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Tapering Is Now Tightening
David R. Kotok
July 19, 2014

For a long time, as we saw it, tapering and the threat of tapering (as in last year’s taper tantrum) did not constitute tightening. Today we explore why we believe the situation has now changed.

In order to understand why tapering was not tightening initially, we must momentarily set aside all influences on US Treasury note and bond interest rates that fall outside of the Federal Reserve’s program. Pretend for a minute that foreign exchange flows, geopolitical risks, inflation expectations, deflation expectations, sovereign debt biases, preferred habitat buyers, and a million other things are all neutral. They never are, but for this exercise pretend that they are so.

We have observed and commented on QE and the expansion of the Federal Reserve’s balance sheet for several years, as the Fed emphasized intermediate- and long-term maturities as a mechanism by which to absorb the net issuance of US Treasury securities.

Let’s think of it this way. The federal deficit was $1 trillion, and the Fed was buying securities at the rate of $85 billion per month, or approximately $1 trillion yearly. Thus, the Fed purchased the entire amount of issuance that the federal government presented to the market. If all things were otherwise neutral, the market impact was zero. There was no influence to change interest rates; hence they could stay very low.

But in the economic recovery phase, the federal deficit commenced shrinking sooner than the Fed commenced tapering. There reached a point at which the Fed was acquiring more than 100% of the net new issuance of US government securities. At that point, the Fed’s buying activity was withdrawing those securities from holders in the US and around the world. Essentially the Fed was bidding up the price and dropping the yield of those Treasury securities, and it was doing so in the long-duration end of the distribution of those securities.

The Fed has taken the duration of its assets from two years prior to the Lehman-AIG crisis all the way out to six years, which is the present estimate. It is hard to visualize the Fed taking that duration out any farther. There are not enough securities left, even if the Fed continues to roll every security reaching maturity into the longest possible available replacement security. We can conclude that the duration shift, otherwise known as a “twist,” is over. A six-year duration of the Fed’s balance sheet is about all one can reasonably expect them to obtain.

Now the Fed commences the tapering process, incrementally stepping down its purchases of $85 billion per month to lesser amounts. The Fed has said that it will complete that task and reach zero before the end of this year. The target month is October. The current rate of purchases is $35 billion a month, or approximately $400 billion at an annualized run rate.

The federal deficit has declined as well. Because of the shrinkage of the deficit, the run rate of Fed purchases and issuance by the US government are still about the same as the amount of Fed purchases. Before, the balance was $1 trillion issued and $1 trillion absorbed by the Fed. Presently, it is approximately $400 billion issued and $400 billion absorbed by the Fed. The Fed is on a glide path to zero, but the deficit remains a long way from zero. In July, August, September, and October of this year, for the first time, the net issuance of US government securities will exceed the absorption by the Fed as it tapers.

The process of tapering is a gradual one that has been discussed by Fed officials continuously, and it is clear that, in the absence of some extreme reaction, they are going to sustain this path. What does that mean?

By autumn, we will see issuance of US government securities at a rate of somewhere close to $400 billion annualized, whereas Fed absorption will be at zero. The Fed will continue to replace its maturities, but that practice will not add duration or supply any stimulus.

In July, August, September, and October, for the first time, the change in rate between what the Fed absorbs and what the Treasury issues will result in a shift. That shift is a tightening.

Will the markets respond to that tightening? We do not know. Have they responded to similar shifts in history? Absolutely. Could the shift be dramatic? We do not know. Could the response be benign? Yes. Could the response increase volatility and intensify market reactions to other events, many of which we have, for the purposes of this discussion, been assumed to be neutral? Absolutely.

We are about to get back to a neutral place. The neutral place means the impact of issuance of debt by the government will again become a significant factor even if the rate is $400 billion per year. The other factors that we listed above and many more that have not been listed here are about to become more direct and substantial influences on interest rates. The reality is that their effects over the last seven years have been dampened by Fed policy.

The effect of Fed policy on US-denominated assets has been to create a continued upward bias in the prices of those assets. Stocks, bonds, real estate, collectibles, and any asset that is sensitive to interest rates have had the benefit of this extraordinary policy for five or six years. That support is coming to an end.

At Cumberland, we have no idea whether the transition will be benign and gradual or abrupt and volatile. There is no way to know. Therefore, we have taken a cash reserve position in our US ETF and US ETF Core accounts. We are maintaining that position as we navigate this transition period of July, August, September, and October. After years of stimulus, we’ve reached a tipping point that remaps the investing landscape in ways we cannot clearly foresee: for the rest of this year, tapering will be tightening.

~~~

David R. Kotok, Chairman and Chief Investment Officer

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When the stock market rose 30 percent in 2013, plenty of fund managers had a triumphant year.

Almost anyone can post good numbers in a bull market, though. It’s like sprinting downhill with the wind at your back: The chances are good that you’ll be pleased with your own performance.

Outperforming most other people consistently, year in and year out, is obviously a much more difficult feat, in any competition. But how rare is it, exactly, for stock market investing?

A new study by S.&P. Dow Jones Indices has some fresh and startling answers. The study, “Does Past Performance Matter? The Persistence Scorecard,” provides new arguments for investing in passively managed index funds — those that merely try to match market returns, not beat them.

Yet it won’t end the debate over active versus passive investing, because it also shows that a small number of active investors do manage to turn in remarkably good streaks for fairly long periods.

The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn’t guarantee future returns.

The S.&P. Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)

The team selected the 25 percent of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

The answer was a vanishingly small number: Just 0.07 percent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.

The study sliced and diced the mutual fund universe in a number of other ways, too, each time finding the same core truth: Very few funds achieved consistent and persistent outperformance. Furthermore, sustained outperformance declined rapidly over time. And the report said, “The data shows a likelihood for the best-performing funds to become the worst-performing funds and vice versa.”

What should investors make of these findings? There is one clear implication, said Keith Loggie, senior director of global research and design at S.&P. Dow Jones Indices.

“It is very difficult for active fund managers to consistently outperform their peers and remain in the top quartile of performance over long periods of time,” he said. “There is no evidence that a fund that outperforms in one period, or even over several consecutive periods, has any greater likelihood than other funds of outperforming in the future.”

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This seems to bolster the case for index-fund investing. After all, if a fund manager with a great year can’t be counted on to outperform other fund managers later, it’s reasonable to ask: Why bother trying to beat the market at all?

A separate series of annual S.&P. Dow Jones studies has found that over extended periods, the average actively managed fund lags the average index fund. All of this may be enough to persuade you to abandon actively managed funds entirely.

But the story is more complex than that: The study also demonstrates that active managers can actually beat the market. Remember those two funds that did so consistently over the five years through March? The study didn’t identify them, but at my request Mr. Loggie did.

They were the Hodges Small Cap fund and the AMG SouthernSun Small Cap fund, which were also the top two general domestic funds over the last five years through June, according to Morningstar performance rankings conducted recently for The New York Times.

Each fund has rewarded shareholders spectacularly, turning a $10,000 investment to $35,000 over those five years, the Morningstar data shows. By contrast, the same investment in a Standard & Poor’s 500-stock index fund would have become more than $23,000. While hardly shabby, that’s not nearly as good.

I called the managers of the two funds. Both had good things to say about index funds, and about their own brand of investing.

Craig Hodges, manager of the family-run Hodges Small Cap fund, said that index funds are fine for many people, but that the intensive scrutiny his team applies to the often-neglected small- and midcap parts of the market should enable the fund to outperform the overall market in the future. “We won’t do it all the time, of course,” he said. “We’ll have bad times. We’ll make mistakes. But over the long run, I think we can keep doing very well.”

Michael W. Cook, the lead manager of the SouthernSun Small Cap fund and the founder of the firm that runs it, had a similarly nuanced view.

Index funds deserve to be core holdings for many investors, he said, and despite his own fund’s exceptional record, it may not be a good choice for everyone.

“One thing you don’t want to do is just read about performance numbers — ours or anybody else’s — and put money into an investment,” he said. “Chasing past returns doesn’t make sense.”

Asset allocation is crucial, Mr. Cook said. Before putting money into a fund like his, he said, ask yourself: Do you really need more small-cap stocks in your portfolio? These smaller companies can be volatile, and they may well decline in price. Janet L. Yellen, the Federal Reserve chairwoman, warned last week of “stretched” valuations for small-cap stocks.

That said, Mr. Cook spoke with the conviction of a true believer about patient, shoe-leather stock-picking discipline. He looks to buy shares in “businesses that we can own for a lifetime,” he said. “We spend a lot of time understanding businesses we buy. And we keep checking them and their competitors and their industries. We need to really understand them.”

Mr. Cook has closed his fund to new investors so that he can maintain control over the portfolio’s quality, he said. If the fund eventually reopens, and you want to consider investing in it, he said, “You shouldn’t expect that we’ll perform at the very top every quarter — we won’t do that, I’m pretty sure.” He said that he was happy about the last five years, but that they didn’t prove much.

Over the long haul, which is probably 50 years or more, he said, he will look back at his fund’s track record, and he hopes he will be able to conclude: “We had a good approach. We worked hard and we did well for investors.”

In the meantime, though, past performance doesn’t guarantee future returns.

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inflection-points

Always interesting to see where the market is relative to itself. It would be hard to be a first time buyer here [if buying SPY]. I am a partial seller of already existing positions.

Rev Beat Rate Q214

Revenue growth, rather than EPS, is probably more informative in this easy money environment. The data is only for 1 week [so far].

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NEW YORK (TheStreet) — Codexis (CDXS_) soared to a 52-week high of $2.65 on Tuesday after the biocatalyst developer announced a technology licensing agreement with GlaxoSmithKline (GSK_).

The deal grants GlaxoSmithKline a license to use Codexis’ CodeEvolver protein engineering platform technology to develop enzymes to help manufacture its pharmaceutical and health care products. GSK can also use it to create new therapeutic, diagnostic and prophylactic products.

Codexis can receive up to $25 million in approximately the next two years, $6 million up front and the other $19 million “subject to satisfactory completion of technology transfer milestones,” according to the agreement. Codexis can also receive additional milestone payments of $5.75 million to $38.5 million per project “based on GSK’s successful application of the licensed technology.” Finally, Codexis is eligible for royalties from net sales of some GSK products developed with CodeEvolver.

My perennial underperformer might just catch fire.

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Last word, though, goes to Dr Doom himself — investor Marc Faber, editor of the Gloom, Boom and Doom report, who declared a few days ago to CNBC: “I think it’s a colossal bubble in all asset prices, and eventually it will burst, and maybe it has begun to burst already.”

This market continues to be hated. That in of itself almost mandates that it goes higher still. However with monetary policy looking to change, the one direction nature of the market will end.

QE will be history by October. Interest rates are supposedly going to remain low pending economic data – the unemployment metric is no longer the variable.

Markets can rise into a rising rate environment – at least for a time. The changeover point [as most things in markets] is not that defined. Therefore, as always, you need to have a strategy of staying in stocks, taking profits, standing ready to buy not the dips, but the bottom. Buying dips in a falling market is a bad strategy.

These two charts illustrate the current divide.

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Flippe-floppe’s oscillator. Like any oscillator, the deeper pullbacks are [i] more reliable in a bull market and [ii] are more profitable, assuming you sell at some point, to re-enter.

ppt1

Wage inflation starting to rise. Notice the correlation to interest rates.

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gimo

Just starting to have a look at the fundamentals of this company. Nothing to do with the fundamentals, but look at that technical divergence.

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