I believe that the market activity of the last two weeks of the 3^rd quarter represents an acquiescence of leading financial institutions to the likelihood of a recession.   A recession is probably two thirds priced into the stock market levels as of October 4th. Several indicators have turned south and the Federal Reserve is out of bullets.  Operation Twist introduced in late September was met with a vote of no confidence from Wall Street as investors sold stocks.

Operation Twist is very simple:  Our government wants to buy the debt of our government.  They want to make and buy longer dated bonds so that whenever our emerging market creditors get nervous we are not quite so reliant upon them. This means that the Federal Reserve is purchasing the debt that our government keeps piling up. It is inflationary. This inflation is of a purely financial nature and has not been reflected in wages.  The global slump means we still have deflation among consumer goods and commodity inflation is material, volatile and overall measured. The Fed and Treasury have effectively coordinated inflation to dilute our creditors.  The Federal Reserve’s ballooning balance sheet appears to be dismissed by the market and thus eventually mispriced.  Quantitative pioneer and Gravity patriarch Sir Isaac Newton took to stock market speculation during his life, after losing money speculating in the South Sea Company stock in the 1720s during the bubble.  "I can calculate the motions of heavenly bodies, but not the madness of people."

 I believe that a recession in this country at this time will be relatively benign on company earnings, despite a favorable probability of occurrence.   Companies are prepared for this double dip.  Companies have reasonable margins, profitability and two trillion dollars in cash coffers.  Companies are also relatively smaller contributors to United States GDP compared to the American consumer and our government. This recession despite all of the sincere efforts of Barrack Obama will be on the backs of Americans.  

The portfolio strategies at work today contain the same themes executed in prior quarters.   We see superior return potential in emerging markets, multi-dimensional inflation protection  and increasingly, a greater focus on companies comprising America's leading industries, such as Apple, Amazon, and Google which have become quite affordable.

 Dividend paying stocks have yields so far in excess of Treasury Notes that we remain willing to take the risk, especially with the support of True Diversification™. Earnings power in sectors like energy, basic materials and telecommunications appear also very robust.

We see the Diversification Optimization™ process delivering on expectations across all equity models.  Our greatest success this quarter was the near perfect timing of a market distress call.  On the evening of the Senate vote to raise the debt ceiling, we advised all clients and relationships to take temporary refuge in cash.  We saw a uniquely anticipatable event with a large imbalance of profit and ruin.  At that point, there was no profit expectation priced into the best scenarios. With the political maelstrom providing even odds of outcomes the loss probability and magnitude was mispriced, especially with a downgrade a real possibility regardless of the Senate’s actions.  Unfortunately, these events came to pass and the market understood nothing more than fear and refuge.

The S&P 500 through 10/4/11 is down approximately 17%, 10% of which we were able to sidestep. We do not fancy ourselves as market timers and would expect years to pass before taking a similar action. 

Though short-lived, the crisis strategy succeeded in safeguarding assets while the general markets plunged. For those relationships having the necessary flexibility we had a crisis model built to replace the standard model. The crisis model was up several points over its two week lifetime.  In retrospect we would of like to have that model live a little longer, but we were compelled to get back in the markets and let our system do its thing. The Crisis model was very successful with one notable exception; we went short Treasury Bonds. It confounds me how investors flocked to the very assets which were just downgraded in attempt to take refuge from risks resulting from that downgrade.  Sir Isaac, I am right there with you.

We have been avoiding Europe since the inception of our company and we do not see that changing now.   While we are avoiding that space in general, there are laser point opportunities we find intriguing, typically these are deep value stocks which have been unfairly punished by the market.    Let’s not forget that sovereign debt issues should have little impact on equities above and beyond currency deprecation unless they have a leveraged balance sheet themselves.

The biggest new idea, and I mean big in the sense of the size of the opportunity not so much in the size of the return potential is land.  With interest rates globally low, inflation menacing and population growing and no foreseeable changes in any of the above factors, land becomes a legitimate opportunity.   We are currently sifting through opportunities for the best vehicles with which to implement this thesis.  This is clearly a longer term opportunity.

We can now buy the next generation of cloud computing, leading innovators and great consumer brands at near unprecedented prices last seen in the early 1980’s.  Cheap interest rates and lots of cash are also catalytic to merger and acquisition activity.  We favor several opportunities in private equity and see other opportunities developing soon among the few surviving investment banks. 

Risk on / risk off is a new Wall Street catch phrase.  I despise it.  Risk on / risk off has been governing market behavior for several weeks.  It is a legacy of antiquated theory that assumes more risk = more return. This is a paradigm which exaggerates market turmoil. It is not a view held at Gravity Capital Partners. We believe that return is a function of having an information advantage.   While we are reluctantly adapting models to the prevalence of risk on / risk off behavior we are not adopting that strategy.  It is a short-term timing strategy at heart, clothed in the darkest corner of dogmatic Nobel Prize theory.

Gravity Capital Partners prefers investment ideas which enable a sustainable performance advantage.  This is the great opportunity for quantitative investment strategies.  Picking stocks day in and day out provides rapidly dissipating opportunities while a quantitative technique can be mined for years.  We are currently researching coordinated rebalancing tactics that, within the context of Diversification Optimization™, can provide a superior mechanism to harvest volatility of an individual asset.  We may begin to see an individual investments’ volatility as an asset, not a liability.

 We are also at one of those junctures in which it behooves me to sincerely recommend that everybody calm down and take a few deep breaths.  Our clients do not need this reminder but since my commentary is typically passed to investors with real jobs, families and non-obsessive interests in quantitative finance, this message is important to you; please relax.  Do-it-yourself investors buy and sell out of emotion at the wrong times.  As such, they wildly under perform traditional benchmarks like the S&P 500.  The whole key to buying low and selling high is buying low and selling high.  It is so important I am almost compelled to repeat myself.  Be greedy when others are fearful and fearful when others are greedy.

The current valuation of the S&P 500 is 11.95 times earnings.   A reversion to trend would bring that multiple to 18-19% with our interest rate environment.  Such a reversion would bring a return on investment of 55%. Fundamentally, stocks are priced on the basis of discounted cash flows.  This equation and its variations are really the only critical mathematics any finance student learns.  The formula for a price of an endless series of cash flows is simply the cash flow payment divided by the interest rate assumed as the cost of capital.   In summer 2011, the Federal Reserve set a historical policy that guaranteed Fed Funds Rates would remain near zero % through summer 2013. In any fraction, the smaller the denominator the greater the value. Here, a low interest rate or discount rate provides for a higher stock valuation. This is the most fundamental equation in finance. 

Can we experience continued deleveraging among banks, households and our government and still benefit from expanding credit that enables wider adoption of attractive low discount rates?  I believe the answer is a timid “yes”.  The price may be inflation, but the political will is there to support it. Your portfolio should too.

In essence, while we seek diversifying investments around the globe the fundamental core stock factor is now favorable even with recession looming.  The value of future earnings streams is priced very cheaply compared to other financial assets, even after accounting for a modest contraction in those earnings streams precipitated by a likely recession.

 

Gravity Capital Partners (GCP) is a unique investment management company which partners with leading wealth management firms to create customized model portfolios based on the software platform and intellectual property developed at Gravity Investments since2000. GCP uses a sophisticated and proprietary system called Gsphere which creates portfolios based on True Diversification®. True Diversification® portfolios are proven to protect capital without sacrificing performance. Gravity holds patents, issued and pending for Diversification Optimization, visualization, measurement, prediction and search technologies.

 

 

 

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www.gravityinvestments.com