February 23, 2011
Greetings Clients & Friends,
I wanted to provide a quick update on the recent action in global markets, current events, and the associated effects on Smith Capital client portfolios. Yesterday, on the heels of intensifying unrest across the middle east over the weekend, and with Monday being a market holiday, Tuesday arrived with a bang. From Monday to Tuesday Asian and European stock markets fell hard while oil prices soared over 7%. As a result, U.S. stocks fell across the board, declining around 2% on average, while the volatility index (VIX), which tracks the implied volatility of put options on the market, soared higher by over 25%.
The good news – Smith Capital client portfolios had a fairly good day. Accounts that still have a modest exposure to equities only fell by about 0.5% on average, due to our high cash levels, bond positions and hedge positions. Our more tactical portfolios actually rose for the day, due to high cash levels, hedge positions, strategic bond exposures, and especially due to to our recent positions in crude oil and volatility. Yes, the two asset classes that were up big yesterday – oil and volatility – we had exposure to within a couple of the Smith Capital model portfolios.
As a reminder, over the last couple months I have been communicating to you my growing concern about the sustainability of the recent market rally. In commentaries posted on our website since January I have been outlining why I have been maneuvering toward a more defensive allocation across each of the Smith Capital model portfolios. (Please review those commentaries for a review of my thought process, thesis, and concerns).
Remember, our strategy is quite contrarian, so we look to buy stuff when the masses are selling, fearful and negative, which creates value. On the flip-side, we look to sell stuff when the masses flip over to exuberance, euphoria, complacency, and over-confidence, which creates over-valuation and a disregard for potential risks.
Over the last few weeks the latter has characterized the U.S. and European markets. Investors had grown overly bullish, overly confident, and highly complacent with regard to risk. With markets moving higher, pundits, strategists, and analysts tripping over themselves to raise their forecasts and call for a new bull market, and a guaranteed backstop from the Federal Reserve to prop up stocks, the mantra has become full speed ahead with stock exposure.
In the meantime, Rome burns!!! The equity markets have just brushed off mounting risks from multiple angles, including massive fiscal deficit and debt problems mounting across the globe, massive upheaval around the middle east, and escalating food and commodity inflation that will be disruptive to the global economy.
Hence, I have felt it prudent to move back into the turtle shell a bit, raise cash, and put on some hedges. I have made this clear in several recent commentaries.
One of the big issues I have been analyzing is the fact that as the U.S. stock market marches higher day by day, the risk was mounting that a significant decline would unfold very quickly, which could wipe out several weeks of gains within a few days. This tends to be the nature of the market. When you get into a trend like we have been in, and complacency sets in, the market produces gains over a stretched period. Then, all of a sudden, once everybody is on the same side of the fence, an event occurs to spike up fear and volatility, and everybody heads for the gate at the same time. This typically produces quick, severe declines that are very hard to time perfectly. Hence, our desire to get ahead of the herd.
This is also the reason I recently put on a long volatility position. Over the last few weeks nobody has been concerned about buying “insurance” on their stock exposure, which has driven the cost of that insurance lower, (i.e. the volatility index has been slipping lower and lower). Therefore, we recently added an ETF to certain client portfolios that gives us exposure to the VIX index so that when the fear button gets pushed by the market we already have the insurance in place. This manifested yesterday with the VIX going up 25%, and the associated ETF we own rising 12%. I believe this is just the beginning of these kind of moves, and I will be looking to add to such positions.
As I mentioned, we also recently added a position to crude oil (USO), which I believe will move higher as middle east tensions escalate and the peak oil story starts to spread again. This benefited us yesterday, and should do fairly well over the intermediate-term.
One last quick comment on geo-political risk. We seem to be in the midst of the age of protests! It first began in Europe with the citizenry protesting government austerity measures that have to be imposed to cut back on deficit spending. Now political protests are breaking out around the middle east, which I don’t believe will lead to the utopia of democracy in the middle east. I actually believe it will lead more to radical trends taking hold, culminating in an eventual attack on Israel. This will all be de-stabilizing for the region and the world.
Further, we now have a protest movement taking hold in the U.S. What began in Wisconsin, driven by government employees protesting Wisconsin’s own version of “austerity” measures, is now spreading to over 27 other states across the country. All of this comes down to one simple thing – governments have over-promised and are now facing the consequences of out of control spending and deficits. Regardless of your perspective, the outcome looks daunting. This all has the potential to be disruptive for the fragile recovering economy. It definitely represents a risk that must be factored into our portfolio strategies.
In summary, we remain vigilant to manage risk and take advantage of opportunities we identify in the current environment. As much as our high cash levels may have frustrated some of our clients and even me recently, I sincerely believe it has been the right course of action for each of our clients well-being.
As always, thanks for the opportunity to serve you and your families.
Chad R. Smith
Managing Director