The Broyhill Letter (Q3-10)

8/8/2019 The Broyhill Letter (Q3-10)

1/5

T H E B R O Y H I L L L E T T E R

Monetary policy is not a magic elixir that can solve every economic ill. Doctors must diagnose the disease correctly if they are to prescribe thecorrect medicine. Otherwise, they could do the patient more harm than good.

Charles Plosser, President of the Philadelphia Fed

Executive Summary

Our choices today are rife with unintended consequences. A major corollary of current Fed policy aimed at aiding the

recovery is continued liquidityflows into emerging markets and natural resources. The combination of competitive de-

valuation andQuantitative Easingpoints to continued strength in emerging markets and rising commodity prices now, but

the potential for speculative extremes are not far on the horizon. It is too early to say with confidence that the Fed will be

successful in blowing another bubble, but the odds are certainly stacked in favor of the printing press. After experiencing

the bursting of two Fed-induced bubbles in one decade (neither of which monetary policy makers take responsibility for),

investors should monitor sentiment and emerging market credit spreads closely for signs of exuberance, which would also

be reflected in extreme valuations and lopsided fund flows. Third times a charm?

We dont expect QE2, a new program of large-scale asset purchases, to provide much of a lift to cyclical growth. We doubt

job prospects will be improved dramatically by the central bank acquiring another trillion (or two, three or four . . . ) of

treasury bonds, or that housing activity will increase given that roughly half of US homeowners are underwater on their

mortgages today. In the long-term, printing presses cannot stimulate aggregate demand, create new technologies, update

infrastructure, reduce unemployment or pay down debt. Policies that place particular emphasis on short term highs have

often produced violent crashes over the long term. At present, markets are entirely dependent upon the Fed to increase

household wealth by keeping asset prices higher than they otherwise would be, as promised by Brian Sack Executive,

Vice President of the Federal Reserve Bank of New York. But as investors, we are not rewarded for our policy suggestions,

nor are we rewarded for portfolio positioning based on what shouldbe done. Rather, we must play the hand we are dealt,and the combination of a Bernanke-led printing press kicking off a classic Third Year rally in the Presidential Cycle may

well be the ace in the hole for risk assets over the next twelve months.

Year Three Little Birds

Dont worry about a thing, cause every

little thing gonna be all right. Three Little

Birdsis a song by Bob Marley & The Wail-

ers from their 1977 album Exodus. It is

one of Bob Marleys most popular songs,

and allegedly, a Greenspan-Bernanke

favorite as well. We are worriers by na-

ture. But history would suggest that Fed

promises during Year Three of the Presi-

dential Cycle are enough to encourage

speculation and ignite even the most dor-

mant animal spirits. Upon closer inspec-

tion, Year Three rallies are often born

during the fourth quarter of the second

year. According to work done by William

Hester of Hussman Funds, the twelve

month period beginning in October of

the second year of the Presidential

THIRD QUARTER 2010


2/5

Cyclehas enjoyed total returns in excess of 28 percent. Not too shabby, especially when one considers that we have not

registered more than a marginal loss in a singleYear Three for almost a century. The reason is unmistakably simple. Presi-

dents really like being re-elected and a really accommodative Fed in Year Three can do wonders for an incumbents odds.

It appears that President Nixon grasped this concept rather quickly. Evidence from the Nixon tapes clearly reveals that

Nixon pressured then Fed Chairman Arthur Burns to engage in expansionary monetary policies prior to the 1972 election.

Blaming a modest rise in the unemployment rate as one of the reasons he lost the 1960 election, he demanded an expan-

sionary monetary policy in the run-up to the 1972 election.

No investment strategy this simple, or this predictable, should work in practice. Anything this easy to spot and this easy to

follow should ultimately be arbitraged away over time, like any other once-working anomalies of markets past. But, despite

what academic theory would suggest, Fed policy of over-stimulating asset prices and over-encouraging moral hazard has

consistently generated spectacular returns in Year Three. The truth is in the data. The chart below from GMO illustrates

just how well the more speculative quarter of the market has performed over this period. Given the Unusual Uncertainty

of todays macroeconomic landscape, coupled with Fiscal Gridlock in Washington, Bernanke & Co are under even more

extreme pressure to reflate the economy. Between November 3rd and Election Day 2012, the monetary spigots will be

runningWide Open(without a doubt, one of my favorite recently discovered Southern phrases, right up there with bless

your heart).

Manias, Panics and Crashes

Economic historian, Charles P. Kindleberger, provided investors with a conceptual framework for thinking through the

foundations of historys biggest speculations based largely on the work of the now (in)famous Hyman Minsky. The five

stage model (illustrated below) starts with a random displacement or some exogenous shock to the macro system which

always jolts expectations and leads to New Era thinking a New Normalif you will. The majority of the time, said dis-

placement has been in place for years prior to the ultimate investment stampede. Easy money fans the flames of specula-

tion as the publics attention is captured by rising prices. It also helps when there are convenient vehicles to invest in the

New Era allowing the public to participate en masse coincidentally, we understand if the new physical copper ETFs were

fully subscribed, they would take about 50% of total LME stocks off the market.

THIRD QUARTER 2010

2

Source: GMO Quarterly Letter - Night of the Living Fed - October 2010


3/5

Ultimately the boom becomes euphoric as

participation becomes widespread and theo-

ries chase prices higher, all the while justify-

ing why normal measuring sticks of valuation

are no longer relevant. There is nothing so

disturbing to ones well-being and judgment

as to see a friend get rich, but inevitably

booms turn to bust when credit growth

slows and prices stop rising. Once prices

begin their descent, speculators rush for the

proverbial exit of the crowded theatre, bank-

ruptcies increase, frauds are discovered andrevulsion sets in. The policy reaction to the

bust (i.e. Quantitative Easing) caused by the

collapse of the previous bubble, often sets in

motion a chain of events leading to the next

Financial Mania.

Easy Money

It may appear premature to begin contemplating the next invest-

ment stampede, but bull markets often originate from the ashes of

the previous bust. New opportunities emerge from the displacement

caused by the prior bubble, and flourish on a diet of easy money and

credit. The return of speculation is the primary determinant of wherecredit inflation manifests itself. Here, the cost of borrowing is key.

With the developed world mired in a Liquidity Trap, interest rates

across the G7 should hover around the zero bound for as far as

our eyes can see. The result is that as long as China and friends con-

tinue to peg their currencies to the Burning Buck, emerging markets

will continue to import US monetary policy pushing related asset

prices higher.

The growing prospect for an emerging market bubble has all of the

elements described above. It qualifies as a New Era candidate with

displacement in the making for some time, as BRIC share of global

GDP has grown significantly in the past quarter century. It is now

easy for investors to allocate to the emerging world with an almost

unlimited number of liquid ETFs available in the marketplace today.

Decoupling is slowly coming back in vogue and valuations remain

fair, suggesting that as prices move higher, money will follow and

potentially push them to extremes. Finally, the secular nature of this

shift, combined with the cyclical stimulus in place today, make the

prospects for such a move that much more attractive. Emerging

Markets share of global GDP has risen from 21% to 37% from 1990

through 2008. Their share of Market Cap was still just 12% of world

markets. To get a sense of what a bubble looks like in 1990 Japan

3

THIRD QUARTER 2010


4/5

represented 40% of the worlds entire market capitalization!! We have a long way to go.

Bull markets emerge in waves much like the rise in commodity prices experienced over the past decade. Resource bulls,

close relatives to emerging market bulls, point to the kind of arithmetic that shows Chinas per-capita commodity utiliza-

tion as a fraction of Americas. The obvious implication is that there is quite a large move ahead of us a move that is

easily visualized by the average investor. Importantly, bubbles are often based on long term expectations condensed into

a short term time span perhaps as short as a twelve month period such as Year Three of the Presidential Cycle. Of

course, commodity prices also have the additional tailwind of lower real interest rates Cruising Aboard QE2. Lord John

Maynard Keynes warned that, There is no subtler, no surer means of overturning the existing basis of society than to

debauch the currency. Put simply, too much money chasing too few goods provides commodities with pricing power rela-

tive to fiat currencies. Look only as far as the recent move in gold for a view of this trend in action. A Fed Boss enamored

with Easy Money provides assurance that real interest rates will remain low, which should favor the long term gold price.Consequently, November and December have historically made up a significant portion of golds annual gains, even when

beginning the fourth quarter near highs for the year.

Bottom Line

When the facts change, we change

our mind. We have remained defen-

sively positioned for most of the

year as risk was clearly elevated by

monetary authorities debating glob-

al exit strategies and fiscal policy-

makers arguing for increased auster-

ity. Despite measures of sentimentregistering excessive pessimism dur-

ing the third quarter, we maintained

this focus on capital preservation

in front of the historically risky

months of September and October.

In hindsight, we would have been

better served buying last quarters

lows in pessimism, but the poten-

tial for a larger waterfall decline

prevented us from doing so. Fast

forward to today - with a green light

from the Fed and Bernankes petal

to the metal as we enter Year Three, the facts have changed. True, valuations remain largely unfavorable (although emerg-

ing market equities are more reasonably priced) and broad macroeconomic risks have not vanished, so we are not throw-

ing caution to the wind. But incredibly, the record indicates that even elevated starting valuations have not reduced the

magnitude of gains in Year Three. One only needs to look back to the tech bubble for an example. After over-stimulating

the market in years one and two, Greenspan had markets partying like it was 1999 in Year Three. But in two thousand zero

zero . . . party over, oops, outta time.

The year 1999 was also similar in that it was another period of highly correlated asset prices. Like golds tendencies into

year-end, winners extended their lead in the fourth quarter. Policy mistakes reinforced this phenomenon then, and look

likely to repeat this mistake again. Our work indicates that emerging markets and natural resources have the most

4

THIRD QUARTER 2010

Source: Robert Shiller, Broyhill Asset Management


5/5

appreciation potential ahead of the

coming liquidity avalanche, while

long term treasuries still provide

insurance against a deflationary

relapse in the near term. But we

would not chase the market higher

at these levels. The recent advance

has brought most markets back

to their April highs as the MSCI

World Index has now gone almost

50 straight days without as much as

a 2% correction. Persistent strengthhas left investors complacent and

equities extremely vulnerable to

disappointment. With expectations again elevated, any unexpected developments should serve as a catalyst for a sell-off.

Unless the Fed dazzles investors with shock and awe, the market appears to be set up for a classic buy the rumor, sell

the news reaction. Under such a scenario, we would expect emerging markets, natural resources and related assets to

underperform given the high beta and correlations across markets. So for investors underweight risk today, a correction

should relieve the current complacency, provide an attractive entry point and set the market up for a year-end rally. An

abrupt decline that cleared overbought levels and injected renewed fear into the psyche of speculators might provide a

better base for the typical Third Year Boom.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The authors opinions

are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice

or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of

any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not

guaranteed.

5

THIRD QUARTER 2010

The Broyhill Letter (Q3-10)

Documents

Transcript of The Broyhill Letter (Q3-10)