We write mostly to tell you that we have examined all of the recent economic and company specific evidence that we can find and see nothing that changes our views or themes.  Tensions in the Ukraine and the Middle East have obviously elevated the geopolitical risk factors of investment decision making.  Nonetheless, we have made no major shifts because of these events as we were already quite cautious.

The most critical point we can make at this juncture is that it seems clear to us that the Fed is set to end QE in October at a point when sustainable growth is no more assured than when it commenced this latest ill-conceived scheme.  In addition, Japan’s mammoth money printing effort looks to have been a failed policy as well given poor economic data from that nation.

We put forth two more thoughts.  First, though we wish it were otherwise, under the adage of “give a man (or woman) a hammer…” we would not be surprised to see more QE in the next year if equity markets correct substantially or economic growth becomes even more disappointing.    Second, we would suggest that if the end of QE causes treasury rates to rise meaningfully, which we doubt, then it just might be riskier markets like equities, high yield bonds, and European sovereign debt including that of Italy and Spain which run into major trouble.  After all, we do know that those asset classes stand out as the most expensive that they have ever been on the misguided belief that QE has somehow removed company specific and default risks across the board.

With so many stocks already down 15-20% from their highs, we would suggest that investors are beginning to wake up to the fact that the central planners are unable to insure against each and every case of earnings disappointment, though they speak as if they can.  In addition, rapidly falling European financials stocks indicate risks are mounting in another region declared “fixed.”  Italy is now officially back in recession and its equity market has cracked 15%.  Furthermore, credit ratios do not look to have turned the corner in a positive way across the EU.

The central bankers have been backed into a corner because they have been left with only one tool and it has failed to produce the authentic recovery they and their text books promised.  Having made no moves to tighten policy after so many years since the last official recession in the U.S. and constantly cheering for equities even at these multi-year highs, we wonder what is really left to placate markets let alone alleviate economic dysfunction.  The big question is what happens when those still fawning over the Fed realize that earnings have not remotely kept pace with stock prices.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

Our investment theme has been and will remain that most investors are placing too much credence in central bankers’ words and policies, which are celebrated on Wall Street, while mostly hurting those on Main Street.  The labor force participation rate is still stuck at multi-decade lows…even after all the money printing.  Housing activity has rolled over again. GDP growth was likely flat, at best, for the first half of the year.

Below the surface, many equities are not nearly as euphoric as the major indices.  Perhaps this spring’s buzz around the release of Flash Boys, a book describing the equity market high-jinks of recent years, has curbed rigged trading.  Bonds have rallied on the realization that growth is quite slow.  Gold and silver have rallied on the increased desire for insurance against policy mistakes.  From a valuation perspective time is absolutely on the side of those who don’t run with the herd.  Why bet that equity valuations become even more expensive than the most expensive valuations ever seen?  There’s no reason to assume the downside risk of those gambling that they will know when to sell.  History tells us that doorway will get crowded.

The U.S. equity market trades at a multiple of GDP that we have witnessed only during the historic bubble periods.  The median stock has never traded at a higher multiple of revenues in any data we have examined.  The divergence between company fundamentals and stock prices remains stunning.  Caterpillar Inc. (CAT) trades near all-time highs, yet sales trends for its heavy equipment are dreadful.   We struggle to find a retailer or restaurant company that is doing well, yet most of these stocks trade as if consumers were spending freely, not pinching pennies as their CEO’s will attest.  Auto sales have picked up on the back of a sub-prime lending surge, inventory building, and higher fleet sales, but that is not much cause for cheer because those tailwinds are hardly sustainable.

We may continue to see some slightly troublesome data on the inflation front in the near term, which the Fed will try to ignore.  However, the globe has too much labor and capital because policy in recent years has led to the creation of additional capacity at a time when there was already too much.  For the time being, that should contain inflationary pressures.  Meanwhile, wage pressures remain low as much of the job creation has been poor quality and part-time.  The weird reality of China building a replica of Manhattan is more than just an interesting story; it is a spooky sign of the magnitude of the current bubble.

The recently released BEA (Bureau of Economic Analysis) tally of corporate profits for the first quarter showed a meaningful decline.  In addition, with most companies in the S&P 500 having now reported for the same period, the quarterly total looks lower than the fourth quarter.  Trailing twelve month reported earnings are essentially unchanged. Yet the S&P 500 is trading near its all-time high water mark.  A rational investor simply does not pay ever higher prices for a flattening stream of earnings with inflated valuations.  And we know that Fed liquidity, even in its extreme, has historically been incapable of preventing major market declines.

Perhaps the decline in earnings momentum is beginning to weigh.  The average stock in the Russell 2000 is down over 20% from its 52-week high even as the Fed and other central bankers continue QE efforts.  But we have to remember that this market has been full of upside surprises.

In a world where growth is always over-promised by leaders who continue to stifle and corrupt free markets by printing fiat currencies while simultaneously cheering for stock markets, our dogged adherence to value investing and cycle dynamics seems more than reasonable.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

With the release of a near zero first quarter GDP number it became clear that the economy is showing few signs of the robust activity that many market participants and prognosticators had predicted to start the year.  Weather may be partly to blame, but it is not nearly as responsible as many proclaim.  Earnings reports for the first quarter were not as well received as they had been in prior periods and that is weighing on sentiment as well.  The turmoil in the Ukraine has not helped, but we think equities are mostly falling under their own weight.

One big picture fact still trumps everything else that an investment professional should be conveying to investors at this point: in looking at many decades of data, based on price to revenues, U.S. equities are broadly the most expensive they have ever been.  That really should be all that matters to anyone tasked with making investment decisions.  No amount of stock picking ability can overcome that reality.  Therein lays the rationale for our cautious equity positioning.  We are enormously glad we can pursue value on the short side.

Below the surface of the S&P500, a good deal of damage has already occurred in many stocks in recent months, particularly those that were the most overpriced.  You might not believe it, but the average stock in the Russell 3000 is down about 20% from its 52-week high.

Our sincerest belief remains that our future success is purely a function of our willingness to remain on the right side of historic valuations.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

When we step back from the current insanity which seems to pass for investment activity these days, there are some big picture opportunities which have worked quite well in decades past and we will stick to those.  We concern ourselves with the investment cycle, which stretches five years or more.  Nonetheless, let’s consider what bad quarters might mean for us given our current investment posture.

• First, lower quality stocks, which are already more overvalued than we have ever seen must become more overvalued.
• Second, interest rates must spike dramatically at a time when U.S. GDP is stuck between 1 and 2% in an extremely over-levered global economy that would crater if that happened.
• Third,  prices for precious metals (real money) would have to move dramatically lower in an environment where central bankers are doing their level best to devalue fiat currencies by creating trillions more of them.

Obviously, all three of those can happen, but the odds suggest over time we should profit.  We also think the occurrence of one of those risk scenarios would likely prove a benefit to one of the other two bets.

We found it quite a sign of the times that within the span of 24 hours recently, Flash Boys author, Michael Lewis, appeared on “60 Minutes” exposing the inferior trading structure of current equity markets to the masses and new Fed Chairwoman Janet Yellen spoke about the need for ultra-easy monetary policy to continue five years into the “recovery.”  We do not think one can understand how this stock bubble formed without putting those two pieces together. Both elements serve to obscure reality and widen the gap between GDP and S&P.

The computerized exchanges of today are confusing, can make price discovery almost impossible, and heavily favor those who focus on scalping tiny gains over fractions of a second.  At the same time, the Fed has encouraged highly speculative activity at the expense of organic economic activity to a degree that is embarrassing to any central banker with the slightest bit of common sense.  Many investors act as if the Fed will literally make good on any losses that they suffer down to the last penny, like some sort of implicit insurance policy.  Add in China’s incredible debt growth and Japanese QE and you just about have a complete picture.

Bubble has become the default economic scenario because the current system is unsustainable without it, but, of course, downside risks remain enormous when reality inevitably intervenes.  For instance, we point to the stunning drop in mortgage loan originations in recent weeks as our choice for the one piece of anecdotal evidence that flies in the face of conventional “wisdom” this month. At the same time, from what we hear, hedge funds are no longer snapping up houses like they did last year with the Fed’s free money.  That could be a problem for those betting on a real estate recovery.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

While poor results from countless retailers like Staples and restaurants like McDonald’s remind us just how most businesses and consumers are responding to QE, equity market sentiment remains at historically extreme bullish levels.  We could go on for hours about anecdotal evidence like the ebullience in social media and 3-D printing stocks and other signs of euphoria.  We read that even Goldman Sachs has joined the chorus of those, like us, who look at the historic math and simply state that on the key metric of price to sales equities are pushing the envelope.

Last week Dallas Fed President Richard Fisher, who happens to have experience in asset management, unlike many of his colleagues, said:  “I fear that we are feeding imbalances similar to those that played a role in the run-up to the financial crisis. With its massive asset purchases, the Fed is distorting financial markets and creating incentives for managers and market players to take increasing risk, some of which may result in tears. And all this is happening in uncharted territory. We have aided creation of massive excess bank reserves without a clear plan for how to drain them when the time comes.”

He also mentioned that “stock market metrics such as price to projected forward earnings, price-to-sales ratios and market capitalization as a percentage of GDP are at eye-popping levels not seen since the dot-com boom of the late 1990s.”

We agree!

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

We liken the current QE-juiced equity market environment to performance enhancing drug use in Major League Baseball.  First, many market participants believe the Fed’s QE has a steroidal effect when in fact its efforts are but a placebo.  In addition, the fences in the ballparks have been moved in 150 feet or so, but all the signage still indicates that the dimensions from home plate are unchanged.  Meanwhile the pundits can’t stop talking about how many homeruns are being hit and the immense talents of the players. For instance, when we first started in the business, 300,000 new jobs in a monthly BLS employment report was considered good news and 200,000 jobs was needed each month just to keep pace with population growth.  Now, in spite of a larger population in the U.S versus twenty-five years ago, 175,000 jobs are celebrated even when labor force participation is back at the low levels last seen thirty years ago.  Meanwhile, the S&P500 is priced as if the teams (companies) are replete with sluggers who can hit the ball 600 feet as the median stock is valued at the most expensive levels it has been in many decades of data based on price-to-sales.

Longer term treasury, mortgage, and municipal bonds are cheap relative to nominal global economic growth and precious metals (the original money) are cheap relative to the trillions in paper currencies created by the powers-that-be in recent years.  The very things that make the most sense in the current environment are also the most compelling as most market participants follow the bouncing ball of Fed-induced equity levitation that seems like a new national pastime.  We think many are confused (and rightfully so) because of the existence of conflicting elements of both inflation (stocks, art, some real estate, food, energy) and deflation (wages, chain store revenues).  They bizarrely choose equity speculation on a tightrope without the safety net of reasonable valuation because the Fed and the pundits encourage it.

While recent weeks seem to favor the deflationary elements of this milieu as evidenced by soft employment data, company specific news as well as weaker equity markets and stronger bond markets, we would not be surprised if reflation/growth talk continues to show itself into the spring.  Not only does Wall Street always love a “happy days are here again” story, but come March the central banks may have to lean back toward a more dovish posture (if that’s possible) when the data stream remains mostly punk.   Specifically, we expect the “basket case” known as Europe to try to keep animal spirits aloft with some EU leadership policy initiative or another.  Germany’s high court punted on deciding the legality of the ECB’s bond-buying scheme in a timely “see-no-evil” hand-off of responsibility.  Also, Japan’s deciders may feel compelled to make some more noise as 2013’s fireworks fade.  It’s just what deciders do when variances from the script occur.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

Despite the constant noise of the mainstream script, the tug-of-war between central bank reflation and the deflationary effect of extreme global indebtedness is the real story.  We don’t feel compelled to choose sides because our approach to valuations suggests we should be happily agnostic in the inflation/deflation debate.  As is always the case, we are positioned based on bottom-up analysis, but pay significant heed to the big picture.

The market’s primary narrative remains that the Fed can taper QE because growth is so strong due to its own efforts.  In other words, they’re patting themselves on the back for something they really haven’t done.  Also, according to the doctrine of the script, emerging markets like Turkey may look a bit troublesome, Argentina and Brazil may be imploding, and China may finally be facing the downside of a credit bubble, but those issues are contained.  Plus, the weather in the U.S. is completely responsible for any bad news here.  This logic makes us shiver.  An end to the script would be as welcome as an end to winter weather.

We understand their motives, but remain outside the cult.  We wonder what’s in the Kool-Aid most are drinking that twists reality into the pre-approved storyline that supplants the truth and alters perception so completely.  Along those lines, market optimism as expressed by extreme levels of margin debt causes us to wonder if maybe marijuana use was legalized and encouraged on most trading floors last year.  No wonder cannabis-related equities have been hot items driven, we thought, by state-level legislative changes, but maybe other factors are at work as well.

Bad news remains ignored or spun.  More than anything, the 24/7 linkage between the dollar/yen and S&P500 futures reminds us that a massive crowd is on board the market cruise ship with  rough seas ahead.  When the computers decide that it’s time to head to port instead of bidding stocks every quarter-hour of the trading day the passengers will stage a mutiny.

Evidence of deflation and weak growth, often hidden so well under the veil of the script, made itself known recently.  Besides two bad employment report so far in 2014, Amazon’s disappointing revenues (same as most other retailers) seem to make clear that Holiday sales were not commensurate with the S&P500 at 1,850.  Weather is not the only factor when the biggest internet retailer posts disappointing numbers.  Considering it was just reported that real disposable income in the U.S. rose only 0.7% in 2013 (weakest since 2009) and unit labor costs were down 1.3% in the fourth quarter, such retail weakness only makes sense.  Especially when inflation in the stuff most people need to survive is much higher than the government tells us.    Elsewhere, real base wages in Japan hit a sixteen-year low in 2013 in spite of QE efforts there that make our Fed seem lazy.

Apparently, according to our most telling anecdote of economic troubles, even liquor is not selling well in emerging markets as Diageo management informed us.  That helps explain the much discussed tremors in those regions.  Pockets of relative strength remain domestic industrial and commercial real estate markets, but we wonder how long that can continue with final demand for goods so shaky.  For instance, real estate developers are responding to false signals emanating from public equity markets.  Someone might want to tell them that the data of each passing month suggests that the U.S. is over supplied with malls and shopping center square footage.  We recently read that trips to the store are down massively in the last few years, but fearless developers need nothing more than to see rising stock prices to make them want nothing other than to erect a new strip shopping center closer to some yet undiscovered slice of retail spending power.  Clearly they ignore our letters and maybe they know something we don’t, but we think that after twenty years of this gig, we might recognize this sort of massive capital misallocation inspired by the Fed’s easy money.  We suspect that the order book at Boeing is replete with more than a few jet requests predicated on the belief that things just must be really great because CNBC tells all who will listen that internet stocks are surging.

We think it is really quite simple.  Because QE has not helped the real economy in the form of income growth and remains just a “magic trick” favored by hucksters who just don’t know what else to do or talk about, record equity valuations should continue to become suspect on a name by name basis when more companies disappoint in coming quarters as their earnings are reported.  The system remains tenuously stable as government transfer payments are used to placate the masses who are encouraged to further indenture themselves to personal debts which become impossible to service, yet help maintain spending habits.  The Catch 22 is that if money velocity rises and wages begin to reflate, then corporate earnings, profit margins and stocks will come under pressure.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

Twenty years ago, at my prior firm, my portfolio manager partner and I sat across the table from a then recently departed member of the FOMC in the offices of a major brokerage house in New York. He tried to convince us that if the Fed wanted the price of crude oil to be $100 per barrel, then it would be $100.  Because oil was trading at around $25, I was quite skeptical of the possibility that the Fed could pull off such a maneuver.  I vigorously stated my belief that the laws of supply and demand would eventually confound the Fed’s efforts at manipulation.  I also asked why it was wise or desirable for the Fed to exert such control over oil or markets here that were relatively free compared to others across the globe.  After all, the U.S. powers-that-be would not want to travel the road of their then derided Japanese counterparts who had daily attempted to influence securities trading.

The fact that this guy had so badly missed seeing the onset of the 1990-91 recession when he was still on the FOMC caused me to wonder why he was so confident.  He was very animated to the point of being comical in arguing that the Fed had the power to control the price of just about anything.  The conversation went on for thirty minutes or so until my salesmen at the time politely intervened (as any good salesmen feels compelled to do in a somewhat heated situation).   I have thought quite a lot about that incident recently and question just how long the Fed’s current power over equities, which we term “magic,” can last.

We have recently written about the power of the main stream media/Fed script for 2013 and current data and corporate news have further convinced us that we are on to something.  Employment data for December was terrible and many retailers and restaurants had weak Holiday sales based on company comments, yet the pundits are singing “happy days are here again.”  December auto sales were softer as well and inventories are quite high according to the CEO of AutoNation.  The talking heads just blame the weather (we do agree it played a part).  However, the big picture remains the same:  secular weakness from debt burdens continues to dampen growth in a big way.  An S&P 500 over 1,800 is not indicative of an economy susceptible to some ice and rain.  For goodness sakes, the number of people who have left the workforce soared to almost 92 million in the U.S. in 2013.  Yet because the media and the Street stick to a positive storyline, the Fed’s grand QE experiment has pushed equity bullishness to historic extremes in the face of the lowest labor force participation rate in over thirty years.

The dramatic Baltic Dry Index collapse thus far in January seems to indicate global trade remains soft into 2014.  Today we heard this from one of our best sources, Fastenal (FAST), a key player in construction and other industries:

“In Dec 2013 we issued a press release intended to provide an update on the fourth quarter of 2013. This is only the second time, in our 26 years of being a public company, we have taken this step. Our goal is to keep this type of communication very rare. We took this step because our December sales trends were weak, but, more importantly, because our gross margin trends were deteriorating. In the days following our release, our sales and gross margin trends continued to weaken. This weakening was worse than we expected and this created additional drain on our ability to grow earnings.”

Housing is a sector that is supposed to lead the way, yet Wells Fargo and the other major players are enduring a brutal collapse in their mortgage businesses.

My skepticism of Fed power from that meeting twenty years ago has been tested to say the least by the events of 2013.  Last month in this letter we introduced Ben Strong, a once celebrated Fed figure of the 1920’s.  I have often wished his ghost could have been with me on that day long ago in Midtown Manhattan as I debated the wisdom and limits of central bank activism.   Investors of that past era believed Mr. Strong could do no wrong when markets roared as he provided extreme liquidity.  Many behaved as if economic downturns had been eliminated until 1929 arrived and even some of the luminaries of finance suffered devastating losses because they had abandoned discipline.  Suddenly that Ben did not look so bulletproof. But what of our Ben?  Well, if 2008-09 did not make clear the fallibility of the modern Fed, then perhaps nothing will.  For months in 2008, as the housing market came unglued, the accepted wisdom was that Fed accommodation would prevent a market collapse.  It didn’t.

Scott Brown, CFA, Founding Partner

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

Bull markets tend to bring out movies about the world of finance.  However, like the bullish Time magazine cover we have mentioned in recent months, they can be powerful contra-indicators.  For instance, Wall Street came out in 1987 and Boiler Room arrived in 2000, marking critical turning points after significant market surges.  This cycle has brought us a remake of The Great Gatsby (eery timing given our view that we are re-living the 1920’s in many ways) and more recently The Wolf of Wall Street.  We have seen neither, but they reminds us how tightly scripted markets have become, as if the writers, directors, and producers somewhere have a story to tell us each trading day, and boy do they stick to the plot.  Markets in cycles past have had a similar feel, but nothing like today.  Perhaps it is because computer algorithms dominate trading completely and are quite adept at managing prices around the story line 24/7.

We call the current market movie “Mirage.” The script goes like this: the Fed is the heroic protagonist, dropping cash on Wall Street.  The prime beneficiary of QE is the S&P 500.  The Fed creates an illusion of well-being.  Central bankers and policy makers in Europe and Japan wear the white hats too as they play up any signs of growth and promise to do anything they can to support markets.  The private sector and the real economy do not even play “bit” parts.  According to the script, the FOMC, in its infinite brilliance, will stop printing money at the exact perfect time in the distant future and equities will to continue to thrive as rates remain ultra-low.  Villain bonds and precious metals are to be feared because QE might end today and the Fed might actually tighten policy tomorrow.   Please pardon the disconnect between our last two statements because that’s what the markets do every day. It’s a gaping hole in the plot, we know.

The storyline includes no mention of the massive overbuilding in China, which helped corporate profitability in the U.S immensely, or any other factor that was outside of Fed control, like FASB easing mark-to-market rules for banks. The computers relentlessly trade all asset classes in a tight band around this storyline, as if the movie was completely nonfiction.  Huge sums of money are placing identical bets as the herd grows larger, drawn into the engrossing plot.  The intrinsic value of securities is not important, just listen to Bernanke.  How the computers treat asset classes most days is the only thing that matters in this flick. Momentum rules the roost.

By our best measures, this “movie” has pushed equities to all-time high valuations.  Yet apparently many participants feel compelled to buy stocks.  Although some are skeptical of this year’s price move in equities and other risky assets like EU bonds, few seem willing to leave the party just yet.  What strikes us as astounding is that just about every professional believes they can get out the door at just the right time and are even advising investors to do the same.  That doorway will get mighty crowded at some point.

We think we know how the sequel goes.  Tepid growth fades to recession because massive global debts simply cannot be overcome in spite of central banks’ liquidity binge.  Consumers, businesses, and governments are already overly indebted in the U.S. and many other nations, but the powers-that-be attempt to create ever more debt to grow our way out of the chasm.  However, both the desire to borrow and the desire to lend have passed their peaks and additional debt would be quite difficult to service.  It is a “Catch 22” that central bank balance sheet expansion cannot defeat; the critical limit has been reached. According to this script, after a few painful years, only debt restructuring can clear the path for future growth.  To avoid this pain, every country will continue debasing its currency in a “beggar thy neighbor” strategy to repay obligations with cheaper money, but this just leads to more asset bubbles and future crashes.  The sequel will likely include an earnings collapse because of the slowing economy and the unsustainability of current record profit margins.  Stocks should correct, but may just go mostly sideways for years.  High quality bonds should do well in a flight to quality.  Precious metals should rise in a flight to safety, as well as their relative scarcity versus the ever increasing supply of fiat currencies backed by nothing.

If we ever wondered about the long-term impact of QE, we think the cratering of mortgage applications to the lowest levels in twelve year answers the question.  Inman News reported that Trulia’s Chief Economist recently tweeted that “increased mortgage rates — which jumped in the spring over worries that the Fed would dial back its stimulus program — have ‘whacked’ refinance applications, and the housing recovery has been too weak to fill the gap with purchase loans.”  How real was any supposed housing recovery anyway?  It was facilitated by a bunch of hedge funds buying properties and artificially driving up prices in major markets.  For instance, the New York Times quoted a local broker who said “maybe 70 percent of the sales we were seeing were to hedge funds, investors and others taking advantage of what was happening in Brooklyn. Only about 30 percent were actual end users or first-time buyers.”  This is going on all over the country to various degrees and that’s a problem.  What a mirage! Have we learned nothing from the bubble of 2006-2007?

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.