THE AMPHORA REPORT
Vol 3, 17 January 2012 www.amphora-alpha.com
IN THIS EDITION
HOPE IS NOT A STRATEGY
Financial markets have ushered in 2012 with a collective sigh of relief. 2011, the year of the neverending crises, is over. Although the crises continue, equity markets have risen moderately monthto-date. There is clearly hope that things in 2012 will improve. While hope may not be a strategy, past episodes of misplaced hope are instructive. With specific reference to the early 1930s, as the US Great Depression unfolded, the first quarter was always positive for the stock market. Yet these gains, and more, were given up in the subsequent quarter, and the negative trend continued through the remainder of the year. Thinking specifically about 2012, we can see a number of reasons for caution. However, investors must keep in mind that central banks around the world stand ready to print money in response to deflationary pressures, something missing in the early 1930s. As such, while cash continues to provide liquidity, it fails to provide a reliable store of value.
SOME OBSERVATIONS FROM THE EARLY 1930S Amid an insolvent financial system dependent on central bank money creation (and an implied bail-out) for survival, the US economy today faces structural economic headwinds comparable in key respects to those it faced in the early 1930s. Even the global context is somewhat similar, in that there was a European banking crisis in the early 1930s which, 1 many believe, exacerbated the downturn in the US. As such, it is entirely reasonable to compare contemporary US economic developments to those of the 1930s. It follows that it is also reasonable to compare stock market developments, as these necessarily reflect changing expectations for key economic variables such as growth, inflation and corporate profit margins. It is well known, of course, that the stock market took a pounding in 1930-32, following the initial crash in Q4 1929. Less well known, however, is that in the years 1930-32, January was one of the better months and Q1 was one of the better quarters. The following table presents these statistics: DOW JONES INDUSTRIAL AVERAGE RETURNS
Year January return Monthly average Q1 return Quarterly average
Source: Federal Reserve
1930 2.2% -2.8% 12.3% -7.8%
1931 -1.1% -5.6% 6.9% -15.8%
1932 -1.6% -1.4% 0.7% -1.3%
comes to the current, multi-year, secular bear market, January and Q1 2012 are likely to be positive. For what it is worth, however, history does suggest that we should not take January‟s price action, or that of Q1, as indicative of any sort of trend. Indeed, to the extent that we would take January or Q1 as significant, it would be as a contrary indicator of what to expect for the full year. These observations contradict the conventional wisdom, which holds that January is in fact a reliable indicator of the full-year trend. This is best explained by pointing out that, in most years, the stock market tends to rise. It might not rise strongly, but rise it normally does, and thus a positive January can appear, by association, to point the way. The problem, of course, is two-fold. First, association is not causation. Second, and more worrying, is that when the stock market does have a bad year, it tends to drop rather sharply, sometimes wiping out the gains of multiple previous years, as in the early 1930s, the early 2000s or 2008. And, unfortunately, a positive January is next to useless when it comes to avoiding such declines. If anything, the so-called „January effect‟ is a tempting lure into a bear trap, best avoided by cautious investors. CONTEXTUAL REASONS FOR CAUTION To many, stocks appear cheap. Price-earnings multiples are low, implying high earnings yields; nonfinancial corporate balance sheets are relatively liquid, implying no need to raise funds and dilute shareholders; and there is a huge pool of unemployed workers, constraining wage growth and, by implication, enabling unusually high profit margins. At first glance, therefore, stocks would seem a buy or, at a minimum, fair-value.
Now admittedly this is a small sample of data. I would not for a moment purport to claim that, when it
Americans sometimes treat their Great Depression as an isolated event. It was anything but. Devastated by WWI, continental Europe suffered a series of banking and currency crises in the postwar period. Eventually, in 1931, even the British pound devalued, leaving the dollar as the only gold-backed currency to take the deflationary strain. A wave of US bank failures soon followed.
It makes a huge difference whether one assumes a 4% or 2% trend global real economic growth rate. only that I do not feel that a valuation-based approach to the sector is valid at present. this should be excellent news for corporates looking to expand. there is a huge pool of unemployed and also underemployed workers. Try that with a too-big-to-fail financial firm. normal sign of a healthy economy.
. calculable odds. including the US. This newsletter has consistently made the case that global growth will remain sub-par until a substantial deleveraging of both the private and public sectors has taken place. Not a bad entry point. Developedworld workers‟ share of national income (GDP) is likely to increase significantly from currently depressed levels. the expected return on capital „invested‟—using high school maths and zero economic. As China and other emerging markets become relatively more expensive. it should be rather obvious to all observers at this point that the global economy faces major structural economic headwinds. are subject to the same law of diminishing returns as essentially all economic activity. the global public sector continues to grow its debt pile at an astonishing rate. for example. That will need to wait. First. new jobs are more likely to be created at home. however. it is true that. This is an entirely natural. interest rates are low just about everywhere. More recently. Given the structural headwinds noted above and the leveraged state of US corporations. not global. I would not be at all surprised to see that happen again. what matters to corporations is the marginal cost of labour around the world. The great globalisation profits boom is largely over. When doing so. in the US. there is also one taking place domestically. namely. 17 January 2012 www. At the time. According to available data. In theory. (I have seen one analysis conclude that the financial sector is now so risky for investors that it is simply one big casino. not just in one country. Domestic wage pressures are likely to remain muted even in the event that there is substantial jobs growth in the coming quarters. market. potentially. anecdotal evidence of current wage negotiations.com
Like anything in economics. that wages in the developing world —where most jobs are being created—have been trending rapidly higher in recent years. While no one can predict just how long the deleveraging is going to take. Offshoring benefits for profitability. Just as there is an economic rebalancing now underway globally. As we know. annual wage growth has been in the mid-double-digits since the mid-2000s. There is just no way that productivity gains.) So leaving financials aside. so does the historically elevated level of corporate profit margins. Second. Third. Equity P/E ratios are highly sensitive to large moves in interest rates. What is negative for corporate profit margins generally is perhaps positive for jobs growth in the western economies. including periodic worker strikes. was high in a historical comparison. this is going to impact corporates‟ profit margins. For this discussion. In the age of globalisation. how does context inform valuations at present? There are several things to note. implying elevated corporate leverage.
The problem with this theory is that it is purely domestic.THE AMPHORA REPORT
Vol 3. Here we discover a troubling trend for corporate profitability. Casino games work according to clear. A final observation here has to do with interest rates. suggests that rapid wage growth continues. at 65. while real. That is being kind. must be placed in context. I am not saying financial shares are not attractive here. can compensate for wage growth of this magnitude.amphora-alpha. essentially unchanged.5% in Q3 last year. it is less clear that valuations are attractive. in particular in those economies most in need of deleveraging. political or insider knowledge. Financials‟ balance sheets are now so opaque and the sector so micromanaged by policymakers and regulators that I believe financials have become impossible to value. grow their revenue bases. equity valuations will be the most attractive they have been since at least the early 1980s. Inevitably. the P/E ratio for the broad US stock market fell into the single-digits. higher interest rates weigh on equity market valuations. One can „value‟ a casino game—ie.6%. as deleveraging runs its course and the demand for investment capital again increases. As it ends. and the various positives noted above. The most recent Federal Reserve data shows that this ratio was 65. just because a corporation is liquid does not mean it is not leveraged. stock market valuations. for example. Take China as perhaps the most important example. regulatory. In the early 1980s. Other factors equal. for some of the structural headwinds to abate. Due to compounding effects. as I pointed out in last November‟ s Report (Fighting Solvency Time-Bombs with Liquidity Bazookas). I observed that. it is a stretch to hope that corporates are going to draw substantially on this liquidity in the coming quarters to expand capacity and. however. While there has been modest progress on the former front. one consequence is that. Of course. this means that Chinese wages have doubled over this period. historically associated with wartime spending. when the gentle deleveraging of the late 1970s turned into something rather rougher amid higher interest rates. we are going to leave financials out. These may be stronger in some places than others but enough of global demand is affected and valuation metrics need to be adjusted accordingly. even those that accrue to economies of scale. Europe and Japan. interest rates are going to rise. Global economic rebalancing takes time. the corporate debt to net-worth ratio. should that occur. with outcomes normally distributed. turning to wage growth.
Moreover. thereby pushing up prices. in particular for an investor who thinks in nominal rather than real terms. inflationary policies are not necessarily to be feared. in fact I would prefer an allocation to certain equities. Back in the 1990s and early 2000s. yielding less than 2%. the political winds are blowing that way. “Don‟t fight the Fed. as l ong as corporate profits rise more or less in line with inflation. Adding taxation into the equation implies an ever lower real rate of return. in particular non-financial corporates. Purchasing stocks when the Fed was easing policy and selling when they were tightening was a profitable strategy on average in the 1950s. as a bond bull and dollar bear. when I ran interest rate and currency strategy teams at major global investment banks. I sense
that. I would prefer an allocation to non-financial corporate junk bonds—closely correlated with equities—rather than to government bonds. more often than not. From an equity investor‟s perspective. they do offer better value than either government bonds or cash and should be overweighted in a portfolio limited to these instruments. a 2% yield translates into a negative real rate of return. Beyond a certain point. COMMODITIES AS AN ALTERNATIVE Although I didn‟t plan things this way. shifting the investment demand function for the latter. equities emerge the winner. As we know. as the inflation costs grow. however. given the state of the world. as various countries cut rates and/or peg their currencies. tradeoff) for holding real assets (ie. when the dollar declines as a result of a US-centred asset deflation (eg. offer attractive value here. the fact of the matter is. while serving certain interests. to an allocation to bonds. energy. this merely transfers deflationary pressure from the US to other economies. While inflation may undermine the economy‟s growth potential over time. not just versus the dollar. the capital stock not only ceases to expand. “Don‟t fight the Fed. One by one. by misallocating resources from productive to unproductive uses and also depressing the real savings rate. What is true in theory is also observed in history: Countries with chronically high inflation tend to have lower potential growth rates. specifically. I‟ve acquired a reputation as a commodities bull. in my opinion.” At most times. As such. with gold having the strongest historical 2 claim to this role. It did not. gold still appears to be in an uptrend. more fearful of deflation than inflation.” Now I am under no illusions here. ultimately create more problems than they solve. I had a rather different reputation. as interest rates decline. the Fed has held an inflationary policy bias for decades. in certain countries. And while I believe that higher marginal tax rates on savings are about the worst thing that could be done to a deleveraging economy. given central banks‟ generally inflationary biases. be they other metals. including of course 2011.
. the opportunity cost (ie. Of course this raises the question of whether such limits should apply in the first place. but as seen in the below chart. rather it followed from a series of developments and my analysis thereof. “Don‟t fight inflationary policies. BY Q3. This is not to say that I anticipate an imminent rise in government bond yields. versus all currencies. Within bonds. however. What was only implicit.THE AMPHORA REPORT
Vol 3. So while in real terms equities do not. Q4 2011 was not good for gold. In brief. GOLD WAS LOOKING VERY EXPENSIVE VERSUS OTHER COMMODITIES (JAN 2005=100)
500 450 400
300 250 200
100 50 2005 2006 2007 2008 2009 2010 2011
Source: CME Group
My original research on the relationships between interest rates. While in the previous section I pointed out that equity valuations should be depressed. this has been good advice. commodities and gold was published in 2003 and is available here. Moreover. currencies. I realised that. but begins to consume itself through depreciation (ie.” Inflationary policies. then equity prices can rise alongside.” has meant. 17 January 2012 www. dot-com or housing market debubbling). But the risks of holding government bonds here are asymmetric. including those of the financial sector. in a chronically inflationary environment. My conversion to commodities did not come all at once. inflationadjusted terms continue to rise. became explicit under Fed Chairmen Greenspan and Bernanke. work as well in the 1970s or 2000s.com
DON’T FIGHT CENTRAL BANKS! There is an old adage in US financial circles: “Don‟t fight the Fed. gold has remained in a secular bull market ever since. however. It is important to observe.amphora-alpha. gold was beginning to look extremely expensive versus commodities generally. 1980s and 1990s. commodities) declines. at current rates of inflation. I don‟t. I realised that. Sure enough. or agricultural products. however. but when the choice is constrained to investing in equities versus either cash or bonds. that by Q3 2011. investors find that commodities provide not only an alternative but also superior store of value. central banks in other economies then lower interest rates in response and/or peg their currencies. eschew cash and bonds. This is not to argue that equity prices in real. 1960s. a lack of real savings). Eventually.” translates into specific action: “Buy equities.
a pair of cotton jeans (~8. an investor could do worse than to buy a broadly diversified commodities exchangetraded fund or. common sense.000 litres). in which the gold price is already somewhat elevated relative to consumable commodities. can become relative to those things that we do consume. for those set up to trade futures. notably food. so it also demonstrates that there is a limit to just how expensive gold. Just because it comes out of the tap when you turn it does not mean that it comes cheaply.
.000 litres).amphora-alpha. however. and the commoditiy inputs from which they derive. While I am on no account a „water expert‟ I am well-aware just how much of the stuff goes into a bushel of wheat (~50. the ultimate „non-consumable‟. While there is no magic ratio between gold and everything else. in which the dollar has already declined a long way versus most currencies. straightforward ways to profit. there is. let the markets decide. you could do worse than to build a position in agricultural commodities. While some might be more attractive than others at present. would be to acquire an exposure to water purification and infrastructure firms and facilities in key locations around the world. However. when it comes to consumable commodities. While taken for granted in certain parts of the world. or value. volume. or a large hamburger (~5. I would prefer to be regarded as a „diversification bull‟. yet is not traded on an exchange: fresh water. Although I have acquired a reputation as a commodities bull.THE AMPHORA REPORT
Vol 3. it is a proportionately larger input into agricultural production. That. is to consider the one which is consumed more than any other. 17 January 2012 www. So for investors who believe that there are serious water scarcity issues looming on the horizon and are looking for simple. I would favour diversifying into the latter. THE MOST VALUABLE COMMODITY OF ALL? One final thought. is a topic for another Amphora Report. above which you sell the former to buy the latter. most probably. in a world in which central banks are wedded to inflationary policies. In my view. thereby realising superior diversification benefits. Water is a vital input into life as we know it.com
Just as history demonstrates that inflationary policies favour equities over bonds and favour gold over paper currencies. to spread a position around a handful of commodities with relative low correlations to one another. by weight. It is an input into many industrial processes. in others it is worth its weight in… well. Even better. especially in the quantities and in the locations required to produce much of what we consume. of course.000 litres). of course. clothing and shelter.
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AMPHORA: A lateral-handled ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. Nothing in this report shall be deemed to constitute financial or other professional advice in any way. New York and Germany. This report is produced by us in the United Kingdom and we make no representation that any material contained in this report is appropriate for any other jurisdiction. quantitative strategies. having worked for European and US investment banks in London.amphora-alpha.
JOHN BUTLER john. where he and his team were voted #1 in the Institutional Investor research survey. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences. John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London. tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities. Prior to joining DB in 2007. costs or expenses nor for any loss of profit that results from the content of this report or any material in it or website links or references embedded within it.butler@amphora-alpha. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London. 17 January 2012 www.THE AMPHORA REPORT
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