The Rear View Mirror

Tuesday, July 31st, 2012

A great, timeless sketch from Carl Richards.

Richards is an American fee-based financial planner and author. His sketches appear in the New York Times Bucks Blog and he writes a column for Morningstar (USA). Through simple drawings, he makes complex financial concepts easy to understand. We admire that.

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On the Financial Press (Mark Grant)

Tuesday, July 31st, 2012

Via Mark E. Grant, author of Out of the Box,

This is a piece I have wanted to do for some time now. I am on TV with some frequency and I have been quoted in any number of places and I have had the opportunity to get to know a number of journalists and I count some as good friends of mine. Having had the opportunity to gain a further understanding of how financial reporting works I would say that there are tremendous gaps in reporting on events and earnings, on opportunities and pitfalls and on what is really important.

I can tell you that when you are invited on TV that it is a week to weeks in advance so that whoever is going to be on at a particular point in time is a matter of chance. It is certainly true that guests are lined up for certain events such as the release of the Fed’s minutes or when the GDP is announced but this is generally not the case with a few exceptions such as those that I have noted. Consequently when an event happens it is left to the commentators on-air to give some kind of analysis and while this is helpful in some cases; it is markedly not in others as the complexity of the issue overwhelms some reporter’s knowledge. In our digital world some business channel should disperse 300 video cameras to various investment professionals so that they could come on-line immediately and dispense some educated opinion. This would be one suggestion of mine.

Next I would say that the financial press is far behind in what the public would like or needs as evidenced by the outflow of money from equities and equity funds and into bonds and bond funds. The financial TV press is still fixated on stocks, addressing day traders that are a much smaller group of people than in times past and, in my opinion, many shows treat investments as if they were some kind of casino enterprise. In other words, there is a lot of coverage that is directed towards speculators and not nearly enough directed toward investors.

The bond markets are multiples of the size of the equity markets and coverage here is close to nil as retail and institutions alike concentrate much more on investing in bonds rather than putting their core money in equities. The media could focus on bond mutual funds, fixed-income ETF’s, which muni funds are performing well and why and examine the credits of the Municipalities and new upcoming deals the way they examine corporate earnings and the next IPO. Americans took a 36% hit to wealth during the American Financial Crisis and many people and institutions want their money in the senior position of the capital structure, in bonds, so that they do not lose their principal and the media barely gives a nod to providing information for fixed-income investments during their entire programming day. This is a huge error in judgment in my opinion and one that should be corrected. Even in the area of news it seems to be that one question is how some event will affect the stock markets but there should also be a discussion of how it affects the bond markets and the interplay between the two markets should be evaluated.

There is an old saying on Wall Street that to be successful one must “follow the money” and it is quite statistically evident that the money has flowed into fixed-income investments and that the financial press has not followed it. I say this without rancor or even criticism but just in an honest attempt to provide a suggestion for the people that are employed in the financial media. Even in what is very liquid, that is listed, that trades in small and large size there is a tremendous gap, in my view in coverage. There is a whole liquid market in preferred stocks, in a number of listed bonds, in ETF’s, in mutual fund shares that could be compared and should be compared to any return on dividends. A dividend can be increased or waived with a singular board meeting in most cases while the non-payment of senior debt throws a company into bankruptcy and in many instances, these days, it is possible to find corporate bonds with a higher yield than some company’s dividend and yet this is almost never discussed or evaluated. Certainly the public is heavily invested in municipal bonds to avoid tax consequences and there are new deals that come out daily and yet there is scarcely a mention of these new issues while IPO’s are discussed and touted with great frequency.  Most people and most institutions are investors, not speculators and the real money investors are getting the short shrift in my opinion.

There should be discussions about how the money managers are doing and comparisons should be made. Various specific fund managers should be highlighted and either given a thumbs up or a thumbs down based upon their performance. The same could be done for ETF’s as compared in various spaces such as mortgages, high yield or emerging markets. Various publications such as the Wall Street Journal and Barrons make some stabs at this but none of the television media even notice that these other options exist as their concentration is almost 100% on equities. Each and every day there are not only new Municipal bond offerings but bonds linked to inflation or step-up bonds of one kind or another or some new corporate debt deal. The fixed-income market is every bit as exciting as equities but it is brushed aside by the media almost as if it didn’t exist and I think it would be in everyone’s interest if there was a re-think by the various media enterprises.

My final comment would be directed at analysis. We have talk shows that analyze the events in Washington, world news and so forth and yet there is almost no in-depth commentary on the financial markets. When you are a guest on TV, as an example, you generally have three to five minutes on air. The reporter can and does ask you almost anything and even if you answer the question directly there is no real time to give an informative response. I have been asked any number of times “How do you fix Europe” and it is just not possible to give any kind of real answer in some three minute segment. People seem to like and watch programs such as “Sixty Minutes” or “Face the Nation” and I would like to suggest that some media group or another provides thirty minutes with some Wall Street professionals to address the important financial questions or to provide some explanation of asset-allocation or why one sector of the market is now better than another. All of this does not need to be dull or boring and it could be presented in some fashion that would hold the attention of those watching and the playing field should include all types of investments and not just equities. That is my opinion and I hope that some of you may take my viewpoint into consideration and also that some others of my brethren might make their opinions known. The people on Wall Street may not be the biggest part of any audience but we are the people that pay for the ads so, in the end, we do matter. I get the joke that news of any sort must be entertaining but I can assure you that any number of investment professionals are quite capable of presenting information in an interesting fashion. The investment world has changed and I encourage the media to grasp it and to change as a result.

Copyright © Mark Grant

Mr. Grant is a graduate of Occidental College and has been on Wall Street for thirty-seven years in various senior management positions. He has run Capital Markets for four Investment Banks and been on the Board of Directors of four Investment Banks. Mr. Grant was also the President of a public company in the telecommunications field and on its Board of Directors for several years while he continued his work on Wall Street. He currently works at a publically traded Investment Bank and is a Managing Director of the firm. He runs the Corporate Syndicate Department and also the Structured Finance Department. Mr. Grant also writes a commentary on the financial markets, “Out of the Box,” that is only distributed to large institutions in money management and is published each day by MTN-I, a very respected operation geared towards structured finance out of London. Mr. Grant is the only market commentator for MTN-I. Mr. Grant is also quoted often in a number of prominent business publications and he can be found, with some regularity, on various TV and radio shows concerning the financial markets. The total distribution of Mr. Grant’s commentary is approximately 5,500 financial institutions in forty-eight countries. Mr. Grant runs a team whose associations include a number of Sovereign Wealth Funds, Central Banks, Mutual Funds, Bank Trust Departments, major Insurance Companies and other money managers of various sizes.

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S&P 500 Rolling Ten Year Returns: Better Than You Think

Tuesday, July 31st, 2012

by Bespoke Investment Group

While the period from March 2000 through now has been classified as the dark ages for investing, the rolling ten year returns for the S&P 500 hit their highest levels since January 2008 this month.  The chart below shows the historical rolling ten-year returns for the S&P 500 going back to 1938.  As shown in the chart, the returns have been rebounding from multi-decade lows in the last couple of years and are now up to 51.9%. In other words, $100 invested in the S&P 500 ten years ago this month is worth $151.9 today.

Before we start calling it a golden age for equities, though, we would note that a big reason for the current positive level is the fact that this Summer also represents the 10-year anniversary of the end of the dot-com bear market that went from Spring 2000 through Summer 2002.  Time sure flies when you’re having fun.  Doesn’t it?

Copyright © Bespoke Investment Group

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Will the Market’s Direction Determine the Presidency?

Tuesday, July 31st, 2012

After the first few months of President Barack Obama’s term in office, I wrote about the carnival rollercoaster the market was riding. Looking at the blue line below, that post may have foreshadowed his tenure! The average of four-year presidential cycles from 1953 through 2008 shows that the S&P 500 Index generally remains flat for almost the first two years, before heading higher in the second half.

Despite the S&P’s wild ride, the market is significantly higher than when Obama took the oath. Does this ensure a victory for the 2012 election?

To paraphrase common fund disclosure, past performance is not indicative of future presidential performance. Rather, victory for the president depends on what the market does in the next few critical months.

If the S&P remains strong, then the answer might be yes, says Adam Hamilton from Zeal Intelligence. He points to research done by InvesTech, which looked at market results during the two months leading up to the presidential election since 1900. If stocks rise in September and October, the incumbent party usually wins the presidency; if equities drop, the incumbent typically loses. “Out of the last 28 presidential elections, this simple indicator has proven correct 25 times. This is an astounding 89 percent success rate!”

Piper Jaffray found very similar results. The firm reviewed the S&P 500 performance for the three months prior to an election year since 1928. According to its study, the incumbent party won 11 out of 14 times when the S&P rose, and lost 6 out of 7 presidential elections when the S&P declined over the three months.

So why does this happen? It’s the market’s effect on Americans’ psyche. Adam says, “When the stock markets are strong so everyone feels better about the future, incumbents are more likely to win.”

Adam explains what many of us feel: When stock prices are rising, people are more optimistic, and spend more; when markets take a turn for the worse, people become concerned and spend less. “Not surprisingly, these behavioral changes spawned by our rising and falling portfolios also carry over into the voting booths.”

With this in mind, a market correction in the months coming up to the election means Americans will “naturally start getting worried and anxious,” says Adam. “So they start to look for a change in leadership to fix things, to improve the economy and their own chances for success. If an election happens then, they like to vote in new blood for change.”

Read his article in its entirety.

So how has the market typically performed? Going back to Piper Jaffray’s data, since 1928, August has historically been a “much stronger month” during election years as compared to all years. The S&P typically sees a return of about 1 percent in August; during election years, this number pops to about 3.5 percent. Also during election years, September and October have historically declined slightly.

In early August last year, the S&P dropped 12 percent in three days because of the unease over the eurocrisis and the U.S. debt downgrade. Both have parallels to what’s happening today, says Ed Hyman from ISI. He speculates that the U.S. will see a “repeat of 2010/2011, which implies a weaker economy for a few more months before improving in the fall.”

However, there are positive signs in the U.S. market today, with ISI pointing to an energy and tech boom, interest rates near zero and a cheap dollar. Also, U.S. consumers are reducing their debt burdens, with household debt as a percentage of disposable income having come off its high, and house prices in America are “among the world’s cheapest,” according to The Economist.

Which way do you think the market will head over the next few months? Let us know at editor@usfunds.com.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. The S&P 500 Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. By clicking the link above, you will be directed to a third-party website. U.S. Global Investors does not endorse all information supplied by this website and is not responsible for its content.

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Bill Gross: Investment Outlook (August 2012)

Tuesday, July 31st, 2012

by William H. Gross, Managing Director, PIMCO

• The long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return since 1912.
• The legitimate question that market analysts, government forecasters and pension consultants should answer is how that return can be duplicated in the future.
• Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades.

The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of “stocks for the long run” or any run have mellowed as well. I “tweeted” last month that the souring attitude might be a generational thing: “Boomers can’t take risk. Gen X and Y believe in Facebook but not its stock. Gen Z has no money.” True enough, but my tweetering 95-character message still didn’t answer the question as to where the love or the aspen-like green went, and why it seemed to disappear so quickly. Several generations were weaned and in fact grew wealthier believing that pieces of paper representing “shares” of future profits were something more than a conditional IOU that came with risk. Hadn’t history confirmed it? Jeremy Siegel’s rather ill-timed book affirming the equity cult, published in the late 1990s, allowed for brief cyclical bear markets, but showered scorn on any heretic willing to question the inevitability of a decade-long period of upside stock market performance compared to the alternatives. Now in 2012, however, an investor can periodically compare the return of stocks for the past 10, 20 and 30 years, and find that long-term Treasury bonds have been the higher returning and obviously “safer” investment than a diversified portfolio of equities. In turn it would show that higher risk is usually, but not always, rewarded with excess return.

Got Stocks?

Chart 1 displays a rather different storyline, one which overwhelmingly favors stocks over a century’s time – truly the long run. This long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return (known as the Siegel constant) since 1912 that Generations X and Y perhaps should study more closely. Had they been alive in 1912 and lived to the ripe old age of 100, they would have turned what on the graph appears to be a $1 investment into more than $500 (inflation adjusted) over the interim. No wonder today’s Boomers became Siegel disciples. Letting money do the hard work instead of working hard for the money was an historical inevitability it seemed.

Yet the 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)? The commonsensical “illogic” of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world! Owners of “shares” using the rather simple “rule of 72” would double their advantage every 24 years and in another century’s time would have 16 times as much as the skeptics who decided to skip class and play hooky from the stock market.

Cult followers, despite this logic, still have the argument of history on their side and it deserves an explanation. Has the past 100-year experience shown in Chart 1 really been comparable to a chain letter which eventually exhausts its momentum due to a lack of willing players? In part, but not entirely. Common sense would argue that appropriately priced stocks should return more than bonds. Their dividends are variable, their cash flows less certain and therefore an equity risk premium should exist which compensates stockholders for their junior position in the capital structure. Companies typically borrow money at less than their return on equity and therefore compound their return at the expense of lenders. If GDP and wealth grew at 3.5% per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that. Long-term historical returns for Treasury bill and government/corporate bondholders validate that logic, and it seems sensible to assume that same relationship for the next 100 years. “Stocks for the really long run” would have been a better Siegel book title.

Yet despite the past 30-year history of stock and bond returns that belie the really long term, it is not the future win/place perfecta order of finish that I quarrel with, but its 6.6% “constant” real return assumption and the huge historical advantage that stocks presumably command. Chart 2 points out one of the additional reasons why equities have done so well compared to GNP/wealth creation. Economists will confirm that not only the return differentials within capital itself (bonds versus stocks to keep it simple) but the division of GDP between capital, labor and government can significantly advantage one sector versus the other. Chart 2 confirms that real wage gains for labor have been declining as a percentage of GDP since the early 1970s, a 40-year stretch which has yielded the majority of the past century’s real return advantage to stocks. Labor gaveth, capital tooketh away in part due to the significant shift to globalization and the utilization of cheaper emerging market labor. In addition, government has conceded a piece of their GDP share via lower taxes over the same time period. Corporate tax rates are now at 30-year lows as a percentage of GDP and it is therefore not too surprising that those 6.6% historical real returns were 3% higher than actual wealth creation for such a long period.

The legitimate question that market analysts, government forecasters and pension consultants should answer is how that 6.6% real return can possibly be duplicated in the future given today’s initial conditions which historically have never been more favorable for corporate profits. If labor and indeed government must demand some recompense for the four decade’s long downward tilting teeter-totter of wealth creation, and if GDP growth itself is slowing significantly due to deleveraging in a New Normal economy, then how can stocks appreciate at 6.6% real? They cannot, absent a productivity miracle that resembles Apple’s wizardry.

Got Bonds?

My ultimate destination in this Investment Outlook lies a few paragraphs ahead so let me lay its foundation by dissing and dismissing the past 30 years’ experience of the bond market as well. With long Treasuries currently yielding 2.55%, it is even more of a stretch to assume that long-term bonds – and the bond market – will replicate the performance of decades past. The Barclay’s U.S. Aggregate Bond Index – a composite of investment grade bonds and mortgages – today yields only 1.8% with an average maturity of 6–7 years. Capital gains legitimately emanate from singular starting points of 14½%, as in 1981, not the current level in 2012. What you see is what you get more often than not in the bond market, so momentum-following investors are bound to be disappointed if they look to the bond market’s past 30-year history for future salvation, instead of mere survival at the current level of interest rates.

Together then, a presumed 2% return for bonds and an historically low percentage nominal return for stocks – call it 4%, when combined in a diversified portfolio produce a nominal return of 3% and an expected inflation adjusted return near zero. The Siegel constant of 6.6% real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned. The simple point though whether approached in real or nominal space is that U.S. and global economies will undergo substantial change if they mistakenly expect asset price appreciation to do the heavy lifting over the next few decades. Private pension funds, government budgets and household savings balances have in many cases been predicated and justified on the basis of 7–8% minimum asset appreciation annually. One of the country’s largest state pension funds for instance recently assumed that its diversified portfolio would appreciate at a real rate of 4.75%. Assuming a goodly portion of that is in bonds yielding at 1–2% real, then stocks must do some very heavy lifting at 7–8% after adjusting for inflation. That is unlikely. If/when that does not happen, then the economy’s wheels start spinning like a two-wheel-drive sedan on a sandy beach. Instead of thrusting forward, spending patterns flatline or reverse; instead of thriving, a growing number of households and corporations experience a haircut of wealth and/or default; instead of returning to old norms, economies begin to resemble the lost decades of Japan.

Some of the adjustments are already occurring. Recent elections in San Jose and San Diego, California, have mandated haircuts to pensions for government employees. Wisconsin’s failed gubernational recall validated the same sentiment. Voided private pensions of auto and auto parts suppliers following Lehman 2008 may be a forerunner as well for private corporations. The commonsensical conclusion is clear: If financial assets no longer work for you at a rate far and above the rate of true wealth creation, then you must work longer for your money, suffer a haircut on your existing holdings and entitlements, or both. There are still tricks to be played and gimmicks to be employed. For example – the accounting legislation just passed into law by the Congress and signed by the President allows corporations to discount liabilities at an average yield for the past 15 years! But accounting acts of magic aside, this and other developed countries have for too long made promises they can’t keep, especially if asset markets fail to respond as they have historically.

Reflating to Prosperity

The primary magic potion that policymakers have always applied in such a predicament is to inflate their way out of the corner. The easiest way to produce 7–8% yields for bonds over the next 30 years is to inflate them as quickly as possible to 7–8%! Woe to the holder of long-term bonds in the process! Similarly for stocks because they fare poorly as well in inflationary periods. Yet if profits can be reflated to 5–10% annual growth rates, if the U.S. economy can grow nominally at 6–7% as it did in the 70s and 80s, then America’s and indeed the global economy’s liabilities can be “reflated” away. The problem with all of that of course is that inflation doesn’t create real wealth and it doesn’t fairly distribute its pain and benefits to labor/government/or corporate interests. Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades. Financial repression, QEs of all sorts and sizes, and even negative nominal interest rates now experienced in Switzerland and five other Euroland countries may dominate the timescape. The cult of equity may be dying, but the cult of inflation may only have just begun.

William H. Gross
Managing Director

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Copyright © 2012, PIMCO

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Sharp Decline in Earnings? Chart Explains Four Major Waves of Earnings Growth

Tuesday, July 31st, 2012

by Mike “Mish” Shedlock, Global Economics Analysis

For the first time in three years, US Quarterly Earnings are Poised to Drop.

Third-quarter earnings of Standard & Poor’s 500 companies are now expected to fall 0.1 percent from a year ago, a sharp revision from the July 1 forecast of 3.1 percent growth, Thomson Reuters data showed on Thursday.

That would be the first decline in earnings since the third quarter of 2009, the data showed.

Earnings in the tech sector are now expected to rise only 5.8 percent — less than half the forecast of 13.1 percent growth, according to an estimate at the start of the month, Thomson Reuters data showed.

The materials sector is forecast to see an earnings drop of 11.4 percent for the third quarter, worse than the forecast of a 3.3 percent decline at the start of July, Thomson Reuters data showed. Slumping commodity prices and reduced demand from China have hurt that sector.

Sales Look Worse Than Earnings

While earnings performance has held up so far for the second quarter — with results in from about half of the S&P 500 companies — revenue has looked much gloomier.

Just 41 percent of companies have beaten revenue estimates, the lowest since the first quarter of 2009 and only the fourth time in the past 10 years that the beat rate was under 50 percent.

Revenue growth is expected to have increased just 1.2 percent for the second quarter, Thomson Reuters data showed.

Don’t Worry Companies Will Still “Beat the Street”

In spite of those downgrades, history suggests corporations will still “Beat the Street”.
even in 2008 and 2009 the majority of firms beat estimates. Here is the way the process works:

• Corporations give analysts “tips” regarding profit expectations.
• Those profit expectations are purposely low.
• Wall Street analysts lower estimates, if necessary, as the quarter progresses such that corporations can “beat the street”.
• If corporations are going to miss and need an extra penny, they change tax assumption or make other “one time” adjustments as necessary.
• Corporations beat the street by a penny with “pro-forma” (after adjustment) reporting.

Percentage of Companies that “Beat the Street”

click on chart for sharper image

The last time companies failed to “beat the street” was third quarter of 1998. At the earnings trough in third quarter of 2008, 58% of companies in the S&P 500 still managed to “beat the street”.

The above chart from Understandings Earnings Estimates by James Bianco on the Big Picture Blog.

Corporate Profits

Inquiring minds may be interested in charts of corporate profits.

Corporate After-Tax Profits As Percent of Real GDP

Four Major Waves of Earnings Growth

1. A stunning rise in corporate profits as a percent of GDP started when Nixon closed the gold window, effectively ending the last semblance of the gold standard. In response, the trade deficit soared as did an exodus of manufacturing jobs.
2. A second massive rise in corporate profits began with the Greenspan Fed-sponsored internet bubble culminating in 2000 with a liquidity push out of misguided fears of a Y2K crash.
3. The third big jump in corporate earnings started in 2001 when the Greenspan Fed (followed by the Bernanke Fed), ignited housing and debt bubbles of epic magnitude. Financial profits soared at the expense of the greater fool going deep in debt buying houses right before the housing bust.
4. In 2009, the Bernanke Fed slashed interest rates across the board, clobbering those on fixed income, to bail out banks. A side-effect was lower interest rates on corporate bonds which also  added to corporate profits.

Bubbles Don’t Benefit Real Economy

Government sponsored repatriation tax holidays along the way also added to corporate profits, as did the Fed paying interest on Excess reserves now sitting at about $1.5 trillion parked at the Fed.

Little of this benefited the real economy or produced any lasting jobs. Housing and finance jobs collapsed in the global financial crisis and are not coming back. Nor is another internet boom on the horizon.

With each crisis, the shrinking middle class has suffered at the expense of banks and corporations able to export jobs and capital. Small US Corporations not able to get the same tax benefits as GE, Apple, Google, Microsoft, etc., have not benefited from Fed policy.

Four Solutions

1. End fractional reserve lending
2. Return to the gold standard
3. End the Fed and its bubble-blowing policies
4. Revise corporate tax policy so as to not give breaks to corporations that export jobs and hold profits overseas. US-based small manufacturers are at a huge disadvantage to corporations like GE that pay negative tax.

Regarding point number 2, please consider Hugo Salinas Price and Michael Pettis on the Trade Imbalance Dilemma; Gold’s Honest Discipline Revisited

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

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The Longest Yard (Crescenzi)

Tuesday, July 31st, 2012

by Tony Crescenzi, PIMCO

• As the global slowdown progresses, we can expect central banks to deploy more policy tools – without limits – to stem the pace of deleveraging.
• In Europe, quantitative easing using ESM bonds could prove to be another bridge that buys politicians more time, but does not solve the root problem.
• We expect real economic growth in China to be muted. While some stabilization is possible later this year, it is hard to foresee a sustained recovery.

Saddled with debt and mindful of recalcitrant investors, nations in the developed world have lost their ability to solve their economic woes by adding more debt, leading them more than ever to rely upon central bank action. It is fantasy, however, to think that central banks can keep the game going for long. No central bank ever created anything tangible – you won’t find any stories about a Fed chairman discovering electricity or creating the light bulb. What central banks are best at creating is fiat currencies, and these are only as valuable as what they are backed by, whether it be gold, silver or the productive capability of a nation. Create or print too many of these and they will have no value to anyone, save for nerdy numismatists.

All that a central banker can do to add value to society is help foster financial conditions that facilitate the efficient use of capital, but even here central bankers can get it wrong and produce exactly the opposite result. The housing bubbles that preceded the onset of the recent financial crisis are proof; they were in fact at the heart of the crisis.

Central bankers today are striving valiantly to help smooth the deleveraging process by promoting conditions aimed at reflating the value of financial and real assets that would otherwise almost certainly fall in price. This isn’t easy to do because the world is striving just as valiantly to reduce its debt, taking actions that result in persistent downward pressure on asset values.

Central bank liquidity can’t turn the lights on in Italy

The orderly liquidation of debt requires economic growth. By boosting asset prices, central bankers have sought to promote economic growth and buy time for the fiscal authorities of the developed world to formulate and implement growth-oriented policies. Global investors have been patient, but the repeated failure of policymakers has their patience running thin.

No amount of central bank liquidity by the Federal Reserve, the European Central Bank (ECB) or any other central bank can possibly fix what ails the developed economies. The ECB, for example, can’t fix the fact that Italy ranks 109th out of 183 countries in providing electricity. Nor can it fix the fact that Spain ranks 133rd in the ease of opening a business. How about Greece?

Can the ECB reduce the size of government, improve tax collection or reduce the number of occupations Greece considers so hazardous that hairdressers, pastry chefs and clarinet players can retire in their early 50s? In the U.S., can the Fed reduce the outsized growth rate of the entitlement system? Central bankers can do nothing about these competitiveness issues, but the restoration of growth and competitiveness is essential to improving the ability to repay debt.

To use football vernacular – and here I mean American-style football – central bankers have taken the ball about as far down the gridiron as they can. To be sure, they can still do more; the Fed could implement another round of asset purchases, cap Treasury rates, cut the interest rate it pays banks on excess reserves, extend further its conditional promise to keep rates low, or perhaps consider some form of credit easing. If the Fed did any of these it would mark another courageous effort by The Decider, Fed Chairman Ben Bernanke, but it will never get the ball into the end zone.

To cross the goal line, to restore growth and competitiveness, the fiscal authority – not the monetary authority – must move the ball. This isn’t easy because the citizens of the world are voicing their objection to the changes necessary to do so. Try all you might, central banker, but at the 99th yard you will find the longest yard!

Unlimited global monetary policy – Ben Emons

In recent media debates, some commentators have pointed out that quantitative easing (QE) programs may have seen their effectiveness diminish. However, monetary policymakers in both developed and emerging markets continue to pursue easing measures. Different kinds of policies emerged, such as the Bank of England’s direct lending scheme, known as “credit easing.” The European Central Bank and the Danish central bank went another direction, cutting their deposit rates to zero or even negative. The lower zero bound is often viewed as a constraint, a limit in using conventional tools. The ECB and Danish central bank decisions to cut deposit rates showed how conventional policy is not necessarily limited. In fact, all central banks could cut deposit rates or rates on excess reserves in order to “force” out large cash balances held at the central bank to stimulate lending.

There could be “practical limits,” where QE or deposit rate cuts cause nominal and real interest rates to turn negative, affecting future income streams on savings accounts, pension funds and money market portfolios. The central banks’ growing market share in longer-term Treasury bonds and their low yields has added to the challenge. These practical limits are not necessarily seen as a barrier, evident by the recent string of actions by emerging and developed market central banks. Milton Friedman argued in his 1968 paper, “The Role of Monetary Policy,” how monetary policy should be based on limits. His view was that policy should not “peg” interest rates for a prolonged period of time or it may lead to structural inflation. Friedman pointed out that rapid monetary base growth was generally associated with high nominal rates, a sign in his view of easy policy, e.g., Brazil in the 1960s. Low interest rates were related to slow money growth, like the U.S. during the 1930s, which Friedman viewed as tighter monetary policy. Friedman saw the setting of rates connected to the amount of money growth the central bank would conduct to influence price expectations. When interest rates are pegged in an environment of seemingly stable inflation expectations, Friedman noted a risk of disconnect where the monetary base could become uncontrollable and lead to higher inflation.

In today’s environment of low interest rates, monetary base growth and stable inflation expectations, such disconnect is not seen as a risk, as debt deleveraging has been overwhelming. Since most major central banks see deflation as a bigger risk at this point, practical limits or those limits that Friedman spoke of do not seem to be tempering the willingness of global central banks to go further. In fact, as the global slowdown materializes further, we can expect more policy tools will be deployed to stem the pace of deleveraging, and without any limits.

The ECB can only provide a bridge – Andrew Bosomworth

The ECB can only provide a bridge for the European monetary union’s problems, not a solution. Its decision to cut all policy rates by 25 basis points (bps) earlier this month signaled the bank’s ongoing willingness to provide that bridge by creating time for political and fiscal agents to implement durable solutions. Judging by the gyrations in yields on southern European bonds since the ECB’s meeting, however, markets were evidently disappointed the ECB did not announce further unconventional measures to shore up Europe’s dysfunctional bond markets. Even after ECB president Mario Draghi’s “whatever it takes” statement on 26 July, we still have not seen yields on outer peripherals drop to sustainable levels.

Market expectations for unconventional measures derive from at least two sources. First, since the ECB crossed the Rubicon in 2010 by buying Greek government bonds, markets now believe the bank will do whatever it possibly can to prevent the Economic and Monetary Union (EMU) from breaking up; the costs of not doing so would be too great. Indeed, the ECB currently holds €211 billion in securities from previous forays into the bond market. Second, some market participants, policymakers and influential figures, like Italy’s prime minister and the head of the IMF, are lobbying the ECB to buy even more in order to drive southern European bond yields lower.

Such proposals are shortsighted and address the symptoms rather than cause of the EMU’s problem. Buying bonds without fixing the design faults in the EMU’s governance structure is a near-term fix whose beneficial effects, like painkillers, will soon wear off. Were the ECB to follow lobbyists’ calls and resume the Securities Market Program (under which it bought government debt in 2010 and 2011), it will not solve the governance structure problem. However, buying bonds to ward off deflation once conventional monetary policy has reached the zero lower bound is likely warranted.

The ECB usually refers to Article 123 of the Treaty on the Functioning of the European Union, which prohibits it from financing governments’ budget deficits. The ECB’s reasoning is not entirely clear, given the same European law (part of the Lisbon Treaty) governs both the ECB and Bank of England (BoE) yet the latter buys government bonds as part of its quantitative easing. We think the explanation lies in differences between the ECB and BoE’s perceived risk of deflation, the degree of trust between the monetary and fiscal authorities and the fragmentation of the EMU government bond market relative to the singularity of the United Kingdom’s government bond market owing to its centralized fiscal policy.

As credit to the EMU’s private sector declines – the natural consequence of deleveraging after a credit boom – the risk of deflation in Europe is likely to rise. We think deflationary forces will intensify, making a further reduction in the main refinancing rate to 0.5% likely and perhaps necessitating quantitative easing. Which government bonds might the ECB buy in those circumstances?

The ECB’s capital key (which reflects each member country’s proportional contribution to total capital) suggests about one-quarter and the largest allocation of purchases would be in German Bunds. But capital flight to Bunds has already driven their yields abnormally low, suggesting quantitative easing would achieve little. And the ECB would send mixed signals if it concentrated purchases in Italian and Spanish government bonds. Would the ECB do this to offset eurozone-wide deflation risks or to compensate for member states’ reluctance to centralize fiscal policy?

Purchasing the bonds of the European Stability Mechanism (ESM) could circumvent this dilemma. Unlike the ECB, the ESM is designed to provide member states with financial assistance subject to conditionality. While it lacks the same degree of democratic legitimacy as Europe’s parliaments, at least the ESM is a child born of the democracy. However, like its predecessor, the European Financial Stability Facility (EFSF), the ESM’s main weakness is that it is unfunded. We think the ESM will find it equally difficult to raise sufficient funds from the capital market at low enough yields to perform the job it is designed for. And even if it finds buyers, the ESM will likely crowd out demand for other government bonds from Italy, Belgium, France and Austria, thereby raising their borrowing costs. Quantitative easing using ESM bonds could thus prove to be yet another bridge that buys politicians more time but does not solve the root problem. When it comes to Europe there is only one thing we can say with certainty: This crisis is not yet over.

People’s Bank of China moves to counter weakening growth – Isaac Meng

Policymakers in China face different limitations today than those in the U.S. and Europe, but they too have had to respond to the strain in the global economy, especially as slowing global demand exerts downward pressure on China’s export-investment-driven growth model. In a surprise move, the People’s Bank of China (PBOC) cut its benchmark rate by 25 bps twice within a month. The PBOC also deregulated deposit rates, allowing a 10% float above the benchmark, which largely offsets the cut’s effect on deposit and lending rates.

Though one to two months earlier than the market expected, the latest rate cut is not surprising in light of weakening growth and a slowing inflation outlook. Second quarter growth at 7.6% is barely above target, and inflation risk is easing fast with CPI likely stay below 2.5% over the next two to three quarters versus the PBOC’s target of 4%. Even though rates were cut by 50 bps, China’s real rates are still rising because CPI is heading down toward 2%. If the PBOC targets positive real deposit rates as a floor in the medium term, then there is still room to cut another 25 bps to 50 bps. The 8% to 9% average lending rates remain too high for borrowers struggling to deleverage amid a deepening industrial slowdown.

With the Chinese yuan’s outlook and foreign flows turning to a more balanced stance, the PBOC needs to further unwind past foreign exchange sterilizations, most likely by cutting the Reserve Requirement Ratio by 50 bps per quarter to maintain money market rates in the range of 2.5%–3.0%.

Despite room for monetary easing, the PBOC still seems behind the curve in easing financial conditions. Chinese banks remain tight in credit and slow to cut their lending rates. Domestic Chinese borrowers have excess capacity to deleverage, and the yuan’s nominal effective exchange rate is rising amid a rigid foreign exchange rate regime. Thus, we expect real economic growth in China to be muted and slow, and while some stabilization is possible in late 2012, it is hard to see a sustained recovery.

Past performance is not a guarantee or a reliable indicator of future results. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.

Copyright © 2012, PIMCO.

Tags: Asset Values, Central Banks, Downward Pressure, Economic Growth In China, Economic Woes, Efficient Use, Fed Chairman, Fiat Currencies, Financial Crisis, Global Slowdown, Gold Silver, Light Bulb, Longest Yard, Numismatists, PIMCO, Policy Tools, Productive Capability, Real Assets, Root Problem, Tony Crescenzi
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Babe Ruth? (Saut)

Tuesday, July 31st, 2012

“Babe Ruth?”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

July 30, 2012

“Sure Babe Ruth was good, but could he play hoops?”

… The answer is, the Babe played hoops at least once according to his biographer, Bob Creamer, in a pickup game with high school varsity players and looked “pretty good.” It is fairly certain, however, that the Bambino was not Air Ruth.

… The fact is that even for the greatest physical specimens, going from one sport to another and competing at high levels – let alone the highest levels – may not quite translate, for a variety of reasons.

The man who was called “the greatest athlete of all time,” Jim Thorpe, was an Olympic decathlon champion and star football player who, a teammate said, “could outrun a deer.” But he was a bust as a major league baseball player.

… It seems that the hardest thing to do in sports is something that you may not have been trained in at an early age to develop the muscle memory, may not have the desire or may not have developed the requisite physical and mental skills.

Some talented athletes have been driven out of baseball because they feared being hit by a pitch. “Stepping into the bucket” is the next step to departing the game. Fear of injury plays a role in sports, and while one athlete may deal with it in one arena, he may not in another.

… Ira Berkow; Sports section of the [New York] Times, 1/19/94

A Wall Street Parallel: It seems that the hardest thing to do in investing is something you may not have been trained in at an early age – especially the 30-something mutual fund managers – how to survive a sideways market. The memory and experience are not there because the majority of Wall Street’s brokers and fund managers have never lived through a 12-year wide swinging trading range stock market like the 1966 – 1982 affair, let alone live through a real bear market like 1973 – 1974. Most were in grade school back then. Such thoughts conjure up memories of the ubiquitous advertisement during the 1973 – 74 bear market showing a kid riding a tricycle with the verbiage, “What was your mutual fund manager doing during the last bear market?” Indeed, the past 12 years has been pretty tough with the S&P 500 (SPX/1385.07) trading in a range between roughly 700 and 1500 punctuated by multiple tactical bull and bear moves. Consequently, not many portfolio managers have been able to outperform the overall stock market averages. Indeed, year-to-date (YTD) of the 515 mutual funds that benchmark themselves against the SPX, or similar index, only 24% are beating said index. For the other 76% the fear of stepping into the “bear bucket” is the next step to departing the Wall Street game entirely. Fear of losses and poor performance plays a role in investing and while a young perpetual “bull” may deal with it in an easy-to-win up-market, they may not in a sideways to down market.

Such frustrations are being reflected in ISI’s latest hedge fund survey that shows long equity exposure has declined to 44.1%, which is lower than the 47.2% equity allocation at the August 8/9th “emotional low” of last year. Meanwhile, retail investors are on track to redeem another $5 billion from equity-centric mutual funds this month, bringing the YTD total redemption to about $37 billion, the second biggest outflow next to 2008. Then there is the shrinking stock exchange volume combined with investor apathy as reflected in the AAII’s (American Association of Individual Investors) survey that week before last had the “bulls” at only a 22.19% reading. Typically when the bullish sentiment reading is below 25% stocks rally on average 5%; and that is exactly what happened last week as the SPX climbed 4.3% from Tuesday’s intraday low of 1329.24. Plainly, the two major market moving news items were rumors that the Federal Reserve is going make a policy announcement at this week’s FOMC meeting, and then there was this quote from the European Central Bank President Mario Draghi:

“Within our mandate, the ECB is willing to do whatever it takes to preserve the euro and, believe me, it will be enough.”

As stated in Friday’s verbal strategy comment, such an ECB statement should come as no surprise, for I have opined for months that: 1) you don’t throw $1 trillion at a problem and then walk away if it doesn’t work, the world just doesn’t work that way; 2) politicians, bureaucrats and bankers are the same in Europe as they are here, they do not want to lose their power and if the EU implodes they ALL lose their power; and, 3) if the EU implodes there will be no need for the ECB! Hence, I take Mario Draghi at his word that, “Within our mandate, the ECB is willing to do whatever it takes to preserve the euro and, believe me, it will be enough.”

Speaking to this week’s Federal Reserve meeting, I continue to think the odds of a policy move are high because if the Fed waits until the September meeting it will be viewed as being too political with the Presidential election so close. To be sure, just like the Supreme Court did not want to “step into the [too] political bucket,” I don’t think the Fed wants to do that either. The risk then becomes, if the Fed stands pat at this week’s meeting how does the stock market react? My hunch would be that the SPX stalls out at current levels, but doesn’t necessarily have a big decline. The quid pro quo is that if in the near term Euroquake has really been taken off of the table, and if the Fed does adopt a QE3 type of policy at this week’s FOMC meeting, last week’s upside breakout by the SPX above the 1360 – 1366 level could prove sustainable, leading to another upside breakout above the May reaction high of 1422 amid universal disbelief. Worth noting is that according to the astute Bespoke organization during the fourth year of the Presidential Cycle, August has been up 67% of the time with an average gain of 2.3% (helped by a 14.1% gain in 2000). The best August ever for the OTC was 2000’s +14.1%, with the worst performance in 1998 of -19.0%.

The call for this week: A number of “trees” fell in the forest last week and nobody was around to hear them. First, after extensive studies requested by local residents, the EPA has determined the drinking water in Dimock, Pennsylvania has NOT been contaminated by the use of fracking. Maybe that’s why the energy sector was up by 1.94% last week. It was bettered, however, by the financials (+2.82%) and materials (2.51%), which is pretty strange sector rotation if we are heading into a recession. Second, Reuters reported that three of the nation’s largest public pension funds have announced investment returns of between 1% and 1.8%, far below the 8% that large funds have typically targeted. As repeatedly scribed in these missives, when it becomes apparent that our economy is not headed into recession, I think there will be a massive shift from fixed income into dividend-paying stocks, such as Johnson & Johnson (JNJ/$69.52), which is rated Outperform by our fundamental analyst. As often stated, I would much rather own a good dividend-paying stock for the next 10 years rather than the 10-year Treasury Note.

Tags: fracking, Saut, Shale, Shale Oil
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Strange Group of Leadership Sectors

Tuesday, July 31st, 2012

It is hard to get behind any sort of pronounced rally when these are the sector ETFs showing the best relative strength

1. SPDR Utilites (XLU)
2. iShares Investment Grade Bond (LQD)
3. iShares Preferred Stocks (PFF)
4. Market Vectors Oil Services (OIH)
5. SPDR Consumer Staples (XLP)

Other than #4, that is one defensive group of leadership sectors.

Of course there have been bounces in more “beta” sectors as we have had the “everything must go up” days (student body left) but many of those groups have bounced off big selloffs.   There is some percolating action in broader energy, and a few snippets of technology but by and large hard to find much else as sustained leaders.

This leadership group we currently have is much more akin to what was keeping markets elevated in December 2011.  Recall on the first day of 2012 there was a massive sector rotation out of the above groups, and into the pro cyclicals as if on a dime.  That led to a pronounced multi month rally.  Therefore for those seeking the same, it would seem likely a similar type of rotation needs to occur.

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Gold at ECB: Accident or Strategy?

Tuesday, July 31st, 2012

by Axel Merk, Merk Funds

When the euro was launched, the European Central Bank (ECB) held approximately 15% of its assets in gold. That ratio has remained reasonably stable, giving rise to a variety of chatter, including suggestions that it may displace the U.S. dollar. We pursue the question on whether the ECB’s gold holdings are an accident or strategy.

Let’s look at the numbers. Below is a chart depicting the percentage of gold relative to the ECB’s total assets. As one can see, the percentage has remained reasonably stable despite a significant growth in total assets.

Total assets of a central bank may be considered a proxy for the amount of money that has been “printed”; it’s a crude measure as it does not reflect physical money printed; nor does it reflect money in circulation; neither does it reflect sterilization activities that also show a rise in assets. Still, a central bank balance sheet is often referred to as the printing press as money is literally created out of thin air (by the stroke of a keyboard) when assets are purchased. Federal Reserve (Fed) Chairman Bernanke has referred to this fiat money feature as the printing press. We like to think of it as super-money, as central bank purchases provide cash to the banking system, allowing them to lend a multiple of the money that has been “printed”. While banks have been reluctant to lend (the velocity of money has been low), the analogy we like to give is that if you give a baby a gun, just because no one gets hurt does not mean it is not dangerous. That said, let’s look at total assets at the ECB:

The interpretation shows that while money can be printed, wealth cannot be created out of thin air: as money is printed, gold has appreciated versus the euro. So while inflation has not shown up in indicators such as the Consumer Price Index, monetary easing is rightfully reflected in the price of gold.

Diving a little deeper to determine how much of this is strategy versus accident, let’s look at the gold holdings at the ECB once more:

The ECB marks its gold holdings to market, i.e. uses market prices for gold. The ECB was selling gold from the inception of the euro until the onset of the financial crisis; since then, the ECB’s gold holdings have remained stable. To understand the motivation, one needs to note that when one refers to ECB gold holdings, one is actually talking about Euro area gold holdings. While the ECB holds some gold, most gold is held by the respective central banks (this is not a discussion of where such gold is physically located):

Relevant is that each nation in the Eurozone pursues its own agenda with regard to its gold holdings. Germany has resisted political pressure within Germany to sell gold, as Bundesbank (Buba) profits would need to be transferred to the government; the hawkish Buba has indicated that it would be considered selling gold to help finance the government’s deficit. Italy, as one can see, has not sold any gold. Conversely, as a percentage of their holdings, the Netherlands had been rather eager to sell gold up until the financial crisis; Portugal, too, was an aggressive seller. As one can see, gold sales are not particularly related to the financial health of a Eurozone nation, but more to the cultural attitude in the respective nations towards gold.

Let’s cross the Atlantic to see whether the ECB’s gold strategy is undermining the U.S. dollar. The Fed’s gold stock is valued at $44.22 per fine troy ounce. For purposes of the chart below, we adjust the Fed’s gold holdings to market prices:

Note that the chart above starts in 2006, so as to focus on the period of the financial crisis. The Fed has been more aggressive than the ECB in printing money. As such, the percentage of gold in relation to total holdings has declined at the Fed in a more pronounced fashion. There is clearly no perfect relationship between the size of the balance sheet and the price of gold, as other factors also influence the supply and demand of gold; however, increasing the supply of fiat money (dollar, euros) may decrease its value when measured in real assets, such as gold. We have in the past referred to the Fed as the champ in printing money (as measured by the percentage balance sheet growth since August 2008), although the Bank of England has, as of late, taken on that title. But we digress.

From what we see, central banks have been scared into holding gold since the onset of the financial crisis. Beyond that, we don’t see an active strategy at the ECB to keep its gold reserves at 15% of total assets. Instead, the ECB’s comparatively measured approach has simply lead to a reasonably stable percentage of gold reserves. Of course that was before ECB President Draghi said on July 26, 2012, that he shall do “whatever it takes to preserve the euro.” (an interpretation of that may be that more money printing is on the way). For now, the cultural differences in responding to the financial crisis (Europe: think austerity; US: think growth) suggest that the euro should outperform the U.S. dollar over the long term, assuming the not-so-negligible scenario of a more severe fallout from the Eurozone debt crisis won’t materialize.

It may help to keep in mind that historically inflation is the response to a deflationary shock. If market forces were left to themselves, we believe the credit bust of 2008 would have caused a major deflationary shock. It’s the reaction of policy makers that fight market forces that may lead to inflation. Bernanke as of late brushed off such pessimism. As the charts above show, however, gold has been a sensitive – and sensible I might add – indicator to the trigger-friendliness of our central bankers.

We have long argued that investors may want to take a diversified approach to something as mundane as cash. Please sign up to our newsletter to be informed as we discuss global dynamics and their impact on currencies. Please also follow me on Twitter to receive real-time updates on the economy, currencies, and global dynamics.

Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds

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