How To Turn 50, and other Weekend Reads

Friday, July 27th, 2012

Here are this week’s reading diversions for your personal enlightement. Have a splendid weekend!

Crooks Prey on Hotel Internet Connections

If you’ve ever taken a laptop on a work trip, here’s some troubling news: The FBI and national cybercrime agencies are warning people traveling abroad to be wary of shady scammers planting malware via insecure hotel Internet connections.

Sharon Greenthal: How To Turn 50

I’m happier at 50 than I was at 40. I feel more sure of myself. I love my work. I have terrific friends and family. Maybe your life is different — maybe you’re not so happy right now, and change is needed, for whatever reason. And yet, if you think about it, really give it some thought, I bet there are plenty of details you wouldn’t change about all the years you’ve spent on this earth.

Top 10 Organic Foods – Pesticides, Hormones in Fruit, Chicken, Fish – AARP

Sure, you want to keep your grocery bills under control. But sometimes it pays to spend a little bit more on what you eat. Here are 10 foods that could be worth every extra penny.

The Healing Properties of Lemons « Bel Marra Nutritionals | Health Advice | Natural Health Products

Lemons are not amongst the top healing foods merely because of their vitamin C content—their health benefits extend much further. They are an excellent source of the mineral potassium, which is essential for smooth electrical transmission in the nervous system and brain.  A deficiency in potassium has been linked to anxiety, depression and memory problems; as such, the regular consumption of lemons may help to prevent these disorders.  Potassium is also essential for cardiovascular health.

Bicycle Your Way to Better Brain Health | Psychology Today

Exercise is one of the best – and cheapest- anti-aging antidotes. I’m willing to guess that you already knew that, even if you are a little shaky on the how’s and why’s. But you may not have realized that all forms of exercise are not equally effective, even when the exercise really revs up your heart and your muscles. It turns out that although everyone benefits from a lifestyle that includes regular workouts, it’s the bicyclists who seem to garner the most rewards from their efforts, including the benefits of greater road safety.

Milk Is Actually Really Bad For You – Business Insider

Milk was once christened “nature’s perfect food,” says Mark Bittman at The New York Times. The Department of Agriculture recommends three 8-ounce glasses of the stuff a day (which equals about 1.5 pounds). After all: It builds strong bones, is packed with nutrients, and helps kids grow taller. But drinking dairy can be problematic, and its most notorious ingredient, lactose, is indigestible by a significant percentage of Americans. Here, five reasons milk actually doesn’t do a body good:

Almonds And 10 Other Foods That Can Help You Maintain A Healthy Weight

Nuts may get a bad rap as being high in fat, but a new study suggests that people trying to maintain a healthy weight can still eat them without sacrificing poundage — and get a cholesterol benefit, to boot, a small new study suggests.

Sitting At Work: Why It’s Dangerous And What You Can Do

“Prolonged sitting has been shown to disrupt metabolic function resulting in increased plasma triglyceride levels, decreased levels of high-density lipoprotein cholesterol, and decreased insulin sensitivity,” Dr. Hidde van der Ploeg, a senior research fellow at the University of Sydney’s School of Public Health in Australia, told TIME’s Healthland.

Reasons to Wear Sunglasses – Health Benefits of Sunglasses – Oprah.com

Photo: Thinkstock
You slather on SPF 50 to shield your skin from the sun. But what about your naked eyes? In a 2012 survey, less than half of 10,000 Americans polled recognized the health benefits of sunglasses, and 27 percent of respondents reported never wearing them. Yet this simple and stylish accessory* can protect your eyes from a host of conditions caused by ultraviolet rays:

Tags: Anxiety Depression, Brain Health, Cardiovascular Health, Cybercrime, Electrical Transmission, Enlightement, Grocery Bills, Healing Foods, Healing Properties, Health Advice, Health Psychology, Hotel Internet, Lemons, Memory Problems, Natural Health Products, Organic Foods, Psychology Today, Terrific Friends, Vitamin C Content, Work Trip
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Spot the Socialists

Friday, July 27th, 2012

Source: Economist

(h/t: Barry Ritholtz)

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Guest Post: Don’t Forget Index Trading Costs

Friday, July 27th, 2012

Don’t Forget Index Trading Costs

By Paul Amery, Index Universe | July 25, 2012

Remember to check the assumptions made for the cost of trading when examining a new index concept.

[This blog initially appeared on our sister site, IndexUniverse.eu.]

Vanguard’s warning of the perils of index data mining is timely. As the number of “smart beta” index concepts increases, each promising superior performance than old-fashioned, capitalisation-weighted benchmarks, the possibility of investors getting hoodwinked also grows.

Just about anything can be used to “predict” something else if you use historical data series creatively enough. According to fund manager David Leinweber, the Wall Street Journal reports, annual butter production in Bangladesh “explained” 75% of the annual returns of the S&P 500 over a 13-year period. If you throw in data for US cheese production and the combined sheep population of the US and Bangladesh, Leinweber says, you get to “forecast” US stock prices with 99% accuracy.

Not everyone got the joke. A number of firms asked Leinweber to share his data on Bangladeshi butter production so that they could build a trading strategy around them, the WSJ tells us. Were any index and ETF providers looking for a new smart beta concept among them, by any chance?

Vanguard has its own axe to grind in all this, we shouldn’t forget. The firm sticks religiously to using traditional, cap-weighted indices as the basis for its passive funds, arguing that anything else is an active bet on market behaviour and should be recognised as such. I’ve argued before that this is as much as a commercial strategy as anything else—Vanguard’s huge size precludes it from even considering index concepts that are in any way capacity-constrained, as many non-cap-weighted approaches are.

But a good first step in assessing an index promising “smart beta” and outperformance is surely to ask oneself if the underlying investment concept makes sense. Does Research Affiliates’ “fundamental indexation” approach in equity markets, which uses companies’ revenues, profits, book values and dividends as a way of determining index weights, hold water as a strategy? It does for me.

Does the same firm’s alternative weighting scheme for sovereign bond markets (which is based on countries’ GDP, energy consumption, population and rescaled land area) work as a stand-alone investment concept? I’m not so sure. Does a smart beta strategy focused on historical stock volatilities work as a predictor of future risks? For me, not at all.

There’s also one topic Vanguard didn’t touch on in its review of the pre- and post-launch performance of newer indices—trading costs. Even if you like a new index idea, how do you know that the costs of buying and selling index constituents have been reflected accurately and fairly in the back-test?

There’s an obvious incentive for the promoters of a new index to flatter its historical “performance” by taking an optimistic view of how much it would have cost to buy and sell the index constituents over time. And while cap-weighted benchmarks are largely self-rebalancing, typically generating only a few percentage points of turnover a year, newer index concepts can easily involve annual internal index turnover of hundreds, even thousands of percent.

Historically, it appears that many index providers have dealt with the thorny problem of internal trading costs very simply—by disregarding them completely.

“Turnover-related costs…[have] been widely ignored in index construction, based on the assumption that [these] are negligible for the typical investor. Index providers essentially follow the basic theory that (equity) markets are free of transaction costs,” Konrad Sippel of STOXX writes in an article to be published in the September/October Journal of Indexes Europe, in an issue focussing on index tradeability (you can sign up for a free subscription here).

“Another reason for not including cost-related elements is of course that these are very hard to measure transparently and consistently, as each investor has different cost structures, depending on their individual circumstances. The introduction of client-specific cost elements would dilute the function of an independent and transparent index,” Sippel goes on to point out.

In other words, trading costs incurred by index-related fund management activity may end up being reflected in tracking error of portfolios run against the index, rather than being internalised in the index’s return itself. But there is no common practice in this area. Some (fixed income) index providers do make a charge to their benchmarks’ return to reflect the cost of bonds’ entry and exit into the index portfolio. Equity indices tend to be calculated on the basis of recorded end-of-day trades in the index constituents, presenting a problem if index-tracking funds can’t deal on the same terms.

There are no easy answers here. Index tradeability is a subject that involves complex questions of market structure, technology and regulation. But it’s an increasingly relevant one as the number of smart beta launches multiplies.

As passive fund management moves further away from its cap-weighted roots, and as more and more markets suffer from patchy liquidity, checking what internal turnover a newly advertised index strategy generates and what the associated trading costs are is vital.

Copyright © http://www.IndexUniverse.eu

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Barton Biggs on When Wall Street Went Off its Moorings

Friday, July 27th, 2012

By Frederick J. Sheehan, author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession

Barton Biggs (1932-2012) will be remembered by most of us for the words he wrote as strategist at Morgan Stanley. He worked at the firm for 30-odd years. He did not waver in his dismissal of Internet bubble promoters. At the same time, Morgan Stanley deserves credit since it did not fire Barton Biggs, Byron Wien, or Stephen Roach during that period when most Wall Street firms replaced nourishment with treacle.

Two events come to mind.

In the summer of 1999, Barton Biggs debated James K. Glassman. This was the high summer – or, at least, the final summer – of the Internet bubble. It was obviously ridiculous but there was still time to get rich quick. To quote myself: “During the first four months of 1999, the average first-day percentage gains on IPOs were 271% (in January), 145% (February), 146% (March) and (119%) in April. More to the point is the lack of any operating record on the part of these enterprises. They were often no more than lavish compensation schemes for the promoters. Many of the companies had never earned a cent; quite often, they had never sold a thing; and not infrequently, they had neither a product to sell nor intended to develop a business.

“The book that captured the national idiom was Dow 36,000, by James K. Glassman and Kevin Hassett. They posted a preview on the editorial page of the Wall Street Journal on March 17, 1999: “Our calculations show that with earnings growing in the long-term at the same rate as the gross domestic product, and Treasury bonds below 6%, a perfectly reasonable level for the Dow would be 36,000 – tomorrow, not 10 or 20 years from now.”

The debate between Biggs and Glassman is a classic example of people believing what they want to believe while ignoring the proverbial elephant in the room. Of course, in 2012, the obvious catastrophic consequences of central banking’s destruction of the world’s currencies as well as stock, bond, and commodities markets are not up for discussion.

Barton Biggs was considered a nuisance or maybe senile by the stock touts, since he was “perennially bearish.” The phrase seemed attached to his name. He was always “the perennially bearish Barton Biggs.” Glassman argued the Internet was the most important invention of the twentieth century. Biggs probably thought Glassman was an idiot, but was more diplomatic. Biggs made some obvious comments: air conditioning was more important – Atlanta and Singapore would be small towns without it. The audience voted. Glassman won: 80 to 2. Biggs’ received a vote from his wife. Biggs later wrote that Glassman and Hassett “should be ashamed of themselves.” Both were scholars who “were arguing [what] was patently ridiculous.”

(As a side note, the greatest stock jockey of them all, Federal Reserve Chairman Alan Greenspan, even at this stage of constant media manipulation, sided with Biggs. On May 6, 1999, the reprobate had said: “I do not say we are in a new era, because I have experienced too many alleged new eras in my lifetime that have come and gone…. There was far greater justification to view the future with the unbridled optimism of a presumed new era a century ago…. In a very short number of years the world witnessed an astounding list of new creations: electric power and light, radios, phonographs, telephones, motion pictures, x-rays, and motor vehicles, just to begin the list.”)

The former Marine Corps infantry officer (Biggs, that is) was already a remnant. It was put to me: “1994 seems to me now the year when Wall Street broke from its moorings. Brokerage firms were losing their older ‘customer’s men.’ The senior ranks on Wall Street had included a lot of Marine Corps and Naval officers from World War II and the Korean War. They kept it simple. They put their customers first. Those role models were leaving and there was a vacuum. It was every man for himself and if you didn’t like it you either left or were forced to leave.” This is not a phenomenon isolated on Wall Street. Self-control has disappeared en masse. (For more about that annus horribilis, see  “Is it 1994 Again?” and “Sidelights to 1994.”

In the April 11, 1994, issue of Barron’s, Alan Abelson quoted from Barton Biggs’ weekly letter to Morgan Stanley clients. Quoting Abelson (omitting ellipses): “In his latest epistle for Morgan Stanley, the incomparable Barton Biggs reflects on secular bear markets: “Secular Bear Markets Ain’t No Fun.” A secular bear market, in Barton’s definition is a biggie – the major stock averages decline at least 40%. [Biggs counted seven secular bear markets in the twentieth century - FJS] He finds it ‘unnerving’ that all the secular bear markets came out of the clear-blue economic sky. In each and every case, he goes on, stocks were overvalued and greed was rampant.

“The one secular bear market of modern times came in 1973-1974. ‘The Nifty-Fifty was decimated, with declines of 60% common and some wipeouts like Avon (135 to 18), Polaroid (70 to 6) and Corning Glass (61 to 13). The broadest measures of equities at the time – the Value Line Composite, which peaked in December 1968 – was down 75% six years later.’

“And then Barton remembers what that secular bear market was like. ‘For me it was waking up every night in the spring of 1970 like clockwork at 3 a.m. in a cold sweat and agonizing the rest of the night over our portfolio. (I was a hedge fund manager then.) In the summer and fall of 1974 when the declines were endless day after day, you seriously wondered how you were going to support your family and where you could get a job outside of Wall Street. There were no answers. People you knew in the business – salesmen, money managers – just disappeared, and years later you heard they had moved to Indianapolis and were teaching seventh grade.’”

Glassman and Hassett thrive in an America without moorings. This illustrates a defining characteristic of our times. Dow 36,000 turned them into celebrities. It was published at the moment it would receive the greatest applause. The opportunists could not have been more wrong if they tried. The media noise for Dow 36,000 would turn them into greater celebrities.

They continued to promote themselves on the Wall Street Journal’s op-ed page:

“Dow 36000? It’s Still a Good Bet”

-Glassman and Hassett, Wall Street Journal, Headline of Op-ed, March 20, 2001

“Diversify, Diversify, Diversify”

-Glassman and Hassett, Wall Street Journal, Headline of Op-ed, January 18, 2002

“[Glassman and Hassett] maintain it isn’t their fault that people now focus only on their optimistic title and not on the caveats…. ‘If you didn’t have a sensational conclusion that follows from reasonable steps, people wouldn’t pay attention,’ Mr. Hassett says….Mr. Glassman sounds less sure about the title. ‘That’s the only thing about the book I’d consider changing,’ he says.”

-”Dow 36,000 Gurus Hold to Their View Amid Downturn” Wall Street Journal,July 29, 2002

“When our book, Dow 36,000 was published in September, 1999, the Dow Jones Industrial Average stood at 10318. The Dow closed yesterday at 8736. What went wrong? Actually, nothing.”

-Glassman and Hassett, Wall Street Journal, August 1, 2002

“[W]hile such signs of speculation are troubling, there is little solid evidence that a real estate bubble is puffing up.”

- James K. Glassman, “Housing Bubble?,” Capitalism Magazine, May 24, 2005

Glassman would later say 36,000 was a long-term prediction: See Wall Street Journal quote from March 17, 1999.

Glassman & Hassett went on to star at the American Enterprise Institute, a think tank in Washington. Glassman was Undersecretary of State for Public Diplomacy and Public Affairs for President George W. Bush. In this capacity Glassman led “the State Department’s struggling efforts to improve the U.S.’s image abroad” particularly “in the Muslim World.” Hassett was an economic adviser to John McCain in his 2008 presidential campaign.

The world is their oyster. The apathy and sense of defeat among the American people is aggravated by witnessing the unflagging success of those who have behaved the worst and the amoral behavior of the hallowed institutions that promote them.

About Frederick Sheehan

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession. He is the co-author of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve. Mr. Sheehan was Director of Asset Allocation Services at John Hancock Financial Services in Boston. For more than a decade, Mr. Sheehan wrote the monthly “Market Outlook” and quarterly “Market Review” for clients. He is a frequent contributor to Marc Faber’s “Gloom, Boom & Doom Report.” He also has written articles for “Whiskey & Gunpowder” and the Prudent Bear website, among others. He currently serves as an advisor to an investment firm and a non-profit foundation. A Chartered Financial Analyst, Mr. Sheehan is a graduate of Columbia Business School.

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The Worst Deal?

Friday, July 27th, 2012

by Tom Brakke, Research Puzzle

What is “the worst deal”?  Well, there are a lot to choose from — witness the bath that Microsoft took on aQuantive.

But it’s hard to argue with an article from the Wall Street Journal that the Bank of America (BAC) purchase of Countrywide Financial (CFC) ranks right up there.  Eddy Elfenbein posted an excerpt of it that included this:

“‘It is the worst deal in the history of American finance,’ said Tony Plath, a banking and finance professor at the University of North Carolina at Charlotte.  ‘Hands down.’”

The chart above illustrates the total returns over the last quarter century for BAC and the S&P 500.  Also shown are the returns for CFC and Merrill Lynch (MER) from 1986 until BAC bought them in mid-2008 and early 2009 respectively.  I threw MER in there to show the extraordinary returns it had and then lost, just as CFC and BAC did.

I once wrote about the Green Tree Financial saga and the “securitization of assumptions.”  Countrywide was like that, with an overly-tanned pitchman that pumped those assumptions on CNBC.  Eager for product to feed the machine, the sell-side played along.  The failure of the buy-side is harder to explain.  (Chart:  Bloomberg terminal.)

the enormous radio

It’s just a few pages long — no, not the latest research puzzle posting, which is way shorter than that.  Rather, the short story by John Cheever that inspired it.  What if you had an enormous radio that you could use to tune into investment deliberations?

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Anything But Market Timing

Friday, July 27th, 2012

There are many definitions of market timing. Some are broad and some are narrow. Mine is broad. I believe market timing occurs when an investment decision is made based on a market prediction. That pretty much covers it all.

The phrase market timing tends to have a negative connotation, so the investment industry covers it up by calling it other names. The most often used name is tactical asset allocation. Cerulli Associates defines “tactical” as involving changes to a portfolio’s allocation based on any forward looking market expectation. The forward looking expectation can be derived from economics analysis, fundamental analysis, price trends or other means.

Michael Kitces and I took opposites sides in the market timing versus tactical asset allocation debate during a recent interview published in CFA Magazine.  Michael is a respected financial planner and publisher who adamantly believes that tactical asset allocation is not market timing. He differentiates the two by the size of the allocation change and the duration of the move.

“The stereotypical market timer moves in or all out of investments at their whim…Tactical asset allocation typically implements changes in a far more modest fashion, typically in the 2-5% range, which 10-20% as the outer limit…[and] have a much longer time horizon, spanning months or even years.”

So, what is the breakpoint? Is it 2 or 5%, 10 or 20%, months or years? As long as you’re not making a big allocation change then it’s tactical and not timing? In other words, you’re saying that when you’re only a little bit pregnant, you’re not really pregnant.

The problem with tactical asset allocation is that it looks, sounds, smells, tastes, acts and feels so much like market timing that calling it anything but market timing becomes an issue in itself. Like Michael, advisers who practice the art of market guessing spend an inordinate amount of time trying to redefine what they’re doing rather than just calling it what it is – market timing.

Other common names for market timing include opportunistic investing, sector rotation, active asset allocation, top-down allocation, bottom-up allocation, global modeling, algorithmic positioning, defensive investing, and the list goes on. New wrapping paper is used every year but the fruitcake never changes.

This debate is important because more advisers are using market timing strategies. A 2011 survey by Cerulli Associates found that 61 percent of advisers are now using some type of timing in portfolio management. That’s up over 8 percent from 2010. Unfortunately, advisers remain notoriously bad at market timing according to CXO Advisory Group’s Guru Grades. Quality does not correlate with quantity.

I haven’t yet said how I feel about market timing. Well, here’s the way I look at it. I’d rather be certain of a good return than hopeful of a great one. If you play with fire, you’re going to get burned.

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Biderman Batters ‘Believe-Me’-Draghi

Friday, July 27th, 2012

 
Somewhat stunned by the market’s exuberant reaction to Mario Draghi’s ‘Believe Me’ speech this morning, Charles Biderman, CEO of TrimTabs, sees the slow-motion train-wreck that is the European crisis speeding up and rapidly running out of track. Stepping back to look again at the European big picture; Biderman sees a bunch of economies whose citizens are making less money than before (and even before the current recessions European economies were not generating enough taxable income to pay current government expenses).

Now, a worsening recession means there will be less taxable income for governments to fund ever growing entitlements. Add that to a huge pile of dismal bad debts, and Charles sees the European crisis as “not a solvable problem the way the world works today.” Neither Draghi nor any of the bankers even bothers to talk about the real problem of not enough regional income and too much government spending.

Draghi’s only solution is some form of money printing. “Printing money to pay bills maybe will work over the short term. But long term, it cannot”; if money printing works in the real world why not print and give every one a billion Dollars, Euros or Yen? While governments will do anything to maintain the status quo (and avoid the tough times ahead), Charles succinctly reminds that, “the road to hell is paved with good intentions.”

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4 Myths About the FED Debunked

Friday, July 27th, 2012

by Jeff Miller, A Dash of Insight

The Fed is a favorite target for the financial punditry.  Anyone can and does join in, offering ideas that are completely without evidentiary support.  Meanwhile, there is plenty of factual information about the Fed, but it is widely ignored.

Here are four common mistakes that you frequently see in the commentary from the  pseudo-experts.  These blunders are so widespread that it is pointless to cite a specific source.

The Fed is Sidelined by the Upcoming Election

This one is a persistent theme among those who have absolutely no special knowledge or experience.  Many pundits analyze government organizations by pretending that the policymakers are a small group with a strong common motive and the ability to act in secret.  They basically take their own limited experience about how the world works and assume that they can explain government actions that way.

One reporter from the floor recently reported the latest convoluted notion:  The FOMC would not act at next week’s meeting, but would instead delay so that the positive effect of its policy action would not occur before the election.

That is really deep!  Some of the same sources show a chart that quite liberally changes the dates of Fed policy to correspond to market moves.  In some cases the move occurs at the first hint of a policy change.  This is completely inconsistent.

The Fed Acts Based Upon the Stock Market

One commentator recently opined that the Fed would not act right now because the stock market was not really threatened.  The Fed would wait until there was a serious selloff to use its few remaining bullets — maybe 1100 in the S&P.

In fact, there is absolutely no evidence that the Fed acts to prop up the stock market.  The Fed behaves in line with a dual mandate for stable prices and low unemployment.  With prices not a threat, the emphasis is on economic growth.

There is a source of confusion — the Fed embraces the stock market as one source of how well they are doing on the economy.  While the objective is not directly to support stock prices, a successful economic policy would have that result.  The occasional reference to higher asset prices is pounced upon by conspiracy buffs.

How can we tell the difference?

1. We could listen to Bernanke’s testimony, where he has repeatedly stated the economic objectives — and also that the political circumstances are not a factor.
2. We could go to the official transcripts of the meetings, now available for many years and extending up to 2006.   These are full transcripts.  If someone wants to assert political or stock motivations, let him find the evidence in the actual record.  Put up or shut up!
3. Forget the stupid conspiracy notion.  The FOMC meetings have many participants, some of whom would be happy to report any secret moves.

The Fed is Out of Ammunition

A popular theme is that the Fed can do little more because short rates are already at near-zero levels and the perception is that the effect of asset purchases has been reduced.

It is difficult to discuss an erroneous viewpoint without specifying a source, and I do not want to create a straw man.  With this in mind, the Fed critics — who have been on the job for years — did not imagine any of the current actions either.  The “out of bullets” meme is many years old.  Why should we believe them now?

Instead, you could look at commentary from an actual authority, a former Vice-Chair of the Fed.  Alan Blinder, writing in the WSJ, offers five different ideas that the Fed could use.  Any of these surprises could catch traders leaning the wrong way.

The Fed Knows the Employment Data

This is a bonus item.  I predict that whatever the Fed does next week, the talking heads will speculate that it is based on an early read from the employment report.

This idea is completely false, and contravenes official regulations.  The President gets an early look on Thursday afternoon (via the Council of Economic Advisors) and the Fed gets a few data points to help with their Wednesday release on Industrial Production.

That is all!

This was a specific question in a BLS webinar that I attended two years ago.  Here was the answer:

This is quite authoritative, and you will definitely not see it anywhere else.  My fearless forecast is that the conspiracy buffs will be in action on this next week!

Investment Conclusion

The basic conclusion for investors is a familiar one for readers of “A Dash.”  There is no substitute for finding actual experts and sources.  Accept no substitutes!

Bernanke will act if additional economic weakness indicates the need.  He will not have advance info on the employment report, so Fed action might not occur at the upcoming meeting.  While it may be fun to speculate on conspiracies and politics, this is not the path to a profitable investment.

Fighting central banks is a losing proposition for investors.

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After the Downgrade: German Stocks or Bonds?

Friday, July 27th, 2012

Amid rising uncertainty surrounding Europe, Moody’s earlier this week lowered its outlookfor Germany. Now, given the likelihood that Europe will continue to be a source of economic risk and investor angst, many investors are wondering whether they should stick with German assets. For now, I think the answer is “yes” on German stocks but “no” on bonds.

As the largest economy and paymaster of Europe, Germany is at the center of the European crisis. Despite this, both German equities – up more than 12% year-to-date – and German government bonds have performed well in 2012.

Viewed in isolation, Germany looks to be one of the more resilient developed markets. The German economy grew 3% in 2011, outpacing the United States, and is expected to grow by around 1% in 2012. Inflation is falling, German companies remain world-class exporters, and the return-on-equity (ROE) for German companies remains close to 13%, comfortably above its 10-year average.

The risk of course is what lies right outside German borders. Some investors are worried that Germany will ultimately acquiesce to assuming even more liabilities from the southern European countries. Others worry about an even more disruptive scenario: a euro breakup.

Under the euro-breakup scenario, German bonds would probably appreciate in price and investors will probably be better off with German bonds than German stocks. However, in my view, the more likely scenario is that the euro survives after a prolonged and costly transition toward fiscal union. This process will be painful for both German stocks and bonds – lower growth will hurt stocks and mutualizing the debt of other countries will hurt bonds. However, in my opinion, German stock prices already reflect the pain that further integration will entail while bonds don’t.

In fact, German stocks appear cheap. The DAX Index is yielding roughly 4%, more than twice the level of long-term German government bonds. German stocks sell for 9x forward earnings, as measured by price to earnings (P/E), and roughly 1.1x book value, as measured by price to book (P/B). These valuations compare favorably with those of other developed countries, whose equities trade at more than 14x and more than 1.60x P/B.

German debt, on the other hand, looks expensive. Ten-year bonds are yielding 1.165%, even lower than U.S. Treasuries. As is the case in the United States, the yield on government debt is now well below the current inflation rate. Unless inflation falls sharply in the coming years, investors are accepting a negative real yield for the privilege of loaning to the German government.

To be sure, a risk to both asset classes is further downward pressure on the euro given economists’ expectation of another rate cut from the European Central Bank later this year.

But for the reasons I cite above, going forward, I would stick with German stocks but lighten up on German bonds. Investors can access the German equities through the iShares MSCI Germany Index Fund, (NYSEARCA: EWG).

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

The author is long EWG

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country may be subject to higher volatility.
Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

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Hope is Not a Strategy

Friday, July 27th, 2012

It is a market dominated by hope.  There is the hope that one good data point or “breaking story” will emerge from somewhere, anywhere and will reverse the malaise that has characterized this market since the early April, 2012 top.

There is the ultimate hope that the Federal Reserve will initiate QE.  Everyone is banking on this.  We know that QE won’t save the economy or put off the inevitable recession, but it may provide hope for stock prices.  But whoever said QE was about Main Street in the first place?

There is earnings hope.  But market darling, Apple, didn’t get the message.  Oh that’s ok, this is just a temporary hiccup in the road and of course, it is a buying opportunity.  At least this is how one analyst put it yesterday as they were 100% positive that Apple would be higher 6 months from now.

There is the capitulation hope.  This is hoping that yesterday’s price action was capitulation.  It seems a little early for investors to capitulate as prices haven’t fallen too far, but after capitulation, we all know that prices must go up.  So I guess we can hope for that.

There is also the oversold bounce hope.  Measures of market breadth, like the McClellan Oscillator, have become oversold, and the markets always bounce when they become oversold.  Don’t they?  Then of course, we can hope that oversold bounce will morph into something more.

Lastly, there is the “R” word hope.  This is hoping that the “R” word is resilient and not recession.  Investors are hoping that the markets are resilient and will come roaring back.   But the data seems to point towards recession.

Hope is wonderful, and for investors, who are positioned poorly, hope is all you have at this point.  Just remember, hope is not a strategy!

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