February 2013 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,

So far 2013 has unfolded mostly in line with the expectations voiced in last month’s letter. Valuation, stimulus and sentiment have combined to give the market a generous boost to start the year. The S&P 500 was up 5% in January which, like last year, was the best January since 1997.

In last year’s February letter I pointed out that a good January has historically been a good sign for the rest of the year: “Since 1957 there have been 18 times that the S&P 500 was up 4% or more in January. In those 18 years, the S&P was up an average of 21%, and returned double digits for the full year 17 out of 18 times.” I wrote then that these statistics were encouraging, but that a high single digit to low double digit return was more likely for 2012. This year I am inclined to believe that the S&P 500 could be up 20% at some point mid-year, but it would be surprising to me if it held on to close the year at that level.

It is worth noting that the Dow, which has a longer history than the S&P 500, also shows strong returns in years with a large gain in January. However, 1914, 1929 and 1987 were also all years with big gains in the first month. These years have the unfortunate distinction of being ones in which the Dow had its three worst days in history, all of which came in the last few months of the year. That’s not to say a crash is likely, but it is something to keep in mind should markets become over-extended as the year goes on.

For now, investors aren't spending much time thinking about negative scenarios. As the year started, people were still gloomy about the prospects for 2013, but one month into the year the mood has gotten much more optimistic much faster than I expected. Signs of optimism are numerous: flows into equity funds were the largest in a decade, negative economic reports have had little effect on the market, the Euro has recovered back to €/$1.35, and even the US Congress is getting the benefit of the doubt. After years of constant crisis people seem ready to take risks again, including CEO's, who have been very upbeat on recent conference calls.

When investors become this bullish, it means that it’s important to act cautiously. Rapidly rising prices are warning signs that price insensitive investors have entered the markets. They bring with them the opportunity to sell at higher than reasonable prices, but also introduce added volatility.

This is an uncomfortable circumstance for investors who are price sensitive, but it’s not yet time to sound the alarms for two principal reasons. 1) Valuation is becoming stretched but not necessarily extreme. My work at the individual stock level suggests that the average stock could rise another 20% before valuation makes no logical sense. 2) I suspect that most of the new found bulls are really bears in bull clothing ready to turn on the market at a moment’s notice. We’re not quite at the level where there is unanimous belief in the bull, which is typically the final phase of a bull market.

Still, such positive sentiment does increase the chances that there could be short term pullbacks over the next few weeks and months. Markets never rise in a straight line and so mild corrections are within normal expectations. Absent unique opportunities, we are unlikely to be large buyers of stocks for the time being. We continue to be happy to sell at the right prices.

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.

January 2013 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,

2012 was a good year for the stock market, although that’s probably surprising news to many casual observers. The S&P 500 finished the year up 13.4% before dividends, which is a few percent better than the median return of the last 50 years. Last January I wrote that a double digit return from the market would not be surprising in 2012 based on cheap valuations and the timing of a typical economic cycle. Indeed that’s what ended up happening: stocks went from slightly cheap to slightly expensive and the economic cycle continued to provide a favorable tailwind.

The economy and markets continue to recover at a pace which is mostly consistent with past cycles. Nominal GDP grew at a robust 5.5% in the 3rd quarter and even unemployment is falling at a pace in line with historical averages. Likewise, since 2009 the S&P 500 has almost exactly tracked its rise from 2003 to 2007. Charts of the S&P from 2003, 2004, 2005 and 2006 look almost identical to charts from 2009, 2010, 2011 and 2012, and 2012 ended just 3 points from where 2006 did.

Assuming that the cycle continues to track historical norms, 2013 begins in an interesting spot. As I have written before, the average length of an economic expansion is 42 months overall and 59 months in the post-war era. The current expansion turned 42 as of the end of the year, so we’re just approaching the point where a recession would not be abnormal. Despite several scares in the past few years, the odds of a recession have actually been quite low up until now but are starting to increase. For the first time this cycle, I wouldn’t be surprised to see hints of a recession start to pop up in 2013. However I think it would be more likely to see these signs in the second half of the year if they come at all.

If we do start to get some hints of recession it’s likely that they will be faint at first and largely ignored by the broader markets—gradually building steam over time. Fixed income markets are most likely to be at the epicenter of any recession, because investors have poured money into “safe” assets and pushed interest rates to levels that are unpalatable to any rational investor. So for the fifth year in a row I will be predicting rising interest rates in 2013. Let’s see if I can maintain a perfect track record in this regard: 0/5.

Setting aside concerns of a future recession, I am actually starting 2013 as one of the more bullish people that I know. Recessions typically don’t happen when people are cautious, as they are today; they happen when caution is thrown to the wind and valuations become extreme. Although multiples have expanded, there is still precedent for them to go higher, especially when combined with an overwhelming amount of government stimulus. Whereas last year 1450 was the maximum level that I believed the market could reasonably bear, this year 1650 seems possible to me, and privately I would be willing to admit that I would not be surprised to see a number much higher than that. In 2013 caution, valuation and stimulus could create a potent cocktail for equities.

So, after reinvesting most of our cash in November, we continue to take a favorable view of equities generally. As always, we stand ready to sell at the margin when our individual holdings reach our price levels and are happy to buy where we find bargains. Cheers to a happy and healthy 2013!

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.

December 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,

November was the wildest month for equity markets since…last November. The S&P 500 was down as much as 5% mid-month, but managed to finish slightly positive thanks to a late month rally. One might recall that this is nearly identical to the trading pattern of November 2011, when the S&P 500 was down by 7.5% mid month, but finished down only slightly. That reversal was the beginning of a five-month-20%-rally for stocks. Let’s hope that the pattern continues to hold.

Certainly there are plenty of reasons why we shouldn't have a repeat of last year though: the fiscal cliff hangs over the market, earnings growth has been slowing, Europe is still unresolved and China has lost some of its shine. But there was lots of gloom this time last year too, and that didn't impede a big rally. As I've written before, one of the only things I can guarantee investors is that the market will swing between times of extreme optimism and extreme pessimism. Counterintuitively, pessimism is actually what tends to propel the market higher, because when people become so focused on what’s wrong with the world it creates an opportunity for known problems to be solved rather than new problems created.

Right now the problem that everyone is focused on is the fiscal cliff. For most of the year I have focused on this problem as well, but after further analysis I’m glad to write that I think the cliff could be more manageable than the market currently expects. Ultimately the cliff itself is a bit of a red herring because the alternative to the cliff is a compromise, which means higher taxes and lower spending (just like the cliff). Either way there is going to be deficit reduction in 2013. This is “bad” to the extent that it means a removal of short term stimulus, but in the “worst” case circumstance the deficit would be reduced by about $45B per month, which is almost exactly the same amount of money that the Fed will be providing to the economy via QE3. The Fed is doing everything it can to create a monetary cushion to land on in the event that we hurl ourselves over the cliff. In the short term, I think there is a good chance that it could work.

Two caveats: 1) there is a strong possibility that going over the cliff could be so damaging to market psychology that it won’t matter that the alternative wouldn't have been much different. 2) What’s good for the short term is not necessarily good for the long term. Deficits boost the economy today, but both fiscal and monetary stimulus must be reduced at some point. The US economy cannot exist in a state of perpetual economic stimulus, and the true cliff will come when congress addresses entitlements and the Fed stops printing money. Those ideas aren't even currently part of the national dialogue, which is far from positive. The “good” news is that for now market participants will likely continue to ignore the elephant in the room and bid securities prices higher. The bad news is that the more we ignore it, the bigger the elephant will be when we are finally forced to deal with it. Alas, all this is for another day.

In terms of our portfolios, I’m happy with how we are navigating this period. In the middle of last month, we reinvested a sizable portion of our cash position and were able to benefit from the pullback by buying some really good companies at favorable prices. As long as we continue to do this, I feel confident that we can continue to do well in a variety of investment environments.

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.

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.

October 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.

A lot changed in September.

The S&P 500 finished up 2.5% for the month and up 5.5% for the quarter, but if you blinked you may have missed most of the gain because almost all of it happened on two days. On September 6th and September 13th the index rose by a combined 52 points or about 3.7%. Counting that and the 33 point gain that happened on the last day of June, 85 out of the 193 points that we have rallied from the June lows have come on three trading days.

Each of those three days had an important commonality: central bankers drove the market. Back in June, the market rallied when Mario Draghi hinted that the ECB might be working on a new plan to save the Eurozone. On September 6th he rekindled that hope with a pledge to buy an unlimited amount of sovereign bonds if things got worse. Then on September 14th Ben Bernanke outdid him by not just threatening but committing to open ended bond purchases.

This most recent round of easing represents the most radical Fed move yet because it takes money printing from a finite proposition to an infinite one. The Fed has said that it won’t stop printing money until the economy is well into recovery, and has thus given everything it has left to try to stimulate near term economic activity. If this fails the only option remaining is to print even more rapidly or perhaps buy riskier securities.

If the economy reaches Bernanke’s goals, it will likely be in spite of QE3, not because of it. At its most fundamental level, the point of QE is to manage market psychology and awaken Keynes’ “animal spirits.” Bernanke is certainly changing market psychology, but I’m not sure that he is doing so for the better. I have yet to hear a CEO say that he or she is more likely to hire another worker because the Fed has pumped another trillion dollars into the economy. Unfortunately there is zero empirical evidence that money printing can lead to real economic growth. On the other hand, there is plenty of empirical historical evidence that it can lead to inflation.

QE3 creates more inflation risk than either of its predecessors because the economy is not nearly as impaired as it once was. We are no longer in the juicy part of the cycle when economic indicators can slingshot higher as the economy moves from a low level of capacity utilization to a high level. The “V” has occurred, and now earnings are beginning to flat-line. This doesn’t mean that they have to go down, but it does mean that the economy is reaching its potential output. High capacity utilization plus stimulus leads to CPI inflation.

For our portfolios this means that we will be making some significant adjustments before the year is done. In the near term, I continue to expect a market pullback on the realization that earnings growth is slowing, but in the long term, cash is quickly losing its status as a safe harbor, and we hold too much of it. Counter-intuitively, equities are becoming one of the safest assets to hold because earnings will eventually grow with inflation. However, most investors continue to pull money out of equities, which could create the right circumstances for a blast higher if individuals ever felt the need to get back into the market, like if rates started to finally move higher...

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.

September 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,

The beginning of September marks an unofficial end to the summer, and for Wall Street that means it’s time to get back to work. The period that begins with going away in May ends with Labor Day, and the news flow, which slows to a crawl in late August, picks back up in September.

Prices set after Labor Day carry a little more weight than they do in July or August because there’s a sense that everyone is back in the office and the judgment of the market represents the opinions of all investors, not just a sampling of those not on vacation. Therefore, what happens in early September can often set the tone for the rest of the year. If the market gets off with a bang, it can lead to more prolonged rallies. However, a less than exuberant embrace of the markets to start September can lead to extreme late month volatility as investors dash for the exits before year end. This year, there are plenty of reasons that I can see the market tipping either way.

On the one hand, there are still plenty of storm clouds. Europe continues to be a source of discomfort, while China is even more troubling. Official statistics and anecdotal evidence are confirming Chinese weakness, and some are starting to whisper that Chinese GDP growth could be as low as 5% going forward. For many US companies, China had been a centerpiece of future growth plans, and so a slowing Chinese economy poses a greater threat to US stock prices than Europe does. On the bright side the Chinese have already cut rates once and monetary policy does tend to be effective with some lag, so worries about China may be slightly premature.

While international markets show weakness, the US continues to be a relatively brighter spot on the world stage. Economic activity remains sluggish, but so far the consumer isn’t slowing further. Retail sales for the back to school season were extremely encouraging, and best of all housing is showing signs of genuine strength. Over the longer term, I remain skeptical of what housing prices will do in a rising interest rate environment, but in the near term, inventories have finally normalized and pricing is beginning to rise. Psychologically, individual investors still seem much more comfortable investing in real estate than in stocks. At these relative prices, I think that’s misguided, but increased that positive sentiment may produce some near term price appreciation. From an economic standpoint, housing has been the missing piece for the US recovery and so if the housing market returns, we may see a stronger economy yet to come. This includes an employment recovery, which would be a huge surprise to the stock market and could provide a boost to new all time highs.

Between here and there, we still have to contend with plenty of politics, including the presidential election and most importantly the fiscal cliff. How congress handles that problem could make or break the next few months. The most likely scenario is that congress will kick the can down the road again, but with the US congress anything is possible.

Our positioning is mostly unchanged from August: highly conservative cash position, with the expectation that our stock picks will carry our portfolios. A pullback would be more than welcome to give us the opportunity to make purchases at lower prices.

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.

August 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,

Last month the S&P 500 was up by 1.26% and the stock market is almost back to its 2012 highs after a big rally to begin August. Currently the S&P 500 index is just below the 1400 level, which is only 20 points lower than it was before prices began their usual summer swoon. On paper, it has been a good year for equities, but the mood surrounding the market certainly doesn’t reflect the numbers. Most investors remain downbeat.

One reason that the mood is negative is that even though the S&P 500 is up 10% year to date, much of this gain is relative to a generous starting point. The S&P 500 began the year 9% below its highest level from 2011, and so most of this year’s gains have served to recover lost ground from last year. When people look at their account statements it doesn’t feel like anyone has made a whole lot of progress, because compared to this time last year, the index has only risen modestly.

Another part of the negative mood can be attributed to the fact that rising indices are masking some troubling underlying trends in individual securities. July was a brutal month for many stocks that reported earnings. Small earnings misses were penalized with huge declines in market value, while earnings beats didn’t seem to be met with huge increases. This pattern along with ongoing weak market volume suggests that some segments of the market have “gone bid-less” meaning that when sellers are looking to exit a position there just aren’t enough buyers to accommodate them at the prevailing market price. Mutual fund flow data continues to confirm that more individual investors are exiting the equity markets than entering them.

For the indices to be rising, of course there have to be some segments of the market that are doing well though. Prices have been rising in larger, blue chip, more “defensive” names as investors look to avoid volatility. Since these companies tend to be larger, they have an outsized weighting in the indices and thus buoy the index value. However, many of these companies are less likely to be held in an actively managed equity portfolio and so many mangers are watching a much different market than the indexes are implying. CNBC reported this morning that only 13% of active managers are actually outperforming so far this year. This has increased the overall level of skittishness in the market, which can lead to exaggerated moves, both up and down.

Because we are extremely price sensitive investors, the market movement has left us in an interesting position. On the one hand declines in individual stocks have led to some excellent bargains. But on the other, the indices are returning to levels at which I’m not as comfortable committing a larger portion of our cash. As I’ve written before, I think it makes sense to end 2012 somewhere around 1450 on the S&P 500. If anything, July’s data makes me more inclined to think the target should be lower, not higher. Given what I see as an increasingly difficult environment, I took the opportunities created by the market to sell some of our positions and raise extra cash in our portfolios. Especially as the Presidential election begins to come into greater focus, the months ahead could be a bumpy ride.

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.