Balanced Funds Strategy Update

With all the cross-currents in the market, extended valuations and the narrowing breadth of the overall advance we have started making some adjustments to our strategy to mitigate some of the downside risks from the high growth sectors as well as get some exposure to some of the laggards that we might see playing a bit of ‘catch up’.  The bottom line is that we think we have pushed the envelope a bit too far on the growth/low interest trade and have made some shifts into value stocks, taken profits on a large portion of our technology and utility positions and reduced bond exposure.  On the other side we’ve added some cyclical exposures (Nutrien, Teck Resources, Martinrea, Tourmaline Energy, BMO, Manulife and CIBC in Canada.   In the U.S. we maintain holdings in the semi-conductor stocks and added some financials (Citi, Bank of America) as well as industrials such as 3M.    We still expect gold to do well over the next few years as real interest rates will stay low, the U.S. dollar continues to weaken and inflation is actually starting to rise a bit.  We have reduced our gold positions a bit, though, as we are concerned that they have run too far, too fast and could see a pullback in the short term.  We still have about a 5-6% position in the sector and would add to that on any pronounced weakness, as we see this upward move in precious metals as a longer-term move. 

Updated Hedge Fund Strategy

While taking profits on growth stocks we have started to short sell some growth and tech indices (IWF and QQQE) as well as shorting the U.S. long bond ETF (TLT) as a play on the potential for rising interest rates at the longer end of the yield curve.  We also lightened a bit on our gold/silver holdings for the same reason and added some long exposure in industrial/cyclical stocks and financials as well as some value indices in the U.S. (Russell 2000 Value ETF; IWD)

The premise of our logic for the strategy adjustments is not as much that we believe in any ‘V-shaped’ recovery, although we have to admit some of the data we’re seeing out of Europe and China has been surprisingly strong.  But we are starting to see some interest rate pressures on the longer end of the yield curve in the U.S. due to the absolute massive amount of borrowing required to be done to fund their fiscal deficits and to offset the capital outflows from a weakening US dollar, as well as downgrade concerns on US credit.   Sure, the Fed will keep short term interest rates at zero ‘ad infinitum’ and will continue to buy up all the corporate and government debt by blowing up their balance sheet.   But we think that the amount of new supply will overwhelm even that amount of buying and that rates further out the curve will start to push higher.  Inflation is also expected to pick up which would push up nominal yields as well.   This is not the type of market that would be able to absorb even the slightest increase in interest rates unless it was accompanied by a substantial pick-up in growth, something we clearly do no see on the horizon.   Growth stocks in particular would be the most susceptible to a sharp pullback on any firming of the interest rate spectrum.  It’s also very important to recognize that these markets have been 100% about money flows, and those have all been to the high growth/safety sectors for a long time.  Any shift from that to more ‘value-oriented’ sector, such as finanicals, could result in major price moves on both sides, out of those high growth stories and into the laggards.  The upward move in gold stocks over the past few months shows how large the response can be when it takes hold in a smaller sector.

One group of stocks that should finally get some traction from this ‘shift to value’, if it indeed occurs, are the financials.  Net income for the banking industry as a whole plunged 70% from a year before to $18.78 billion, according to the FDIC report.  It was up slightly from the first quarter, but both periods represent the lowest quarterly income since early 2010. The profits are skewed by the big four banks, JPMorgan, Bank of America, Citigroup and Wells Fargo, which make up roughly half the drop.  Although actual credit losses will start to pile up in the next few quarters, we think that the massive provisions put in place during the last two quarters by the banks could prove more than sufficient to absorb those losses.  The chart below shows provisions for the three largest banks in the most recent quarter exceeded those during the worst quarter of the Financial Crisis.  We would also note though, that those peak provisions came in the first quarter of 2009, which ended up being when the stock market hit its lowest level.  While losses are only starting to occur and provisions will continue at high levels, we feel that the risk-reward ratio is now skewed to the upside for bank stocks as the worst data now appears to be mostly behind them and yet stocks have not participated in the recovery.

The other, more sobering, message from the banks is as their gauge for the broader economy.  There have signaled they anticipate a longer, deeper recession than they first expected in the spring.  Though much of the economy has held up relatively well, the banks say government stimulus and other temporary reprieves have likely delayed the pain, not overcome it.  Many lenders are bracing for a wave of defaults.  Banks were whacked with the lowest lending margin in the history of the FDIC’s data, which goes back to 1984. The average net interest margin, the difference between what the banks make on loans and pay out on deposits, shrank to 2.81% compared with 3.39% a year ago. The Federal Reserve slashed interest rates to near zero in March, and emergency cuts hit income faster than the banks could reduce their deposit costs.

Finally, we aren’t betting against Tesla in our Hedge Fund yet, as that has been a dangerous and disastrous idea for a long time, as Tesla stock has gained more than 800% over the past year.  But there will come a time to make the bet against this stock and we wonder it the optimism over the upcoming stock split might present that opportunity.  We certainly do see froth in its shares versus the rest of the auto sector with Tesla valued at roughly $1 million per vehicle delivered while General Motors, on the other hand, is valued at less than $10,000 per car delivered, less than 1/100th of Tesla’s valuation!  Moreover, without incentives and grants, Tesla is still not profitable on an operating basis.  All the other major manufacturers are in the process of rolling out electric vehicles.   While Tesla clearly has the lead at this stage and obvious ‘first-mover advantage,’ we are not as convinced that they can maintain this lead against companies that have been in this business for many decades.   At the very least, the other auto companies should receive some valuations for their electric car businesses within the total company.  That alone would make a ‘long GM/short Tesla’ trade a profitable one.  But like all else in the investment world, “timing is everything!”

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