Jamie Horvat Fears Extended Period of Stagflation

by: FP Trading Desk

Jamie Horvat
Senior Portfolio Manager
Sprott Asset Management

Q) When did you know this was no ordinary stock market correction?

A) The question that should be asked is – when did you feel that the market was beginning to face serious headwinds? As, once you realized that a market correction of the magnitude experienced was upon us, it was too late to react. That said, the first significant hint that the market was due for some type of pull back, came with the collapse of the two Bear Stearns Hedge Funds during the second week of July 2007 – the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. This was the turning point that seemed to accelerate the removal of liquidity/leverage and the reduction in the velocity of money out of the market place and resulted in a cascading effect of loans and margin being called around the world. The loss of ongoing liquidity eventually resulted in the Fed beginning to aggressively cut rates in the fall of 2007 from 5.25% to its current level of 0.25%.

During the fall of 2006 and into early 2007 we had already begun to reduce our exposure to small cap names within the portfolios that we ran at our former employer and began focusing on the larger more liquid securities. This approach was accelerated as 2007 progressed, as well as increasing the cash position of each fund we managed. 2007 ended up being a year where small caps underperformed their large cap brethren for the first time in several years. The collapse of Bear Stearns and eventual sale to JP Morgan at $10 per share during March 2008 was another large indicator to the market that liquidity was still being removed from the marketplace. Although one can anticipate a market correction and feel that they are positioning the portfolios correctly, very few were properly positioned for such an aggressive sell off in the fall of 2008.

Q) How did your clients and others react?

A) The reaction from our clients was largely broken down into two groups -- those who panicked and those who saw it as an opportunity. A larger group of individuals/clients reacted as most people do – with a heard mentality and began indiscriminate selling. Although it may be an unfair comment, as I am unaware of each individual investor’s situation and the amount of leverage that may have been employed by each in the market. This was largely a crisis of liquidity and as loans/margin was being called everywhere – investors sold positions as required. Many brokers/planners at the time informed us that they were no longer accepting calls from their clients and were simply selling positions to raise cash and protect what they had left.

However, along with the panic there was the smaller subset of investors, brokers and planners that we dealt with that saw the crash as an opportunity. This group felt that they had properly positioned themselves and/or their clients earlier in the year in an attempt to deal with such a fall. They seemed to have raised cash levels earlier and their questions revolved around when we thought a bottom would be made and what investments were best suited for their 5 and 10 year investment plan? Unfortunately this was a much smaller subset of investors.

Q) What was the best move/trade you made during the initial sell off?

A) Unfortunately one had to be positioned prior to the market meltdown, however most did not anticipate a sell-off of this magnitude. During January 2008 Charles Oliver and myself moved over to Sprott Asset Management LP, initially to take over the Sprott Gold and Precious Minerals Fund but also during September 18, 2008 – at what could be the height of the Lehman collapse and AIG bailout – we launched the Sprott All Cap Fund. We had spent the majority of the year moving the portfolio to larger, more liquid companies and also significantly increased the bullion position. This was a very tough year to transition a fund where liquidity continued to be removed from the market, with the resultant decline for the S&P/TSX Venture Index of 71.44% as a testament to that fact. Although our performance suffered along with the rest of the market, bullion performed relatively well, rising by 5.77% and acted as a mitigating factor to the rest of the market decline.

Q) What is your view of market now?

A) Although all market bubbles tend to be created by the extension of too much credit and easy money; throughout history markets tend to rhyme but don’t often exactly repeat. For several years we have been running with the thesis that the market has similarities to that of the 1965 to 1985 time period, where the developing economies of China and India have been assuming the prior role of Japan and South Korea. Global growth more recently has been propped up by the continually movement of developing nations to a developed nation status and we are now in a period of sideways, volatile markets where a battle between inflation and deflation is being played out (similar to that experienced during 1973 to 1976).

Once again, I fear we are setting up for an extended period of stagflation – where inflation and low economic growth with higher unemployment can occur simultaneously. Government stimulus programs and spending are now attempting to fill the void left by a lack of consumer spending. Through various programs and quantitative easing the governments attempt to inflate the system is cheapening fiat money versus all hard assets and real goods. Stagflation and potentially hyperinflation are always the result of a government spending more than it earns.
With US unemployment running at 9.7% (16.5% when adjusted for the underemployed, dejected and part-time labour force) any recovery will be a slow one.

Consumers are the lifeblood of any economy, however the current economy is being supported by an unprecedented amount of government stimulus globally. Cash for clunkers, cash for durables, the home buyers credits and various other schemes have the result of bringing forward all future consumer demand into one or two quarters and increasing moral hazard – as consumers refuse to purchase goods unless they are incentivized to do so. Companies cannot cost-cut their way to prosperity and at some point investors are going to want to see top line growth. Mortgage delinquencies and foreclosures continue to edge higher (one in 10 borrowers is behind on a payment and one in 25 homes in the US is in foreclosure), while nominal incomes (personal wealth) continue to edge lower, all while banks refuse to lend.

Fannie Mae (FNM), Freddie Mac (FRE) and the Federal Housing Administration in the US, through government-affiliated programs currently make up 90% of all new mortgages. Thus, we will remain in a sideways, trading oriented market and have the potential to experience a double dip recession as the stimulus spending wanes. I personally do not believe that we will experience another depression, as an endless supply of dollars will be printed to ensure an eventual recovery, but I also do not believe that we are going to experience a “v”. The issue of the toxic assets, CDS and other derivatives as well as ongoing balance sheet repair (by both individuals and companies) will ensure that the recovery will be a slow one.

Q) How are you playing it now?

A) When we launched the Sprott All Cap Fund during the fall of 2008, we went out and marketed to potential investors our belief that we would experience sideways volatile markets. We sought investors who, like us, thought that the next few years could be the best buying opportunity they would witness in their lifetimes – but required them to have a longer term investment horizon. We have been focused on acquiring companies that we believe have solid management teams and solid long-term fundamentals that will trade off of their “hard-asset” values and have the potential to maintain and/or pass through and cost price increases.

Thus we have been avoiding companies that have historically traded as a “financial asset” and have employed large amounts of leverage as part of their business model. The focus has been on acquiring solid companies during dower periods in the market when there appears to be no other buyer, while during periods of what we see as short-term market euphoria trimming/shorting companies that are trading well above their fundamental value. We believe that this strategy will serve us well as the market and the economy slowly builds a pass from which to grow upon in the future.