Welcome to the Vitus Capital Blog!
Notes to myself, possibly of interest to others.
-- Bill Northlich

Thursday, December 30, 2010

Vitus Update - Happy New Year 2011 (The Vitus Newsletter)

Long time no talk.  Sorry.  Frankly I've been in quandary mode.  

Right now the thing causing me such angst is that while usual economic suspects such as employment, housing, and consumer credit continue to loose ground, the stock market seems to be in irrational exuberance mode.

Why the "divergence"?  

Basically, it's QE2.  Jeremy Grantham and others have said that the purpose of QE2 was/is to inflate assets (stocks mainly), in order to achieve a wealth effect and make the rich feel better so they go out and spend.  It seems to have worked/be working.

Many liberal economists are up in arms about this (and the recent deal to extend Bush tax cuts), complaining that at best these are extremely expensive, inefficient and unproven ways to stimulate the economy.  Robert Shiller, says that, well, activity does beget activity, and because more traditional stimulus spending is not politically possible, things like QE2 can possibly “work”.

In fact, recently there have been a number of notable, quotable positive headlines (eg, here, here, here, here, ...)  Market punditry is awash in positive sentiment, while dropping standard-issue caveats of the “possibility” of a near-term pullback.  I’ve said before that we (I) can get too caught up in the economic details while meanwhile most people just go about living their lives hoping for and planing for the best.  In other words, for the 80% of folks who are employed, things maybe don’t look so bad.  

Still, there are plenty of hard-core doom-sayers (here, here).  I admit that I am more in the camp of the latter than I am amongst the all-is-ok group.

With that in mind, I’ll stick my neck out ant offer the

Vitus 2011 Market Prognosis.  

We’ve reached the end of the traditional Santa Claus rally - now it is time for the traditional first-of-the-year small cap rally.  QE2 will be happening through 6/11.  Therefore, the Market will be uppish or at least not crash until then.   IOW, we will have a business-as-usual feeling in the markets out to mid year; folks will tend to forget about the bad fundamentals.  Success will beget some success, and by summer as the market approaches the 2007 highs of S&P 1500, reality will set in.  

After mid-year, with unemployment and housing not materially improving, there will be some kind of hopefully minor shock to the system:  The mere cessation of QE2; One or more large banks revealed to be again in need of bailout; The Tea Party refusing to continue to fund Freddie/Fannie, stopping housing finance and thus housing itself in it’s tracks; some “exogenous” shock such as North Korea or China acting out.  In any case, at that point gold and bonds will (re)-take off, and stocks will drop, especially tech and non-blue-chips - down to the S&P 1000 area.  The S&P will end the year at 1150 at best.

Some Suggestions.

My secret sources say gold will take off in Q1.  Rosenberg thinks bonds will take off again in Q1.  If these, or 1000 other things happen, the neat scenario above is “inoperative”.  But it’s my story and I’m sticking to it - until at least 2011.

Rosenberg has provided his investment plan for what he thinks will be a long-term deflationary environment.  (The deflation argument, despite volatile commodity prices, is still valid)  Indeed, if there were not a real deflation possibility, why would the Fed be taking such a chance with QE2?).  Anyway, the plan:

  • Focus on safe yield: High-quality corporates (non-cyclical, high cash reserves, minimal refinancing needs). Corporate balance sheets are in very good shape.
  • Equities: focus on reliable dividend growth/yield; preferred shares (“income” orientation).  [Under the tax deal, the top tax rate on dividends will stay at 15%. … in the months prior to the tax deal being struck between the White House and the GOP leadership, income/dividend ETFs saw a noticeable deceleration in net inflows — to $698 million in November from $1.7 billion in both September and October. ]
  • Whether it be credit or equities, focus on companies with low debt/equity ratios and high liquid asset ratios — balance sheet quality is even more important than usual. Avoid highly leveraged companies.
  • Even hard assets that provide an income stream work well in a deflationary environment (ie, oil and gas royalties, REITs, etc...).
  • Focus on sectors or companies with these micro characteristics: low fixed costs, high variable cost, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity (utilities, staples, health care — these sectors are also unloved and under owned by institutional portfolio managers).
  • Alternative assets: allocate significant portion of asset mix to strategies that are not reliant on rising equity markets and where volatility can be used to advantage.
  • Precious metals: A hedge against the reflationary policies aimed at defusing deflationary risks — money printing, rolling currency depreciations, heightened trade frictions, and government procurement policies
  • Agriculture, esp. agriculture equipment (Deer)
That’s it for 2010.  All the best to you and yours in the New Year!


  1. I have a question. What is the mechanism of transmission of QE2 into higher share prices? It seems important to understand what that mechanism is, because when it can no longer be sustained or the FED decides to turn it off, the markets may change. I hear two explanations. One is that QE2 depresses (or was supposed to depress) short term Treasury rates. But that did not happen: treasury rates went up. The other explanation is that a speech by the FOMC chairman in which he said that QE2 is supposed to work by the wealth effect somehow triggered the stock buying rally – that does make much sense, does it.

  2. Two quick points. More later.
    - The action was not supposed to depress Treasury rates, it was supposed to depress real rates. This has happened. I have a link supporting this squirreled away somewhere; I'll supply here later.
    - The wealth effect is basically the right answer IMO. The market is up! There are any number of people who attribute this to QE2. Grantham makes the case very solidly at http://goo.gl/MacA6 (supplied in the above post). He of course sees a lot of downside to the QE2 way of doing things, but acknowledges the necessity of doing it. I have some other refs which I'll also supply if I can find 'em. Thanks...

  3. Could not find prev. mentioned ref on interest rates. Will look more.

    For now, more on wealth effect: "Stocks are products of two inputs. They need lower interest rates, which allows the equity risk premium to be higher. Lower rates are here for a long while. In addition, stocks need the corporate ability to finance at those low interest rates. Both are in place and will be sustained for an “extended period.” Stocks also need high productivity and low labor-cost pressure. Both are in place." David Kotok, http://goo.gl/19buo