Friday, January 7, 2011

2010 in review - Ari Paul

2010 climbed a "wall of worry." We began the year with a growing Eurozone debt crisis and a sharp fall in the value of the Euro; the European Central Bank and IMF came to the rescue with a series of massive bailouts. The big US banks faced new regulations and lawsuits over mortgage fraud, but little came of either. A "flash crash" in May sent the market 9% lower in under an hour, and evidence of a double dip recession showed up in July.
More important than all of this however, was the quantitative easing. The federal reserve launched a new round of quantitative easing in which they bought almost all new treasury issuance and kept long-term interest rates around 3%. This supported an equity market rally of 11%. It also supported a huge run up in commodity prices, including 30% in gold and copper and 36% in agricultural commodities.

The quantitative easing also supported a moderate recovery in economic activity with roughly 3% GDP growth and 3.5% growth in retail sales, although unemployment remains near the highs at 9.6%.

As we reached the end of the year, investor sentiment reached very bullish levels. Mom & pop are still pulling their money from the market, but hedge funds, analysts, and pundits have jumped on the bullish trend with both feet. The equity rally is supported by strong fundamentals from companies. Corporate earnings and growth have been strong and companies are sitting on a growing cash pile. Current valuations look reasonable if US GDP grows about 3% a year going forward, and we avoid a new major crisis. My view on that likelihood has not changed; policymakers spent the last 3 years kicking the economic crisis can a few years further down the road. I'll write at greater length about the risks facing us in 2011 in a couple weeks.

An honest periodic self-appraisal is a healthy habit for any investor. I started off 2010 by anticipating the Eurozone crisis and capturing most of the Euro's collapse with a sizable short position. In mid-2010 I suggested adding to our long commodity position with a special focus on agricultural commodities, and that too worked out very well. However, like in 2009, my single biggest position was short US equities, and that was very wrong. Fortunately, the huge gains in commodities compensated for the smaller equity rally in my portfolio. I have moderately reduced all position sizes but remain short US equities, long agricultural commodities, and slightly short the Euro. I also have tiny equity positions of long GST and short MCO. I still believe the only hope for decent equity performance is continued money printing, which will cause severe inflation. If instead we get a deflationary shock, that will send equities down sharply. Generally though, this is a boring time to be a value investor. From a bottom up perspective, US equities and corporate bonds look roughly fair while emerging market equities are moderately overpriced. The most important driver of all markets remain the US and European central banks.

No comments:

Post a Comment