Perception vs. Reality (Sonders)

Tuesday, August 31st, 2010

Key points

• Market volume continues its traditional August swoon, making it difficult to gauge much from stock market action. Economic data continues to tell a mixed story, as growth slows and risks rise.
• Confidence is key to consumer spending, business investment and stock market performance. The Federal Reserve and the government are attempting to instill that confidence in the American public, but so far have had little success.
• Emerging markets continue to show signs of growth and China’s market has been performing well. Germany also has posted some nice numbers lately, but Japan remains a concern.

With the Dow Jones Industrial Average posting triple-digit gains and losses during the past couple of weeks, it can be easy to get caught up in overreaction. However, these market moves have occurred on some of the lowest trading volume days of the year, meaning that they’re hardly a referendum on the overall consensus of market participants.

In fact, during the past month, there’s been little consensus as the overall market indexes are roughly flat. Bears have pointed to deteriorating economic data as a sign of an impending double-dip recession, while bulls have directed attention to a good earnings season, increasing merger-and-acquisition activity and continued accommodative monetary policy.

This again illustrates the folly, in our opinion, of trying to time the market. Where the market goes in the near term is virtually impossible to predict. Following the recent Federal Open Market Committee meeting where the Fed demonstrated its commitment to continued extremely accommodative monetary policy, the market initially responded relatively well, only to sell off during the next trading day.

Additionally, we want to again caution investors about reading too much into so-called technical indicators. While they can be a tool in your overall market analysis, there’s little evidence that the majority of indicators can be consistently relied upon.

Recent attention has been paid to the “Hindenberg Omen,” a relatively complicated set of technical conditions which has preceded every market crash since 1987 that was recently breached. However, it’s important to note—but is rarely reported—that this indicator has flashed multiple times during the past 20+ years when there hasn’t been a crash. In fact, more than 75% of the time the Omen has been a false signal, according to The Wall Street Journal.

We continue to advocate a long-term view on equity investments. If you need money in the near term, don’t invest it in equities—short-term performance can be too volatile.

That doesn’t, however, mean to just buy and ignore your investments. It’s important to use dips and rallies to add or subtract to positions as necessary and to monitor your investments to track changes in approach, style or performance and adjust as necessary.

Economic growth slowing, but remains positive
Although rhetoric surrounding a double-dip recession has increased throughout the summer, we remain relatively optimistic that economic growth will remain positive (albeit low) and that from a sentiment and valuation perspective, the stock market appears relatively attractive. While volatility will continue, alternatives to stocks are relatively unattractive.

Yields on bonds are near all-time lows, while interest rates on cash deposits remain at virtually zero. Meanwhile, the dividend yield on the Dow is approximately 2.9%, greater than the 10-year Treasury yield of approximately 2.5%. Maintaining a balanced, diversified portfolio is important and we believe that for most investors, it makes sense to keep some of your portfolio in stocks.

While we don’t think we’re slipping back into recession, risks are rising and warrant watching. Initial jobless claims remain stubbornly high, with a recent reading again hitting the 500,000 mark, the highest level since November of last year.

Housing also continues to languish, as housing starts were up 1.7% in July, but more forward-looking building permits were down 3.1%. Adding concern, existing home sales fell 27.2% in July to the lowest level in 15 years, as inventories surged to 12.5 months worth of supply.

These results should be taken with a grain of salt, however, as the April expiration of the Federal tax housing credit continues to distort numbers. We continue to believe that historically low mortgage rates and record affordability will help support the housing recovery—but that it will be a slow process and could bounce along the bottom for some time.

Positive news also exists (though it’s getting less attention) as both Institute for Supply Management surveys remain in expansionary territory and the recent industrial production reading gained a surprisingly strong 1% month over month. We still believe positive economic growth is the most likely course, as we turn to the Index of Leading Economic Indicators (LEI), which posted a 0.1% gain in July and are still in territory indicating economic expansion.

Leading economic indicators still signaling expansion

Click to enlarge
Source: FactSet, US Conference Board, as of August 24, 2010.

In fact, according to BCA research, of the 10 underlying components that make up the LEI, six are either flat or rising, indicating some decent underlying strength.

And we don’t want to overlook the historically best predictor of recessions, the spread in the yield curve. There’s been talk lately that the low end of the curve has been held artificially low through the actions of the Fed, thereby rendering the predictive power of the yield curve mute.

We caution against the “this time is different” mentality—we’ve heard it many times in the past, and rarely has it truly been different. As of now, the yield curve (though flattening modestly as economic growth has weakened) remains relatively steep, indicating low probability of an impending recession.

Yield curve not signaling recession

Click to enlarge
Source: FactSet, Federal Reserve, as of August 24, 2010.

Confidence is key
One of the major keys to improving the housing and labor markets, as well as boosting economic growth, is for confidence in the economic system to return. There are small signs that it’s slowly returning, although they remain tenuous.

The recent Federal Reserve Senior Loan Officer Survey on Bank Lending Practices showed that lending standards eased somewhat during the past three months. In fact, for the first time since 2006, big banks’ standards for small businesses eased, potentially freeing up credit for the all-important small-business sector.

However, loan demand remains roughly unchanged, indicating continued uncertainty. Businesses wary of economic prospects, political policy and tax status are extremely hesitant to invest in capital or hire new workers—and if your competitors aren’t hiring or investing, there’s less incentive for you to do so.

The Fed is still trying to reassure markets that it will remain stimulative for the foreseeable future. In fact, during its last meeting, the Fed made the largely symbolic gesture of reinvesting proceeds from paid-off agency securities rather than let its balance sheet decrease by even that small amount.

While we don’t know if this is the best course of action, and worry that the Fed has stayed at the well too long (rendering low rates somewhat ineffective) the Fed is undoubtedly committed to doing its best to avoid a repeat recession.

Confidence in the economic policies of the government, both federal and local, seems to be near its lowest levels in recent memory. States and municipalities continue to struggle with large budget deficits, requiring the cutting of services and laying off workers, while the federal government can’t seem to decide on its best course of action.

On the one hand, talk continues of another stimulus package, while, according to The Wall Street Journal, approximately $164 billion of the $230 billion allocated toward infrastructure projects during the last round of stimulus remains unspent.

The Obama administration is searching for ways to entice businesses to hire more workers, while at the same time issuing new regulations and policies that make it more expensive to do business. Meanwhile, talk of raising taxes on many small businesses continues.

While we’ve always tilted toward the side of free markets, it appears to us that the government needs to provide some certainty going forward, whatever its approach may be. Businesses can adapt to many things, but they need to know the ground rules before they feel confident enough to move forward—confidence they apparently don’t have right now.

Emerging markets buoy global growth
Confidence is also an issue internationally, with increasing concerns about the prospect of a global double-dip recession. However, we look to the strength of emerging-market economies to help keep global growth positive. Emerging-market economies have grown in importance, advancing 2.5% in 2009, almost enough to offset the 3.2% decline during the developed-economy recession, as the world economy fell 0.6% in aggregate in 2009.

Growth in advanced economies will likely be at low levels in 2010 and 2011, and while a global double dip is a growing risk, we believe it’s still a low-probability event.

Meanwhile, emerging markets are forecasted to grow faster, as they’re largely unburdened by the high levels of government and consumer debt that exists in much of the developed world, and banks tend to be healthier. Additionally, consumers have become an important part of the growth in many emerging countries as household incomes rise, as we’ve discussed in articles on Brazil and India.

China slowing, but no hard landing
Many emerging markets tend to have their growth tied to economic prospects in China, which has been a primary source of global growth. While exports are an important part of the Chinese economy (but could slow in coming months), fixed investment is the highest percentage of China’s gross domestic product (GDP) at nearly 50% in 2009, propelled by property construction and government stimulus spending on infrastructure.

We expect infrastructure and property construction in China to slow over the near term as government stimulus levels off and the housing market is affected by measures intended to cool speculation. Encouragingly, steep property price declines have catalyzed sales, but we expect additional supply in coming months, further suppressing prices. The Chinese property market benefitted from rapid loan growth and wealthy individuals’ speculative investments, as there are few investment options in China.

With property prices falling, the government ordered bank stress tests. Chinese banks lack transparency, but we don’t think a collapse in the banking system is likely. Banks announced plans to raise $96 billion this year to strengthen their balance sheets, and a majority are state-owned, boosting their viability.

China’s economy is slowing, but the government strives to maintain 8% growth to keep employment high and to avoid civil unrest. Unlike many developed countries, China has the pocketbook to issue new stimulus if growth slows too much.

It’s probably too soon for China to restart stimulus, but we continue to believe further tightening has been delayed. The outperformance of the Shanghai Composite relative to the S&P 500® index during the past the six weeks is notable, as this market has led in recent years.

China outperforms as tightening delayed

Click to enlarge
Source: FactSet, Shanghai Stock Exchange, Standard & Poor’s, as of August 25, 2010.

We remain constructive on emerging-market equities, as their higher growth outlook and below-average multiples gives them the ability to continue to outperform developed-market stocks.

A tale of two exporters: Japan’s dominance slips, Germany surprises to upside
Businesses allowed inventories to plunge so they could conserve cash given high uncertainty during the recession. As a result, the global recovery was driven by manufacturing and exports, benefitting from inventory building, as well as low levels of positive demand.

However, now that inventory building appears to be leveling off and with global growth slowing, many economies can no longer rely solely on exports for growth. Many countries need internal consumption to take the economic baton and help make the recovery self-sustaining.

As such, the lack of consumer spending by Japan’s aging population, amid a deflationary environment wherein spending is postponed, reduces Japan’s outlook. Additionally, the surging yen has reduced exporters’ prospects.

In fact, Japan ceded the position as the second-largest economy in the world to China during the June quarter, and China’s higher growth implies that this situation is likely to persist.

Japan loses no. 2 position to China

Click to enlarge
Source: FactSet, International Monetary Fund, as of August 25, 2010. Note: 2010 figures are estimates.

While Japan seems poised to benefit from China’s growth, and China accounted for 20% of the Japan’s June exports, Japan imports more from China than it exports. For the time being, the two countries appear to be working as partners to produce goods destined for consumption elsewhere.

On the other hand, Germany’s economy has been surprisingly strong, with its prominent export sector benefiting from a declining euro. The pace of GDP growth is likely to slow from the 9% quarter-over-quarter (q/q) annualized pace in the second quarter, which also benefitted from a construction rebound after being held back by poor weather in the first quarter.

However, German private consumption in the second quarter rose 2.4% q/q annualized, the first increase since the second quarter 2009. In contrast to the near-term outlook for Japan, if German consumers continue to spend, the recovery could enter a self-sustaining phase and boost Europe overall, as Germany constitutes about a quarter of the region’s economy.

Central bank action influences currency outlook
The Fed’s move to maintain the size of its balance sheet effectively delays its exit strategy. Additionally, comments from the Bank of England’s chief, Mervyn King, indicate that the BoE appears to be considering the possibility of extending further stimulus.

Meanwhile, the European Central Bank (ECB) remains opposed to providing stimulus, barely budging even in the face of a market riot over government debt in the second quarter.

However, the Bank of Japan’s lack of action has confounded market watchers. Japan may have entered a liquidity trap amid a deflationary environment, wherein injections of money fail to catalyze lending and spending as purchasing decisions are postponed. A surging yen increases the probability of action by the BoJ, using either unconventional monetary stimulus or currency intervention.

Double-dip recession fears have created demand for the safe-haven status of the US dollar. Additionally, the euro worked off some of the sharp rebound after plunging amid the euro-area debt crisis this year. With the euro comprising 58% of the US Dollar Index (which measures the performance of the US dollar against a basket of currencies), we expect the index to fall as the dollar weakens, as the Fed could exit monetary stimulus later than the ECB.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Tags: Acquisition Activity, Brazil, BRIC, BRICs, Canadian Market, Charles Schwab, China, Double Dip Recession, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Earnings Season, Economic Data, Federal Open Market Committee, India, Liz Ann Sonders, Market Indexes, Market Moves, Market Participants, Market Volume, Merger Acquisition, Merger And Acquisition, Open Market Committee, Overreaction, Russia, S Market, Stock Market Action, Stock Market Performance, Technical Indicators, Volume Days
Posted in Brazil, India, Infrastructure, Markets, Outlook | Comments Off

Bernanke Presents Fed’s Options and Indicates Deflation Not a Significant Risk

Tuesday, August 31st, 2010

August 27, 2010

Chairman Bernanke kicked off the annual symposium in Jackson Hole with a blueprint for the future course of monetary policy. In his opinion, “the recovery of output and employment in the United States has slowed in recent months, to a pace somewhat weaker than most FOMC participants projected earlier this year.” (The central tendency of the Fed’s forecast in July for 2010 is 3.0% to 3.5%). He also noted that “despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place.”

Bernanke listed four options the Fed has in its arsenal with the costs and benefits of each alternative. First, the Fed can purchase longer term securities and increase the size of the balance sheet. However, Mr. Bernanke indicated that this strategy works best during times of “financial stress.” He also added that large purchases of additional securities would leave the public less confident about the Fed’s ability to manage a smooth exit. The reduction of confidence would translate into an “undesired increase in inflation expectations.” Bernanke stressed that the Fed has developed several tools to ensure a smooth exit and Fed officials have spoken extensively about these tools to moderate concerns of the public. Second, Mr. Bernanke noted that the Fed could communicate to investors that it “anticipates keeping the target for the federal funds rate low for a longer period than is currently priced in the markets.” The main drawback of this tool is that it may be a challenge to convey the FOMC’s intentions with precision. Third, the Fed could reduce interest rates it pays on excess reserves (currently 25 bps). Bernanke sees this route as fraught with the potential of reducing liquidity of the federal funds market. Fourth, he mentioned a controversial solution – announcing a medium term inflation target that is above a level consistent with price stability. Bernanke considers this option inappropriate for the United States and sees it suitable in situations of an extended period of deflation. He supported this opinion with the fact that inflation and inflation expectations are within a range of price stability in the United States and would not require this strategy. Given these opinions about the alternatives the Fed has, it appears that purchases of securities will probably prevail, if necessary.

Bernanke’s description of the circumstances under which the Fed would consider further easing of monetary policy is the crux of the speech. These remarks offer guidance pertaining to the course of near term monetary policy:

“First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.”

Real GDP Growth Slows in Q2, Second-Half Likely to Mimic This Trend

Real GDP of the U.S. economy grew at annual rate of 1.6% in the second quarter, revised down from the advance estimate of 2.4%. The upward revision of imports to a 32.4% increase from the earlier estimate of a 28.8% gain was the major reason for the downward revision, in addition to a smaller accumulation of inventories ($63.2 billion vs. $75.7 billion in the advance estimate) and a nearly flat reading of outlays on non-residential structures (+0.4% vs. +5.2%). Partly offsetting positive contributions came from upward revisions of consumer spending (+2.0% vs. +1.6% in the advance report) and equipment and software spending (+24.9% vs. +21.9% in advance estimate).

Corporate profits increased 4.6% in the second quarter vs. a 10.6% gain in the first quarter. Domestic non-financial industries (+8.1%) made the larger contribution to corporate profits in the second quarter, while profits of the financial industry inched down 0.1% and profits from abroad rose 1.4%.

A tepid increase in real GDP is projected for the second-half of the year, putting the Q4-to-Q4 increase at 2.2% after a nearly flat reading in 2009. Bernanke indicated that the Fed stands ready to provide additional financial accommodation to maintain the pace of economic activity, if necessary (See remarks about Bernanke’s speech above).

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

Copyright (c) Northern Trust

Tags: Arsenal, Balance Sheet, Blueprint, Bps, Central Tendency, Drawback, Excess Reserves, Fed Officials, Federal Funds Rate, Financial Stress, Fomc, Inflation Expectations, Inflation Target, interest rates, Jackson Hole, liquidity, Monetary Policy, Preconditions, Price Stability, Term Inflation
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Has the Fed Defused the Neutron Bomb? (Kolivakis)

Tuesday, August 31st, 2010

Via Pension Pulse.

Bruce Friesen of Global Investment Solutions forwarded Randall Forsyth’s article which appeared in Barron’s earlier this week, Deflation: the Neutron Bomb of Balance Sheets:

Low interests rates have made these the best of times for borrowers but the worst for savers and investors.

Blue-chip corporations never had it so good with the likes of Dow Jones Industrial Average members International Business Machines (IBM) able to issue new three-year notes at 1% and Johnson & Johnson (JNJ) paying less than 3% for new 10-year debt.

But these historically low bond yields have a darker side: According to a new report from Fitch Ratings, ultra-low interest rates will exacerbate the underfunding of many U.S. corporations’ pension plans.

Just as with American workers who have failed to save enough for retirement and have seen their assets lose value, companies also will have no choice but set aside more of their earnings. And just as that means belt-tightening for consumers, it means corporations have less to distribute to their shareholders.

The burden of funding traditional pension plans—known as defined-benefit plans—is why they have waned in Corporate America. More common are defined-contribution plans—such as the ubiquitous 401(k)s—that have supplanted DB plans in the private sector. As has been reported widely, DB plans remain the standard in the public sector, which are decimating budgets of many states and municipalities.

But, according to Fitch, the low-yield, deflationary environment is adding to the problems of underfunded corporate pension plans. Again, the problem is two-fold: The decline in the values of investments, such as traditional stocks and commercial real estate, has hurt the asset side. The rush into so-called alternative investments such as hedge funds right at their peaks didn’t help. The flip side is that low interest rates increase the present value of future liabilities.

(Time out for those who aren’t finance geeks. If you put $1 in a savings account at 7%, in 10 years you would have $2. Trust me on that. That means the future value of $1 in 10 years, compounded at 7%, is $2. Conversely, the present value of that $2 invested for 10 years is $1.

But what if interest rates are just half as high, or 3.5%, a far more realistic yield for a 10-year, high-grade corporate bond? The present value of that $2 in 10 years is $1.42. Trust me again on that, or get a financial calculator or find one on the Web. In other words, where it took only $1 for you to wind up with $2 in 10 years if you invest at 7%, it takes an investment of $1.42 to end up with that same $2 in 10 years at 3.5%. That means you have to set aside 42% more today to meet your savings goal a decade hence.)

Thus, a decline in bond yields can be as devastating to a savings plan as a drop in the stock market. According to Kenneth S. Hackel, president of CT Capital, a financial advisory firm, 1% cut in a retirement plan’s assumed rate of return is roughly equal to a 15% decline in stock prices.

Fitch’s analysts find the mean assumed return for corporate pension plans in 2008 and 2009 was 8%. That’s with an allocation to fixed-income assets of 34% of the total. Treasuries and investment-grade corporate bonds yield far less than 8%, which is closer to the very long-term return from equities, which means they haven’t locked in much of yesterday’s higher yields. And, in case you need to be reminded, over the past decade or so, the return from stocks has been practically nil.

In line with Hackel’s rough calculation, Fitch reckons a 1% cut in the assumed discount rate for companies’ DB plan can result in a 10%-20% increase in the present value of future liabilities. How to bridge that gap?

“The fact is that there are no shortcuts—prudent management will likely require contributions well in excess of the minimum required given low yields and low equity returns,” Fitch analysts write. Simply hoping for higher equity returns or bond yields simply isn’t prudent, they add.

So, what’s the answer? You know those hefty cash holdings on corporate balance sheets on which the bulls keep harping? Fitch thinks pension funding requirements will have dibs on corporate cash flows, and then the stock of cash on companies’ balance sheets.

That’s the thing about deflation; it’s like a neutron bomb for corporate, public-sector and consumer balance sheets. Asset values and returns get decimated while liabilities remain standing. Except that falling interest rates make those future liabilities more onerous, requiring more belt-tightening, which only exacerbates the deflation.

As I’ve repeatedly stated, deflation is the arch nemesis of the financial sector and the Fed will do whatever it takes to avert it. Moreover, in order to address pension deficits, you need a rise in bond yields (lowers present value of future liabilities) and a rise in asset prices. In other words, you need a lot more days like Friday where stocks took off and bond yields backed up.

The Fed’s policy has been geared towards the big banks and their big hedge fund clients. Reflate and inflate is the official policy. By borrowing at zero and investing in higher yielding Treasuries, banks lock in the spread, making instant profits which they then use to trade risk assets all around the world.

Is this policy succeeding? Yes and no. It’s helping banks shore up their balance sheets and some elite hedge funds who thrive on volatility, but doing little to help the real economy which remains weak at this stage of the cycle.

However, that all may be changing. Over the weekend, I will go over some encouraging signs that receive little or no attention in mainstream media. Below, listen to an interview with Nigel Gault, chief U.S. economist at IHS Global Insight as he discusses his views on the US economy and his take on Ben Bernanke’s speech at the Fed’s annual Jackson Hole confab.

Tags: Alternative Investments, Benefit Plans, Bond Yields, Chip Corporations, Commercial Real Estate, Corporate Pension, Darker Side, Defused, Dow Jones, Fitch Ratings, Flip Side, Friesen, Global Investment, Interests Rates, International Business Machines, Investment Solutions, Low Interest Rates, Neutron Bomb, Present Value, S Corporations, Traditional Pension
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A Bad Case of Economic Hypochondria? (Kolivakis)

Tuesday, August 31st, 2010

Via Pension Pulse.

Following my latest post on whether the Fed has defused the neutron bomb, a senior pension fund manager sent me a link to AXA Investment Managers’ latest weekly comment by Eric Chaney, Deflation may have won a battle, but not the war.

It is an excellent read and demonstrates why any discussion on the inflation/deflation debate which doesn’t take into account what’s going on outside the US is missing the bigger picture. I quote the following:

Although contemporaneous estimates of output gaps are somewhat elusive, the broad picture is clear: a growing portion of the global economy is facing inflation risks and the bulk of developed economies is no longer in the deflation danger zone. This uneven dynamic distribution matters a lot for investors, who need to make up their mind about inflation. One key lesson from the past cycle is that price movements have a larger common component than in previous times; call it the globalisation factor. Matteo Ciccarelli and Benoît Mojon estimated that “(inflation rates of) OECD countries have a common factor that alone accounts for nearly 70% of their variance” (ECB working paper, October 2005), a finding that is consistent with later research by Haroon Mumtaz and Paolo Surico (Bank of England working paper, February 2008). In such a world, the fact that China, India and Brazil have entered into the inflation risk zone matters more than Spain, Ireland and Greece being on the brink of deflation.

Mr. Chaney concludes by stating:

In sum, there is no evidence that deflation has gained much ground during the summer. For sure, a double dip of the US economy would tick a few boxes in the deflation camp. Yet the most likely scenario in our view is that the US has embarked on a slow growth cycle, the mirror image of the artificially debt-fuelled previous decade, rather than on a stop-and-go cycle. Once the markets get a clearer picture of business cycle developments, which may unfortunately take several months, there are good reasons to believe that the current deflation buzz will be quickly replaced by its opposite. In the meantime, enjoy the bond rally!

There are other encouraging signs suggesting that the global recovery is back on track. This past week, the CPB Netherlands Bureau for Economic Policy Analysis released its World Trade Monitor for June 2010, showing that world trade was up 0.7% month on month after an upwardly revised 2.3% increase in May.

Why is this significant? Because, as Yanick Desnoyers, Assistant Chief Economist at the National Bank of Canada discusses below, Global trade volume finally back to its previous peak:

According to CPB Netherlands Bureau for Economic Policy Analysis, the volume of world trade grew 0.7% in June after an upwardly revised 2.3% gain in May. This represents the ninth increase in ten months. Global trade volume is now expanding at a 21.2% growth on twelve month basis, just shy of the 23% peak registered in May. In the second quarter as a whole, global volume trade was up a significant 15.3%. As today’s hot chart shows (click on char above), it took only about a year for world trade volume to virtually get back to its previous peak.

On the global industrial output side, the index is already in an expansion mode with a 0.7% gain above its previous peak, despite the fact that IP is still down 10% in advanced economies. After all, it seems that fears of sovereign debt contagion from the Euro zone earlier in the spring did not have a material impact on global trade volume. Despite an upcoming slowdown in the U.S., we are still forecasting an above 4% global GDP growth in 2010.

What this tells you is that this cycle is different than previous cycles because the Emerging economies are the source of growth. Too many analysts are focused solely on what is going on in the US and other developed economies. I too had written about Galton’s fallacy and the myth of decoupling, but maybe this view needs to be revisited.

Tags: Axa Investment Managers, Bad Case, Bank Of England, Brazil, Canadian Market, China, Ciccarelli, Danger Zone, Double Dip, Eric Chaney, Global Economy, Haroon, India, Inflation Deflation, Inflation Rates, Inflation Risk, Inflation Risks, Later Research, Mirror Image, Mumtaz, Neutron Bomb, Oecd Countries, Output Gaps, Pension Fund Manager
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Hugh Hendry – The Battle Over Potash

Tuesday, August 31st, 2010

Hugh Hendry appeared on BBC this week headlining an interesting discussion about Western vs. Eastern Agriculture and Potash and shared these thoughts:

“The Chinese and the Canadians hate each other, here. There’s been a profound game of roulette. Chinese consumption of Potash is 35% less than we use in Western agriculture. The Chinese were very aggrieved when they saw the chart with potash at $1000 per ton.They stopped; they haven’t been consuming in the manner they should and they risk an absolute collapse in their yields.”

“Again, we made this point, that for thirty years, the price of agriculture has collapsed, its fallen 90% in real terms, so we haven’t invested in the sector.”

“As a world society, we’re now acutely vulnerable in the business of feeding ourselves. We haven’t spent enough, and we haven’t organized the production of agriculture in a manner which is appropriate.”

By the way, Congratulations to Hugh Hendry on being awarded Global Macro-Hedge Fund Manager YTD, according to Bloomberg.

Tags: Absolute, Agriculture, Bbc, Canadian Market, Canadians, Collapse, Consumption, Game, Game Roulette, Global Macro, Hedge Fund Manager, Hugh Hendry, Potash, risk, Roulette, Thirty Years, Western Agriculture
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Doug Kass: “I just can’t be that negative now”

Monday, August 30th, 2010

Despite the the stock market averages taking a nosedive over the past few, strategist Doug Kass said on Tuesday he “just can’t be that negative now”.

That’s largely because Kass thinks the doom-sayers – such as economist David Rosenberg of Gluskin Sheff, who said the economy is in a depression, not a recession – are missing key points. Click on the image for the skinny.

Source: CNBC, August 24, 2010.

Tags: Cnbc, David Rosenberg, Depression, Doom Sayers, Doug Kass, Economist, Economy, Gluskin Sheff, Nosedive, Recession, Scheff, Stock Market Averages, Strategist
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US stock market returns – what is in store?

Monday, August 30th, 2010

Stock market movements since the start of the credit crisis have been characterised by relatively high volatility as uncertainty became paramount. And as new pieces of the economics puzzle are added every day, investors are increasingly struggling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Has the market started topping out and is a primary bear market about to resume, or is a new secular bull market merely correcting the strong rally that commenced in March 2009, before moving higher? Or is a “muddle-through” trading range in store?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with not many people actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns, as done by Jeremy Grantham’s GMO. Our study covered the period from 1871 to August 2010 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

The cheapest quintile had an average PE of 8.6 with an average ten-year forward real return of 10.9% per annum, whereas the most expensive quintile had an average PE of 24.2 with an average ten-year forward real return of only 2.4% per annum.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% intervals (see diagrams A.2 and A.3).

This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is that the ten-year forward real returns on investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.

Based on the above research findings, with the S&P 500 Index’s current ten-year normalised PE of 19.3% and dividend yield of 2.1%, investors should be aware of the fact that the market is by historical standards above “average value” territory. As far as the market in general is concerned, this argues for unexciting long-term returns, and possibly a “muddle-through” trading range for quite a number of years to come.

Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current valuation levels. As a matter of fact, there is a distinct possibility of below-average returns.

Tags: Asset Management, Bear Market, Creating Wealth, Credit Crisis, Investment Returns, Jeremy Grantham, Muddle, Patient Approach, Pe Ratios, Predecessors, Price Earnings, Pundits, Quintile, Rallies, Secular Bull Market, Stock Market Returns, Stock Prices, Stock Valuations, Store Stock, Volatility
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Close Those Longs in the Bond Market!

Monday, August 30th, 2010

The yield on the US 10-year Treasury Note sank from a high of 3.97% in April to touch 2.49% recently.

Source: StockCharts.com

But just what is the bond market trying to tell us? My analysis indicates that more than 75% of the yield on the 10-year note can be explained by MZM velocity, calculated as the ratio between GDP (current terms) and MZM (money zero maturity). When the historical relationship is applied to the current yield on the 10-year note of 2.54% it indicates that the bond market is expecting MZM velocity to fall from 1.55 to 1.47. Given the most recently released numbers for MZM a fall in MZM velocity will de facto imply that the US economy has shrunk by 5.2% in current money terms in the third quarter on a quarter-ago basis (22.5% annualised). You have to ask yourself whether this is realistic or not. What it means is that the bond market is saying that the US is already in a deep recession – therefore the double dip is already here!

The market has been wrong before. It tends to overshoot the underlying economic fundamentals significantly. In the final quarter of 2008 the market anticipated a much worse underlying economy than that which has eventuated. Since the second quarter of 2009 through the first quarter of this year the market was overly bearish on bonds by forcing up yields in anticipation of a much stronger economy. Is the market now overly bullish on bonds and bearish on the economy by forcing the yield on the 10-year note to levels similar to those that prevailed in the midst of the liquidity crisis?

Tags: 10 Year Treasury, Analysis Indicates That, Anticipation, Bond Market, Consumer Confidence Index, Cue, Current Yield, Double Dip, Economic Fundamentals, First Quarter, GDP, Liquidity Crisis, Midst, Money Terms, Mzm, Recession, Second Quarter, Velocity, Year Treasury Note, Zero Maturity
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Opportunities in the Bad News?

Monday, August 30th, 2010

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors.

There’s been plenty of bleak news coming out of the equity markets and the U.S. economy as a whole. Are there opportunities hidden within that bad news? Are we now in one of those “blood in the streets” scenarios that Rothschild (and many investors after him) found so appealing?

If you believe in the cyclical nature of markets, the chart below from Stifel Nicolaus may be of interest. This chart shows the 10-year rolling return of the S&P Stock Market Composite going back nearly two centuries—current performance (inside the circled area) is at low levels only seen during the Great Depression.

The negative news flow keeps many investors on the sidelines waiting for sunnier days, while those who believe that what goes down eventually comes back up may see an opportunity to snap up equities at bargain prices.

A similar story line may be created for the next chart, which was produced by Old Mutual insurance company. The MSCI World Index is a measure of stock market performance across the world (including the U.S.).

The chart shows how the growth rate can swing wildly based on global events, but what’s clear is that the negative rolling 10-year growth since 2008 is unmatched in the past four decades. Markets have always bounced back, and as you can see on both charts, the best gains tend to be posted early in the turnaround.

One more data point—over the past decade, Treasury bonds have outperformed U.S. equities by nearly 90 percent. This is the widest margin of such outperformance over a rolling 10-year period in more than a century.

J.P. Morgan points out that history shows equities eventually reversing that trend, and when they do, they on average climb more than 250 percent over 10 years—a compounded annual growth rate of 13.6 percent.

The persistent bad macroeconomic news makes another round of “quantitative easing” (i.e., money injection) by the Federal Reserve increasingly likely. This could be good for equities by lowering long-term interest rates, stimulating the economy and boosting valuations.

It’s often said that hope is not an investment strategy, and that’s certainly true. It’s also true that hopelessness is also not an investment strategy. History and cycles are not perfect predictors, but it’s worthwhile to pay attention to these indicators.

I would also invite you to take our G-20 flag quiz—not only is it fun, it also teaches you a little about one of the most important global economic groups. If you have already done the quiz, try it again—you can always increase your speed and accuracy.

Copyright (c) U.S. Global Investors

Tags: Bad News, Bargain Prices, Chief Investment Officer, Cyclical Nature, Federal Reserve, Frank Holmes, Global Events, Great Depression, J P Morgan, Macroeconomic News, Msci World Index, Mutual Insurance Company, Negative News, Outperformance, Rothschild, Scenarios, Sidelines, Stock Market Performance, Treasury Bonds, U S Global Investors
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Faber and Shiff: Bond Bubble Trouble?

Saturday, August 28th, 2010

This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

As I’ve been saying for some time that the bond market is screaming for an imminent burst,  Dr. Marc Faber and Mr. Peter Schiff also spoke with CNBC on August 23 warning of a bond bubble trouble.

Faber – Stay away from a 19-year rally
Faber advises investors to “stay away from Treasuries as they’ve been rallying since 1981–equivalent to a 19-year bull run”–when the 10-year bottomed out on Sep. 21, 1981. Faber says Dec. 18, 2008 was the peak of the bond bubble with yields of 2.08% and 2.53% on the 10-year and 30-year respectively. (See 10-year chart)

“I think  there isn’t much upside potential in Treasuries unless it’s for the short term. Even the short term is uncertain. But if I look 10 years ahead, where do I want to have my money? Certainly not in U.S. Treasuries.”

Faber’s biggest concern is that because of a weak economy, the U.S. budget deficit will likely remain high, and continue to go up under the Obama administration, which could make interest payments on government debt unbearable.

He also warned against the misguided confidence arising from still strong foreign demand for U.S. Treasuries:

“In 1999 and 2000, foreigners (bought) the NASDAQ and what happened afterwards was a major collapse. I would not look at foreign buying as a very intelligent leading indicator.”

Faber says a better place for investor’s money now is farm land and, agricultural commodities, and gold should also be a part of an investor’s portfolio.

Schiff – The mother of all bubbles
Schiff basically declares the bond market the mother of all bubbles, and notes that when the bubble bursts, the loss will dwarf the combined losses of the bubbles of the stock market and  real estate. Eventually, the government will either inflate or default. Either way will ultimately make bond investors go bust.

For risk-averse investors, Schiff believes gold and foreign bonds such as Switzerland where government debt level is not as high, would be better options than U.S. treasuries.

My thoughts
Dismal economic data have spooked investors flocking to Treasuries, driving down yields. Traditionally, bonds are considered to be safer and less volatile than equities and commodities. However, the financial markets have evolved in such a way that the same players are active in all sectors, employing the same trading technique. This, in part, has made bonds behave almost like stocks with similar volatility. (See comparison chart.)

So, investors should start looking at bonds the same way as equities and commodities, and now is the time to move out of bonds and into either equities (dividend-paying blue chips as noted in my previous post), or commodities such as gold.

And for the highly risk averse, parking in cash for the short term would still be better  than staying in “the mother of all bubbles”.

(Recommended Reading: Self-fulfilling Prophecy: The Bond Trade, Yield: Dow 30 vs. 10-year U.S. Treasury, and Bonds & Equities: Expect a Major Shift)

Video Source: CNBC

Source: Dian Chu, Economic Forecasts & Opinions, August 25, 2010.

Tags: Agricultural commodities, Bond Investors, Bond Market, Bubble Trouble, Bubbles, Budget Deficit, Bull Run, Cnbc, Commodities, Dian, Dr Marc Faber, Economic Forecasts, Gold, Government Debt, Interest Payments, Leading Indicator, Market Analyst, Nasdaq, Peter Schiff, Shiff, Stock Market, Treasuries
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