Interview – Steve Lehman, Dana Meissner from Federated

Last Wednesday, May 28, I interviewed Steve Lehman and Dana Meissner, who are the co-managers of Federated’s Market Opportunities fund

Here’s a description of the fund from the product information page that can be found here.

The fund seeks to provide absolute (positive) returns with a low correlation to the U.S. equity market by investing globally in a wide variety of asset classes. It may also sell securities short and can have an overall net long or short position relative to particular asset classes. The fund pursues its investment objective using a contrarian value orientation.

They generally have a dim view of equity markets, but they were appropriately bullish early in 2009.  You might want to put away any sharp objects before reading on.

Steven Lehman

Well, when Dana and I wake up—not together each morning—when we wake up we have no idea where the markets are going to go. We have very little confidence. I think that the system is really quite precarious. You brought up the intraday crisis, if not panic of a couple of weeks ago, and that, to us, showed how fragile the system really is. So we don’t think the markets are smoothly functioning and efficient. And we do take a top-down approach when it comes to asset classes. Along with that is a bottom-up approach because the fund has become a multi-asset fund—we’re in a number of asset classes around the world; it’s not just a stock fund anymore. When it was more of a stock fund there was the combination of the top-down view along with bottom up. It always made sense to me that the bottom-up view had to corroborate with the top-down approach, and if it didn’t then something was wrong and that warranted a reassessment of the view.

I’m guessing that you think the Thursday crash was more a drying up of bids as opposed to what some have labeled “fat fingers” in the immediate aftermath.

Yes.

Dana Meissner

 

What is your market outlook for the rest of the year—the global outlook?

Well, we’re trying to sort of walk a tight rope because we think that the potential decline for equities is multiples of the potential gains from here. But particularly when the house view here is for a 15-20% rise in the markets, it’s hard for us to take an extreme short position because on a shorter-term basis there could be a final surge up, but we think the markets, particularly in the U.S. are in a topping process. And there could be a further advance before the final top is reached. We don’t know if the top has been reached already, but we think a moderate net-short position is the most appropriate strategy.

In his latest letter, Jeremy Grantham of GMO talked a possible race for the old highs.

He said—what—1,500 or so on the S & P? If he’s right then we’re in trouble with this fund because we think that—for managers like us, who are net short—the worst case is 1,300 or 1,350, but that’s just our guess.

What’s your biggest worry for the average person to be aware of—not a long-short manager, per se?

The average person has been conditioned to buy each dip for the last 12+ months, with that being—over and over—a winning strategy, and so I think that—to the extent that the knee-jerk reaction that people are looking to employ here—that might be the biggest risk, that one of these times buying the dip might not be the right course of action. So, for us, the way we’re positioned—the way we’re looking at things—admittedly, a bit too early—it seems this time there are some signs that this might be a more meaningful correction or decline—not just your garden variety pullback of 5-10%. We might get another opportunity to get more long.

In generally, we’ve been looking for a recurrence of what happened in the second half of 2008, although to a milder extent, and that’s true for equity markets, risk assets, and currencies—sort of across the board—so that’s how we’re positioned, for something like that to happen again.

What does “2008 again” mean—would you spotlight any particular catalysts?

Well, no; it would just be a reversal in risk assets. That would be emerging market currencies, equities, and bonds; further strength in the dollar and U.S. Treasuries. Unlike 2008, we think gold may do better. We’re still quite enthusiastic on gold stocks, but in 2008 gold fell about 15% in the second half and gold stocks fell about 50% because they performed like stocks and not like gold.

[I asked, as a later follow up, for a bullet point from Steve on why gold would do well. He said that he’d been bullish on it for the past ten years and thinks it will do well as people lose faith in paper money.]

There was news out recently that a gold-dispensing ATM had been installed in Dubai. Is gold a bit too popular right now?

Well, we think that gold and gold stocks are due for a correction. They’ve both run up pretty sharply in recent weeks. Ordinarily, that news item about the ATM in Dubai would be somewhat unsettling to us as contrarian managers here. But the TV ads, as I recall, are all asking people to sell their gold. They’re not pushing gold coins on people; they’re trying to get people to sell their gold. Gold is a small market. It’s hard enough to guess where stock prices are going these days, but gold is such a small market that–and I do suspect that authorities around the world have tried to contain the price of gold, if not depress the price of gold– it can move very sharply one way or another, but we would be buyers on a correction, unlike with traditional equities.

From the standpoint of the average guy, is there anything out there you see as bullish for financial markets?

There are certain sectors of the market, the defensive, income-producing parts of the market that have been a source of funds for a lot of the speculative positions that people have taken. So we feel that a lot of money has been taken out of sectors like healthcare, for example, and it’s probably gone to fuel some of the extreme positions that were reached in things like small caps, consumer discretionary, and technology—pockets of the market like that. Especially given our outlook, but even given a more normalized outlook, there are quite a few opportunities we’re finding in the healthcare sector that should do pretty well, going forward. That’s a sector I like.

Do you have any thoughts on the best places to be in over next the short, medium, and long term?

We would probably say gold and agricultural commodities.

If you had to be somewhere in U.S. equities are there any places that look good?

There are some—we’re finding a few opportunities within energy, as well, related to the dual effect of the selloff in oil, selloff in commodities, and then, obviously, the problem with the oil leak, and so we’ve seen some names pop up on to the first page of our screen within that sector, as well. We feel pretty comfortable with the valuations because there’s not only earnings and cash flow, but there’s tangible book support for a handful of the names we’re finding in the drilling space.

Have you been able to pinpoint a general reason for the selloff in crude?

There was a large build in crude inventories over the past couple of reporting periods that I think, when combined with the other macro factors going on, have contributed to the selloff in that commodity. The commodity selloff is becoming somewhat significant because a lot of the individual commodities and groups of commodities that held at the 200-day moving average back in January and February period have broken through decisively to the downside: copper, oil, and the CRB index; so it has certainly been a significant correction.

How about the other commodities? Do you have any thoughts on them?

We generally have not favored industrial metals because we’re generally bearish on economic growth prospects—particularly out of China, so it’s definitely an area we would avoid for the shorter term.

Traditionally, there have been the three asset classes of stocks, bonds, and cash, but in light of a market that’s likely to go sideways for some time, is there a need to rethink those classifications?

We would turn on its head the traditional notion of core and satellite funds. We think that satellite funds that include alternative investments should be the core of the portfolio for the future and the plain vanilla approach would be the supplement—large-growth managers and that sort of thing—use those as supplements to the core. We think that an absolute return approach using alternative asset classes is the likeliest way to succeed in years to come.

A lot of managers grew up in the greatest bull market of all time and it reinforced the idea that quality equities could be bought and held, and in the shorter term, added to on dips. Could you comment on the concept of a buy-and-hold approach to equities?

That’s an area where we have a very high level of conviction. We make guesses about markets, but we firmly think that buy-and-hold is dead at least until the conditions are in place for the next bull market, and we think that’s going to be a while. Absent a crash it’ll be a while until conditions are in place for a multi-year bull market, so we think that investors should have a trading mindset, and if they can’t do that they should just step aside and go do something else.

…and those conditions for the next bull market would include low valuations, a distaste for equities . . . Are there any other things I’m missing—newspaper stories, cover stories, and the like?

All of those—fundamentals, technicals, valuations—we’d be looking for all three to become favorable.

In our very simple work we’ve done here, if you take those past secular bull and bear markets, you could project the current bear market to end, at the soonest, at the end of 2016. Do you have a view that’s significantly different?

We’re looking day-to-day and week-to-week here. It makes for interesting cocktail chatter to talk about whether it ends in 2012 or 2016, but it’s difficult to say because some say the market topped in 2000; some say in 2007, but either way we think it’s going to be a while. In addition to what I just said about buy-and-sell, we expect volatility to be very high in the months to come, and in an environment like that it’ll be, at best, a choppy period that would extend for some time. That would be the best case in our view. It would be like the mid-1960s to the 1980s, where the Dow didn’t break above and stay above 1,000 for about 18 years. We think we’re in the midst of a period like that, if not in a period like the 1930s, or the period in Japan. Either way, this is not a time to buy and hold.

Some folks in the alternative asset space say that mutual funds can’t compete for talent with the performance-based pay of hedge funds and the like. Is a mutual fund the appropriate vehicle for an absolute-return strategy?

Most people can’t afford a hedge fund. If you’re talking about a multi-millionaire who can afford to pay a hedge fund’s fee, well, then, that’s probably the best place. We think that there aren’t many places for a retail investor to gain access to something similar if not quite as good, so there are some funds, like Market Opportunities, and there are others that don’t do exactly what we do, but their goal is the same.

What I would say is that we have a lot of flexibility—I mean different people have different things that float their boats, but if we achieve our objectives we make plenty of money, and we have a lot of flexibility; we’re allowed to remain at arm’s length from what is otherwise a pretty traditional equity department here. So I think that we enjoy the latitude we’re given to do the work, and we enjoy coming to work each day and don’t have any trouble paying the bills.

Thanks a lot, guys.

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