ELF
Capital Management, LLC
(Endowment
Like Fund Management)
This is the ELF Capital Management, LLC Market Letter
for the month of July 2006. If you
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Thanks for your interest and we hope you enjoy the letter.
How did your investment portfolio do during the months of May and June? How about into July thus far? Did you see the Fed train coming down the tracks? Did you buy into the market weakness? Did you sit and watch? Or, did you get scared off and raise cash or go short? What do you think about the volatility we just experienced? Did you play it right?
As I wrote last month, when markets move dramatically, both professional investors, and those served by them, will test their beliefs and convictions about how to be invested.
It is my theory, that the correction and significant volatility experienced in global equity markets was a direct result of anxiety promoted by the rookie chairman, Ben Bernanke, flexing his muscles and exerting his newly appointed monetary policy leadership powers. And, he had a little help from his friends within the Federal Reserve System. Little else could explain such a dramatic turning point for financial markets across the globe.
According
to the US Congress’ Joint Economic Committee Report, dated March 1997: “Although
the Federal Reserve—our Central Bank (or monetary authority)—is one of the
country's most powerful economic institutions, it is also one of the most
misunderstood. For Congress, the Federal
Reserve is relevant because (1) the U.S. Constitution (Article I, Section 8)
explicitly gives Congress the power over money and the regulation of its value
and (2) this responsibility was delegated by Congress to the Federal Reserve…
Congress has important responsibilities for overseeing the Federal Reserve and
monetary policy.”
In this
same “white paper” intended for Members of Congress, it counsels that “Congressional
oversight of the Federal Reserve and monetary policy is important because:
So, why is it that the global markets reacted as volatile as they did?
As readers of our newsletter well know, wealth management is
the ultimate goal of all that we do at ELF
Capital Management. Yes, we promote our
services; yet, you will find that we always seek to present thought provoking
topics that are relevant to our wide audience.
This month’s letter will discus monetary policy, the Fed,
it’s powers and explore what caused fear in the markets these past couple of
months. Whether you think those at the
Fed are brilliant or incompetent, you’ll want to read this before drawing any
conclusions. Following this discussion please be sure to spend some time
looking over our market comment and performance at the end of this letter to
find out how we navigated through the market’s turbulence. It should be well worth the investment of
time.
Most
macroeconomic textbooks define monetary policy as the regulation of a nation’s
money supply to influence its economic activity to be in line with its
political objectives; whereas, fiscal policy involves legislating governmental
taxing and spending policies to achieve similar goals. As opposed to fiscal policy, monetary policy can
be implemented more rapidly, it is considered more flexible, and possibly a
more dominant means to impact economic activity.
To
understand the regulation of money supply, we should take a little time to
understand money. Why does it exist and
how come it impacts our lives the way it does?
Money –
currency – exists for our convenience.
It serves as a medium of exchange so that we can acquire goods and
services without the challenges of bartering – instead of having to exchange
goods or services for goods or services; it allows us to exchange goods or services
for money for goods or services. Also;
it serves as yardstick for pricing goods and services and can be saved or
loaned and it can be expected to retain its value – except from the
diminishment from inflation or from rising foreign exchange rates.
So, how
does the regulation of money impact economic activity?
According
to
On the
other side of the equation, National Bureau of Economic Research analyst, Anna
Schwartz, comments: “An increase in the
supply of money puts more money in the hands of consumers, making them feel
wealthier, thus stimulating increased spending [or, increased aggregate demand]. Business firms respond to increased sales by
ordering more raw materials and increasing production. The spread of business activity increases the
demand for labor and raises the demand for capital goods…If the money supply
continues to expand, prices begin to rise, especially if output growth reaches
capacity limits. As the public begins to
expect inflation, lenders insist on higher interest rates to offset an expected
decline in purchasing power over the life of their loans.”
This all
sounds simple. Right? Well, to me, both of these explanations seem too
simple. At the same time, it might lead some
of us to believe that monetary policy is an exact science with a cause and
effect relationship that is absolute and easily managed. This couldn’t be further from the truth. So, how does one begin to understand the
impact of monetary policy on economic activity?
While there
are many schools of thought in economics, those considered to be monetarists
believe that a change in the money supply will lead to a change interest rates
causing a change in aggregate demand which impacts economic activity. Did you follow all of that? OK then, let’s take a few steps backward and discuss
some basic concepts.
Quoting
from Investopedia.com, “Supply and demand is perhaps one of the most fundamental
concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a
product or service is desired by buyers. The quantity demanded is the amount of a
product people are willing to buy at a certain price; the relationship between
price and quantity demanded is known as the demand relationship. Supply represents how much the market can
offer. The quantity supplied refers to
the amount of a certain good producers are willing to supply when receiving a
certain price. The correlation between
price and how much of a good or service is supplied to the market is known as
the supply relationship.”
So, what is
the rationale for interest rate and aggregate demand changes occurring as a
result of changes in the money supply?
One theory
hinges on the belief that, when a central bank, like the US Federal Reserve
Bank, increases the cash reserves held by its member banks, those banks will have
more money available to loan and can reduce their interest rates to encourage
borrowing. At lower interest rates,
consumers and firms are likely to be more willing to borrow to make purchases,
and aggregate demand can increase.
Alternatively, when a central bank decreases the reserves held by its
member banks, the banks will have less money available to loan and will increase
their interest rates in an effort to coordinate with the central bank’s desires.
At higher interest rates, consumers and
firms are more apt to repay debt, begin saving and reduce purchases. This should have an effect of reducing
aggregate demand.
By
definition, aggregate demand is considered to be the total demand for goods and
services in any given economy. And, when
defining aggregate demand as a measurable macro-economic value, it is
considered to be equal to the sum of all personal consumption, business investment
and government expenditures during or within a particular time period.
In equation form, AD = C + I + G + (X – M) which is also the equation for GDP, or gross domestic product. In this equation, C represents consumers' expenditure on goods and services; I represents investment spending by companies; G represents Government spending on publicly provided goods and services including public and merit goods while excluding transfer payments like welfare and entitlements (a substantial increase in government spending would be classified as an expansionary fiscal policy); X represents exports and M represents imports of goods and services to other countries. (X-M is the current account of the balance of payments.)
While a
highly criticized concept, the Quantity Theory of Money offers yet another expression
of aggregate demand. In equation form, M x V = AD. This theory is derived from the Fisher Equation
of Exchange, MV = PT, named after
Irving Fisher (1867–1947), where M
is the supply of money, V is the
velocity with which money is spent on final goods and services (also referred
to as final output, or T) during any
given time period, and P is the
average price level of this output. The
equation simply suggests that the quantity of money spent equals the quantity
of money used. The quantity theory, in
its debut as a popular theory, assumed that V and T were both
constant. Thus, it was argued that any
change in M leads directly to a
change in P. In other words, increase the money supply and
you simply cause inflation. Haven’t you
heard the adage that inflation is the result of “too many dollars chasing too
few goods”? The roots of that old saying
come from this equation.
Yet, I
don’t for a moment believe that velocity (V)
or final output of goods and services (T)
ever remain constant. Didn’t we just
discuss that increasing the money supply is supposed to increase spending? As well, doesn’t it seem logical that
companies will increase capacity to supply goods and services to meet
demand? That is, until resources start
becoming scarce and profit margins have reached a point of diminishing
returns. Then price inflation would be
reasonable resultant expectation. Right?
So, now
with this understanding, what does the Federal Reserve Bank do and how do they
influence economic activity?
The Federal Reserve and Its Powers
The Federal
Reserve System (the “Fed”) was created by Congress on
The
structure of the Fed is comprised of (a) a Board of Governors who provides
national level leadership; (b) twelve regional Federal Reserve Banks that serve
as the operating arms of the Fed; and, (c) the Federal Open market Committee
(or, “FOMC”) which acts as the monetary policy decision-making unit. It is an independent agency of the
Controlling
the money supply and credit is substantially accomplished through three formal methods
or tools. The primary and most frequently
used tool is known as open-market operations and is employed to alter bank
reserves and influence short-term interest rates. When the Fed buys US Treasury and federal
agency securities on the open market, the money it uses to pay for these purchases
expands the money supply. Conversely,
when it sells these securities, the money it receives from these sales shrinks
the money supply. To a lesser extent,
the Fed can also employ adjustments to the discount rate (the rate it charges
member banks for over-night loans) and changes in reserve requirements (the
portion of deposits that cannot be extended for loans) as policy tools. The Fed uses these tools to influence the Fed
Funds Rate (the rate member banks charge each other for over-night loans) which
serves as its key monetary policy instrument. Movements in this rate, in turn, influence a
wide array of financial and economic variables with differing time lags.
The Fed
also has an informal tool that can be rapidly implemented. It is called moral suasion. Moral suasion
is a persuasion tactic used by the Fed to influence and pressure banks,
investors and consumers into adhering to desired policy goals. It is the Fed’s way of exercising the
persuasive power of talk rather than legislation. The “moral” aspect comes from the pressure
for “moral responsibility” to operate in a way that is consistent with
furthering the good of the economy. In
Some Concluding Thoughts
Two years
ago, mid April, then Fed Chairman Greenspan provided his most optimistic
assessment yet on the US economy, saying, “growth has come into a period of
more vigorous expansion…As I have noted previously, the federal-funds rate must
rise at some point to prevent pressures on price inflation from eventually
emerging,” Greenspan told the Joint Economic Committee of Congress. Not being known for making often use of his
Fed powers of moral suasion, he startled fixed income investors – into taking
losses – and prepared them for rising interest rates and the possible threat of
inflation.
Prior to Ben Bernanke being sworn is as our new Fed Chairman
on
After the
minutes from the Fed’s March meeting were released, it was believed suggested
that the Fed would soon pause on lifting their target Fed Funds rate. This seemed to be reinforced when Bernanke he
hinted that policy makers may soon pause during testimony before Congress on
April 27th. The markets
rallied to new highs. Then, a few days
later in an interview with CNBC’s Maria Bartiromo, Bernanke began to create
massive uncertainty by stating that his comments were misinterpreted. It wasn’t long after the April CPI figures
came out in mid-May that Fed officials came out hawkishly in force to state
that: "If inflation turns out to exceed ... our target range, I do not
believe we can count on a slowing economy to bring inflation down, by itself,
quickly". This prospect incited a
sell-off in stocks, globally, as investors seem wary that the Fed will lean
toward risking a recession rather than gamble that the last 17 interest rate
increases, together with record oil prices, will tame the inflation outlook.
At present,
there seems to be great doubt that the new Fed will pull the
ELF Capital Management Investment Performance Update
What started in May, continued into June and, because we are
so late in getting out his month’s letter, we can report, is continuing into
July. It doesn’t take looking at the VIX
– the Chicago Board Options Exchange Volatility Index – to see that volatility
has gone “through the roof” these last couple of months. It is sure keeping us on our toes and we are
working double shifts just to stay on top of the fast pace of world
geopolitical and economic events. I
can’t remember when we’ve worked harder remaining chained to our desks. At the same time, we are adding to staff.
While there seems to be a great deal of uncertainty
circulating in the markets at present, we are making some interesting
observations that we are hoping to take advantage of. It seems that an over-sold condition exists
in a number of market sectors that are delivering good results that we expect
should continue through this economic environment. At the same time, other sectors that we would
expect to under-perform appear rich in value.
We are positioning our accounts accordingly.
For our taxable accounts, we are very much positioned in a
market neutral strategy, with a slight long bias, at present and our plan
accounts are approximately 45% long our best equity ideas with the balance in
cash and high yielding floating rate notes.
As a result, portfolio turnover is running higher than normal, yet we do
not expect to continue at this same pace going forward.
For the month ended June
30, 2006, our one-month
performance is down 1.23%, our three-month return is down 2.31% and our
one-year return is up 9.42%.
For
disclosure purposes, past performance is not necessarily indicative of future
results and ELF Capital Management LLC (ELF), formerly Hoffman White &
Kaelber Financial Services LLC, cannot guarantee the success of its
services. There is a chance that
investments managed by ELF may lose a substantial amount of their initial
value.
ELF is an
independent discretionary investment management firm established in February
2003. ELF manages a strategic allocation
of primarily exchange-traded index funds (ETFs), and may invest in other
carefully selected securities. ELF may
also employ hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for
both individual and business clients.
The ELF ETF
Strategy returns presented herein represents a composite of actual results from
all client portfolios managed by ELF.
Currently, it is the only composite presented by ELF and separate client
account portfolio positions are substantially similar, except as may be
modified for retirement plan accounts and accounts with net equity of $60,000
or less. There is no minimum account
size for inclusion into ELF’s ETF Strategy composite and accounts with net
equity of $60,000 or less have a tendency to downwardly skew the combined
results.
The
performance data presented herein includes the reinvestment of dividends and
capital gains; as well, ELF’s ETF Strategy composite returns are presented
after deducting actual management fees, transaction costs or other expenses, if
any. ELF charges an annual investment
management fee as follows: 1.25% on the first $250,000; 1.00% on the next
$750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.