November 2012 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management's clients. It is reproduced here for informational purposes for the readers of this blog.

Dear Investors,

Tonight the presidential election will finally be over and the markets will have some certainty about who will be in charge of the US government for the next four years. The victor will celebrate, but I’m not sure that he should be so happy to have the job. Whoever is president, the next four years could bring some of the biggest challenges faced by an administration since Roosevelt.

The next president will have to make important decisions about the course of the public debt and deficits, which will determine the health of the American economy for decades to come. In dealing with these issues he will be forced to choose between inflicting short-term pain and risking long-term damage. Politically, neither is palatable, but real leadership requires the former. In his first term, Obama clearly chose the latter, but perhaps without the goal of re-election hanging over his head he can finally push for real change. On the other hand, if Romney is elected he will have to worry about a 2nd term and therefore may find it harder to think longer term than Obama can.

Unfortunately, either candidate will be confronted with these challenges before he’s even sworn into office. The fiscal cliff is rapidly approaching and a decision must be made about how to deal with it. If there isn’t a compromise, then recession is almost certain. If there is a short-term fix (which most expect) then maybe recession is avoided in the immediate term, but probably not for long. It’s highly likely that the next presidential term will face another recession anyways.

Statistically we should be on the lookout for one late next year, and to make matters worse, the next time recession hits, the president probably wont have the same stimulus tools at his disposal as he did in the last one. The odds are that $1T budget deficits and unlimited Quantitative Easing will be central to the cause of the next recession rather than a solution for it.

From a market perspective, next year is an eternity away though. For now, the only thing that most people care about is whether the market will go up or down on Wednesday. It’s easy to make the argument either way no matter who wins. Most market participants aren’t particularly fond of Obama, but they do love Bernanke’s QE policies, which are more likely to continue in an Obama presidency. Alternatively, while more investors would probably prefer Romney for the long term, in the near term uncertainty over QE would be extremely damaging to market sentiment.

Near term, most investors actually aren’t paying attention to a much more important force than the election: QE3 hasn’t technically hit the markets yet. The mortgages that the Fed has purchased take about 60 days to settle, so the first purchases made in mid September will begin to clear next week. Curiously, markets have gone down ever since QE3 was announced, and this is probably at least part of the explanation. We should start to see more of a boost from QE once the trades clear.

That leaves us still with lots of cash but looking to start reinvesting over the next few weeks. That cash served us well in October as markets declined, but I continue to expect the S&P 500 to get somewhere closer to 1450 by year-end. As I mentioned last month, cash becomes a less valuable commodity when the Fed prints more of it.

Scott Krisiloff, CFA

Opinions voiced in the letter should not be viewed as a recommendation of any specific investment. Past performance is not a guarantee or reliable indicator of future results. Investing is subject to risk including loss of principal. Investors should consider the suitability of any investment strategy within the context of their personal portfolio.