narrow?
JG: Within equity markets, the consumer sectors are likely to do well. When we talk about yield, if we do total yield, the lowest yield is utilities (probably also most overvalued). Highest yield is consumer discretionary. With unemployment getting better, both staples and discretionary are likely to be a surprise. Credit balance sheets are unbelievably deleveraged. There’s lot of opportunity.
ME: Opportunity is attractive. There’s risk, but it’s the likelihoods that favour them.
JG: Emerging market equities: faster growth, stronger balance sheets, cheaper valuations. But they’re higher beta, so if the world falls apart, they will too. If they grow faster and cheaper with higher quality, that’s a natural place for opportunities.
MS: Do you perceive any underappreciated opportunities?
10:50 JG: If you’re a talented pairs trader, you can make money. Bet good apples against bad apples, not apples against oranges.
MS: Quality underperformed early this year. Hedge fund guys will say short a high-quality company.
ME: If you take out political effects, there will be lower correlations. There was a man at Occupy Wall Street with a sign that said “Stop correlations.” He got it.
JG: The way you make money in this environment: put on a trade that’s right, company’s doing well, but stocks move together and you have correlation. But if there’s a fall in correlation, you make money. Money gets made when correlations decrease. Active managers and hedge fund managers will do well this year, better than last year.
10:48 ME: The big threat is that the fundamental problem is financial — it’s the US government. That makes it much more frightening than a recession. One of the reasons for volatility is that it’s financial and political, not economic.
JG: Mother of all recessions (2008) was a 35% decline in earnings and 50% decline in stocks. You can’t tell how far down things are. A normal recession lasts 2 quarters, ugly 1 year. If we pull out in March, April (and typically you do), this would have been a shoulder shrug, and you could have had a 15% decline in profitability.
ME: If Europe flies apart, if US is downgraded again or misses an interest rate payment, or double dip occurs — we say these things are unlikely — we could reapproach the old lows if you want to scare yourself. But the risk-on trade is the best bet. But if you ordered me to make a bear scenario, the market could suffer terribly if all 3 things go wrong.
10:43 MS: If we avert disaster, in DJIA terms, what will we be looking at?
JG: The growth hasn’t really shown up in the markets. Democracy impediment? Everyone thought Japan was going to take over the world when I was in high school. If you look at China’s projections, I bet it won’t have higher growth than Europe. It’s a 10-year event that China has been powerful. We forget history. No one thought Communism was going to win, but Chinese communism is ok.
10:41 MS: How many big hedge fund managers will tell you that Europe’s dysfunctional, but the Chinese know how to run an economy. If only at a pen stroke we could say we’ll do it.
ME: Germany has an electorate to play to. They believe they’re over a barrel, but the public doesn’t. The leadership has been willing to go to the brink because the public isn’t with them. (JG 100% agrees.)
JG: Everybody’s played their hand. You have to be a really good poker player to take this thing to the brink like Germany has.
MS: Germany is going to own Europe if they keep writing cheques.
JG: We’re underweight Europe (every asset allocation committee is underweight Europe). The whole world agrees. If Europe doesn’t blow itself up, it’ll be an outperformer. If Europe doesn’t have a credit event, that’s a huge win.
10:39 MS: People are saying P&G and Unilever are basically the same, and buying Unilever because it’s European and undervalued. What do you think?
ME: Valuations in Europe suggest the market recognizes there’s no easy way out. There’s an opportunity, but probably an immediate opportunity. They don’t usually say much at Davos. Europe is facing recession. If they fail, people will worry about fundamentals. They may have a cure worse than the disease. They have lots of hurdles to jump.
10:37 MS: Based on 2011, Europe would be a surprise if it outperformed. Is there a chance that Europe will do well?
10:36 ME: The housing market is finding some stability. That’s not an engine of growth. There’s huge inventory waiting in the wings. That will cap prices. We had a sector that was in freefall, so stability looks good by comparison.
JG: We decided to rent (2005), not buy, because we thought the real estate world with blow up. But then I worked for Bear Sterns, so I lost more on that trade than my house.
MS: QE wasn’t effective, and we created social unrest in emerging markets because of inflation. It created pressure elsewhere. If you look at its US impact, it wasn’t higher growth rates. You got the worst response: higher food prices and not inflation in our wages. It was unfavourable.
Corn was up same amount as copper at one point. 88% correlation between oil and S&P. You can’t shrink institutional participation in real asset markets, but it’s sort of an unintended consequences.
Jonathan, you sold your house in early 2000s because you had a bad feeling about markets.
ME: Fed is disappointed with the QEs (quantitative easing). They’re desperate that they’ve run out of tools. We need action on the fiscal side. We need the smoldering log to respond with more than a flash. In 1-2 years, I don’t want to fight the flood of liquidity.
JG: If you look at the US budget and the way we’re financed, we’re financed by short-term paper (ugly). If the Fed raised rates, we’d blow up the federal budget. Same thing — people in bonds, if you moved short-term rates to a reasonable rate, the damage to retirees would be enormous. It reminds me of a smoldering log and throw kerosene on and it keeps lighting up, but there’s no more fuel. You have to unwind it. But in the short run, the market wants more, and loves the liquidity.
ME: If we’re not getting to the fundamentals in the US, we’re not going to get to them in Europe. ECB is buying time. If they expect to solve their problems, we’re good as dead. We haven’t addressed the problems, and the market knows they exist at least through 2010. You have this ECB buying time, whether it works or not we’ll see. I have my doubts. You have to change the geopolitical model in Europe to work out these problems. Don’t fight the ECB in this case.
JG: There’s 100% chance they’ll agree on a plan, but 0% chance they’ll follow through. It doesn’t cost Greece anything to say yes I’ll have someone from Frankfurt look over my budget. But wait until the first budget, when they recommend changing the retirement age. The market is willing to accept the absurd and roll with it. A mistake I’ve made is that I haven’t bet against a statement I don’t believe.
MS: Individual investor doesn’t walk around with a benchmark hanging over his head (versus professional), that’s an advantage.
Do you think the European members will have a long-term plan?
JG: Economies grow. So if we had a high water mark with a date, the market will get dragged higher because the pie gets bigger. Advisors tell clients to readjust expectations, but that’s challenging. Look at the pension plans: 60/40 portfolio with 8% return assumption — few people would recommend that. So how do I get to retirement? Luckily, I don’t have to explain that to the public.
ME: How much time do you have in investing? If you’re 26, you’ll see higher highs before you need the money before retirement. If you’re 60, you shouldn’t be betting on 2007 numbers (all time high). We have a bias to the risk-on trade, but we won’t be capturing the all-time highs anytime soon. Markets aren’t ready to stretch valuations. Markets are behind earnings over the last 3 years. We’re not going to go into a 1982-1999 secular bull market, though.
MS: The question is, is the top of the range the all time high? Can I wait it out? At the core of the debate of asset allocation, can we expect higher returns?
10:21 JG: Everyone is thrilled with 2%, but 9% deficit (nominal). That’s not a massive success. First trade deficit ever in Japan. This is a developed market issue. My caution — debt overhangs aren’t just in Europe. The market is struggling with that.
MS: 2.5% annualized rate for a few mths — perception is that something will hit. Is it that something exogenous will always happen?
ME: Double dip scares were real in 2011. If market believes 2% is sustainable, that’s a huge improvement over 2011. The market was terrified that we were going into recession. Buying the 2% explains why VIX is down, and why confidence is up.
JG: The U.S. downgrade didn’t have a huge effect. The market is saying we’ll have growth with volatility. We’re stuck with this. If growth rate on equity is lower, 12.5 sounds ok if 14 is regular. Markets could be reading the same message.
MS: What is a risk-free pool of capital that we can access? That’s a distortive thing, we don’t know.
ME: ECB was missing last year. Awakened in August 2011 to the fact that they didn’t have the resources to survive. That’s motivation for a bureaucrat. They reversed the rate increases, and said don’t worry about capital, we’ll buy you time. They’re not solving the fundamental issues. We had a market all through 2011 — there were waves of panic re: Europe. With ECB, it’s calming down the market. There’s a player who will calm these waters. It hasn’t erased this valuation thing. All you’re going to get from safety is safety, not a real yield.
JG: The market has been willing to say if you’ve taken out the downside tail risk from European banks, and the worst thing is a Greek default, that’s ok. Maybe the markets are rational.
MS: There is a disconnect. What about the non-treasury credit markets?
10:15 JG: You have a treasury market, that with under 1.9% yield screams world is coming an end. Stocks aren’t moving too much, volatility is down. There’s a huge disconnect between bond market and stock market, which embodies more optimism.
10:14 ME: We’re not going to get a mean reversion, you’re right. If you look at companies with histories of regular dividend payments and increases, their dividend yields are higher than their own bond yields. Since the best you’ll get on a bond is the yield, usually the upfront dividend yield is lower than bond yield. So the market is expecting dividend cuts, price depreciation, or both. We see opportunity, not as great as Oct 2011, but still. We are looking for high single digits on earnings.
10:11 Jonathan Golub: 2011 there was euphoria during beginning. Market has been up since Oct 3, 2011 19%. But, I’ll take the other side Milton. We had a multiple of 10.2 in Oct 2011 on stock market, VIX 46, higher than Lehman collapse. Now 10.2 has become 12.4, VIX has fallen. So what’s normal? 1970s, valuations were lower. This market compared to non-investment-grade debt, you’re close to fair value. You’re probably in an environment where multiples are 10-14.
10:10 Milton Ezrati: I disagree. We’re in the same boat as 12 mths ago. If you look at valuations, markets are braced for disaster. That’s a critical piece of info. They’ve done well, but still, with dividend yields higher than bond yields, markets are ready for disaster. On the expectation that we’ll avoid disaster, we prefer risk-on trades over the safe havens.
10:08 Michael Santoli: Last year’s theme could have been what we do know didn’t kill us. The big picture risks were well-discussed and agonized over. Yet in U.S., investment returns didn’t suffer horribly. So we’re thinking of riskier assets early this year. So Milton, how do you characterize the landscape?
10:06 Moderator is an associate editor for Barron’s, Michael Santoli, who writes the Streetwise column.
10:02 Good to know: reps from the local IMCA chapter are near the ladies’ bathroom. I know who to look for during the breaks.
9:59 This conference is ridiculously on time. I like it.
Click through below for Geo-Politics and Global Business in the New Decade with Marvin Zonis, PhD, University of Chicago Booth School of Business
