SAVE THE DATE! - Before we jump into the markets, we want to invite you to a special event we are hosting where Clyde Kendzierski will be presenting his market outlook and have a Q&A session for all interested.  The gathering will be Wednesday, May 30 at 7pm in Long Beach.  We will have drinks and hors d’oeuvres.  Let me assure you that it will be a fun night where we can hopefully all learn a little bit. 

If you are interested in attending, please RSVP to Christopher Kendzierski at  This e-mail address is being protected from spambots. You need JavaScript enabled to view it  by Monday, May 7 so that we can ensure we have the capacity to accommodate everyone who would like to join us.  We expect to have a large capacity so feel free to invite your family, friends, neighbors, or anyone else you think might be interested!  It should prove to be an interesting night!

The Fed revealed its own April Fools trick in the form of minutes from the March meeting.  Two days earlier, the stock, bond, and precious metals markets all remained confident that Bernanke & Co. would provide an endless supply of liquidity.  April Fools!  Now it is clear that further stimulus is dependent upon evidence that the economy is once again at risk of re-entering recession.  Even the perma-doves like Janet Yellen, who expect rates to remain extraordinarily low through 2014, acknowledge rates should rise if the economic data justify it.

Bernanke's original quantitative easing (QE1) was exactly the right response to the liquidity crisis a few years ago.  Yields on US Government debt were a lot higher than nominal GDP, which went negative in 2009.  Unfortunately, the success of QE1 encouraged the Fed to do more in the form of QE2.  Much like a decade earlier (following the bursting of the tech bubble), the Fed provided critical fuel for the subsequent housing bubble.  That bubble in turn triggered the liquidity crisis, necessitating QE1 etc, etc. You know the story.  Forgive me if I sound a little like Ron Paul…The inflationary bill for the short-term boost provided by QE2 won’t come due for a year or two, but it will come.

Proving that even a blind squirrel gets an acorn occasionally, the Fed has not compounded the error with QE3.  They did however embark on something at year-end called “Operation Twist”.  Unlike QE, which is the equivalent of printing money, Operation Twist is the equivalent of taking money out of one pocket (raising short term interest rates) and putting it in the other pocket (reducing long term interest rates).  By itself, Operation Twist provides no inflationary fuel (there’s plenty of that already).  Instead, this particular effort was aimed at lowering mortgage rates.  Like QE1 this has been successful in addressing a specific problem.  Prior to Operation Twist, mortgage rates remained stubbornly high relative to TBond yields, although nominally at record lows.  That gap has now been reduced to more normal levels spurring activity in the housing sector.  It has largely gone unnoticed that both short term (1 year Libor) and long term (20-30 yr TBond) yields have trended higher since last September. A still accommodative but less aggressive Fed has taken it’s toll on gold prices (which have trended down since last September).

The recently released minutes provide some hope that the Fed is shifting toward the right path, accepting the risk of slower growth, rather than increasing the risks of future stagflation. Even without additional QE, inflation is likely to revert to its long-term norm of 3-3.5% over the next few years.  That kind of inflation is way too high relative to current bond prices, and way too low relative to the price of gold.  Unfortunately investors stung by the stock market twice in the last decade have continued to shift into bonds and gold.  These assets, whose prices have risen dramatically over the last few years, are now as overvalued as stocks and real estate were before they crashed.  Retail investors have found yet another opportunity to get their clocks cleaned.

The concentration of retail money in bonds and money market funds (rather than stocks) has deluded many analysts into fantasizing about the pool of assets on the sidelines ready to fuel a huge stock market rally.  It is true that big stock rallies traditionally come when retail buyers return to the market at ever-higher prices.  It hasn’t happened this time.  As I have argued for the last few years, the retail investor is not coming back en masse to the stock market for years (possibly decades). The combination of a stock market that has delivered nothing but volatility for a decade, combined with the adverse demographics of baby boomers retiring, make any rush into stocks highly unlikely in the next few years.

Week after week, month after month, stock market volume continues to shrink as retail investors shift more and more money out of stocks into bonds.  Record low trading volume means that a very small number of buyers (or sellers) can move prices dramatically higher (or lower).  Recently, in spite of the retail buyers’ strike, stock prices have risen as portfolio and pension managers recognize the risks in bonds and reallocation has resulted in a little buying.  Insane prices for bonds and precious metals make US stocks the best houses in a bad neighborhood of financial assets.  Stocks feel cheap because the Fed has been buying up bonds (the really bad houses) at high prices.  We even have some (very small) portion of our portfolio in stocks.  Just remember when the neighborhood turns out to be a war zone, even the best house can still be a dangerous place.

The good news is that the US economy is growing and jobs are being created.  The news is good, but not wonderful.  Despite the creation of a couple million jobs in the past year, real (adjusted for inflation) personal income in the US is virtually unchanged from a year ago.  Median Household Income is sitting at a level not seen for 15 years!  Furthermore, personal savings rates as a percentage of disposable income have declined to multi-year lows.  Although, at least some of this additional consumption that is fueling GDP growth may be funded by reduced mortgage payments via refinancing.

Source: US Census Bureau

Source: Bureau of Economic Analysis

Modest growth provides a limited boost to corporate profits.  We must not forget that for the past few years, 50% of the profits in the S&P 500 have come from outside the US.  That half is shrinking as the recession in Europe and the slowdown in China are taking their toll.  Quarterly profits fell about 8% in the final quarter of last year.  Maybe they will rebound a little this quarter, but the percentage of companies warning that their earnings will be lower than previously forecast has risen sharply.  If profits are peaking, stocks, like bonds, are a much better investing idea only at lower prices.

If money leaves gold, bonds and stocks where will it go?  Basically the money is shifting out of financial assets back into the real economy; payrolls, inflation, and reviving home sales add up to big bucks.  That loud sucking sound workers hear is inflation taking money out of their paychecks as the cost of daily living rises much faster than prices overall. 

The recent rental demand for housing has got investors scrambling to purchase moderately priced individual homes.  Homes (including townhouses and condos) are the one investable asset still at reasonable prices.  I can tell you that from my own recent experiences of having multiple condominium deals swooped out from under me that median home prices are as low or lower than at any time in my adult life relative to both rents and average incomes. According to the National Association of Realtors, their Affordability Index recently hit all time highs.  The problem, of course, is that real estate can suck up a huge amount of liquid, investable money when today’s buyers are mostly paying cash.  For those who can get credit, today’s sub 4% mortgage rates make the deal even better.

If you’re not ready to become a landlord, the next best choice is to be patient.  Most investors are rarely comfortable with zero return that cash and short-term instruments offer currently (blinding them to the reality that the alternatives could mean big losses).  We are not like most investors.  Missing some potential short-term gains to avoid significant risk of loss strikes us as a good idea!

We remain comfortable with some money in the bank or money market funds (at least until the prices of stocks, bonds or gold return to earth). The rest of our money is mostly in ultra-short bond and bank loan funds (assets that won’t be hurt by rising interest rates).  If you must own some stocks (as we must), buy stocks that will directly benefit from the rise in prices of single-family properties relative to the price of other assets.  What little money we have in equities is mostly concentrated in bank stocks.  Banks will go up and down with the market, but overall I expect them to lose less and gain more as housing outperforms the rest of the economy.

Some long-time readers have expressed to my staff and myself that they hear this tale from me too often.  How can we make any money when financial assets are always overvalued??  The answer is patience.  The last decade and a half has seen some pretty phenomenal bubbles and extension of price swings to simply crazy levels.

Source: Standard & Poors

Source: Kitco, Financial Solutions Group

Lacking the gift of the Second-Sight, we have no way of predicting just how crazy markets will get.  However, we firmly believe that when we underpay for financial assets that eventually the market will recognize the discount, and as an owner of these assets, we will be rewarded.  In the meantime, we must wait and protect our capital. 

Our long-term performance speaks to the rewards for patience and protection of capital.

*March 24, 2000 thru April 2, 2012 represents two complete stock market cycles.  From the 2000 peak, thru the 2002 trough, to the 2007 peak, thru the 2009 trough and finally back to the 2012 peak.  As we've discussed before, we believe measuring a manager through complete bull and bear markets presents a more fair interpretation of the results.  Aggressive managers will look better in bull markets where conservative managers will look better in bear markets.  A long-term manager should look great at the end of both.  Returns for FSG Diversified Sector Program are presented net of all fees and expenses.  Please see notes regarding performance below.  

As we’ve oft-repeated in these missives, our focus as portfolio managers is risk-based.  Where other managers see dollar signs in their eyes and only then (the good ones at least) identify the risks involved, we scour the investment universe for the risks present across asset classes, and secondly determine where we get paid to take that risk.  It’s a macabre way to live.  Full of skepticism.  But that’s why we live it…So you don’t have to.  It is our job to worry for you.  Recognize however, that our typically conservative posturing does not mean we are perma-bears.  During times of extreme over-valuation, we yell from the rooftops.  But conversely, during periods of extreme under-valuation, we will yell just as loud.  Witness early 2009 when we couldn’t find a truck large enough to back up!  Frankly, I feel we have a similar (not as extreme) situation in single-family real estate now.  In between, we simply manage risk by scaling in and out of positions as the changing landscape warrants.

Clyde Kendzierski