U.S. stock market – long-term indicators favor bulls

Tuesday, August 7th, 2012

I published a post yesterday on the short-term technical outlook of the U.S. benchmark S&P 500 Index (SPX 1401.35 �‘0.51%), referring to conflicting indicators but stating that the rally could have more legs. When the message of the short-term charts is murky, it is often useful also to consult long-term indicators to provide some guidance.

Let’s consider, by means of example, monthly data for the S&P 500. A simple 12-month rate of change, or ROC, indicator seems to pick up the major turning points quite well. Let me say straightaway that monthly indicators are of little help when it comes to market timing, but they do come in handy for defining the primary trend. The ROC line below zero depicted bear trends quite clearly, as in 1990 (not shown), 1994, 2000 to 2003, and from 2007 to March 2009. Right now, the ROC line is “safely” in positive territory after threatening to breach the zero line in June.

The combination of a series of higher lows (i.e. rising bottoms) and positive longer-term momentum probably gives the bulls the benefit of the doubt, but needless to say I will be watching this space quite closely.

Source: StockCharts.com

Tags: Amp, Benchmark, Benefit Of The Doubt, Bottoms, Bulls, Guidance, Legs, Lows, Market Timing, Momentum, Rally, Spx, Technical Outlook, Term Charts, Term Indicators, U S Stock Market, Zero Line
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Default Risk Falls for US Banks and Brokers (Bespoke)

Tuesday, August 7th, 2012

by Bespoke Investment Group

Below are charts that show the change in default risk (5-year credit default swaps) over the past two and a half years for six of the most widely followed banks and brokers here in the US.  Over the past week or so, these financial firms have seen a pretty big drop in default risk as their stock prices have moved higher.

Morgan Stanley (MS) still has the highest default risk at 322 bps, followed by Goldman Sachs (GS) at 247 bps.  Bank of America (BAC) and Citigroup (C) are in the middle of the pack, while JP Morgan (JPM) and Wells Fargo (WFC) have the lowest default risk.  Wells Fargo (WFC) is the only company with a 5-year CDS price below 100 bps, clearly establishing it as the “safest” of the big US financial firms.

Tags: Bac, Bank Of America, Banks, Bps, Citigroup, Citigroup C, Credit Default Swaps, Default Risk, Goldman Sachs, Investment Group, Jp Morgan, Jpm, Morgan Stanley, Sachs Gs, Stock Prices, Two And A Half Years, Wells Fargo, Wfc
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Bond Model Positive = Risk Off

Tuesday, August 7th, 2012

by Guy Lerner, The Technical Take

Our bond model turned positive one week ago, and since the bottom in March, 2009, this has generally meant “risk off” for the markets.

Figure 1 is a weekly chart of the SP500.  In the lower panel is an analogue representation of our bond model.  Currently with the value “up”, the bond model is positive and we should expect higher bond prices and lower yields.  Looking at the SP500, I have put buy and sell signals on the price bars that corresponds to those times when the bond model is positive.  As you can see, the bond model was positive during the market tops of 2010 and 2011.  In each instance, rising bond prices was forecasting economic weakness that ultimately led to QE2 and Operation Twist.

Figure 1. SP500 v. Bond Model/ weekly

Since March, 2009 with the bond model positive (i.e., falling yields), the SP500 has gained 14.99% on a cumulative basis, and as you can see, the majority of the gains occurred in the initial thrust from the lows.  Since 2010, buying equities when the bond model is positive has produced a little gains for your efforts.  But there has been a lot volatility.  Clearly, this has been the “risk off” period.  In contrast, since March, 2009 with the bond model negative (i.e., rising yields), the SP500 has gained 39.04% cumulatively.  All 9 trades have been winners.

In summary, our bond model is positive.  Over the past 2 years, this has coincided with economic weakness and an equity market top in 2010 and 2011.

Copyright © The Technical Take

Tags: Analogue, Bond Market, Bond Prices, Cumulative Basis, Economic Weakness, Figure 1, Guy Lerner, Initial Thrust, Lows, Market Tops, Qe2, risk, S&P500, Signals, Trades, Volatility
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Note to Bond King: Check Your Math

Tuesday, August 7th, 2012

by Seth J. Masters, AllianceBernstein

August 6, 2012

The Wall Street Journal published an article on August 1 headlined: “Bill Gross: Equities are Dead.” In fairness to Gross, what he actually wrote in his August “Investment Outlook” was, “the cult of equities is dying.” We agree with most of Gross’s argument—but not with his unsupported forecast of extremely low  stock returns.

Let’s take a look at Gross’s claims:

1) Gross notes that bonds have outperformed stocks for the last 10, 20 and 30 years. With long US Treasuries currently yielding 2.7%, it is unlikely that bonds will replicate the performance of decades past.

We agree. That is why stocks are attractive today relative to bonds. Bonds—having outperformed—are now unusually expensive and have low expected returns going forward. By contrast, stocks—having performed poorly—are cheaper than normal and are likely to significantly outperform bonds over the next 10 years.

2) Gross argues that US stocks can’t maintain their 6.6% average annualized real return over the last 100 years. The 6.6% real equity return was 3% higher than real GDP growth, with shareholders gaining at the expense of labor and government. Labor and government must demand some recompense for wealth creation, and GDP growth itself must slow due to deleveraging.

We agree. We are now in a lower return environment. The question is, how low? Let’s concede that stocks will grow in line with real GDP. Over the long haul, real GDP growth primarily reflects population (growing a little over 1%) and productivity (growing just above 2%). That would give us a projected real equity return of maybe 3%—less than half the historical 6.6% rate.

3) Gross asserts that stocks will have a nominal return of 4%.

This is where Gross’s math gets fuzzy. Why this sudden switch to nominal instead of real returns? Does Gross expect that US population will shrink, productivity gains will disappear, and inflation will remain quiescent forever? That is what needs to happen for long-term nominal GDP growth to be as low as 4%. The scenario is possible, but hardly likely. Just assuming that inflation runs at a relatively tame 3% with below-normal real GDP growth of another 3%, we’d have nominal equity returns of 6% or so. That looks quite attractive when you get just 2.7% for holding long bonds to maturity.

In our recently published paper “The Case for the 20,000 Dow,” we show that with reasonable assumptions we can get returns in the 6% to 7% range and that the Dow hits that target in five to 10 years. We will also lay out our argument in an upcoming blog post.

Most investors today are very concerned about equity volatility, and for good reason. But there is another risk that should concern investors: the risk that their investments will not keep up with inflation and meet their goals. As investors balance short-term market risk against the long-run risk of falling short of their objectives, we think an appropriate allocation to equities continues to improve the likelihood for success.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer of Asset Allocation and Defined Contribution Investments at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Alliancebernstein, August 1, Bill Gross, Bonds, Equity Return, Fairness, GDP, GDP Growth, Government Labor, inflation, Investment Outlook, Productivity Gains, Real Gdp, Recompense, Seth, Stock Returns, Treasuries, Wall Street Journal, Wealth Creation
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Secular Outlook: Policy Confusions & Inflection Points (PIMCO)

Tuesday, August 7th, 2012

Secular Outlook:
Policy Confusions & Inflection Points

by Mohamed El Erian, PIMCO

• During this important annual event, PIMCO colleagues from around the world debate the major trends that will play out over the next three to five years, focusing not on what should happen, but what is likely to happen. Based on the 2012 Secular Forum discussions, we expect three themes to play out: continued policy and political confusion, overly incremental public and private sector responses and, therefore, greater potential for inflection points.
• In terms of regions, the status quo is no longer an option for Europe. The higher probability outcome – though not dominant – is a smaller and less imperfect eurozone. The journey would be bumpy and expensive; and it would require much more responsive and agile policymaking. Thus, the horrible risk of eurozone fragmentation is not de minimis.
• The U.S. will look good relative to Europe, outperforming in terms of growth and financial stability; but, amid political scrimmages rather than grand bargains, concerns will remain about growth, jobs, inequality, debt and deficits. Financial repression will persist as growth proves insufficient to quickly and safely delever segments that are over-indebted.
• Emerging economies, meanwhile, will continue to outpace both Europe and the U.S. over the secular horizon. Their path of expansion and convergence will be more volatile, especially as some countries undertake needed and tricky transitions in their growth models (including China).
• Portfolio implications: Maintain a sizable quality bias for sovereigns and corporate credits; supplement high-quality equity positioning (low financial leverage, high operating margins, and growth exposure) with dividend streams, where possible, as a means of de facto shortening duration; consider real assets to guard against confiscation risk; expand risk management to include cost-effective tail hedging; and evolve strategies, guidelines, dividing lines and mindsets that have guided investing in the past but will likely be challenged in the context of inflection dynamics.

This year’s Secular Forum was particularly interesting and, also, very challenging. For 2 ½ days, we debated a range of issues, with lots of time spent on the familiar – such as the twin problem of too much debt and too few jobs, and the related austerity versus growth debate – but also on the less prominent but equally consequential – including the game theoretics of large debt overhangs, as well as how technology is redefining economic, political and social interactions. In the process, we iterated to findings that, we believe, are both consequential and actionable for investment strategies including … but, wait, I am trying to fast-forward a summary write-up that warrants proper introduction and context.

The Secular Forum has proven enormously important for PIMCO’s ability to deliver consistent value to you, our clients. Indeed, if we were to pick the handful of factors that have enabled us to serve you well for more than 40 years, this annual event would certainly be among them. It gathers investment professionals from PIMCO’s 12 offices around the world. Collectively, we engage in a lively debate aimed at identifying the major trends that will play out over the next three to five years (and, critically, not what should happen but, rather, what is likely to happen). Think of the outcome as providing medium-term guardrails for where and how we invest the funds that you have entrusted to us.

It is never easy to take an individual – let alone a group – out of the day-to-day routine and focus on issues that are not urgent now, but will prove both urgent and important over the next few years. To help us do so, we turn each year to thought leaders from outside PIMCO to act as catalysts and to challenge our views, thus also reducing the risk of groupthink; and again this year we were privileged to interact with terrific thinkers who brought lots of interesting ideas to the table. We also listened to our brilliant new class of MBAs and PhDs; and, once again, they provided us with valuable, fresh and provocative perspectives. And all this was mixed with quite a bit of background work and back-and-forth discussion.

Context
To provide context for our discussions, we explicitly started with our priors – the conclusions of previous Forums, adjusted for recent developments, new information and additional analysis.

A year ago, PIMCO concluded that the world would continue to exhibit multi-speed characteristics. Specifically, advanced countries would appear to cyclically recover. But, with lagging policy mindsets, growth would prove insufficient to overcome problems of unusually high (and persistent) unemployment, large budget deficits, rising debts, and worsening income and wealth inequality. For some countries with acute economic and balance sheet stress, we postulated the “virtual certainty of at least one (and probably more) sovereign debt restructurings” during our secular horizon.¹

We painted a different picture for emerging economies. Because they are powered by higher growth, we argued that they would continue to close the global income and wealth gap, lifting millions more out of poverty in the process. We recognized that this would not be linear as countries confront inflationary concerns, disruptive surges in capital inflows and tricky internal transitions (including what Mike Spence, Nobel Laureate in Economics and author of the recent book on “The Next Convergence,” calls the “middle income transition”).

At the global level, we anticipated that the international monetary system would experience stress in accommodating these historic global realignments. Remember, not only would emerging economies grow faster, but they would also have an increasing and ultimately defining influence on the structural behavior of the global economy. Yet, due to deeply entrenched entitlement mindsets in advanced economies and outdated mechanisms in multilateral organizations, global governance would find it difficult to catch up with the evolving new reality, let alone get ahead of it.

This, of course, is what PIMCO had labeled the “new normal” back in early 2009 – one that spoke to delevering
in advanced economies, structural imbalances, and global convergence.² It thus portrayed, as reiterated in last year’s write-up, a post-2008 global financial crisis world that “heals only slowly and unevenly,” “transitions … in a rather messy and uncoordinated fashion,” becomes “increasingly fragmented in terms of cognitive recognition,” and in which “social cohesion is uneven.”

Our medium-term baseline was seen as being subject to two-sided risk scenarios. It could tip into a much better equilibrium if policymakers came up with three “grand bargains” – in Europe, the U.S. and China. But it could also fall victim to a more rapid and disorderly delevering.

These two scenarios were important enough for us to argue for a gradual morphing in the distribution of expected outcomes that underpins many investors’ behavior (and analytical constructs): away from the traditional bell curve that exhibits a dominant mean and thin tails (both very comforting), to a flatter distribution with much fatter tails that, in certain circumstances (Europe), could even go bimodal.

Much of what has transpired over the last 12 months is consistent with these priors. Indeed, at times it has felt as if the fast-forward button had been pressed on our secular themes.

In the run-up to the Forum, we found longer-term issues featuring more prominently in our cyclical discussions, as well as in the deliberations of the Investment Committee (which meets four times a week for two to three hour sessions). And with incrementalism dominating way too many policy reaction functions, these developments also help explain why the world/markets now face potential inflection points over the next three to five years – some probable and others possible.

Key Issues
It did not take us long last week to figure out that this would be one of the more challenging Secular Forums. After all, we were analyzing a global economy buffeted by complex realignments yet lacking proper historical precedents. Meanwhile, monetary policy is in full real-time experimentation mode, political anti-incumbency is growing, and extreme polarization is amplifying rising social tensions. And if this were not enough of a complex cocktail, let us not forget what our colleague Ramin Toloui called the disparate adherence to “alternate realities.” The resulting disagreements – which, increasingly, cover the past, present and future – further undermine any convergence to a common analysis of what ails individual countries, let alone the vision and sense of shared responsibility to solve it.

This combination results in what Jerome Schneider described as a self-reinforcing cycle of largely reactive partial responses, subsequent complacency and recurrent localized crises. The longer this persists, the greater the probability of a series of market inflection points in the next three to five years. Indeed, it should come as no surprise that both policymakers and economists are struggling with what has been oversimplified into the growth versus austerity debate. And the resulting confusion, together with a pronounced tendency for politicians to bicker and dither, has made the problems more complex and the solutions more demanding.

In such a world, we believe that it is particularly important to differentiate well between what one knows with a high degree of both foundation and conviction (the “knowns”), and where sufficient knowledge and confidence can only be built through additional data and analysis (“known unknowns”). This should be combined with enough intellectual agility to change the composition as more information become available; and also with the operational responsiveness required to evolve investment strategies accordingly.

Knowns
The knowns speak to the likely persistence of what has become a familiar combination for too many advanced economies – too little growth, too much debt, high joblessness (particularly among the young and long-term unemployed), excessive political polarization and growing calls for greater social justice.

Given current policies, none of these are likely to go away any time soon absent a major crisis and/or a big political pivot. Moreover, the adjustment processes in certain countries (with Greece being the lead example) have already been undermined by “policies that hurt but don’t work,” a phrase used by British politician Ed Miliband in a different context. As such, they risk a frightening economic, financial, political and social implosion.

This reality will continue to play out most distressingly in a few European countries where the institutional setup is already under strain. Indeed, politicians will find it increasingly difficult to reconcile what Andy Bosomworth labeled as the requirements of democracy, mutualization and conditionality – thus robbing the region of the type of mutual assurances that are critical to a cooperative orderly solution. With that, allocating balance sheet losses becomes even more difficult, both within and across countries.

Simply put, the status quo is no longer an option for Europe over the three to five year horizon. The higher probability outcome is that the eurozone will evolve into a smaller and less imperfect entity – namely, a closer political union of countries with more similar conditions. We believe that this smaller union would likely include the big four (France, Germany, Italy and Spain) which, together with other remaining members, would be underpinned by much stronger regional coordination and financing mechanisms.

We did not come to this view easily – especially as there is no orderly, easy and costless way to get there. Evolving into a smaller and less imperfect zone – as leaders need to do in order to save their important and historical European project, and thus also avoid a major disruption to the global economy – is expensive and uncertain. It requires a lot of proper coordination, a more balanced policy mix, stronger financial circuit breakers (well beyond the ECB’s lender of last resort facilities), less vulnerable banks, and quite a bit of luck too. It could even take a major fragmentation scare to force political leaders to act in a sustained manner.

All this also means that risk of a big derailment (an “existential risk” for the European project) is far from de minimis. Given the series of sustained negative shocks that this would entail – for individual nations, the region and the world as a whole – every political avenue should be pursued to avoid it. But we cannot count on that.

As Thomas Kressin noted, it is not just about the willingness of politicians to keep the eurozone intact. If it does fragment, it will most probably be because the population loses patience, resulting in political and social rejection that is aggravated by a tsunami of private capital outflows. Fortunately, politicians and policymakers still have the ability to get ahead of this, but they need to do so very seriously and very quickly. And for that, they also need a common analysis, a shared vision, and sufficient support.

Over the next three to five years, the U.S. will look good relative to Europe, outperforming in terms of growth and financial stability. That is the good news. The bad news is that Americans live in an absolute and not a relative dimension.

Our political analysis led us to conclude, using Libby Cantrill’s notion, that political scrimmages rather than grand bargains would dominate Washington – a forecast that reflects not only the reality of extreme polarization, but also the impact of significant disagreements among “technocrats” and related policy confusions. The fiscal cliff debate, which is certain to get louder in the coming months, will provide insights in this regard.

In a world that is so far away from any notion of a policy first best, look for the Federal Reserve to maintain its pursuit of financial repression for a number of years; and look for other regulatory bodies to pursue similar avenues in the context of a generally more restrictive regulatory environment. The resulting policy mix, however, will do little to alleviate legitimate concerns about growth, jobs, inequality, debt and deficits. In the process, the underlying structural fragilities of the economy will grow, in both economic and financial terms.

Turning to the emerging economies, we expect them to continue to outpace both Europe and the U.S. over our secular horizon. But don’t look to them to compensate fully for problems elsewhere in the global economy. Also, you should expect them to deliver a more volatile growth path, especially as some countries undertake needed and tricky transition in growth models (including China). Along with all this, also look for greater differentiation among countries in what will become an increasingly heterogeneous grouping.

Yes, we expect emerging economies will account for more than 50% of global GDP in the next three to five years (in purchasing power parity terms). And yes their size and growth rate will influence even more the functioning of the global economy. But this will not overwhelm developments in the advanced countries anchoring the core of the international monetary system. Moreover, with advanced economies attempting to hold on to outdated entitlements, the undeniable shift in economic gravity will not be accompanied by sufficient changes in the manner the global system is governed, wired and interconnected – changes that are important for laying a proper foundation for more balanced global growth and a more robust international system in the future.

So, turning to illustrative numbers, we expect growth in advanced economies to average some 1% annually over the next three to five years (compared to 2’ish% at the 2011 Forum); and some 5% for emerging economies (6% previously). Meanwhile, look for the inflation versus disinflation debate to continue unabated as the tug of war between stimulus and debt deflation plays out.

On balance, we believe that over the next few years, inflationary pressures will slowly build in the global system due to several drivers. Too many cyclical dislocations risk becoming embedded as structural impairments to long-term growth potential, particularly when it comes to the labor markets in advanced economies. With other government entities doing too little, central banks will likely maintain highly accommodating policies for too long. And do not forget the political appeal of resorting to inflation as a means to delever.

Known Unknowns
What about the known unknowns? There are quite a few, including some with the potential to turn some of the slow burn dynamics into sudden shocks, either negative or positive.

Elections and transitions could certainly be game changers. According to calculations by our MBAs/PhDs, more than 50% of global GDP will face a potentially defining change in 2012. Moreover, eight out of 17 eurozone governments have been voted out of office in the last couple of years. So the potential for political upheavals is certainly with us.

Armed with strong new mandates, governments could deliver the “Sputnik moment” that acts as a catalyst for a series of beneficial grand policy bargains. And the impact would be amplified by the crowding-in of significant private capital that is now on the sidelines. More likely, however, is that elections result in a further polarization that complicates economic management. And, as illustrated recently in Greece, the mounting loss of credibility of traditional political parties facilitates the emergence of fringe parties that are eager to dismantle the past but have as yet no coherent and comprehensive plan for the future.

Over the next few years, elections will compound the pressures that governments feel from increasingly restless populations (especially in countries with high youth unemployment, including 51% in Greece and Spain and 36% in Italy and Portugal). As one of our new colleagues, Min Zhang, put it, her generation is looking for “hope and opportunity.” Instead, and also lacking control of the ballot box, they are being saddled by an older generation’s debt and growth impediments. And demographic trends will accentuate the challenges. Under such circumstances, we should not dismiss the possibility of unpredictable sociopolitical reactions that end up further complicating long-standing social compacts and the related functioning of an already stressed international monetary system.

What happens in advanced countries will be of more than passing interest to the healthier part of the global economy, namely the emerging world – a point that Francesc Balcells, Michael Gomez, Ramin Toloui and others stressed.

The longer it takes for the advanced countries to grapple with their growth and debt problems, the greater the imperative for emerging economies to transition to sources of domestic demand to sustain growth. Nowhere is this more important systemically than China.

History suggests that economic, political and social frictions are inherent to such transitions, requiring careful and responsive management. Moreover, as the emerging world itself starts with a set of different initial conditions among individual economies – and a few differences are quite pronounced – some countries will likely be more successful than others, with related surprises.
Have no doubts, the “concentric circle” construct underpinning the international monetary order will be pressured in significant ways in the next three to five years. This is not to postulate a different system. As Rich Clarida argued, there is no alternate system and, therefore, you cannot replace something with nothing. Rather, it is about an increasingly hobbled international order whose anchoring core is weakening on a daily basis, thus undermining the standing of global public goods over the secular horizon. Also, don’t be surprised to see countries in the outer circles (particularly some emerging economies) increasingly establish direct links that bypass the core. Indeed, changing clusters of global influence are likely to be a notable feature of the next three to five years; and the systemic impact is inevitably uncertain.

Technology also provides for meaningful two-sided tails for our baseline hypotheses, especially given that disruptions in this domain easily catch people by surprise.

You would have to be in North Korea to deny that the world is in the midst of empowerment advances that fundamentally alter the relationship between individuals, between states, and between these sets of global actors. As discussed, it is a changing ecosystem that results in two worlds operating simultaneously – but with different protocols, speeds and legal protections: a physical world with government and institutional control, and a virtual one with individuals dominating the creation, dissemination and sharing of content. Over time, the latter will have even greater economic, political and social impact – and do so at times through unanticipated channels.

This provides for the exciting possibility of leapfrogging structural impediments through what Mike Spence calls off-sequence development. Several specific examples were put on the table where technology could serve as a beneficial accelerator. And if we are really lucky (and we mean really, really lucky), perhaps this could also help in dealing with some of the real dangers of self-limiting growth patterns, including those associated with society’s past abuse of the environment. But, again, we should not count on that.

Yet this phenomenon has more than one potential outcome. Some of the empowering technical revolutions can be negatively used to undermine social cohesion and security. Others offer the likelihood of disruptive revolutionary dynamics that are easy to start but prove difficult to control and complete, especially in the absence of sustained leadership.

Implications – The “What”
Our 2012 Secular Forum discussion confirmed that the distribution of expected outcomes for the global economy is both flatter in its belly and fatter in its tails. This is a potentially unstable situation, especially when compared to the conventional bell curve. Moreover, its density has shifted unfavorably in the past 12 months as a result of growing uncertainty, complexity and policy risk premia. In Europe, it has already morphed into a bimodal distribution – a phenomenon that colleagues in our five European offices confront on a daily basis.

In such a world, investors need to retain a claim on the upside while protecting against the downside, including gap risk. They need to be highly differentiated, positioning portfolios for the knowns (both for return generation and for risk mitigation), while also maintaining the right level of optionality in the face of the unknowns. And they must ensure sufficient operational agility to evolve as more data become available, as will inevitably be the case.

In the short run, investors are well advised (indeed, urged) to supplement careful bottom-up security selection with macro, and in particular a deep understanding of the implications of the different policy approaches being used to deal with over-indebted economies generating insufficient growth – directly in advanced economies and indirectly in how this impacts the behavior of others. Specifically, and in the words of Bill Gross, they must seek to engineer a “great escape” from a range of actual and likely realities – be it financial repression in the U.S., default in Greece, or other forms of de facto confiscation elsewhere.³

This, of course, translates into a sizeable quality bias for sovereign and company exposures, the latter both in corporate credit and equity space. Focus on names with high cash balances, low financial leverage, high operating margins and exposure to growth areas. Higher quality sovereign exposure should be concentrated in parts of the yield curve that offer meaningful roll down and are anchored by credible central bank policies. Exposure further out the curve should be taken with caution, focusing on sovereigns with a lower risk of inflation and also utilizing inflation-protected securities. Meanwhile, higher-quality equity exposure should be supplemented, where possible, with a dividend dimension as a means of de facto shortening duration.

Consider real assets when thinking of the range of responses to minimize the multi-faceted risk of financial confiscation, especially as inflationary pressures slowly mount. Again, differentiation will be essential, with emphasis placed on those with low supply elasticities and offering a degree of geopolitical protection.

Currencies are the hardest to call in the world we have described. On the one hand, emerging market currencies will likely be supported by continued productivity gains, strong balance sheets and capital inflows. On the other hand, policymakers there will be hesitant to see their currencies strengthen in a world that is so uncertain, especially if the appreciation is turbocharged by leakages from what they view as excessive liquidity creation in the U.S. Also, expect the U.S. dollar to continue to be the main recipient of flight-to-quality capital, at least for the first part of the secular horizon.

These considerations speak to relatively limited scaling of currency positions pending additional information. And they also shout for careful differentiation.
The bottom line here is a simple one: Wherever you are in the capital structure and in geographical space, be very alert to situations where valuations do not reflect the confiscation risk. And remember, confiscation is not just default. It is also a function of poor protection against inflation, nationalization or the large preemption of company and currency earnings by governments.

And…
The emphasis on minimizing exposure to financial repression will remain as long as central bankers are in control, including a Federal Reserve that is both able and willing to compress interest rates while underwriting the mounting collateral damage and unintended consequences. At some point during the secular horizon, however, investors will most likely need to pivot. Why? Because, absent a much more comprehensive policy response, central bank measures will prove insufficient by themselves to ignite growth dynamics and safely delever over-indebted segments in advanced economies.

Think of two corner solutions anchoring the range of possibilities in this pivot. At one end, central banks end up providing a bridge for other government entities with more effective measures, including on the structural front. And this serves to crowd in private capital currently on the sidelines. At the other end, central bank policies become not just ineffective but also counterproductive as the collateral damage and unintended consequences eventually overwhelm the intended benefits.⁴ In addition to the direct negative impact, this would encourage the private sector to de-risk further, thus sucking more oxygen out of the economy.

For investors, the essence of this pivot involves an overwhelming emphasis on capturing solid and growing value streams that reflect company and sovereign ability to “earn” them through sound fundamentals rather than to “buy” them through financial wizardry. Its exact nature depends on whether other policymakers, with better tools, finally step up to their challenges.

If they do, then an across-the-board risk-on posture would make sense; and government bonds would prove a bad place to be. But this requires the type of political decisiveness and effectiveness that sadly eludes most advanced economies; and it also necessitates better global policy coordination. Accordingly, the other pivot involves even greater emphasis on principal protection – or, to use Bill’s recent characterization, reinforcing the coming of age of investment defense.⁵ And, together, all this speaks to the need more than ever to allow for portfolio repositioning as new data come in and circumstances dictate.

Implications – The “How”
So far, we have discussed “what” investors should consider if they agree with our secular analysis. It does not stop here however. The analysis suggests that the “how” is equally consequential.

Given the likelihood of inflection points, investors will need to be extra careful of traditional market capitalization indices that underpin not just conventional benchmarks but also many passive investment approaches. These can be particularly counterproductive in fixed income when debt is growing beyond safe levels (remember, they encourage the allocation of large and rising sums to increasingly vulnerable credits). In equity space, many of the traditional indices and approaches risk missing out on disruptors that will thrive in dislocated and changing markets and ecosystems.

It is also high time to revisit a whole host of backward-looking labels and dividing lines that often lurk in asset allocation, investment guidelines and mindsets. Are “domestic equities” really domestic when a large and growing portion of company revenues and profits come from other countries? Are advanced government bonds really interest rate risk when countries continue to slip down the credit curve? And are all emerging market sovereign bonds as risky as the term is often seen to imply?

All this speaks not only to increasingly outdated historical distinctions, but also to correlations among asset classes and the flexibility to react to (and combine more optimally) different risk factors. Remember, as Josh Davis, David Fisher and Curtis Mewbourne note, it is about how an investment behaves rather than what it is called.

Led by our analytics and solution capabilities, PIMCO has done a lot of work on this. This particular effort was initiated back in 2006 and we now have encouraging results to share with you – from forward-looking indices (including “Global Advantage” that just celebrated its third anniversary) to solution methodologies and risk factor analysis.

Finally, and perhaps most disappointing for many, society will need to lower its return expectations in general, and particularly its risk-adjusted return expectations. Having produced what Scott Mather called a period of “false economic prosperity,” the enormous multi-year levering of both the public and private sectors in advanced economies also involved the front-loading of investment returns. This can only be maintained and enhanced now through additional leverage (and the set of binding constraints here is set to grow) or through the lifting of structural impediments to growth (a much better approach but unfortunately problematic, at least for now).

As return expectations come down, the asset side of the balance sheet will not be sufficient on its own to meet the objectives of many investors. An even stronger linkage to the liabilities side will be paramount. In many cases, this requires a concurrent evolution in portfolio construction. Moreover, as demonstrated by Vineer Bhansali and Jim Moore, an investment approach that places risk mitigation just on the shoulders of asset class diversification will suffer. It will need to be appropriately supplemented by more sophisticated asset-liability management, cost-effective tail hedging, and a solution (as opposed to just product) mindset.

Bottom Line
In July 2010, the Chairman of the Federal Reserve Board, Ben Bernanke, came up with an elegant term to characterize the United States’ cyclical outlook – he called it “unusually uncertain.” PIMCO’s 2012 Secular Forum suggests that this term could well prove as resilient as our May 2009 forecast for a “new normal.” Given our analysis, Bernanke’s unusual uncertainty applies to more than the cyclical timeframe, and to more than just the United States. It is both secular and global.

Now uncertainty, even of the unusual variety, does not – and should not – translate into investor paralysis. We believe that specific areas of the secular horizon are already clear and actionable today; others are subject to significant two-sided fat tails that should be detailed and managed accordingly.

Over the next few weeks, we will provide you with several more detailed notes from our specialists on how the Forum’s conclusions affect their individual sectors. We will also continue to fill out the secular topology, especially as we learn more about how the global economy is accommodating historic multi-dimensional changes – be they in advanced countries, in emerging economies or in the functioning of the international monetary system. And you can be assured that we will work very hard to do so well ahead of others.

Mohamed A. El-Erian

¹ “Secular Outlook: Navigating the Multi-Speed World,” PIMCO, May 2011.
² “Secular Outlook: A New Normal,” PIMCO, May 2009.
³ “The Great Escape: Delivering in a Delevering World,” PIMCO, April 2012.
⁴ “Evolution, Impact and Limitations of Unusual Central Bank Activism,” PIMCO, April 2012.
⁵ “Defense,” PIMCO, March 2012.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. 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. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.

This material contains the current 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 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.

Copyright © PIMCO

Tags: Confiscation, Confusions, Emerging Economies, Financial Leverage, Financial Repression, Financial Stability, Forum Discussions, Growth Models, Inflection Points, Mohamed El Erian, Operating Margins, Policymaking, Political Confusion, Quality Equity, Real Assets, Risk Management, Scrimmages, Shortening, Sovereigns, World Debate
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Wired: How Wall Street Got Addicted to Light Speed Trading

Tuesday, August 7th, 2012

by Mark Hanna, Market Montage

Last week’s high profile trading debacle has put the focus on high speed algo programs once more.  Like all the other times there is a dislocation of such sort, after a few days, all the fuss will die away and business as usual (70% of all trades now computerized) will continue.  There appears to be no end to it as these folks create so much volume, and exchanges make money off that.  Frankly if there was no real push back after the frightening flash crash of 2010, I don’t know what will ever cause real reform.  Whatever the case there is a nice write up in Wired Magazine that interested readers may want to go read for more on the subject and what is coming down the pike – both real and theoretical.

Some snippets:

• One of the major themes of this year’s conference was “the race to the bottom,” the cost-is-no-object competition for the absolute theoretical minimum trade time. This variable, called latency, is rapidly approaching the physical limits of the universe set by quantum mechanics and relativity. But perhaps not even Einstein fully appreciated the degree to which electromagnetic waves bend in the presence of money. Kevin McPartland of the Tabb Group, which compiles information on the financial industry, projected that companies would spend $2.2 billion in 2010 on trading infrastructure—the high-speed servers that process trades and the fiber-optic cables that link them in a globe-spanning network. And that was before projects were launched to connect New York and London by a new transatlantic cable and London and Tokyo by way of the Arctic Ocean, all just to cut a few hundredths of a second off the time it takes to receive data or send an order.
• The data center of NYSE Euro­next, the international conglomerate that includes the New York Stock Exchange, is in a building in suburban Mahwah, New Jersey, 27 miles from Wall Street. Besides “matching engine” computers that process trades on the exchange, it also houses high-frequency trading servers, which receive data and spit out orders according to programs—algorithms. Traders pay to put their servers in the same building, and to make things fair, engineers scrupulously add extra lengths of cable to equalize the runs among all the servers. Yes, we are talking about a few feet plus or minus. At nearly the speed of light.
• Because of some complicated physics, the speed of light through any medium is inversely proportionate to the medium’s index of refraction—so signals travel about 200,000 kilo­meters per second through fiber-optic cable, compared with 300,000 through the atmosphere. The fastest communication between New York and Chicago would be line-of-sight through the air, which requires a chain of microwave relay towers. Tradeworx is building such a network, as is McKay Brothers, a California firm that hopes its system will be the fastest, with a round-trip latency of less than 9 milliseconds.
• Furthermore, trade on it now, this microsecond. It is only a matter of time, perhaps a few decades, says Alexander Wissner-Gross, a Harvard physicist, before some hedge fund decides it needs a particle accelerator to generate neutrinos, and then everyone will want one. Yes, they travel slower than light, but they indisputably can tunnel through the earth, cutting thousands of miles off an intercontinental message.
• High-frequency traders make money in a vacuum, grabbing for pennies that appear and disappear like the virtual particles of quantum field theory. Their goal is to end each trading day “flat”—out of the market, their profits safely in the bank. Depending on their model, they can do well winning as little as 55 percent of their trades. They are continuously testing prices, looking for patterns and trends or the chance to buy something in one place for $1 and sell it somewhere else for $1.01, or $1.001. Sometimes they aren’t even looking to make money on the trade itself. Under the “maker-taker” model, some exchanges offer tiny incentive payments, or rebates, for posting a quote (to buy or sell a stock) that results in a trade. The exchange charges the other side in the trade, the taker, a slightly higher fee and collects the difference. So an algo can buy a stock, earn a rebate, then sell the stock and earn a rebate for that too. All of this is governed by algorithms whose lifespans can be as short as a few weeks.
• High-frequency trading raises an existential question for capitalism, one that most traders try to avoid confronting: Why do we have stock markets? To promote business investment, is the textbook answer, by assuring investors that they can always sell their shares at a published price—the guarantee of liquidity. From 1792 until 2006, the New York Stock Exchange was a nonprofit quasi utility owned by its members, the brokers who traded there. Today it is an arm of NYSE Euronext, whose own profits and stock price depend on getting high-frequency traders in the door. Trading increasingly is an end in itself, operating at a remove from the goods-and-services-producing part of the economy and taking a growing share of GDP—twice what it did a century ago, when Wall Street was financing the enormous industrial expansion of the economy.

Copyright © Market Montage

Tags: Coming Down The Pike, Engine Computers, Fiber Optic Cables, Hundredths, Interested Readers, International Conglomerate, Mahwah New Jersey, Mark Hanna, Mcpartland, New York Stock, New York Stock Exchange, Object Competition, Quantum Mechanics, Race To The Bottom, Real Push, Speed Servers, Tabb Group, Transatlantic Cable, Which Electromagnetic Waves, York Stock Exchange
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Stock Pickers: “Somebody I Used to Know”

Tuesday, August 7th, 2012

by William Smead, Smead Capital Management

Art has a tendency to express culture. One of today’s catchiest songs does a great job of explaining the relationship between institutional/individual investors and US common stock picking. In Gotye’s, “Somebody I Used to Know”, the lyric writer expresses the pain of a love affair gone awry and the feelings coming out of the former couple in words. To us at Smead Capital Management (SCM), the song captures what has happened since the summer of 1999, when Warren Buffett warned investors about forward stock market returns because of a love affair that institutional and individual investors were having with US large cap stocks. It takes us into today as Bill Gross from Pimco, David Rosenberg from Gluskin, Scheff and others encourage investors to underestimate the benefit of US large cap common stock ownership. At the same time, these purveyors of rational despair are driving investors away from stock picking when it is most likely to be advantageous to both institutions and individuals.

Now and then I think of when we were together
Like when you said you felt so happy you could die
Told myself that you were right for me
But felt so lonely in your company
But that was love and it’s an ache I still remember

Let me take you back to 1999, when investors and US large cap stock picking “were together” and investors loved their stocks until they “ached”. Buffett explained at the Allen and Co. gathering in Sun Valley, Idaho that the Fortune 500 index of common stocks was trading at 30 times earnings and was dooming US large caps to 17 years of sub-par performance. Stocks had performed spectacularly from August of 1982 to that summer day in Sun Valley. After 17 years of only occasional and mostly mild market corrections and years of prosperity, common stock investors in US large cap were “so happy they could die”. Their love for stock picking and stock pickers covered the pages of major media.

As Buffett shared, investors told themselves that common stocks “were right for them”. He quoted a UBS/Gallup poll which showed that the clients of UBS/Paine Webber expected 20% compounded returns over the next five years in US large cap common stocks. Picking common stocks and holding them for a long time was the national pastime. As I remember at that time, the over-pricing of US large cap growth/tech stocks made both Buffett and me feel “so lonely in your company”. No Bill Gross or David Rosenberg or any of today’s well known negative nabobs around to tell us where we’d be now beside the Oracle of Omaha.

Now and then I think of all the times you screwed me over
But had me believing it was always something that I’d done
But I don’t wanna live that way
Reading into every word you say
You said that you could let it go
And I wouldn’t catch you hung up on somebody that you used to know

People massively over did their affection for common stocks in 1999 and laid the groundwork for 12 years of extremely poor historical returns. Today both institutional and individual investors can only “think of all the times that you (US large cap stocks and stock pickers) screwed me over”. The times were the 2000-2002 and 2007-2009 bear markets. Two 40%-plus bear market declines in an eight-year stretch. It caused investors “believing it was always something” they had done. Ultimately, they decided “they didn’t want to live that way, reading into every word (Stocks for the Long Run) you say”. Investors decided common stocks “could be let go” and the stock pickers and US large cap companies were “somebody they used to know”.

But you didn’t have to cut me off
Make out like it never happened and that we were nothing
And I don’t even need your love
But you treat me like a stranger and that feels so rough
No you didn’t have to stoop so low
Have your friends collect your records and then change your number
I guess that I don’t need that though
Now you’re just somebody that I used to know

Unfortunately, the rear-view mirror never creates a good vision of the future. Investors for the most part have dramatically “cut off” their allocation of US large cap equity ownership. Worst of all, they “make like” the good years in the history of the stock market “never happened”. Investors have gone to the ends of the earth and to esoteric and illiquid investments to seek investment affection and act like they “don’t even need your love”. Here is how the logic goes. Investors say, “Stocks have performed poorly the last 12 years and haven’t met our return goals. Therefore, we will assume they never will. It will make me feel better if I assume that successful common stock investing was a statistical aberration and a thing of the past.” Isn’t it terrific that numerous self-interested gurus come by to regularly reinforce this rear-view mirror logic (The Cult of Equity is Dead).

You can get addicted to a certain kind of sadness
Like resignation to the end, always the end
So when we found that we could not make sense
Well you said that we would still be friends
But I’ll admit that I was glad it was over

On May 31, 2012, Randall Forsyth wrote at barrons.com that all of this has morphed into what he calls “rational despair”. Like the song says, “You can get addicted to a certain kind of sadness.” You look around you and see unsolvable economic problems, poor backward-looking stock market returns, dysfunctional governments around the world and you despair in a very logical way. You resign the US economy and stock market to a bad end and you hoard cash or invest in doomsday categories to justify your hopeless attitude. Gotye wrote, “Like resignation to the end, always the end”. If I had five dollars for every doomsday email I’ve been sent in the last three years, I’d be flush with cash. People look at US large cap stocks and stock pickers and “found that we could not make sense”. Some folks have gravitated to large cap indexes and ETFs because they said, “that we would still be friends”. Despite strong returns since the market lows of March 2009, those who despair rationally “admit that they are glad it was over”. It was their love for stocks and stock pickers that was gone.

But you didn’t have to cut me off
Make out like it never happened and that we were nothing
And I don’t even need your love
But you treat me like a stranger and that feels so rough
No you didn’t have to stoop so low
Have your friends collect your records and then change your number
I guess that I don’t need that though
Now you’re just somebody that I used to know

Cutting yourself or your institution off from owning healthy quantities of US large cap stocks based on the logic we’ve explained is like cutting off your nose to spite your face. Women in Northern Europe cut off their nose to look ugly to avoid being raped by conquering armies. In the same way, those who “make out like it (US stocks historically above-average returns among liquid asset classes) never happened” are, in our opinion, dooming themselves to sub-par portfolio performance at a time when above-average returns have never been needed more! Investors treat long duration common stock investing in US large cap stocks “like a stranger and (for stock pickers) that feels so rough”. “You didn’t have to stoop so low” when it comes to your portfolio allocation to US large cap and to active managers in the category.

Today, US large cap stocks are in a more similar position to 1982, than to anything like 1999. In 1982, we had high unemployment, huge budget deficits and loans for home buying or business formation were hard to come by. Stocks had performed poorly for over a decade. Gold, Oil and collectibles were popular among those who saw that era as made up of unsolvable problems and despaired rationally. Fortunately for us, the same guy who warned us in 1999 has laid out the right long-term view for us today. Here is how Warren Buffett puts the current circumstance in excerpts from his annual letter to the shareholders of Berkshire Hathaway called, “The Basic Choices for Investors and the One We Strongly Prefer”:

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.

- Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

Under today’s conditions, therefore, I do not like currency-based investments

- The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative.

As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

- Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.

In our opinion, Buffett is the greatest stock picker of all-time and his portfolio is loaded with undervalued US large Cap stocks. Those who suffer from “rational despair” are massively over-weighted in the currency and unproductive assets that Buffett is warning everyone about. They are just like the bitter former lovers in the song who “wouldn’t catch you hung up on somebody that you used to know”. It is so ironic that investors today are having a love affair with the same asset-class allocation as they did in 1982 (Gold and Commodities). We believe the circumstances today scream for a new love affair to start between investors and US large cap stock pickers. Look at the long-term correlation chart below:

Source: The Big Picture, http://www.ritholtz.com/blog/2011/12/correlation-in-the-markets/

Our advice is to avoid stock pickers when stocks are expensive and correlations are low and milk them for years when correlations are high, like they are now. Correlations were the highest historically in 1982, 1987, 2002-03 and 2008-09. All these instances were around major US stock market low points. It might be time for asset allocators to “collect your records and then change your number” when it comes to US large cap and US large cap stock pickers. In that way you won’t have to look back ten years from now and view US large cap stocks and stock pickers as “just somebody that I used to know”.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results.  It should not be assumed that investing in any securities we recommend will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

Copyright © Smead Capital Management

Tags: Allen And Co, Bill Gross, Cap Stock, Cap Stocks, Common Stock, Common Stocks, David Rosenberg, Fortune 500, Individual Investors, Love Affair, Lyric Writer, PIMCO, Scheff, Smead, Stock Investors, Stock Market Returns, Stock Ownership, Stock Pickers, Sun Valley Idaho, Warren Buffett
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Yogi Berra? (Saut)

Tuesday, August 7th, 2012

by Jeffrey Saut, Chief Investment Strategist, Raymond James

“Yogi Berra”
August 6, 2012

“It’s hard to make predictions, especially about the future.”… Yogi Berra

To be sure, “It’s hard to make predictions, especially about the future,” and last week was no exception. I began the week, as stated in Monday’s missive, noting that there would be a trifecta of potentially market moving news events. The first was the two-day FOMC meeting where I thought the Fed would change its policy statement with a lean toward more accommodation. My reasoning was that the Fed would appear too political by waiting until the September meeting, just a few short weeks before the election. WRONG; and that was pointed out to me in spades on Thursday because while Wednesday’s “no change” policy announcement only produced a stutter step for the S&P 500 (SPX/1390.99), by Thursday the SPX swooned. Indeed, by mid-session the SPX had shed more than 20 points from Wednesday’s closing price (1375), and in the process tagged its intraday low of 1354. By the close, however, the index had recouped about half of those intraday losses, ending the sloppy session at 1365. Actually, Thursday’s late in the day recovery was yet another surprise to me because hereto my early week prediction was there would be no surprise from the European Central Bank meeting. But, a surprise it was with Mario Draghi unwilling to make good on his previous week’s market moving statement that, “Within our mandate, the ECB is willing to do whatever it takes to preserve the euro and, believe me, it will be enough.”

WRONG; and I had to suffer through that night’s, and early Friday morning’s, parade of pundits talking about how bad the employment number might be. Such musings should have had a dilatory effect on the preopening futures, but that wasn’t the case as a number of other rumors swirled down the canyon of Wall Street with positive implications. Still, everyone awaited the numba’! And as stated in Thursday’s verbal strategy comments, I had no idea as to what the number was going to be given the wide dispersion of previous reports; yet, my sense was it was going to be close to consensus. WRONG again because Friday’s number was much better than expected with nonfarm payrolls rising to 163,000 versus the median forecast of +100,000. Lost in the euphoria, however, was that the unemployment rate rose from 8.216% to 8.253%.

So it was three “strikes” and “out” for me and my predictions last week. About the only thing I got right was saying in Thursday morning’s verbal strategy comments that any pullback should be contained in the 1360 -1366 zone so often mentioned in these comments; and contained it was, with Thursday’s close of 1365. Given Friday’s surprise number, the SPX sprinted to its highest closing price since May 3rd and reinforced my more bullish stance of the past few weeks (as opposed to my previous trading range, but not bearish, stance). Friday’s Fling took the SPX up to the top of a parallel channel, as can be seen in the chart on page 3 from the astute Bespoke organization. If it can break out above that channel, last April’s reaction high of 1422 should be the next objective.

Regrettably, a strong earnings season has not been the driver of the upside breakout. Verily, of the 1,702 companies that have reported, the earnings beat ratio stands at 59.9%, well behind the S&P 500’s beat rate of 67.3% (376 companies have reported). Meanwhile, the revenue beat rate stands at only 48.2%. Yet by far the most troubling metric is the company’s forward earnings guidance, which is currently negative. Despite that forward guidance, the bottom up consensus earnings estimates for the SPX remain around $102 for this year and near $115 for 2013. If those estimates are anywhere near the mark, it means the SPX is trading at 13.6x this year’s estimates, and at 12x next year’s estimates, with concurrent earnings yields (earnings ÷ price) of 7.3% and 8.3%, respectively. Using the yield on the 10-year Treasury Note of 1.6% as your risk free rate of return produces what an analyst terms an equity risk premium of 6.7% basis next year’s estimates (earnings yield 8.5% – 1.6% risk free return = 6.9% equity risk premium, or ERP). Investopedia defines an ERP as:

“The excess return that an individual stock, or the overall stock market, provides over a risk-free rate [of return]. This excess return compensates investors for taking on the relatively higher risk of the equity market.”

QED, investors are being “compensated” by 6.7% (ERP) to own the SPX instead of the 10-year T’note.

While the aforementioned valuations are not as parsimonious as they were at last year’s October 4th undercut low (we were very bullish), they are still pretty inexpensive, offering the long-term investor a decent risk/reward ratio when combined with the SPX’s 1.9% dividend yield. Yet, I understand investors’ reluctance to commit capital since it seems like the trading of the “headline” < i>du jour is creating too much volatility. Interestingly, one vehicle that attempts to damp down some of that volatility is the PowerShares S&P 500 Low Volatility ETF (SPLV/$28.05), which consists of the 100 stocks in the S&P 500 with the lowest realized volatility over the trailing 12 months. This ETF currently yields 2.9%; as always, details should be checked before purchase.

Another strategy that has been working for the past few quarters has been to consider companies that have beaten quarterly earnings estimates, as well as revenue estimates, and guided forward estimates higher. Some names from the Raymond James research universe that have recently met these three criteria, are favorably rated by our fundamental analysts, and have “greened up” on indicators, like the SPX chart on page 3 shows, include: BioMed Realty Trust (BMR/$18.76/Outperform); Extra Space Storage (EXR/$33.45/Outperform); Kimco Realty (KIM/$19.94/Outperform); Power-One (PWER/$5.13/Outperform); Post Properties (PPS/$51.23/Strong Buy); and Wabtec (WAB/$78.38/Outperform).

The call for this week: As a sidebar, be sure to look at this month’s edition of < i>Gleanings for further insights from our economist, technical analyst, and my additional thoughts. As far as the stock market, last Friday’s rally extended the upside breakout by the SPX above the often mentioned 1360 – 1366 zone; and at this point, that breakout looks sustainable. The rally has also broken the index above the “neckline” of what a technical analyst would term a reverse head and shoulders bottoming pattern (read: bullishly). That said, the rally has left the SPX at the top of the parallel channel previously mentioned, as well as leaving every macro sector I follow pretty overbought in the short term. Also of note is that while the D-J industrials, the S&P 500, and the D-J Utilities bettered their June reaction highs, the S&P 400 MidCap, the S&P 600 SmallCap, the NASDAQ Composite, the Russell 2000, and the Value Line Arithmetic Index did not (read: potential non-confirmation). Still, the stock market’s internal energy continues to look strong, my proprietary indicators have been “green” on the S&P 500 for six weeks (see chart on page 3), the Dollar Index got crushed on Friday (lower dollar means the “risk trade” is back on), short interest on the NYSE is high, the equity markets survived a potential “flash crash” from the Knight Capital (KCG/$4.05/Market Perform) fallout, the recent investor sentiment figures were about as negative as they ever get, the public liquidated another $2.7 billion of domestic equity mutual funds last week (the highest weekly redemption of the year), the Spanish market rallied 7.41% on Friday, well y’all get the idea. Recently participants have been conditioned to sell each marginal breakout to a new reaction high because it has been followed by a pullback. I am not so sure this breakout plays that way. Indeed, I expect at least a test of the April highs (1422) over the next few weeks before a corrective phase begins.

P.S. – I will be in Boston all week spending time with portfolio managers, seeing accounts, and speaking at a conference. I will try and do my verbal strategy comments, but they are likely going to be abbreviated.

Click here to enlarge
 

Click here to enlarge

Tags: Chief Investment Strategist, ECB, Friday Morning, Futures, jeffrey saut, Mandate, Mario, Missive, Musings, Numba, oil, Policy Announcement, Pundits, Raymond James, S Market, Saut, Spades, Spx, Stutter Step, Trifecta, Wall Street, Yogi Berra
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Erasers (Hussman)

Tuesday, August 7th, 2012

by John Hussman, Hussman Funds

August 6, 2012

I’ve never been very popular in late-stage bull markets. Defending against major losses and achieving our investment objectives over the complete bull-bear market cycle (bull-peak to bull-peak, or bear-trough to bear-trough) requires us to maintain an investment exposure that is essentially proportional to the expected return/risk ratio that is associated with each given set of market conditions. When prevailing market conditions are associated with a sharply negative expected return/risk ratio, as they are at present, and either trend-following measures are negative or several hostile indicator syndromes are in place (what we call Aunt Minnies), we will typically be fully-hedged, and will raise the strike prices of our put options toward the level of the market, in order to defend against steep market losses and indiscriminate selling. At present, we expect an average 10-year total return on the S&P 500 of about 4.7% annually in nominal terms, on the basis of rich normalized valuations. Based on a much broader ensemble of evidence, and considering horizons between 2-weeks and 18-months, we estimate the prospective return/risk ratio of the S&P 500 to be in the most negative 0.6% of all historical observations.

Moderate losses may be a necessary feature of risk-taking, but deep losses are erasers. A typical bear market erases over half of the preceding bull market advance. It is easy to forget – particularly during late-stage bull markets – how strongly this impacts full-cycle returns. The most obvious example, of course, is the 2008-2009 decline, which erased not only the entire total return of the S&P 500 since its 2002 low, but also erased the entire total return of the S&P 500 in excess of Treasury bill yields (its “excess return”) going all the way back to June 1995 – making all of the benefit from risk-taking during the late-1990’s completely for naught. Similarly, the 2000-2002 bear market wiped out the excess return that investors had enjoyed in the S&P 500 all the way back to February 1996. The 1990 bear market wiped out the excess return of the S&P 500 all the way back to January 1987.

Recall that at the 1987 peak, the S&P 500 had quadrupled (including dividends) from the secular low of August 1982. The 1987 crash – which in terms of size was a fairly run-of-the-mill bear of -33.51% from peak to trough – was enough to wipe out nearly half of that preceding total return (do the math: [(4*(1-.3351)-1]/(4-1)-1 = -45%), and slashed the excess return that investors had enjoyed since 1982 by even more than half. This chronicle of unpleasant arithmetic can be extended indefinitely over market history. Regardless of whether stocks are in a secular bull market or a secular bear market, the mathematics of compounding are brutal where large losses are concerned.

It’s instructive that $1 invested in Strategic Growth Fund at its inception, near the beginning of the 2000-2002 bear market was worth 2.72 times the value of an equivalent investment in the S&P 500 by the end of that bear market. Likewise, $1 invested in the Fund at the beginning of the 2007-2009 bear market was worth 2.09 times the value of an equivalent investment in the S&P 500 by the end of that bear market (see The Funds page for complete performance information). Performance gaps that can arise in the overvalued but still-advancing part of the full market cycle can be dramatically recovered by defensive strategies in the declining part of the cycle, which is why we don’t pay excessive attention to short-term tracking differences when market conditions are hostile.

Of course, there’s no assurance that we’ll always achieve our objective of outperforming the market with significantly smaller drawdowns over the complete market cycle. Though we’ve certainly had far less volatility and drawdown than the S&P 500 over the most recent cycle, Strategic Growth Fund lagged the total return of the S&P 500 by just shy of 13% cumulative from the 10/09/2007 peak in the S&P 500 to its most recent peak on 04/02/2012. This outcome primarily reflected my insistence on making our hedging approach robust to Depression-era data (an effort that caused us to miss returns in 2009-early 2010 until we achieved a robust solution using ensemble methods), and the smaller issue that purchasing actual put options has been less effective in periods where central banks have seduced investors to place their faith in “Bernanke puts” and “Draghi puts.” Our 2009-early 2010 miss was not “strategic” in that we would not be similarly defensive in future cycles if presented with identical conditions and evidence. But the fact is that our present defensive stance, particularly since early March, is something that we can be expected to establish over and over again in future cycles if presented with the same evidence.

Our measures of prospective return/risk became steeply negative in early March (see Warning: A New Who’s Who of Awful Times to Invest). Since then, market conditions have satisfied a restrictive set of criteria that have been similarly negative in a very small percentage of historical observations. At present, Strategic Growth Fund is fully-hedged, with most of our index put option strikes raised within about 4% of prevailing market levels, at a cost of less than 2% of assets in time premium looking out toward late-2012. This time premium will decay if the market remains unexpectedly resilient in the coming months and we observe no shift in presently negative market conditions. That said, with an angry army of negative indicator syndromes in place, I don’t expect speculation – even on hopes of further central bank intervention – will be significantly or durably rewarded here.

Suffice it to say that our present defensiveness is an intentional and repeatable aspect of our investment strategy. There are certainly some extraordinary factors that we had to address in the most recent market cycle as a result of the credit crisis and government attempts to defend bad debt, avoid restructuring, and to extend, pretend, and print at all costs. I believe that we can manage a continuation of that policy environment well over time, though periodic frustrations may be more frequent due to short-lived “risk-on” advances. In any event, I have no belief that central bank operations (which do little more than purchase a fraction of the new additions to the mountain of global government debt and replace them with currency and bank reserves) are actually capable of making recessions, bear markets, or the basics of arithmetic things of the past.

Economic Notes

Friday’s headline non-farm payroll employment gain (establishment survey) of 163,000 jobs was surprisingly positive, but far less informative about economic prospects than investors appeared to assume. The household survey, which is used to calculate the unemployment rate, actually showed a drop in civilian employment of 195,000 jobs in July. The increase in the unemployment rate would have been greater if not for the fact that another 150,000 people left the labor force altogether and were therefore not counted as unemployed. The picture was particularly weak for workers 20 years of age and older (where 213,000 jobs were lost), but was slightly rescued by a gain of 18,000 jobs among 16-19 year-olds. While the difference between the establishment and household surveys was unusually large, these disparities aren’t entirely uncommon, and don’t have a great deal of predictive value for either series. It’s probably most accurate to say that the July employment figures were mixed.

Even focusing on the bright spot, which is the establishment survey figure, one immediate fact to note is that year-over-year growth in non-farm payrolls fell below 1.4% back in April, following a brief excursion above that level, and has remained weak since then. As the chart below indicates, a decline in year-over-year payroll employment growth below 1.4% has occurred just before, or already into, each of the past 10 recessions, with no false signals. As usual, we’re skeptical of drawing inferences from a single indicator, and this instance may be different. But given the collapse in new orders and other measures of economic activity across numerous Fed, ISM and global surveys (and a continued decline in the most leading signal that we infer from our unobserved components models), there seems to be little reason for that expectation.

Keep in mind, as we’ve noted regularly over the years, that employment is a lagging economic indicator. The “stream of anecdotes” school of economic analysis may treat every economic report as having equal weight in determining the course of the economy, but the actual sequence is generally as follows: falling consumption growth and new orders -> falling production -> falling employment. The latest employment report appears to be little more than the wagging tail of an already sick puppy, and the tail is not likely to wag that dog to health.

In contrast, the latest JP Morgan global manufacturing report observes that “production and new orders both fell for the second month running in July, with rates of contraction gathering pace.” The chart below presents the global purchasing managers index (PMI), which has now weakened to levels last seen during the last two recessions.

With regard to Europe, it’s interesting how the semantics of the phrase “everything necessary” has been used to obscure the differences between Euro-area countries when it comes to monetizing bad debt. The distinction can be seen in a comment last week by German government spokesman Georg Streiter: “The ECB president said that the ECB will do everything necessary to preserve the euro and the government will do everything politically necessary to preserve the euro.” As long as the phrase is shortened to “everything necessary,” everyone is in agreement. The differences are in the subset of actions that constitute “everything.” For the German government, it is everything politically necessary. For Finland, it is everything necessary provided that collateral is pledged for every loan. For the German courts, it is everything legally necessary. While everyone can be unanimous about their commitment to doing “everything necessary,” it’s important to recognize that “everything” means something different to each party.

Even Mario Draghi had to resort to oxymorons to explain why the ECB did not initiate bond purchases last week despite what investors had taken as a pledge to do so, saying that the endorsement of bond purchases among ECB council members was “unanimous with one reservation” (he then left to enjoy some jumbo shrimp in a plastic glass, but they were found missing, leaving Draghi and his broken fix for an enduring Euro alone together in the deafening silence).

My impression regarding the Euro remains unchanged – liquidity will not durably counter insolvency, and the solvency problem among peripheral European countries is too great to be addressed without debt restructuring. ECB purchases of distressed sovereign debt would most likely have to be permanent purchases, and would therefore represent a fiscal transfer at the expense of stronger countries that would prefer to use the proceeds of money creation for the benefit of their own citizens. Doing those purchases indirectly – the ECB buying the debt of an ESM with a banking license, and the ESM buying distressed debt – does not change the arithmetic. Very reasonably, Germany is only willing to mutualize the debts of its neighbors if it can exert centralized authority over their fiscal policies – in Angela Merkel’s words “liability and control belong together.” But while Europe is geographically united, it is culturally and politically diverse, and a surrender of national sovereignty to the required extent is unlikely.

As a result, the Euro is likely to be pulled apart, and the tensions will probably be greatest across geographic and socioeconomic fault lines. From a geographic perspective, Finland (which insists on good collateral even for EFSF actions) and Italy (where popular sentiment against the Euro is strongest) have the greatest divide. From a socioeconomic standpoint, Germany (which is strongly anti-inflation and more oriented toward free enterprise) and the southern European states of Greece, Italy, Spain and Portugal (which have high debt ratios, heavily socialized economies, and very fragile banks) seem to be the furthest apart. The real question is who will get the Euro if the wish-bone snaps – the stronger more solvent states, or the weaker more inflation-prone states. Until the answer is clear, it will be difficult to anticipate the future direction of the Euro’s value. I would expect the least amount of systemic disruption in the event of an exit from the Euro by the stronger European countries, but that would also be associated with the maximum amount of Euro depreciation as the remaining members are left to inflate as they (and the ECB) please. All of this will be extraordinarily interesting, but it will not be easy.

Market Climate

As of last week, the Market Climate for stocks remained among the most negative 0.6% of historical observations, holding us to a tightly defensive stance. Strategic Growth remains fully hedged, with a staggered-strike position that raises the strike prices of the put option side of our hedge within a few percent of prevailing levels, at a cost of less than 2% of assets in time premium looking out to very late-2012. The Fund’s day-to-day returns can be expected to primarily reflect changes in the value of this time premium and day-to-day performance differences between the stocks held by the Fund and the indices we use to hedge. Strategic International also remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return continues to carry a duration of about one year in Treasury securities, with about 10% of assets in precious metals shares, and a small percentage of assets in utility shares and foreign currencies.

Copyright © Hussman Funds

Tags: Aunt Minnies, Bear Market, Bull Bear, Bull Markets, Erasers, Excess Return, Going All The Way, Horizons, Hussman, Hussman Funds, Investment Objectives, John Hussman, Market Advance, Market Losses, Naught, Necessary Feature, Risk Ratio, Syndromes, Treasury Bill, Trough, Valuations
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Euro to Beat Dollar? Draghi’s Genius

Tuesday, August 7th, 2012

August 7, 2012

Investors have not woken up to it, but last week may have been a game changer. European Central Bank (ECB) President Draghi took tail risks out of the Eurozone, while at the same time forcing closer fiscal integration. He did it all while keeping the ECB out of some political minefields. It’s pure genius. The initial market reaction suggested he might have lost a battle, not realizing that he is winning the war.

Dismayed by a dysfunctional process caused by a lack of leadership and the increasing risk of some of the worst case scenarios playing out, we have been staying away from the euro in our hard currency strategy. As of late last week, those dynamics changed: we are giving the euro another chance, not only because of substantial short covering potential, but also because Draghi’s “whatever it takes” approach might bring about seismic changes in how European integration, fiscal and monetary policy move forward.

In essence, Draghi told the world that the ECB will act like a central bank of a United States of Europe if the integration of European fiscal policy accelerates. The “integration” process hasn’t worked particularly well. In the early years of the Eurozone, peripheral Eurozone countries used cheap access to financing to live beyond their means. Now, the markets have serious doubts about the sustainability of the finances of weaker Eurozone countries. To regain the markets’ trust, governments have nibbled with austerity measures. While the respective governments will take offense to us using the term ‘nibble’ at their hard fought progress, governments have not been able to reduce their debt loads. Politicians blame the high cost of borrowing and speculators. Unfortunately, as long as debt is merely shuffled around, no matter how big any aid package may be, it is unlikely to bring long lasting relief. In an effort to regain the trust of the markets, governments must engage in credible structural reform. Ireland has successfully gone down this path, but politicians have so far been unable to do the same in Spain, Italy and Greece. In Spain, Prime Minister Rajoy enjoys an absolute parliamentary majority and has no excuse. Italy is run by a technocrat; as such, the market is rightfully suspicious. Greece, well, is in a category of her own.

To break the debt spiral of these weaker countries, the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) have been put in place. Accessing these facilities comes with a hefty price tag: giving up sovereign control over one’s budget. However, that’s exactly what a United States of Europe needs: tight fiscal integration. While access to the bailout facilities reduces the immediate cost of borrowing, it may also shut the door to selling bonds in the markets at palatable cost.

That raises the question of what is a palatable cost of borrowing? In the 1990’s, paying 6% for 10-year debt was just normal for some countries. Yet, because so much more debt has piled up, paying 6% is now considered unsustainable – at least unless such draconian budget cuts are introduced to balance budgets even with such high interest burden. And just in case anyone is wondering, the U.S. would be in just as dire a situation, if not worse, if it had to pay 6% on its long-term debt. We are currently concerned about the “fiscal cliff” in the U.S. – but even if the draconian cuts and increased taxes introduced by the fiscal cliff were implemented, the U.S. budget deficit would still be above 3% of GDP (the level that Eurozone nations are intended to stay below). The difference between the U.S. and peripheral Eurozone countries is foremost that the bond market lets the U.S. get away with its deficit spending.

We have long argued that the market provides the best incentive to stop governments from overspending. Spain, Italy, Ireland, Portugal, Greece – all these countries have engaged in astounding reforms, all with the “encouragement” of the bond market. Politicians, however, are most creative in avoiding making tough choices. So how does one square the circle, how does one live with political realities while at the same time provide a path to fiscal sustainability? Politicians have called for the ECB to step in, to buy bonds of weaker Eurozone countries, thus lowering their cost of borrowing. But when the ECB has done that in the past through the Securities Markets Program (SMP), policy makers have lost their motivation to pursue structural reform. Policy makers choose between the cost of acting and the cost of not acting: the moment there is relief in the market, commitment to reform fades. It also puts the ECB into the uncomfortable position of playing judge of whose reform plans are worthy of support and whose are not.

The argument for market intervention is that the “monetary transmission mechanism” is broken. That may be correct, but becoming a political hot potato is no attractive alternative for a central bank.

So ECB President Draghi announced a new philosophical framework last week: the judge of whether sufficient austerity is implemented to warrant ECB support is the conditionality of EFSF/ESM, i.e. the types of rules the International Monetary Fund (IMF) introduces on countries. It’s the best one can hope for if policy makers don’t accept the market’s judgment. In our view, accepting the market pressure would be preferred, but this is the best course of action given the realities presented. Indeed, we consider Draghi’s action nothing short of pure genius.

Draghi’s action is pure genius because it dramatically accelerates fiscal integration in Europe. Already Spain and Italy are contemplating joining the bailout regime, if in turn Draghi will help lower their cost of borrowing. There will certainly be a lot of horse-trading; we also don’t expect all austerity measures to necessarily be fully implemented. But that’s not the point. The point is that weak countries subject themselves to a political body (not a central bank) that negotiates and sets terms. It is the United States of Europe we have been waiting for. With the framework set, the ECB can engage in market operations targeting securities that are part of the program. Draghi already indicated that the focus will be on the short-end of the yield curve (shorter dated Treasury securities); this is akin to what other central banks, like the Federal Reserve (Fed) do; well, the Fed has since moved out the yield curve (longer dated Treasury securities). Longer dated debt will be affected, although significant risk premia over German bonds may continue for some time.

Based on other comments we have seen, odds are that not many others, if any, will agree that Draghi’s actions were “pure genius.” After all, he did not provide the immediate relief all those stimulus addicted market participants have gotten used to. But Draghi understands that the best short-term policy may be a good long-term policy. The short-term policies advocated by many pundits, an aggressive purchase program of peripheral bonds would only achieve that holders of such debt can dump their bonds; buyers would be guaranteed to buy such securities at inflated prices, setting them up for almost certain disappointment (and thus scaring them away from future bond auctions).

Instead, Draghi achieved a great deal: as fiscal integration in the Eurozone may be dramatically accelerated. Importantly, a political process has been put in place. Ironically, it took a monetary policy maker to put a fiscal process in place; yet, Draghi allowed the ECB to be used merely as a catalyst, not as a political pawn.

Draghi also correctly shifts the focus going forward on the increased “fragmentation” in the Eurozone where market participants increasingly focus on domestic rather than intra-European activities. While more needs to be done, other central bank activities under consideration would have amplified rather than reduced fragmentation, would have made the demise of the euro more likely. To address fragmentation issues, work on many fronts needs to take place. Market participants are doing their part by rewriting contracts to clearly state what law they are subject to in case a member country were to leave the Euro.

As such, we started buying the Euro again in our hard currency strategy. Make no mistake about it: we are only putting our foot in the water; we are not yet wholeheartedly embracing the Euro. But we are giving this new framework a chance, as we judge it to be the greatest progress in the Eurozone debt crisis we have seen to date. The coming months will show whether this is to be written off as a trading opportunity or whether it is the new strategic direction that it has the potential of being. Greece may still drop out of the Euro, but such an exit is much less of a threat to Eurozone and global financial stability than it was as recently as a week ago.

Given that currencies trade against one another, this analysis would not be complete without looking at the U.S. dollar. In the U.S., too, many pundits have been disappointed at the lack of action by the Fed. Indeed, we also think the Fed under Bernanke’s leadership is likely to provide more stimulus. But just as Draghi has presented a new philosophical framework for future action, Bernanke may feel he is obliged to provide a new framework for “QE3”. That’s because many have rightfully pointed out that any new action might have limited impact, yet risk ever more unintended consequences. The obvious opportunity that presents itself will be in Jackson Hole, where he will be speaking later this month. The Fed is focused on different issues, notably a sustained recovery after the housing bust. As such, the Fed – and we are putting words into Bernanke’s mouth here – may need to err on the side of inflation. No responsible central banker – never mind closet central banker and chief Keynesian cheerleader Paul Krugman – would ever openly advocate inflation. Let’s just say that Bernanke’s upcoming Jackson Hole speech should be interesting to watch.

For now, with the prospect of ECB action – even if with delays and no guarantee – a number of tail risks have been taken out of the Eurozone. In our assessment, that alone warrants a significantly stronger Euro versus the U.S. dollar. As we discussed, we believe there’s a new wind blowing in the Eurozone. That wind may well take the tailwind of recent months out of the U.S. dollar.

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

This report was prepared by Merk Investments LLC, and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice.

Tags: August 7, Austerity Measures, Cost Of Borrowing, Debt Loads, Doubts, Ecb President, European Integration, Eurozone Countries, Fiscal And Monetary Policy, Fiscal Policy, Genius, Hard Currency, Initial Market, Minefields, Nibble, Seismic Changes, Speculators, United States Of Europe, Winning The War, Worst Case Scenarios
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