Category Archives: Freezing Assets Shout Out

Dorothy, Oz and the Fed.

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Like most people on the planet, I enjoy watching the “Wizard of Oz” (featuring Minnesota native Judy Garland). One of my favorite parts of the movie was when Dorothy pulls back the curtain and discovers that the Great and Powerful Oz is just another one of us and has no supernatural powers. Perhaps this is what investors are thinking to themselves after Fed’s press event last week and how the Fed ending more quantitative aspects of its guidance, which could change the whole “Fed Watch” tone of market of the past few years.

Quantitative guidance I believe had a role for a while; especially during the depths of the crisis and early part of the recovery. The liquidity I thought was truly beneficial and on the qualitative side it gave investors at least the veneer that centralized experts could manage the economy and get us out of the mess.  More recently however it seems that instead of analyzing companies, investors were hyper-analyzing Fed statements and playing guessing games on how the Fed might respond to new data—as measured in recently printed dollars. Thus it felt like we were constantly on the “where will the newly minted dollars go, to growth stocks of course” treadmill.

Now it seems as though the Fed is in the same situation as the rest of us; there no longer is a “formula” to drive our actions. Everything is now data dependent. We now as investors need to view new information about the market and the economy objectively and in conjunction with our individual holdings (or potential holdings), not as some vehicle that can quantitatively drive a certain measure of new liquidity and the beneficiaries of that liquidity. Hopefully, this leads to a situation where we all need to not pay as much attention to that man (now woman) behind the curtain and that we can get back to a stock picker’s market.

(Supply) Chains Keep Us Together

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The Ukrainian crisis is still underway, which got us to thinking about event-driven investing. That and yucca, which I was told was traditional Ukrainian drink. It is mixed in a large communal vessel and then passed to each participant. I tried it with friends a while back and it’s worth the effort—if you aren’t going anywhere for a while. As I mentioned in my last post, I am not a big fan of short-term trades. Having said that, my opinion is that there are investable ideas that come from an unexpected change in world events such as the one in the Ukraine; if one is willing to look deeply into the potential effect on input costs and supply chains.

Using the Ukraine as an example it, and former Soviet Union countries in general, is one of the few places outside of North America that has large scale, and long established, mechanized farming; a left-over from the collectivized farms under Communism. This is one reason the Ukraine is one of the most important grain export countries in the world. Unfortunately for the Ukraine it not only might have lost access to Crimean ports via the recent referendum, many ports on the Black Sea that were not affected by the referendum often have a notable Russian ethnic presence. How this might impact future Ukrainian grain supplies and/or exports via the Black Sea is yet to be seen, but it appears that this has had somewhat of an impact on grain prices as of this writing (California’s drought also likely played a role).

Can an investor find short term opportunities in these situations? I think it is very hard not only due to high frequency trading and artificial intelligence, but also due to corporate hedging. Most companies that have high exposures to commodities hedge their exposures, often for several months out. However after a period of time those hedges expire and need to be rolled over and reflect the new, usually higher, commodity prices. It can difficult for an investor to pinpoint when that might have an impact on earnings estimates, but eventually it should occur in the out years if prices are still elevated.

Additionally uncertainty in supply due to unexpected events can cause companies to reassess supply chains and adjust their sources accordingly. The financial impact depends on a number of factors such as existing worldwide commodity stocks, existing inventories at a particular company, logistical concerns, if a substitute can be used in place of that particular commodity, and the like. It can take time to determine if and when any of these factors, combined or in tandem, have an impact on a company’s costs.

Therefore disruptions in supplies and increased commodity costs might not have a visible effect on margins for several quarters, if at all. Using our example of the Ukrainian Crisis, we might not see grain prices impacts (assuming sustained higher prices) on reported earnings numbers of companies that use those grains this year due to hedging and supply chain factors. However there might be an impact in the out-years that may not be reflected in estimates. Taking advantage of that potential discrepancy may take more time, patience, and research than many investors are willing to undertake. Herein lays the opportunity.

In the meantime do your analysis, be patient, mix up a big batch of yucca, and pass it my way.

Bring Back the Vinyl

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Back in the day when we liked a song we would buy things called albums or CDs. This, for an 80’s era teen, was a risk when disks were $9-$14, so we had to determine if we could live with the album to justify the cost. Fast forward to today it costs $0.99 for one song you know you already like, at least at the moment. However, with songs becoming more commoditized due to so many downloadable options, musical trends can change so quickly that your “cheap” purchase could be a waste of money.

This reminds us of the equity market today. With artificial intelligence and high frequency trading becoming such an important part of market volume (approximately 50-70%) and quote activity (perhaps as high as 90%+), it has had a notable downward impact on average holding periods and likely impacting market volatility, an extreme example being the “flash crash”.  This makes me tell myself every day when I enter the office “chances are I am not trading with humans, but with algorithms and I have no idea how those algorithms are structured.”

Therefore, I tend to do far less short-term trades of individual securities than I once did because of investment horizon risk. Because of these algorithms, my belief is that my risk/reward tradeoff may be neutralized by a computer that can establish correlations and execute risk arbitrage strategies more often, more accurately, and much more quickly than I could ever imagine. This in my opinion adds an element of risk that was not there before. Namely the impact of algorithms impacting market moves more than I anticipate during my investment horizon.

But what about valuation, doesn’t it matter even in shorter-term trades? Yes I believe it does, but likely beyond the investment horizon of my trade. By definition a trade is a very short term holding. It is not an investment. By the time the market does adjust itself, the time horizon for my trade may have passed and I could be stuck with negative alpha longer than planned.

Therefore, like me buying a song that I enjoy for the moment but quickly becoming a thing that takes up bytes on my IPod, short term trading in my view is riskier than it once was due to computerized trading algorithms. That’s why I tend to gravitate to names that I can live with longer than a moment—like my Elvis Costello records.

SWEEEEEEPPPPPP HAAAARRRDDD!!!!!!!

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Originally we were going to write about a disappointing Chinese PMI in conjunction with an improving US manufacturing situation and their macro ramifications, but watching Olympic curling changed our mind. Why? Because curling made me think about how investors may respond to changing macro conditions.

Unlike other ice sports, Curling does not have a Zamboni cleaning the ice between periods (i.e. ends). Therefore ice conditions change during a match affecting the stone’s speed and curl (direction). While changes in the ice are noticeable (often dramatically so) as the match progresses, this is just part of the game. As a result you try to predict how a shot will react in a particular condition. However, strategy—looking for opportunities for good stone placements—never changes.

This is a lot like investing.  There are a lot of changes to the macro playing field occurring constantly; but we usually have no idea to what extent those changes will impact the market in aggregate. Therefore how do we investors adapt to all these changing crosscurrents on our playing field? By ignoring them in the macro and paying close attention to them in the micro. It’s exceptionally hard to predict what a decelerating Chinese manufacturing situation may do to the US economy, but it is far easier to adjust one’s earnings estimates for companies that do or wish to do business in China, such as Emerson Electric, Yum Brands or Apple. If those estimates end up being outside your risk tolerance you can adjust your positions in those names accordingly, likely leading to aggregate changes in your portfolio that reflect these changed circumstances. This often leads to a better decision making process than a top down approach–trying to divine how a perceived macro change will impact a portfolio. Therefore I’ll leave the dramatic macro calls to the talking heads on financial networks.

So like curling, its better that we pay attention to our portfolios one shot at a time than trying to predict how playing conditions will alter the game in total. Conditions in curling ice, and markets, do change but you can make adjustments to your “game” so your tactics change but not your goal—making good shots.

Whether or Not Weather Matters

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Last week January retail sales numbers were released and were below consensus. Some market prognosticators pointed toward bad weather as a factor in the retail sales drop. There is no doubt we have had a tough winter, but are severe weather events enough to change investor strategy?  I don’t think it does.

Why? Part of it perhaps is the media strongly reacting whenever there is a notable weather event in the Northeast, where most reporters reside. This may have an impact on how data is analyzed by investors in the short-term as a good portion of which also live in that region. Plus with weather becoming more of scientific debate with points/counterpoints surrounding global warming, adverse weather often gets more ink than it once did.

Being a Midwesterner, I have always been astounded at the attention that weather events in the Northeast get, especially when it pertains to snowfall. The fact of the matter is that while we in the Midwest get on average more inches snow in total per year, certain major cities in the Northeast usually get on average more large snow accumulation days per year than certain major cities in the Midwest.

Considering the Northeast does get on average many sizable snowstorms, conceptually the market should discount a range of potential severe weather events as many typically happen each year. However this winter arguably has seen worse weather than most, especially here in Minnesota, and some companies have guided numbers down due to weather. But there is also some danger into looking too closely at weather related data points, especially since there were also a large number of consumer discretionary companies that did not guide down due to snowstorms. Additionally, many would say retail sales were somewhat lackluster before January and internet sales, which are arguably weather independent, were also not as robust as earlier months.

But what about truly significant weather events like Hurricane Sandy? Don’t they have an impact on retail sales? Perhaps in the short run, but looking at the chart below one can argue that statistically significant changes in retail sales correspond more toward economic cycles and events (e.g. dot com bust in 2001 and 2008-9 financial crisis) than any weather event in particular.

Data source: US Census Bureau

Therefore I usually figure I am better off from an investment strategy standpoint determining valuations of retail companies, where we are in the cycle, and trying to discern retail trends than trying to predict short-term weather impacts.

Or perhaps as one famous Minnesotan, Bob Dylan, put it “You don’t need a weatherman to know which way the wind blows.”