Currency, Commodities are Out, Smallcaps are In
posted on: January 27, 2008 | about stocks: IWN / IWO Print Email We live, breath and eat this stuff, so it is odd to think that not everyone’s life revolves around the financial markets. Can you even imagine? In our 3 years of managing money under Lenger Asset Management we have never received market driven calls till yesterday. This is even odder, since we have a small client base. For us it is an interesting indicator that fear has reached Main Street. In the past this has signaled a good entry point. The first leg of the down draft could be over. However, let’s take a moment to review the past portfolio, current situations and view moving forward.
We have been making some serious changes in the portfolio, since last post. The following numbers are rough estimates over the early fall. We had been operating off a strong cash base (11%) and had a very strong weights in Large Caps with bias on Growth (IVE & IVW) (62%), International (EFA)(15%), Mid Cap (IWP & IWS) (4%), High Yield Bonds (HYG) (4%), Currency (DBV) (1%) and Commodities (DBC & DJP) (3%). Our case was that things were going to get worse.
In 2007 our Max Growth portfolio clicked out 6.8% (pre Lam fee, but after mutual fund ETF expenses and commissions). The Russell 1000 came in at 5.8%. The Russell 3000 clicked out 5.1%. For those really into the numbers we benchmark off the Russell 3000. As such, our Beta was .6%, Alpha .7%, Sigma 2.6% and an R Squared of .90. It was a good showing for the year. Keep in mind this solution is not designed to shoot the lights out, but marginally out perform with less risk over time. Our portfolio started to change in November with a pause in December and drastic changes occurring this month.
Here is our current max growth portfolio position. We still hold Large Cap with a bias toward growth at 62%. We still hold High Yield Bonds at 4%. Our purchase price was 98.36. We purchased them during last fall’s credit scare, as the yield at the time was 8.3%. We are considering moving more assets into this sector, since the Feds continues to cut rates and the yield is still healthy. We still hold our Mid Cap weights at 4%. We are considering this as a potential source of funds. The weight in international is being held at 15%. We held (EFA) over emerging markets (EEM) for safety purposes. We are looking at lowering our international weighting. We suspect that the dollar could be at an inflection point in the next few months and that growth in foreign markets will slow. We never really bought into the decoupling theory. Although the correlation may have dropped a bit, it is still quite strong. We suspect growth will be reignited in the US first before rippling back out to foreign markets.
All commodity and currency positions have been sold. We need to have a small digression at this point, since the following idea feeds into our main thesis/outlook and needs to be explained. We are in a global slowdown. Demand will be curbed. Commodities will fall back. Additionally, there is the argument that the Treasury is printing dollars and the values in oil and other commodities are just a reflection of this dollar inflation (too many dollars chasing too few goods). A bi-product of the printing press is a cheap dollar (odd that economic theory would call for higher rates to stem inflation). The argument goes that it takes more dollars to buy 1 barrel of oil, thus high oil. We think this argument coupled with demand bore out in 2007. However, demand is slipping and will continue to do so, as we move through this global slowdown.
If you looked at the dollar yesterday, it held up relatively well given the FED rate cut. We believe this was motivated by a flight to safety and the market’s ability to start factoring in rate cuts in other foreign markets, namely EU. You are already starting to see this in the UK.
Let’s take a moment to address inflation from the US perspective. Unemployment is on the rise, so wage induced inflation is not a factor. If our thesis plays out with commodities, then you should see input inflation start to work back out of the value chain. What about the argument of the global liquidity glut. The liquidity machines broke down this summer and fall which caused a temporary closing of the taps. As we are in a fractional banking system, this had to slow the rate of money creation down substantially. Secondly, the Real Estate and the subsequent Financial Derivatives money engine is over.
How much liquidity/value is being destroyed at the moment? You can see this through revaluations of loans and the needs for banks to recapitalize their balance sheets. We suspect this process is not over. However, one important point should be made. The Fed has regained control of the monetary system and money creation. This can be seen as they have stepped in as “The Lender of Last Resort” a few times. We have argued in past post that the bi-product of Greenspans policy was to unleash a private liquidity engine, through so called financial innovation on the back of the Real Estate boom, which took on a life of its own.
In part this was also driven by the Banking Modernization Act, which repealed a lot of the early Glass-Stiegel provisions. These provisions were put in place during the last great credit boom, circa 1920’s. We all know how that ended. That is why we see the banks in such bad shape. The idea was to allow financial institutions to merge in order to enable stability through diversification. Please take note that we are not advocating a 1930’s style depression from this current market fall out. It’s important to understand the seeds of the current crisis. In short the inflation numbers we are seeing now are historic. We see inflation moderating through a pull back in commodities, higher unemployment and liquidity having currently eroded. OK, on to the next really big topic.
Where is the next really big holding? We are almost even scared to talk about it, given the current mood of investor psychology. It is none other than Small Cap Value (IWN). We started buying in November and paused in December, as they rallied. In January we have been buying with a vengeance. Currently, we have 16% in Small Cap Value and 2% in Small Cap Growth (IWO). Our current average in Small Cap Value is $66.92. Small Cap Growth was a carryover from November. We are down -10%. Why have we run toward one of the riskiest sectors in the market? There are a host of reasons.
(IWN) mirrors Russell 2000 value. From an intraday peak of 85.67 hit on 6/1/07 to an intraday low of 57.64 on 1/22/07, the carnage comes out to a loss of -32.78% in roughly 7 months! Yesterday, it closed at 62.75. We are off -6.2% with our holding. The following numbers are for 12 month holding periods. If we take a look at Russell 2000 as a whole, since 1981, the worst total return 12 month holding period has been -27.29%, which was hit on 10/90. If we look back 20 years from 2007, the worst 12 month holding period return for small value has been -21.8% in 1990.
In general, small growth has been more volatile, losing -30.3% in 2002. Over time Value has outpaced Growth both on the 20- and 10-year number. We suspect the 5- and 3-year return number are starting to reflect the current negative state for value, so it is starting to underperform Growth. Those numbers seem soothing, so let’s sound the red flag now. Looking at peak to trough figures for small caps (top to bottom), there have been some real scary drops. Here are the big 4, since 10-9-1979: 3-9-00 to 10-9-02 (-46.06%), 8-25-87 to 10-28-87 (-39.19%), 4-21-98 to 10-8-98 (-36.86%) and 10-9-89 to 10-30-90 (-34.27%). Needless to say, we believe much of the drop has occurred. If we looked at yesterday’s intraday market action it was very encouraging, Small Value opened at $57.64 and closed at 62.75. In fact was one of the rare positives sectors throughout the day.
Let’s take a look at the fundamentals. What has caused this sharp drop in Small Cap Value? If we look under the hood, we see that Russell 2000 Small Cap Value has a significant exposure to the financial sector at 32.77%. This happens to be the current sector, which is getting hammered by the current market and economic turbulence. On a fundamental basis the dividend yield looks great at 2.85%, a P/B of 2.06 and Trailing P/E of 20.31. Currently, Small Cap Growth has a dividend yield of .59%, a P/B of 5.58 and a Trailing P/E of 28.62%. It is obvious to us where the value is at this point. Let’s compare it to Large Cap Value. It has a heavy exposure to the financial sector as well with a 28.08% weight. The Dividend yield is 2.68%, a P/B of 3.23 and a P/E of 18.47%. On a relative basis there seems to be value here.
From an economic viewpoint, lower interest rates have always helped small cap stocks. More importantly: Lower rates aid most financial institutions, such as banks, bottom line in terms of profitability. Our belief is that once the dust settles there could be a period of industry consolidation. Larger companies moving in to pick up cheap market share. We theorize further that many of the small banks sold their loans off to the larger institutions to be collateralized. The remaining exposures are your normal loan and deposits. As rates fall, we believe that many Americans might be able to refinance again. Granted, this may not be as pervasive due to tighter lending standards, but there will be some opportunity for profit. This will help the small bank and mortgage shop.
Well, that’s the view point for now. We are sure it will change and adapt as the year rolls on.
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