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Investing in Large-Cap Stocks:Rafael Resendes Interview Wall Street Transcript (PDF)
Since our last letter, there has been so much economic and political news that it is not really feasible to discuss each item as we typically do and try to frame it in a market context. However, there are a couple of interesting observations we will share. The first concerns the mid-term elections. All indications point to a fairly substantial Republican victory. Some pundits such as Dick Morris suggest that Republicans will likely gain control of the House and Senate. Whether you are a Democrat or Republican, most people tend to agree that divided Executive and Legislative branches of government tend to be a good thing. While no one likes to accommodate an adversary, the risk-averse nature of our elected officials tends to make it very difficult for one controlling party to get anything done when they have to face full responsibility for their actions. Thus a divided government tends to lead to better compromises during times of crisis or inaction. Both tend to be favorable to the deal making and lobbyist bonanzas that tend to result from one party running the entire show. Most recently, we witnessed unsavory deals cut to ensure the passage of President Obama's health care bill; previously we witnessed similar tactics when Republicans controlled both branches of government. During the past 20 years, the result of one party taking over the legislature from the other is mixed. It resulted in balanced budgets for President Clinton and Speaker Gingrich, but was an ineffective partisanship for President Bush and Speaker Pelosi. It may be that since Clinton was in his first term, he had a greater incentive to work with Congress than Bush, who was more or less a lame duck by mid-terms during his second term.
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This election will be particularly interesting, as the general theme by Republicans has morphed from national security to more limited government and fiscal responsibility. Given that the tax code will automatically change in 2011, with taxes increasing across the board, a change in Congress may sway President Obama to change his stance on tax increases as well as the high government spending rate. From a market perspective, both would be positives. The latter issue has become very topical lately, as Paul Krugman and Niall Ferguson have gone at each other in the media lately over the need for additional government stimulus or fiscal restraint. Germany has sided with governmental restraint, calling a play from the Ronald Reagan playbook and insisting on cutting taxes rather than increasing government spending to get the German economy moving. In the UK, newly elected PM David Cameron is also in the cutting spending camp, and after informally polling various cab drivers, he seems to have broader support than the small election margin suggested that put him in office. Thus it will be very interesting to see how US policy evolves during the election season. As summer winds down, this will gain traction in the media and the likely showdown will frame government actions for the next two years and possibly be the driving issue for the next Presidential election. Dr. Victor Canto made a great point at our conference, that if the government just let compound growth work, our deficits and debt will become manageable. In other words, just limit government growth to inflation plus the population growth and our national financial problems will take care of themselves. Obviously, this is easier said than done, much as everyone knows they only need to exercise 60 minutes a day to ensure a healthy life "“ knowing and doing it are two very different things. However, we hope the election brings about a new sense of fiscal responsibility in Washington, which will allow markets to focus on creating value, destroying inefficient firms, funding new ideas, and in the process reduce unemployment and create the growth required to grow the tax base to fund our national debts. One can always hope "“ right? The Congressional races will be very much worth tracking in the months ahead to understand if new change is on the way.
Lastly, we will touch on the current economy. During the 2009 AFG conference, everyone seemed obsessed attaching a letter to the economy with - V, W, or L being the most popular. Our perspective was a bit different; we thought it was more of a BOHICA AA economy "“ "Bend Over Here It Comes Again" (BOHICA) "And Again" (AA). So while today people are debating again whether we will double dip or not, we view our current situation as the "And Again" portion of the economy. At the time, the nation seemed committed to a larger and more active government, the Fed had inflated its balance sheet like crazy, and everywhere taxes seemed to be increasing. It does not surprise us that the economy has been so tepid, in fact this has been one of the weakest economic recoveries on record, and when one considers how far we fell, the recovery looks even worse. As many have pointed out, empirically the odds are very much against a double dip. The point is made by David Kelly of JP Morgan who points out that a double dip has only happened once in the last 70 years, in 1982 when Volker was crushing inflation. As with most things, the past matters until it no longer matters. One question is relevant to decide if the past applies to our present circumstances "“ How many times in the past 70 years have taxes increased with a 10% unemployment rate? Since the answer is none, the past is not likely to be a trusty guide to the present. Should taxes increase as currently dictated by law - our opinion is that a double dip is likely "“ add to that a slowing Europe and China and it seems almost inevitable that we have to endure the "And Again" or what is being commonly referred to as a double dip, before a real recovery can take place. Entering 2010, that realization is what shifted our thoughts towards larger stocks and away from the "risk re-inflation" trade that worked so well during the last half of 2009. The jury is still out on the move, but on a relative basis, large cap stocks appear very attractively priced to smaller, riskier names and should offer superior long-term returns. Getting a better handle on the relative attractiveness of large vs. small cap, growth vs. value, economic sectors, and even countries is an important research area we hope to develop and grasp in the months and years ahead.
Specifically answering the question "“ "What area of the market is most attractive today?" has been an ongoing research project at AFG for quite a while. At this year's conference we discussed some new research we are completing that attempts to answer that question across those dimensions:
"¢ Economic Sectors
"¢ Large/Small and Growth/Value
"¢ Country attractiveness
We have been building the systems and models to build up "views" of each of these areas and compare them to one another across various dimensions to try to gain an edge and tilt individual stock picks in a macro direction. Our work so far has identified 4 factors that seem to have explanatory power sifting out winners and losers. They are:
"¢ Valuation
"¢ Economic Margin Change
"¢ Economic Margin Momentum
"¢ Intermediate Price Momentum
While our research is still not finalized, we would like to share the initial results of our US Sector and Country allocation models with you in the coming week. This all goes with the customary disclaimers that apply to in-process R&D, but the results are certainly promising to date. In the next month's market review, we will share the specific styles, sectors, and countries that our models highlight, again with the usual disclaimers that this is still a work in process. We hope to have our work finalized by the middle of the third quarter and able to publish these Strategic Allocation Models (SAMs) to you consistently thereafter.
For the month of Jun (May 28 "“ Jun 30, 2010), the returns are:
AFG Market Perspective - Long Term
AFG Market Perspective - 2 Year
Whats Working - Russell 1000
Whats Working - Russell 2000
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