Chris Karlin is a featured instructor at Best Ideas 2017.
It has been a month since the presidential election and several recurring issues have come up in conversation. I’m drafting this memo to summarize these issues and outline the approach I’m taking on the road ahead.
We are having a good year and have built upon our gains in the last month. This is despite the usual amount of errors made by your manager. Most aggravating in 2016 have been sales that seemed prudent given the information available at the time, but in hindsight turned out to be far premature. Specifically, I reduced our exposure to financials following the decision of the United Kingdom to exit the European Union thinking that it would mean low rates would persist for a longer duration. This not only proved to be unwarranted in the short run, but became very, very wrong following the election. In addition, I committed an error of omission by being too price sensitive following the election in increasing our financial exposure. The only good news in this is that in both cases my caution cost us excess returns, but these unforced errors did not impair capital.
I have been taking advantage of the post-election market rally to more conservatively position your portfolios. I have let cash build as I have rotated out of both equity and credit investments. I have cautiously initiated a few new positions, but we are sitting on lots of dry powder going into the new year. On a side note, I am very pleased in our performance in 2016 given our conservative positioning and high cash levels.
I approach the craft of investing as an investigator of industries, companies, managements and securities. I have never held myself out as a market prognosticator – not because I don’t have opinions, but rather because I don’t feel like my opinions are any more insightful than most and I was taught not to offer my opinions when they don’t advance the conversation. I’ve been informed this is a Midwestern thing. However, these are strange days indeed and perhaps sharing my opinions will add some value. I have a few.
Most importantly, I believe the US economy will be fine. My personal view of history is that the Great Recession coincided with President Obama’s election and a divided Congress that prioritized obstructing the new President over the assisting Americans facing economic hardship. The deadlocked Congress failed to provide significant fiscal stimulus (and even pushed austerity measures), leaving the Federal Reserve’s accommodative monetary policy to carry the country out of recession. The good news is that the Fed’s efforts were successful in that the country exited recession, but there have been several unintended consequences – the primary two being anemic growth and the asset distortions created by extremely low interest rates for a protracted period.
Going forward, I fully expect fiscal stimulus to increase now that Republicans control the presidency and both branches of Congress. Certainly, there will be debate as there are still a few Republicans who are fiscally conservative, but directionally I am certain that fiscal stimulus will increase – and this should increase the growth rate of the economy.
My expectation is that fiscal stimulus on top of an economy that has been in decent health should provide cover for the Federal Reserve to increase interest rates., I believe the Fed has room to raise rates without slowing down the economy given the exceptionally low rate environment and increasing fiscal stimulus. However, this does not mean that I don’t expect some dislocation in securities markets.
I believe the 30-year bull market in the bond markets has ended simply because there is no room left for it to continue. We very rarely invest in credit that matures beyond 5 years and our credit investments tend to be driven by credit changes rather than interest sensitivity. I fully expect that investors who have leveraged long rate sensitivity portfolios are in for some pain. I have pruned our credit portfolio to take advantage of any dislocations that may occur.
I expect that rising rates will lead to substantial industry rebalancing as investors charge into more economically sensitive names and away from safe harbors like utilities and consumer staples. I have pruned our equity portfolio to take advantage of any dislocations when they occur.
Two things have fascinated me about the President-Elect. First, he has continually demonstrated an ability to convince people that he is whatever they need him to be. Second, he routinely utilizes a negotiating technique of saying so many things, several in direct contradiction with himself, that distracts and confuses both adversaries and supporters alike. At the end of the day, nobody really knows what the President-Elect believes and many simply project onto him the beliefs that they want him to embrace.
It’s futile at this point to project what will get enacted over the next presidency. However, I have reasonable conviction that less will be done than all the things that are suggested will be done. This is for a multitude of reasons including a need to prioritize an agenda, a Republican party that is far from homogenous, the ability of the Democrats in the Senate to filibuster, etc. I also know that there are many things that legislation alone cannot restore – such as the coal industry which is in decline as much due to inexpensive and plentiful natural gas as to environmental regulation. In response, I have pruned our portfolio in areas where I thought we were benefitting from gains that were welcomed, but unwarranted. In addition, I established positions in a few healthcare securities that sold off on the expectation of an immediate and complete repeal of Obamacare – which I expect will be a much more complicated task that will ultimately result in several modifications, but not total repeal.
I believe that market expectations for the President-Elect have reached a point where little risk is priced in. While the Russell 3000 index is up almost 9% since the election, there are 343 companies that are up over 30% since the election – over 10% of index constituents, primarily in the energy, financials, construction and materials sectors. Once again, I have been booking gains and raising cash for what I believe will be a volatile road ahead as expectations and reality often violently collide.
Oil prices have been bolstered by an OPEC agreement to curtail supply. Having learned some expensive lessons on the oil market in recent years, I have come to believe that the vast amounts of domestic petrochemical reserves that are available using modern technology will constrain oil prices around $65 per barrel. While oil remains around $50 per barrel, equities are discounting prices close to $65 per barrel and I have been selling into the rally.
I expect that the person who said ‘May you live in interesting times’ did not foresee the state of the world in 2016, whereas the person who said ‘This time it’s different’ was clearly waiting for this moment. I expect that the year ahead will be particularly challenging for investors, but I believe our cautious temperament will a prudent steward of your capital in what may be volatile times ahead. By adopting an extremely cautious approach, I expect that our primary near term risk may be in underperforming any protracted market exuberance, but equities were not inexpensive going into this rally and the catalysts of reality colliding with high expectations will commence on January 20, 2017.
Meet Chris Karlin, Chief Investment Officer of Aquitania Capital Management.
This post has been excerpted from the Aquitania Capital Management Interim Update Letter.
Disclosure: The discussion of portfolio investments represents the views of the investment manager. These views are current as of the date of this commentary but are subject to change without notice. All information provided is for information purposes only and should not be considered as investment advice or a recommendation to purchase or sell any specific security. Security examples featured are samples for presentation purposes and are intended to illustrate our investment philosophy and its application. While the information presented herein is believed to be reliable, no representations or warranty is made concerning the accuracy of any data presented. Portfolio composition will change due to ongoing management of the portfolios. References to individual securities are for informational purposes only and should not be construed as recommendations by Aquitania Capital Management or its members. Past performance is no guarantee of future results. Actual returns may differ for each client from the returns presented.