One of the few things on which just about everybody can agree during this election season is that our elected officials in Washington, DC have taken on too much debt on our behalf. Voters part company on what to do about it, but most agree it’s a problem that’s not going away. Deciding to borrow money at the government level is so easy; rates are extremely low and the pain of repayment is left to someone else. I just finished reading Roger Lowenstein’s excellent 2009 book, While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis. It provides a sobering portrayal of how many seemingly expedient decisions can in aggregate lead to catastrophe.

I live in Westfield, New Jersey, a town of around 30,000 people, easy commuting distance west of New York City. We are currently facing our own debt choice. It’s not an existential issue, but it illustrates at a grass roots level how the ethos of consumption today creates problems for tomorrow. Westfielders are about to vote on a $16.9 million bond, the proceeds of which will be used to finance two separate projects: 1) roof repairs on a number of school buildings, and 2) installing a lighted turf field (we already have two).

No doubt few Westfielders have any clear concept of what this new indebtedness means to them personally. The numbers governments at all levels spend are often abstract at an individual level. But a clear perspective can be gained by comparing this amount with the $24 million annual property tax revenue collected by Westfield. The proposal is therefore to borrow an amount equal to two thirds of our property taxes. Every property owner will consequently owe an amount equal to this proportion of their annual property tax bill, and in strict financial terms the equity in their home will be reduced by the amount of this obligation. If the money is invested such that Westfield is $17 million more attractive as a place to live, the difference may be made up. But I wonder how many people would willingly vote for this additional personal debt obligation versus those who might approve a somewhat abstract $17 million collective borrowing. It’s just so easy to vote to approve such things if they’re not translated into personal terms. This is how as a country we’ve arrived at a point awash in debt. Roger Lowenstein told his story well, as he always does.

The vote is on September 24th. I shall vote no. We shall see, on a micro basis, whether the fiscal standards we wish our elected officials in Washington DC would follow are the same standards we apply at a local level.

In yesterday’s press conference, Steve Liesman from CNBC asked a highly pertinent question of Chairman Bernanke. Steve asked whether the explicit focus on employment meant that the Fed was now willing to tolerate a higher inflation rate than would otherwise be the case. Bernanke answered predictably by noting that the Fed by law has a dual mandate (maximum employment consistent with stable prices). But in thinking about his comments afterwards and the way they’ve positioned themselves, it seems to be unlikely the Fed will spend any time worrying about inflation until the employment picture improves. Of course there isn’t much evidence of inflation anyway, but we are virtually assured, based on his comments, that if or when things do ultimately pick up the Fed will be a long way behind the curve in terms of raising rates. Negative real returns are here to stay for bond investors. Bernanke made the case for real assets yesterday, including gold which we own through our investment in the gold miners ETF (GDX).

There are some signs that the hedge fund industry is moving towards a more appropriate capital base. Leo Kolivakis, who covers hedge funds and other classes of investment for Canadian pension funds, noted that outflows from hedge funds have picked up recently. Mediocre returns delivered at great expense for several years may be starting to focus attention on the $2TN size of the industry and perhaps cause investors to question their previously held return expectations. The Alternative Investment Managers Association (AIMA) in London, the lobbying group for the industry, must be surprised. They keep issuing reports and analyses telling everybody how good hedge funds have been, although this view seems at odds with the actions of departing investors.

Of course some hedge fund managers are taking the initiative and returning capital to clients, such as Louis Bacon. The industry could use more managers who recognize the prevailing limits on their own strategies. But overall, the article finds that assets are s23% lower than their peak just prior to the financial crisis four years ago.

The problem with the structure of AIMA’s analysis is that it doesn’t contemplate that the industry could ever be overcapitalized, whereas that is what empirical evidence strongly suggests. Fortunately, it’s beginning to look as if hedge fund investors are questioning AIMA’s orthodoxy. 2012 will likely be the 10th straight year in which a simple 60/40 stocks/bonds portfolio has beaten the broad hedge fund industry averages. In a win for the little guy, it’s turning out that investors with quite modest means that render them unqualified to be a “sophisticated” investor (and therefore eligible to be a hedge fund client) are quite easily and cheaply able to outperform investors who have signed up with the Masters of the Universe.

It might strike some a hyperbole to accuse the government of stealing taxpayers money – up there with the conspiracy theories around JFK’s assassination or the staging of the Apollo 11 moon landing in a warehouse in Hollywood. But it’s just the sorry Math confronting savers, most recently highlighted in a CNBC article yesterday. Conventionally, lowering the cost of borrowing should be stimulative for economic activity, but it’s a zero sum game and savers including many retirees are in effect funding this stimulus through negative real returns on their savings. The yields on TIPS (Treasury Inflation Protected Securities) show this quite starkly – 5 year TIPS have a negative yield of 1.47%. What’s even worse for taxable investors is that the income they receive (equal to the CPI) is immediately taxable whereas the negative interest rate isn’t recognizable as a loss until maturity. TIPS don’t belong in taxable accounts.  And of course, the biggest borrower nowadays is the Federal government, so they’re benefitting from setting their own ultra-low borrowing cost.

I’ve been surprised at how little public outcry there has been from savers reacting to this stealth transfer of part of their wealth to borrowers (who of course benefit from ultra-low rates). I doubt that’s about to change, but at least the issue is gaining some attention.

Natural gas is +6% today, in part no doubt because stocks are being rebuilt at slightly faster than over the past five years, according to the Energy Information Agency (EIA). Of course a mild winter like last year will lead to another excess of supply, although the continued switching from coal to gas in energy production is leading to a permanently higher level of underlying demand.

As a result, many natural gas names including Range Resources (RRC) and Comstock Resources (CRK), both of which we own in our Deep Value Equity strategy, are higher today. In addition, Bernstein Research initiated coverage on RRC with a buy recommendation. RRC claims potential resources of up to 60 TCF (Trillion Cubic Feet), enough to supply the U.S. for almost three years. The capex requirements to exploit a fraction of this are beyond RRC’s current capability which is why we think ultimately they’ll be acquired by a far larger company. However, BHP Billiton bought Petrohawk last year for $12.1BN and just recently had to take a $3.3Bn writedown on assets predominantly including natural gas. So other potential acquirers may be cautious about overpaying for assets in what is likely to remain a well supplied domestic natural gas market for the foreseeable future.

Nonetheless, a price closer to $4 per MCF rather than $3 seems likely over the long run given where the fully-loaded marginal cost of production is, and low cost producers such as RRC should be able to continue their production growth under those circumstances.

Over the past few days a few not very surprising things have happened. From Der Spiegel (as reported in the FT) German Chancellor Merkel has concluded that Greece must stay in the Euro and is now focused on ensuring this happens. Although many people (including apparently a majority of German voters) believe Greece should be kicked out (a satisfying and totally justified result of their profligacy) policymakers no doubt recognize that shoring up Spain and Italy (whose bond markets would undoubtedly be under enormous pressure in the event of a “Grexit”) would require sums beyond their current resources (perhaps 1 Trillion Euros). There really is no other choice.

Meanwhile the ECB announced its own version of QE last week over the objections of the Bundesbank. And another month of weak U.S. employment data on Friday made QE3 ever more likely. So Greece is staying in, and government buying of bonds is being broadened. None of this was much of a surprise, but equities have been rallying nevertheless, driven in part by the ever-decreasing attractiveness of fixed income. Mitt Romney even noted on Meet the Press yesterday that equities were higher because where else can you earn a decent return.

Interestingly though, GDP forecasts are not being revised higher. JPMorgan for example notes that consensus forecasts for GDP continue to be subject to modest downward revisions, and many corporations reporting earnings in recent weeks have provided cautious guidance on the near term outlook. It’s also interesting to note the divergence between stable, dividend yielding stocks and the S&P 500. On Friday they actually moved in opposite directions – the iShares Dow Jones Select Dividend Index (DVY) was -0.3% while the S&P 500 was +0.40%. In aggregate this all looks rather as if active equity managers are scrambling to keep up with their benchmarks while the market’s rising – higher beta names are performing well and the market is climbing its wall of worry.

For our part, our largest overall exposure in Deep Value Equities remains the Gold Miners ETF (GDX) since real assets have central bank support through reflation if they fail to improve through stronger economic activity. Our next largest is Corrections Corp (CXW) as we await further developments on their conversion to a REIT. Hedged Dividend Capture has lost around 2% over the past few weeks consistent with its proclivity to underperform a strong equity market. MLPs remain attractive – it’s interesting to note the growing number of unconventional MLP IPOs in recent weeks. A number of private equity firms have been taking public as MLPs businesses that have far more volatile earnings than is normal for the sector. An example is Petrologistics lp (PDH), whose S-1 registration statement includes the warning that, “We may not have sufficient cash available to pay any quarterly distribution on our common units.” Their units offer an 8% distribution yield but that yield could move violently in response to the profitability of polypropylene production rom their single facility. It’s not a name we would own, but developments such as these may begin to alter the make-up of the Alerian MLP Index.

Sell in May and Go Away is an easily remembered rule that worked very well for the past two years. Last year from April 30 to August 31, the S&P 500 lost 11%. Over more than fifty years it’s been sound advice 47% of the time so slightly less effective than a coin flip. However, when it works the results can be memorable, and some spectacular falls in stocks have occurred during this time period including 1966           (-15%), 1974 (-20%), 2002  (-15%) and 2010 (-12%). Recent years have reinforced the rule, with eight out of twelve Summers this millennium representing an unwelcome vacation distraction. Many a holiday has been ruined by portfolio losses on top of that expensive beach house, and no doubt those painful memories persist. However, during the 80s and 90s it worked in only seven years out of 20. Perhaps unsurprisingly, the overall market direction plays a big role. Two thirds of the time Sell in May worked was when the market’s return for the year was negative. So if you’re skilled at selecting good years to be in stocks, you can make your Summers a bit more enjoyable. And for those who want a little bit of an edge, Sell in May followed the pattern set in the first four months of the year 61% of the time. A bad start for the year is a little more likely to continue a few months longer.

In total though, following the Sell in May adage since 1960 would have “cost” an investor on average 0.5% p.a. — more after commissions and taxes are included. Interestingly, most of the 6.3% compounded annual return over this entire period was generated while school was open. As it turns out the Summer that’s about to end ranks #26 with a 1% return, close to the average.  This is a seasonal pattern that’s worth following, but barely. However, while Sell in May is not a profitable strategy, for some investors the foregone return by being out of the market may seem a price worth paying for a quiet vacation.

Although macro issues continue to hang over the market and rising prices were caused in part by the calamities that did not befall (i.e. southern Europe still uses Euros), it is notable how many companies reporting earnings during the Summer revised down earnings guidance and generally expressed caution.  Even the most economically insensitive companies tempered outlooks.  Examples include McDonalds (MCD) who, citing macro headwinds, reported no increase in monthly global comps in July – the worst since April 2003. Coke (KO) experienced declining volumes of 4% in Europe during the second quarter. IBM saw revenues contract globally and profit growth for many companies is relying on improved operating margins rather than top line growth. While it’s never easy to assess whether macro concerns are fully reflected in market prices (or indeed overly reflected) the more cautious outlook recently being provided at the individual company level is noteworthy.

The “fiscal cliff” is also a perplexing hurdle that isn’t yet receiving the respect it deserves. One major investment bank has in its quarterly GDP forecast a fairly smooth sequence of figures from 3Q12 to 1Q13 (+1.5%, +2.0%, +1.5%) that seem to defy common sense. While Washington is consumed with an election countless organizations big and small are planning 2013 capital expenditures and hiring without knowing whether we’ll have a Made in DC recession on January 1^st.  Anecdotally, many companies are already delaying major commitments until they have greater visibility into 2013 economic activity.

Conventional wisdom is that the lame-duck Congress will amiably defer the mandated tax hikes and spending cuts to later in 2013 and the new Congress, whereas many of us recall that this is the same group of legislators who brought America to the verge of “technical” default during the debt ceiling brinkmanship last Summer (when Sell in May worked). Sometime shortly after the election when the celebrations and recriminations are still fresh, one deeply unhappy party will be expected to compromise with another victorious one. While things will probably work out (because they usually do) a crisis-free experience seems unlikely. The Congressional calendar provides just sixteen days when the House will be in session between Election Day and December 14^th when they recess. There seems plenty of room for a miscalculation.

Meanwhile stable, dividend paying stocks are by many measures relatively expensive (most recently highlighted in Barron’s on August 24^th). It’s not surprising that low interest rates and widespread global uncertainty have made, say, Kraft (KFT) appealing, because demand for Oreo cookies and cheese is more predictable than Chinese demand for iron ore or the ability of large banks to both reinvent their business models and avoid endless debilitating investigations and fines. To borrow from Michael Lewis in Liar’s Poker, an investor in Goldman Sachs must ask where will the firm find their next “Herman the German” (AKA gullible buyer of hard to understand securities).

One interesting lesson in the field of Behavioral Finance is that many investors apply unreasonably narrow ranges to their forecasts of outcomes. In other words, most of us have a tendency to be over-confident that we are right about our investment decisions. Which is why, in spite of the preceding cautious market narrative we are not heavily invested in cash at present. As coherent as this letter might (hopefully) appear, it could also be dead wrong, and the longer the investment horizon the more likely the outcome is to be good. However while we haven’t sold everything, we have over the past couple of months shifted in our Deep Value Equity strategy away from cyclical exposure and towards companies whose risk is substantially idiosyncratic. Will Corrections Corp (CXW) convert to a REIT, which should cause a meaningful increase in valuation? Will JCPenney (JCP) carry out a successful transformation? Will AIG continue to buy back the government’s shares in it at half of book value?  Will Warren Buffett repurchase shares in Berkshire (BRK-B) if they fall to within 10% of book value?  Will Burger King (BKW) and Family Dollar (FDO) improve their operating metrics towards those of their peers? All of these are holdings in our Deep Value Equity strategy, along with cash and gold miners (GDX) to protect against deflation and reflation respectively.

Our Hedged Dividend Capture Strategy is very low turnover by design and so retains its positions in stable, low beta dividend paying stocks such as MCD, KO, KFT and others mentioned above. We believe the combination of these long positions with a short S&P500 hedge results in a portfolio uncorrelated with equities. Performance for the year in this strategy is flat, since the +13% return in the S&P500 has generally favored higher beta names with low or no dividend. Interestingly, without Apple (AAPL) the S&P500 would be up 2.2% less than it is so far this year, 16% of its return. Just being short AAPL has reduced performance in this strategy by a little over 1%. It’s an amazing outcome considering AAPL began the year with a 3% weighting in the S&P 500 (it’s now over 4%). We’re not even negative on AAPL, we’re simply short it through its inclusion in the S&P 500.

Master Limited Partnerships (MLPs) continue to look attractive with 6%+ yields and solid growth prospects. Developing new energy infrastructure to support the growing domestic production of oil and natural gas will remain a vital element of energy independence for many years to come. The likelihood of low bond yields for the foreseeable future combined with the inflation protection such assets afford through their ability to raise prices annually make this a useful income-generating investment for many investors. In August we reduced our position in Sunoco Logistics Partners (SXL) in those accounts where this long-held position had become an overweight through strong performance and reallocated towards Oneok Partners (OKS).

All of which goes to show that, had we embraced Sell in May for many sound reasons at the beginning of the Summer we would have been dead wrong then too.

I thought this was a pretty balanced and investor-oriented piece:

http://www.finalternatives.com/node/21480

Only 25% of Germans think Greece should remain in the Euro or receive further additional EU support, according to a Financial Times/Harris poll. Holding opinions unburdened by the need to implement them is an indulgence afforded voters in all democracies. It feels good to punish the tax-dodging Greeks by kicking them out. But if instead these same German voters were asked if they’d contribute perhaps 300BN Euros towards the probably 1 Trillion that would be requires to support Italy and Spain if Greece leaves the Euro, they would probably reject that as well. This is the unpalatable reality no doubt well understood by Germany’s decision makers. In any case, public opinion was against giving up the Deutsche Mark in favor of the Euro as well, but opinion polls don’t necessarily drive political decision making in Germany. For Europe’s biggest economy, keeping Greece in the Euro is unfortunately probably cheaper than kicking them out.

Greece may wind up leaving, but if that turns out to be the best of available options then the future for EU growth will be pretty bleak.

Towards the end of last year we felt there was an interesting opportunity to be long equities hedged with a short position in the Euro. Our thinking was that equities were attractively priced as long as a crisis was averted, and most of the bad things we could imagine would either begin in Europe (i.e. Euro collapse) or affect it more than the U.S. (such as an Israeli strike on Iran given the EU’s greater reliance of Middle East imports than the U.S.). We employed this bias in Fixed Income where long positions in bank debt were combined with short Euro positions.

That trade is no longer interesting, because a short Euro is a less effective hedge now that it’s weakened. But a similar concept exists with gold miners and equities.

Gold and Silver miners have for many months been trading at a healthy discount to the NAV of their reserves. Although the optionality provided by a long position in a miner should be worth something (since a rising gold price ought to create a disproportionate increase in the stock through operating leverage while if gold falls to unprofitable levels they can simply stop digging) the market continues to price the sector at a discount. One obvious move is to buy the Gold Miners ETF (GDX) and short gold itself (GLD). However, this means simply betting on a reversion to the mean of the relationship, and there’s no knowing when that might happen.

Instead, long GDX and short S&P 500 is an interesting trade. Gold is out of favor and a short position isn’t likely to provide much protection from here. If gold does sink, along with GDX, it’s likely to be in response to slower growth so the short equity hedge should provide some protection. But in that scenario the odds of QE increase, so reflation ought to provide some support for the yellow metal. Conversely, if the world avoids all the various disasters that may afflict it, rising markets are likely to lift commodities with them, and the weaker US$ that would result in that scenario would also provide support for GDX.

The correct hedge ratio is less than 1:1 – we prefer something closer to $1 of GDX versus short $0.75 of SPY. And the correlation between GDX and SPY is not as strong at with GLD, but we think this combinaton of exposures makes more sense. In the long run (i.e. years) we don’t think gold will perform as well as equities. Warren Buffett and others have articulated most eloquently the problems with an asset that does nothing, pays no dividend and costs money to store. But we’re entering a period where developed world central banks will be redoubling their efforts at reflating, with the ECB likely to adopt their own form of QE in the next several weeks. Long GDX allows one to invest in mining stocks at a current discount to their reserves without direct exposure to the relationship continuing to deteriorate. This is why we are currently invested in GDX in our Deep Value Equity Strategy, since we think it offers an attractive risk/return profile compared with the broader equity markets.

The chart below shows the last two years of a position long GDX/short 75% SPY, and also the S&P500 itself, both rebased to 100 on August 2, 2010.

Disclosure: Author is Long GDX