Thursday, December 29, 2011

Why do universities have endowments?

Why do universities (in the US and Britain only) have endowments, and should they? And why does no one but Henry Hansmann [pdf, eBook version here] write about this question?

Because they can.  Tax law doesn’t stop them, and why should a University President spend down the fund?  An ongoing high balance in the fund means prestige, a good ranking, and an ability to make credible commitments to quality faculty and quality programs.
Current donors know that their support will feed into something long-run and grand.  Rationally or not, it is less persuasive for an alumni donor to hear a pitch like “We will spend down the corpus.  Penn State will rise seventeen spots in the ratings, for twenty years, and then fade into obscurity.”  Many givers care predominantly about the “here and now,” but they donate to political campaigns, or benevolent charities, not universities.
Ultimately we need a theory of segmented giving, and how board structures of universities support such giving.  University board members benefit most from a prestigious school with a high endowment and other prestigious board members.  In general those boards will support accumulating the endowment, at least if the school has any chance for prestige in the first place.  Spending money within the university instead distributes those benefits to current faculty and students, rather than to the decision-makers over the endowment.
Note that while the most visible colleges and universities usually have large endowments, the median and modal schools have endowments very close to zero.  They have no chance of accumulating their way to substantial prestige benefits.

Alternatively, you could drop the fancy institutional economics and apply crude price theory.  Universities can borrow or otherwise raise money tax-free, and at g > r you should expect ongoing and rising accumulation.
It is striking how much the list of top U.S. universities does not change over the last century, albeit with some new entries from the west coast.  Among other things, that suggests there has been no fancy, expensive and effective new product that a school might invest in and run down its endowment for.  This might change in the next twenty years.  One can imagine a middling school running down its endowment to spend its way to leadership in on-line education.

I have never seen a good paper on which non-profits accumulate endowments and which do not, and how that difference functions as both cause and effect.  I would think, for instance, that the Heritage Foundation has a substantial endowment, but many think tanks do not.

Here is a new paper on university endowments (pdf), by Gilbert and Hrdlicka, asking whether endowments are invested in too risky a fashion.  It also raises the question of how well endowment practices will survive in a time with low rates of return.  Here is a 2008 dialogue on endowment reform.  Here is a 2009 law review piece on university endowments, it is a little slow to load.  Here is a TIAA-CREF perspective (pdf) on the investment committees for university endowments; they tend to be run by donors.  Here is a look at mandatory payout proposals.  Here is a good 2010 paper (pdf) on what happens when endowment values decline, it is called “Why I Lost My Secretary.”

Cutting Buffett Helps Sequoia Fund

Sequoia Fund Inc., (SEQUX) recommended by Warren Buffett when it opened, beat the U.S. stock market over the past four decades, in part because a large piece of the fund was invested in his company, Berkshire Hathaway Inc. (BRK/A)
Heeding Buffett’s warning that Berkshire wouldn’t grow as fast as it once did, the managers of the $4.7 billion fund cut their reliance on the stock almost in half in 2010 and put the cash into companies such as Valeant Pharmaceuticals International Inc. (VRX), a drug distributor. Sequoia is beating the pack again this year, gaining 14 percent through Dec. 27, better than 99 percent of value stock funds, according to data compiled by Bloomberg.
“They have the kind of portfolio Buffett might have if he ran a mutual fund,” Steven Roge, a portfolio manager with Bohemia, New York-based R.W. Roge & Co., said in a telephone interview. His firm, which oversees $200 million, holds shares in Sequoia.
Like Buffett, the managers of Sequoia look for high-quality companies with competitive advantages that the fund can hang onto for long periods. While the scale of Buffett’s $68 billion stock portfolio forces him to buy mainly the largest companies, Sequoia is small enough to benefit from investments in mid-sized businesses.
The fund beat 97 percent of peers over the past 10 and 15 years, according to Morningstar Inc. (MORN) in Chicago. From 1970 to 2010 the fund returned 14 percent annually, compared with 11 percent for the Standard & Poor’s 500 Index. In its best year, 1976, the fund gained 72 percent, according to “The Warren Buffett Way” (John Wiley & Sons, 1994) by Robert Hagstrom. It lost 27 percent in its worst year, 2008.

Buffett’s Praise

Sequoia Fund was co-founded in 1970 by Richard Cunniff and William Ruane, a friend of Buffett since both studied under legendary value investor Benjamin Graham at Columbia University in 1951. When Buffett shut down his investment partnership in 1969 to concentrate on Berkshire Hathaway, he recommended that his clients invest with Ruane.
“Bill formed Sequoia Fund to take care of the smaller investor,” Buffett wrote in an e-mailed response to questions. “A significant percentage of my former partners went with him and many of those still living have their holdings of Sequoia.”
Ruane ran an unconventional fund, closing Sequoia to new investors in 1982 because he didn’t want its size to limit what the fund could buy. It opened again in 2008, three years after Ruane’s death.
Ruane also held a concentrated portfolio. In 2003, Sequoia had 75 percent of its money in its top six holdings, according to a regulatory filing.

‘Six Best Ideas’

Ruane believed that “your six best ideas in life are going to do the best,” David Poppe, who now runs the fund together with Robert Goldfarb, said at a May 2011 investor day for Ruane, Cunniff & Goldfarb Inc., the New York firm that advises Sequoia.
Poppe and Goldfarb didn’t respond to a request to be interviewed. The two were named domestic stock managers of the year for 2010 by Morningstar. They are finalists for the same award for 2011.
Since Ruane’s death, the firm has hired more analysts and added more holdings to the portfolio. At the end of 2010, Sequoia held 34 stocks, an all-time high, according to a letter to shareholders in the fund’s 2010 annual report. The same letter explained why Sequoia reduced its stake in Berkshire Hathaway.

Cutting Berkshire

“When Warren Buffett tells the public that Berkshire’s growth rate will slow in the future, it behooves one to listen,” the fund’s managers wrote. Buffett has said on a number of occasions that a company of Berkshire’s size can’t grow at the pace it did when it was smaller.
“We know we can’t do remotely as well in the future as we have in the past,” Buffett said on April 30 at Berkshire’s annual meeting in Omaha.
Berkshire represented 11 percent of Sequoia’s holdings as of Sept. 30, down from 20 percent at the end of 2009 and 35 percent in 2004, according to fund reports.
Sequoia’s Berkshire stake has been a drag on the fund’s returns in recent years, said Kevin McDevitt, an analyst for Morningstar. Over the past five years, Sequoia rose 4.3 percent a year compared with an annual gain of 1 percent for Berkshire. Over 20 years through November, Berkshire outperformed Sequoia by 2.6 percentage points a year.
“There was a time when you could have said they were riding Buffett’s coattails,” McDevitt said in a telephone interview. “That’s not the case anymore.”

Long-Term Investor

A reduced Berkshire stake hasn’t stopped the fund from investing in a style similar to Buffett’s. In 2011, Buffett bought shares of MasterCard Inc. (MA) and International Business Machines Corp. (IBM), two companies Sequoia already owned.
Buffett’s portfolio contains stocks, such as Coca-Cola Co. (KO) and Wells Fargo & Co. (WFC), that he has owned for more than 20 years. Sequoia has holdings, including TJX Cos. (TJX) and Fastenal Co. (FAST), that have been in the fund for at least 10 years, regulatory filings show.
TJX, a Framingham, Massachusetts-based discount retailer, has appreciated at a rate of 14 percent a year in the 10 years ended Nov. 30, compared with 2.9 percent for the Standard & Poor’s 500 Index, according to data compiled by Bloomberg. Fastenal, an industrial supplier based in Winona, Minnesota, gained 20 percent a year.
“As an investor, if you get the people and the business right, you can let a company do the hard work for you for a long time,” Thomas Russo, a partner at Lancaster, Pennsylvania-based Gardner Russo & Gardner, said in a telephone interview. Russo, who worked at Ruane’s firm from 1984 to 1989, manages $4 billion.

‘Good and Bad’

Sequoia’s patience hasn’t always paid off. Mohawk Industries Inc. (MHK), a carpet maker based in Calhoun, Georgia, and a longtime Sequoia holding, lost 19 percent of its value in the past five years as the housing slump depressed carpet sales.
“In the short term, holding Mohawk has been a really poor decision,” Poppe said at the 2009 investor meeting.
Such self-criticism is common at the meetings. At one session, an investment in Porsche Automobil Holding SE (PAH3), the German automaker, was described as a “disaster.” At another, a manager admitted the firm was too timid about buying MasterCard after it went public in 2006.
“They give you the good and the bad,” said Roge, who has attended several of the firm’s investor meetings.
Sequoia’s managers don’t buy many of the largest stocks because the companies are too well-known and too heavily followed on Wall Street. Their preference is to own businesses “where we believe, not always correctly, that we have an edge in information,” they wrote in their 2009 letter to shareholders.

Valeant Stake

Valeant Pharmaceuticals, the fund’s largest holding, had a market value of less than $7.5 billion (VRX) when Sequoia purchased it in the third quarter of 2010, Bloomberg data show. The Mississauga, Ontario, drug company gained 62 percent this year.
At the 2011 investor meeting, the fund’s managers emphasized Valeant’s unusual business model, which focuses on acquiring drugs with a proven track record rather than spending money on research and development. They also praised the firm’s chief executive officer, J. Michael Pearson.
Goldfarb told investors that over time he has become convinced that the right executive is crucial to a business’s success. “We’re betting more on the jockey and a little less on the horse,” he said in May at the fund’s annual meeting.
Sequoia typically has far more cash than the 3.7 percent held by the average U.S. domestic stock fund. At the end of the third quarter, cash represented 27 percent of the fund’s assets, according to data compiled by Bloomberg.

Holding Cash

Other well-known value investors, such as Seth Klarman, founder of Baupost Group LLC, a Boston-based hedge fund, and Robert Rodriguez, the longtime manager of FPA Capital Fund and current CEO of Los Angeles-based First Pacific Advisors, let cash build up when they can’t find enough attractive investments.
“In good markets cash can be a drag, but we have not had many good markets lately,” Dan Teed, president of Wedgewood Investors Inc. in Erie, Pennsylvania, said in a telephone interview. Teed, whose firm manages more than $100 million, including shares of Sequoia, said the fund’s cash was a plus because it means they “aren’t afraid to take a defensive position.”

Debt Dangers

Klarman and Rodriguez have written about the dangers of the increase in U.S. government debt, warning that it could pose a threat to the economy and the stock market if it is not whittled down.
Goldfarb normally ducks questions about macroeconomic issues at annual meetings, saying he has no special insight into the future of the economy, interest rates or the prices of oil and gold.
At the 2011 annual meeting, in response to an investor question, he sounded a gloomy note about deficits.
“My own feeling is that we’re just repeating the housing bubble in a different form,” he said. “We’ve substituted an unsustainable buildup of government debt for what is an unsustainable buildup of consumer debt. This one really feels worse to me and more dangerous. I think we’re living in a time of false prosperity.”

Wednesday, December 28, 2011

The Dirty Dozen: Fairholme Fund's 12 Largest Holdings

If there is one person for whom 2011 cannot end soon enough, it is Bruce Berkowitz.  The manager of the Fairholme Fund (FAIRX) has had a year where practically all of his holdings have been taken out to the woodshed one by one, resulting in a year to date decline of more than 30% for the fund.

As if the year wasn't bad enough already, today the fund's third largest holding, Sears Holdings (SHLD), announced a 5.2% decline in same store sales and that it would close more than 100 stores.  As a result, SHLD is down more than 25% today alone and 53% YTD.  The table below lists the Fairholme funds 12 largest holdings as of its most recent filing. As shown, all but one of the stocks is down on the year, and three are down more than 50%!

Tuesday, December 27, 2011

Kass: 15 Surprises for 2012

"Never make predictions, especially about the future." -- Casey Stengel
While I had a reasonably successful surprise list for 2011, with about half my surprises coming to fruition, the real story was that I achieved something that is almost impossible to accomplish.
My most important surprise (No. 4) was that the S&P 500 would end the year at exactly the same price that it started the year (1257) and that the range over the course of the year would be narrow (between 1150 and 1300).
As explained below, both predictions were remarkably close to what actually occurred.

My Biggest Surprise for 2011 Was Eerily Prescient

As we entered 2011, most strategists expressed a sanguine economic view of a self-sustaining domestic recovery and shared the view that the S&P 500 would rise by about 17% and would end the year between 1450 and 1500 vs. a year-end 2010 close of 1257.
By contrast, I called for a sideways market, stating that the S&P would be exactly flat year over year. To date, that surprise has almost come true to the exact S&P point. Remarkably, at around midday last Friday, Dec. 23, the S&P 500 was trading at 1257 -- Friday's closing price was 1265 -- precisely the ending price on Dec. 31, 2010! (There are still four trading days left in the year, so technically the exercise is not yet over.)
A flat year is a much rarer occurrence than many would think. According to The Chart Store's Ron Griess, in the 82 years since 1928, when S&P data was first accumulated, the index was unchanged in only one year (1947). And in only three of the 82 years was the annual change in the S&P Index under 1% -- 1947 (0.00%), 1948 (-0.65%) and 1970 (+0.10%).

In addition to the amazing accuracy of my variant S&P forecast, my forecast for the index's full-year trading range was almost as precise -- in both content and from the standpoint of causality.
As I wrote, a year ago, the S&P 500 would exhibit "one of the narrowest price ranges ever."
The surprise expected was that the S&P would never fall below 1150 (it briefly sold at 1090) and never rise above 1300 (it briefly traded at 1360), "as the tension between the cyclical tailwind of monetary ease (and the cyclical economic recovery it brings) would be offset by numerous nontraditional secular challenges (e.g., fiscal imbalances in the U.S. and Europe; a persistently high unemployment rate that fails to decline much, as structural domestic unemployment issues plague the jobs market; and the continued low level of business confidence (reinforced by increased animosity between the Republicans and Democrats) exacerbates an already weak jobs market and retards capital-spending plans." I went on to write, "Despite the current unambiguous signs of an improving domestic economy, as the year progresses, the growing expectation of consistently improving economic growth and a self-sustaining recovery is adversely influenced by continued blows to confidence from Washington, D.C., serving to contribute to a more uneven path of economic growth than the bulls envision."

Dueling Annual Surprise Lists: Kass vs. Wien

By means of background and for those new to Real Money Pro, nine years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley (MS) then Pequot Capital Management and now at Blackstone (BX).
Every year I, and many others, look forward to Byron "Brontosaurus Rex" Wien's annual compilation (hat tip to "Squawk Box's" Joe Kernen for giving him the moniker).
Byron has had a remarkable (and almost uncanny) record of his surprises becoming realities ever since he started his exercise back in 1986. His picks in 2009 were particularly accurate, but his surprises for 2010 were considered by some to be off the mark.
Here is Byron Wien's surprise list for 2011. The tone of almost all of Byron's 2011 surprises was diametrically opposed to my list -- namely, his list was rooted in optimism, while my list was rooted in pessimism. Where I saw slowing and sluggish economic growth, a weak housing market, a European recession by year-end and a lackluster stock market, Byron saw improving prospects. His principal surprises for the economy, interest rates, housing, the eurozone's debt crisis and the housing markets were off the mark in 2011. (Byron is an honest guy, so he would be the first to admit this.)
Specifically, Bryon expected U.S. real GDP growth of close to 5% (real U.S. GDP over the past 12 months saw only a 1.8% growth rate), a 5% yield on the 10-year U.S. note (which now stands at 2.03%, but, hey, I got that one wrong, too!), a year-end S&P 500 close near 1500 (now at 1265), a sharp recovery in housing starts to 600,000 and a rise in the Case-Shiller Home Price Index, and a quiescent and non-market-disruptive European debt situation. He was very correct on the price of gold (where I was far off base) and on benign inflationary pressures.

Lessons Learned Over the Years

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." -- Woody Allen
There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

  1. how wrong conventional wisdom can consistently be;

  2. that uncertainty will persist;

  3. to expect the unexpected;

  4. that the occurrence of Black Swan events are growing in frequency; and

  5. with rapidly changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

Consensus Is Often Wrong

"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." -- "UBS's Top 10 Surprises for 2012" (hat tip to Zero Hedge)
Let's get back to what I mean to accomplish in creating my annual surprise list.
It is important to note that my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these "possible improbable" events. In sports, betting my surprises would be called an "overlay," a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.
The real purpose of this endeavor is a practical one -- that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.
Since the mid-1990s , the quality of Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and groupthink (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today's stock prices.
It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.
Nothing is more obstinate than a fashionable consensus, and my annual exercise recognizes that over the course of time, conventional wisdom is often wrong.
As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank Citigroup (C), the uninterrupted profit growth at Fannie Mae (FNM) and Freddie Mac (FRE), housing's new paradigm (in the mid-2000s) of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

"Consensus is what many people say in chorus but do not believe as individuals." -- Abba Eban (Israeli foreign minister from 1966 to 1974)
In an excellent essay published a year ago, GMO's James Montier made note of the consistent weakness embodied in consensus forecasts. As he puts it, "economists can't forecast for toffee."
Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Montier's Exhibit No. 4 (above) reveals that economists are simply useless when it comes to forecasting:

They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else.... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared! -- James Montier

How Did Consensus Do in 2011?

As we entered 2011, consensus estimates for economic growth, corporate profits, stock price targets and interest rates were generally optimistic and, as is typical, grouped in an extraordinarily tight range. Last year, I chose to use Goldman Sachs' (GS) forecasts as a proxy for the consensus. Here were Goldman's forecasts for 2011, with the likely or actual 2011 full-year returns/results in parentheses:
  • 2011 U.S. real GDP up 3.4% (up 1.8% actual), and global GDP up 4.7% (up 3.8% actual);

  • 2011 S&P 500 operating profits of $94 a share ($97 a share actual);

  • year-end S&P 500 price target at 1450 (Friday, Dec. 23's close: 1265 actual);

  • 2011 inflation (core CPI) of +0.5% (+1.7% actual); and

  • 2011 closing yield on the U.S.10-year Treasury note at 3.75% (2.03% actual).

How Did My Surprise List for 2011 Fare?

"Those who cannot remember the past are condemned to repeat it." -- George Santayana
My surprises for 2011 attacked some of the closely grouped and nearly universally optimistic consensus expectations on the part of money managers, strategists, economists and members of the fourth estate. My intention was not to be a Cassandra or to be a contrarian for contrary's sake but rather to recognize that most prefer the dreams of the future to the history of the past. My surprises embodied an often repeated lesson of history: What seems easy for (bullish) investors to imagine today might prove more difficult to deliver, as prospect is often better than possession.
Looking at history, there was no better example of misplaced optimism than in the period leading up to the Great Decession of 2008-2009, providing a vivid reminder of the poor forecasting ability and investment risks associated with the crowd's baseline expectations and the value of a surprise list that deviates from that consensus.
Three years ago, only the remnants anticipated anything near the magnitude of the fall in the world's economies and capital markets, despite what appeared to be clear and accumulating evidence of economic uncertainty and growing credit risks (and abuses). The analysis of multi-decade charts and economic series convinced most (along with other conclusions) that home prices were incapable of ever dropping, that derivatives and no-/low-document mortgage loans were safe, that there was no level of leverage (institutional and individual) too high and that rating agencies were responsible in their analysis. Importantly, they also failed to see the signposts of an imminent deterioration in business and consumer confidence that was to result in the deepest economic and credit crisis since the early 1930s.
I expressed in my list last year that many of those who were expressing the most extreme levels of optimism for 2011 were the most wrong-footed three years ago and experienced not inconsequential pain in the last investment cycle.
Back in 2008-2009 and again last year (but to a far lesser degree), many investors appeared similar to victims of Plato's allegory of the cave -- a parable about the difficulty of people who exist in a world shaped by false perceptions to contemplate truths that contradict their beliefs. This is why so many investors were blindsided by the last economic downturn and, from my perch, continued to remain conditioned to wearing rose-colored glasses in 2011.

In the famous simile of the cave, Plato compares men to prisoners in a cave who are bound and can look in only one direction. They have a fire behind them and see on a wall the shadows of themselves and of objects behind them. Since they see nothing but the shadows, they regard those shadows as real and are not aware of the objects. Finally one of the prisoners escapes and comes from the cave into the light of the sun. For the first time, he sees real things and realizes that he had been deceived hitherto by the shadows. For the first time, he knows the truth and thinks only with sorrow of his long life in the darkness. -- Werner Heisenberg, Physics and Philosophy: The Revolution in Modern Science
Last year's surprise list achieved about a 50% success ratio. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004 and one-third came to pass in the first year of my surprises in 2003.
My surprise list for 2011 hit on some of the important themes that dominated the investment and economic landscape this year. Below is a list of some of my accurate surprises from last year's list.

  • Markets: As discussed previously, the market was practically unchanged in 2011, and the year's range almost perfectly coincided with my No. 4 surprise. Also, group performance surprises were fulfilled -- for instance, "During the second half of the year, housing stocks crater, and the financial sector's shares erase the (sector-leading) gains made in late 2010 and early 2011." I also was correct in expecting asset managers' shares to fall lower and underperform.

  • The U.S. economy: Real GDP in the U.S., as I expected, was disappointing at about half consensus growth expectations. Screwflation of the middle class was a dominant theme, and I incorporated screwflation in my surprise list and in a Barron's "Other Voices" editorial in June. Americans, I thought, would remain in a foul mood, as the jobs and housing markets failed to improve to the degree expected by most. My surprise of social unrest was also realized around the world -- over there in the Arab Spring and over here in the Occupy Wall Street movement.

  • The European economy: Over there and as I suggested a year ago, "multiple country austerity programs moved Europe back into recession by year-end 2011."

  • China's economy: I wrote that "China continues to tighten, but inflation remains persistent, economic growth disappoints and its stock market weakens further." All happened.

  • U.S. politics: I wrote "increased hostilities between the Republicans and Democrats become a challenge to the market and to the economic recovery next year. As the 2012 election moves closer, President Obama reverses his seemingly newly minted centrist views.... The resulting bickering yields little progress on deficit reduction. Nor does the rancor allow for an advancement of much-needed and focused legislation geared toward reversing the continued weak jobs market." Trust in our leaders was indeed lost throughout 2011 -- approval ratings hit an all-time low during 2011 for Congress) and for the president -- and political gridlock and inertia adversely impacted sentiment as confidence figures plummeted by late summer.

  • Republican presidential candidate: Mitt Romney, as expected, is the Republican Party's presidential frontrunner (but Ryan and Thune never were in the fray).

  • Commodity prices: Throughout the year, "the rise in the price of commodities was one of the primary market themes and concerns."

  • Gold: I was correct in expecting volatility in the price of gold but very wrong in the direction of the price of gold when I wrote, "The price of gold plummets by more than $250 an ounce in a four-week period in 2011 and is among the worst asset classes of the new year. The commodity experiences wild volatility in price (on five to 10 occasions, the price has a daily price change of at least $75), briefly trading under $1,050 an ounce during the year and ending the year between $1,100 and $1,200 an ounce."

  • Takeovers: Though Microsoft (MSFT) has not yet made a bid, my Yahoo! (YHOO) deal surprise turned out to be materially correct. "Among the most notable takeover deals in 2011, Microsoft launches a tender offer for Yahoo!.... The private equity community joins the fray."

  • Internet as the tactical nuke of the digital age: "Cybercrime likely explodes exponentially as the Web is invaded by hackers." Dead on, as serious hacking incidents are occurring with increased frequency.

  • Expanding insider trading charges: It was a record year of insider trading indictments and convictions, from Raj to many other ne'er-do-wells (including research network consultants, hedge funds, corporations and even a member of the board of directors of Goldman Sachs). "The SEC's insider trading case expands dramatically, reaching much further into the canyons of some of the largest hedge funds and mutual funds and to several West Coast-based technology companies." (Some of us even learned this year for the first time that Congress is legally permitted to be in the insider trading game!)
Where did my surprises for 2011 go wrong?

  • Though the price of gold was volatile (and did sustain quick $200-per-ounce drops), it did not fall and was among the best asset classes in 2011.

  • There was no military confrontation between China and India over water rights.

  • The price of oil didn't soar to over $125 a barrel.

  • The yield on the 10-year U.S. note did not spike to 4.25%.

  • Food and restaurant stocks were not among the worst-performing market sectors.

  • Hillary Clinton and Joe Biden did not switch jobs, though Clinton is resigning her post as Secretary of State.

  • While Speaker of the House John Boehner's tenure has been uneven, he was not replaced by Paul Ryan.

  • A third political party did not appear (though it is never too late!).

  • There was no peaceful regime change in Iran.

What Is Consensus for 2012?

As we enter 2012, investors, strategists and talking heads are again grouped in a narrow consensus, but, in contrast with last year's almost universally bullish views on the economy and on the U.S. stock market, the consensus is far more downbeat, reflecting near universal acceptance of Pimco's Bill Gross's "new normal" of de-leveraging, de-globalization and re-regulation.

Again, let's use Goldman Sachs' principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for consensus.
Below are Goldman Sachs' forecasts for 2012:
  • 2012 U.S. real GDP up 1.8%, and global GDP up 3.2%;

  • 2012 S&P 500 operating profits of $100 a share;

  • year-end 2012 S&P 500 price target at 1250;

  • 2012 inflation of +1.7%; and

  • 2012 closing yield on the U.S.10-year Treasury note at 2.50%.

My 15 Surprises for 2012

"More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other to total extinction. Let us pray we have the wisdom to choose correctly." -- Woody Allen
Ever since 2007, my contrarian and variant surprise lists were almost always downbeat relative to consensus. I adopted a Kafkaesque sense of hopelessness and an almost Woody Allen-like sense of foreboding (see quote above). It was as if I was giving a traffic report from the perspective of chronicling the automobile accidents on I-95.

You'll be swell! You'll be great!
Gonna have the whole world on the plate!
Clear the decks! Clear the tracks!
You've got nothing to do but relax.
Blow a kiss. Take a bow.
Honey, everything's coming up roses!
-- Stephen Sondheim and Jule Styne, "Everything's Coming Up Roses"
But, my new surprises for 2012 represent a fundamental turn toward optimism and a marked departure from the pessimism expressed in my recent surprise list history -- as I move metaphorically from the Broadway stage of Woody Allen's 1966 play Don't Drink the Water to Stephen Sondheim and Jule Styne's 1959 Broadway musical Gypsy's "Everything's Coming Up Roses" (see lyrics above).
For the last few years, since the financial and economic crisis of 2008-2009, caution, restraint and the word "no" have characterized and dominated the economic, social and political backdrop. In 2012, however, our surprise list moves toward an inflection point in which bolder steps, expansiveness and the word "yes" begin to dominate the political, economic and stock market stages.
This new, brighter and more positive narrative is the essence and the common thread contained in my surprise list for 2012. (And this year, following each surprise, I am introducing a specific strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables).
Surprise No. 1: The U.S. stock market approaches its all-time high in 2012. The beginning of the New Year brings a stable and range-bound market. A confluence of events, however (discussed further in the body of the 15 Surprises for 2012), allows for the S&P 500 to eclipse the 2000 high of 1527.46 during the second half of the year. The rally occurs as a powerful reallocation trade out of bonds and into stocks provides the fuel for the upside breakout. The market rip occurs in a relatively narrow time frame as the S&P 500 records two consecutive months of double-digit returns in summer/early-fall 2012.
Strategy: Buy out-of-the-money SPDR S&P 500 ETF Trust (SPY) calls.
Surprise No. 2: The growth in the U.S. economy accelerates as the year progresses. The U.S. economy muddles through in early 2012, but, with business, investor and consumer confidence surging in the fall, real GDP accelerates to over 3% in the second half. Unemployment falls slightly more than consensus, but the slack in the labor market continues to constrain wage growth. Domestic automobile industry sales soar well above expectations, benefiting from pent-up demand and an aging U.S. fleet. Inflation is contained but begins to be worrisome (and serves as a market headwind) in late 2012. Corporations' top-line growth is better than expected, and wage increases are contained. Operating margins rise modestly as sales growth lifts productivity and capacity utilization rates. Operating leverage surprises to the upside as 2012 S&P profits exceed $105 a share.
A noteworthy surprise is that the residential real estate market shows surprising strength. The U.S. housing market becomes much bifurcated (in a market of regional haves and have-nots), as areas of the country not impacted adversely by the large shadow inventory of unsold homes enjoy a strong recovery in activity and in pricing. The Washington, D.C., to Boston, Mass., corridor experiences the most vibrant regional growth, while Phoenix, Las Vegas and areas of California remain weak. The New York City market begins to develop a bubbly speculative tone. Florida is the only area of the country that has had large supply imbalances since 2007 that experiences a meaningful recovery, which is led by an unusually strong Miami market.
Strategy: Buy Home Depot (HD), Lowe's (LOW), building materials and homebuilders, and buy auto stocks such as Ford (F) and General Motors (GM).
Surprise No. 3: Former Presidents Bill Clinton and George Bush form a bipartisan coalition that persuades both parties to unite in addressing our fiscal imbalances. The Clinton-Bush initiative, also known as "Simpson-Bowles on steroids," gains overwhelming popular support, and despite strenuous initial opposition, it forces the Democrats and Republicans (months before the November elections) to move toward a grand compromise on fiscal discipline and pro-growth fiscal policy. Interest rates remain subdued, growth prospects become elevated and a feel-good atmosphere begins to permeate our economy in a return of confidence and in our capital markets engendered by the Clinton-Bush initiative.
The Clinton-Bush initiative includes seven basic core policies that are accepted by both political parties.
  1. A broad infrastructure program focused on a massive build-out and improvement of the U.S. infrastructure base -- the restoration of our country's highways, bridges and buildings and an extensive internet bandwidth expansion are embarked upon.

  2. The annual increase in government spending is limited to the change in the CPI.

  3. A comprehensive jobs plan includes new training programs -- all veterans are made eligible to tuition subsidies to vocational schools and colleges.

  4. A Marshall Plan for housing is introduced, highlighted by a nationwide refinancing proposal adopted for all mortgagees (regardless of loan-to-values).

  5. A series of new tax increases, including a plan to raise taxes on the families with an income in excess of $500,000 a year (a two-year income tax surcharge of 5%-10%) and some other more imaginative, outside-the-box proposals (e.g., a tax on sugar products) are introduced.

  6. Mean test entitlements, freeze entitlement payouts and gradually increase the Social Security retirement age to 70 years old.

  7. A comprehensive plan is designed to rapidly develop all our energy resources.
Strategy: See No. 1 surprise strategy. Sell volatility.
Surprise No. 4: Despite the grand compromise, the Republican presidential ticket gains steam as year progresses, and Romney is elected as the forty-fifth President of the United States. The U.S. moved to the left politically in the Democratic tsunami in 2008 and to the right politically as the Republican Party gained control of Congress in 2010; the 2012 election is the tiebreaker. The result of the tiebreaker is that Mitt Romney and Marco Rubio squeak by Barack Obama and Joseph Biden in the November 2012 election. All the five swing battleground states (Florida, Indiana, Missouri, North Carolina and Ohio) go Republican. The Romney-Rubio ticket also wins the states of New Hampshire and Virginia, previously won by Obama in 2008, and the Republicans prevail (270 electoral votes to 268 votes) in one of the closest elections of all time. (Here is a great interactive electoral college map that allows you to make your own predictions.)
Strategy: See No. 3 surprise strategy.
Surprise No. 5: A sloppy start in arresting the European debt crisis leads to far more forceful and successful policy. The EU remains intact after a brief scare in early 2012 caused by Greece's dissatisfaction (and countrywide riots) with imposed austerity measures. The eurozone experiences only a mild recession, as the ECB introduces large-scale quantitative-easing measures that exceed those introduced by the Fed during our financial crisis in 2008-2009.
Strategy: Buy European shares. Buy iShares MSCI Germany Index Fund (EWG) and iShares MSCI France Index Fund (EWQ).
Surprise No. 6: The Fed ties monetary policy to the labor market. In order to encourage corporations to invest and to build up consumer and business confidence, the Fed changes its mandate and promises not to tighten monetary policy until the unemployment rate moves below 6.5%, slightly above the level at which wage pressures might emerge (the Non- Accelerating Inflation Rate of Unemployment).
Strategy: Buy high-quality municipal bonds or the iShares S&P National AMT - Free Municipal Bond Fund (MUB).
Surprise No. 7: Sears Holdings declares bankruptcy. In a spectacular fall, Sears Holdings (SHLD) shares are halted at $18 a share during the early spring, as vendors turn away from the retailer, owing to a continued and more pronounced deterioration in cash flow (already down $800 million 2011 over 2010), earnings and sales. With funding and vendor support evaporating, as paper-thin earnings before interest and taxes margins turn negative and cash flow is insufficient to fund inventory growth. The shares reopen at $0.70 after the company declares bankruptcy and its intention to restructure, as we learn, once again, that being No. 3 in an industry has little value -- especially after store improvements were deferred over the past several years. A major hedge fund and a large REIT join forces in taking over the company. Ten to fifteen percent of Sears' 4,000 Kmart and specialty stores are closed. More than 35,000 of the company's 317,000 full-time workers are laid off. As a major anchor tenant in many of the nation's shopping centers and with no logical store replacement, the REIT industry's shares suffer through the balance of the year, and the major market indices suffer their only meaningful correction of the year. Target (TGT) and Wal-Mart's (WMT) shares eventually soar in the second half of 2012.
Strategy: Buy out-of-the-money Sears Holdings puts, go long Target and Wal-Mart, and short the iShares Dow Jones U.S. Real Estate Index Fund (IYR).
Surprise No. 8: Cyberwarfare intensifies. Our country's State Department's defenses are hacked into and compromised by unknown assailants based outside of the U.S. Our armed forces are place on Defcon Three alert.
Strategy: None.
Surprise No. 9: Financial stocks are a leading market sector. After five years of underperformance, the financial stocks rebound dramatically and outperform the markets, as loan demand recovers, multiple takeovers permeate the financial intermediary scene and domestic institutions enjoy market share gains at the expense of flailing European institutions. With profit expectations low, three years of cost-cutting and some revenue upside surprises (from an improving capital markets, a pronounced rise in M&A activity and better loan demand) contribute to better-than-expected industry profits. P/>
Another tough year
To cover this group
Down 40 to 50
And they're still in the soup Regulation, litigation
And potential mitigation
Time to put it all aside
And enjoy your vacation....
But if Republicans win the White House
It's them I'd like to thank
Cause they'll not only change the top seat
But also the bill of Mr. Dodd and Mr. Frank
So Happy New Year
Hope you found this rap a little clever
And buy some big banks and brokers next year
Don't hide in the regionals forever!

-- "Nomura Securities' Year-End Rap"
Strategy: Buy JPMorgan Chase (JPM), Citigroup and the Financial Select Sector SPDR (XLF).
Surprise No. 10: Despite the advance in the U.S. stock market, high-beta stocks underperform. Though counterintuitive within the framework of a new bull-market leg, the market's lowfliers (low multiple, slower growth) become market highfliers, as their P/E ratios expand.
With the exception of Apple (AAPL), the highfliers -- Priceline (PCLN), Baidu (BIDU), Google (GOOG), Amazon (AMZN) and the like -- disappoint. Apple's share price rises above $550, however, based on continued above-consensus volume growth in the iPhone and iPad. Profit forecasts for 2012 rise to $45 a share (up 60%). In the second quarter, Apple pays a $20-a-share special cash dividend, introduces a regular $1.25-a-share quarterly dividend and splits its shares 10-1. Apple becomes the AT&T (T) of a previous investing generation, a stock now owned by this generation's widows and orphans.
Strategy: Long Apple (common and calls).
Surprise No. 11: Mutual fund inflows return in force. With confidence renewed, domestic equity inflows begin to pour into equity mutual funds by midyear and approach a $100 billion seasonally adjusted annual rate by fourth quarter 2012. The share prices of T. Rowe Price (TROW) and Franklin Resources (BEN) double.
Strategy: Long Legg Mason (LM), T. Rowe Price and Franklin Resources.
Surprise No. 12: We'll see merger mania. Cheap money, low valuations and rising confidence are the troika of factors that contribute to 2012 becoming one of the biggest years ever for mergers and takeovers. Canadian companies are particularly active in acquiring U.S. assets. Canada's Manulife (MFC) acquires life insurer Lincoln National (LNC), two large banks join a bidding war for E*Trade (ETFC), and International Flavors & Fragrances (IFF) and Kellogg (K) are both acquired by non-U.S. entities. Finally, a Canadian bank acquires SunTrust (STI).
Strategy: Long E*Trade, Lincoln National, International Flavors & Fragrances, Kellogg and SunTrust.
Surprise No. 13: The ETF bubble explodes. There are currently about 1,400 ETFs. During 2012, numerous ETFs fail to track and one-third of the current ETFs are forced to close. There are several flash crashes of ETFs listed on the exchanges. The ETF landscape is littered by investor litigation as investor losses mount. New stringent maintenance rules and new offering restrictions are imposed upon the ETF business. The formation of leveraged ETFs is materially restricted by the SEC. (Hat tip to Barry Ritholtz's Big Picture.)
Strategy: Avoid all but the largest ETFs.
Surprise No. 14: China has a soft landing (despite indigestion in the property market), and India has a hard landing. India becomes the emerging-market concern. With India's trade not a driver to GDP growth, its currency in free-fall, pressure to keep interest rates high by its central bank and signs of a contraction in October Industrial Output, India's GDP falls to mid-single-digit levels.
Strategy: Long iShares FTSE/Xinhua China 25 Index Fund (FXI); short WisdomTree India Earnings Fund ETF (EPI) and iPath MSCI India Index ETN (INP).
Surprise No. 15: Israel Attacks Iran. The greatest headwind to the world's equity markets is geopolitical, not economic. Israel attacks Iran in the spring, but, at the outset, the U.S. stays out of the conflict. Iran closes the Strait of Hormuz, and oil prices spike to $125 a barrel.
Strategy: Buy Schlumberger (SLB), ExxonMobil (XOM) and other oil production and exploration stocks.

Thursday, December 08, 2011

S&P 500 Volatility: August - December

It's no surprise that the S&P 500 has been extremely volatile over the last four months, but the picture below really brings the point home.  Going back to the beginning of August, the S&P 500 is down just about 2%, but over that period the index has seen eight declines of 5% or more and eight advances of 5% or more.  To put this volatility into perspective, there were two periods in the 1990s where the S&P 500 went more than a year without a single decline of 5% or more.
With the increased volatility of the market, individual stocks have been seeing major short-term moves.  To view the list of most volatilie stocks in the S&P 1500 please click here.

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.