Archive for September 11th, 2012
Tuesday, September 11th, 2012
Positioning Ahead of the FOMC Meeting
Taking a Core-Satellite Approach with Canadian Equities
Alfred Lee, CFA, CMT, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
September 11, 2012
- While we have recommended an overweight to U.S. equities over the last two years, since early July, the S&P/TSX Composite Index (S&P/TSX) has been outperforming the S&P 500 Composite (SPX). This recent outperformance of Canadian stocks can be partially attributed to the rally in commodity stocks that resulted after a report in the Wall St. Journal noted the U.S. Federal Reserve Board (Fed) was moving closer to adding monetary stimulus to the economy (Chart A). At the same time, the rally in commodities has given the Canadian dollar some positive momentum over the same period, which was a big factor in the outperformance of Canadian equities. The release of the Fed meeting minutes several weeks ago went further to support investor speculation of monetary stimulus.
- Although we still favour U.S. equities over the longer-term, whether Canadian stocks continue to outperform over the short-term largely depends on whether the Fed announces a third installment of quantitative easing (QE3) or some monetary stimulus in the near future. Should we get further hints of some form of monetary stimulus on Thursday, the commodity heavy S&P/TSX would likely continue to rally. On the other hand, if Ben Bernanke disappoints, investors would likely rotate back into lower beta1 and defensive oriented stocks. Though it is likely that the Fed will continue to string the market along and postpone any monetary stimulus until after the Presidential elections, which would prolong the recent rally in cyclical assets.
- Several key indicators to keep an eye on are the spread between the CBOE/S&P Implied Volatility Index (VIX2) and the S&P/TSX 60 VIX Index (VIXC3). If the VIXC drifts below the VIX, it is likely Canadian stocks will outperform over the short-term. However, if the VIXC rises significantly above the VIX, it is likely that Canadian equities will move back to underperforming U.S. stocks. In addition, indicators such as the Cyclical Stocks to Defensive Stocks ratio, would likely turn down should Canadian stocks begin to weaken (Chart B)
- As we pointed out earlier this year in the report “Hidden Rally in Canadian Equities”, there have been many Canadian sectors outside materials and energy that have performed well year-to-date. For example the less cyclical consumer staples and telecommunications sectors are up 14.6%, and 7.0% in total returns year to date, respectively. In comparison the S&P/TSX is up 4.6% on a total return basis year to date, weighed down by the more economically sensitive material and energy sectors.
- Rather than owning a traditional market-cap weighted exchange-traded fund (ETF), investors can build their Canadian exposure using various ETF positions that allow them to better position themselves ahead of the Fed meeting. For example, low beta Canadian stocks have been an exposure factor that has worked so far in 2012. Investors can efficiently gain exposure to lower beta Canadian stocks through the BMO Low Volatility Canadian Equity ETF (ZLB). Investors can then supplement this position with a more cyclical or commodity-oriented ETF, such as the BMO Junior Gold Index ETF (ZJG).
- Instead of holding a broad market Canadian equity ETF, combining ZLB and ZJG together may leave investors well positioned should we see hints of further easing from the Fed. For example, a combination of ZLB and ZJG in a 70%/30% mix has very similar returns to the S&P/TSX (Chart C). On the other hand, should the Fed disappoint investors and elect not to inject further liquidity, investors can drop the ZJG holding, thus efficiently peeling back the commodity trade, leaving the investor with just the more defensive-oriented, lower beta stocks. Keep in mind that the combined ZLB/ZJG position would be limited to a small percentage of portfolio, rather than making up the portfolio on its own.
1 Beta: A measure of systematic risk, of a security or a portfolio in comparison to the market as a whole. A security that has a beta of 1 will move with the market, where as a security with a beta of less than or more than 1 will move less than or more than a market respectively.
2 VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the “investor fear gauge”.
3 VIXC: The Canadian equivalent of the VIX, which is constructed using implied volatilities of the options of the S&P/TSX 60 constituents.
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.
BMO ETFs are managed and administered by BMO Asset Management Inc, an investment fund and portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unit holder that would have reduced returns. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.
Tuesday, September 11th, 2012
One of the deepest mysteries related to the ongoing rally in U.S. equities is the persistent lack of retail investor involvement. QAs we have vociferously noted, U.S. equity mutual fund flows remain solidly negative and interest in single stock trading among individual investors is similarly moribund – while corporate bond volumes remain flat and Treasury volumes higher. As Nick Colas, of ConvergEx group, notes, one missing link to explain this dichotomy must be the fundamental lack of financial literacy among U.S. retail investors, yet this relationship is seldom mentioned as a reason for this group’s ongoing apathy in the face of 4-year highs for domestic stocks. The Securities and Exchange Commission’s recently released study of financial literacy among retail investors outlines just how little this group really knows about capital markets and highlights the underlying rationale behind many of their recent seemingly irrational behaviors.
Stock vs Corporate Bond vs Treasury trading volumes…
Nick Colas, ConvergEx: Retail Investors And Financial Literacy
If the U.S. equity market is such a good party, why is the dance floor so empty? OK – that’s a bit of exaggeration, of course. At the same time, it is hard to overlook declining volumes in stock trading or the persistent redemptions out of U.S. equity mutual funds. A few points here:
- The S&P 500 is up 14.3% year-to-date, but the funds dedicated to this asset class have yet to see a month where money flows are positive.
- Over this year of above-trend performance, in fact, investors have redeemed just over $80 billion in assets from U.S. stock mutual funds, or $250 for every American man, woman and child.
- Look further back, and this pattern hold true for the entire rally from the lows in March 2009. American investors aren’t chasing performance; in fact, they are running from it.
- A recent article on Bloomberg cited a 37% drop in trading volume on U.S. exchanges when comparing the first half of 2008 to the same period in 2012. The August comparison, using data we compile at ConvergEx, shows that trading volumes for last month were down more like 45% from the same month in 2011.
While there are a host of reasons for the decline in U.S. volumes, the issue I would like to focus for the remainder of this note is retail investor knowledge and how this relates to their confidence in capital markets. The connection between these two factors is straightforward: investors need more than a rising market to invest. They need to feel that they understand it and enjoy some level of competence before they trade. An academic paper, published in Management Science (Investor Competence, Trading Frequency, and Home Bias by Graham, Harvey and Huang, July 2009) performed a useful analysis defining this relationship. A few points to summarize their work:
- Using data from surveys conducted by UBS/Gallup, the researchers ranked retail investors by how “Competent” these market participants rated themselves at making their own investment decisions on a 1-5 scale.
- Investors who ranked themselves as significantly more competent traded (4 or more on that 1-5 scale) much more frequently than those who ranked themselves lower. Over half of this group traded at least once a month, versus 28% for the lower-ranked group, for example.
- The research also established that men trade much more than women, with 43% trading once a month, versus just 25% for their female counterparts. Relative youth also correlated with greater trading frequency, as did the level of household income.
- Levels of educational achievement also correlate strongly with the frequency of trading. A retail investor with a post-graduate degree trades stocks on a monthly basis much more frequently than one who did not finish college – 43% of the first group trades monthly, versus just 25% of the latter.
That last point, on education, got me wondering about how much U.S. retail investors really understand about modern capital markets. As it happens, the U.S. Congress had a similar question in the wake of the Financial Crisis and asked the Securities and Exchange Commission to explore the topic as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Their study, released on August 30th, leverages a review of various literature on the topic done by the Library of Congress as well as the SEC’s own findings from focus groups and online surveys of retail investors.
The upshot of these analyses is bleak: “The studies demonstrate that investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.” Much of the +200 page SEC review is not actually about financial literacy, but rather describes how investors process information regarding financial disclosures in the face of this knowledge deficit. The numerous direct quotes from survey and focus group respondents highlights that investors want simple, brief disclosures and explanations, despite their lack of understanding of how capital markets work.
The Library of Congress report, published in December 2011, contains even more chilling details about what U.S. investors actually know about capital markets. The study, which reviews 8 different independent surveys, starts with a key finding of a 2009 FINRA report that “Americans lack basic financial literacy.” The report includes the questions posed by the different surveys, a sample of which I include here, along with a few observations:
- Question: If interest rates rise, what will typically happen to bond prices? Only 21% of the 2009 FINRA National Financial Capability Study knew that the answer was “They will fall.” The same question to a group of active U.S. military got only a 30% correct response rate. In a 2010 Northwest Mutual survey, only 41% knew the relationship between interest rates and bond prices. This may go part of the way to explaining why fixed income products – mutual funds and exchange traded funds, not to mention individual bonds – still enjoy strong money flows despite record low interest rates. What happens to retail investor confidence in these investments when interest rates rise is, therefore, impossible to know.
- Question: Buying a single company’s stock usually provides a safer return than a stock mutual fund? Only 52% of respondents in the 2009 FINRA survey got this right, and a 2007 Moneytrak/IPT survey found that only 39% of respondents knew the definition of “Diversification.”
- Question: What return would you expect from a broadly diversified U.S. stock mutual fund over the long term? The “Correct” answer, according an SEC telephone survey held in 2008, is 10% and 53% of respondents answered as such. Numerous other studies had similar questions about the long run potential of U.S. stocks and most respondents answered in the same vein.
Two points pop out from this line of questioning. The first is that none of the surveys asked “How much volatility are you willing to stand in order to earn that 10%?” That’s a critical variable, and it may well be that retail investors are anchoring their expectations of future volatility against the last 5 years. Second, it might be the case that investors have downgraded their expectations of long-term returns with the paltry returns exhibited by stocks since 2000.
In summary, the data shows that retail investors do not generally have the knowledge necessary to make sense of modern capital markets. Add the volatility of the Financial Crisis and the macro-policy driven stock markets of today, and you have a recipe for reduced confidence in their abilities to invest. Against that backdrop, the asset moves out of stocks and into bonds makes sense.
You might argue that “It was always thus…” and that is a fair point. American investors haven’t grown dumber on financial matters in the last decade; they never had the requisite knowledge to begin with. But it does appear that the events of the last few years have caused some kind of “Tipping point” with regard to investors’ ability to process the world around them. The only prescription to allay their concerns is, I think, time. Time, and continued strong performance from U.S. stocks.
Tuesday, September 11th, 2012
By now you have probably heard how important Apple (AAPL) is for the general indexes especially the NASDAQ (~14% of the index). We saw that yesterday when Apple had one of its rare serious down moves of the year, and took the entire market – especially the NASDAQ which was down a full percent – with it. But this analysis by economist Michael Feroli of JPM is staggering – the launch of iPhone 5 could single-handedly increase the GDP of a $14T economy such as the U.S. by 0.25%-.50%. Wow. Further, he made some interesting comments on how we should expect upside surprises to all ‘retail oriented’ economic data in that time frame.
- Economist Michael Feroli of JPMorgan Chase (JPM) estimated Monday that sales of the new phone, expected to start later this month, “could potentially add” from one-quarter to one-half of a percentage point to the growth rate of U.S. gross domestic product in the final quarter of the year.
- Here’s Feroli’s math: Assume sales of previous-generation iPhones continue “at a solid pace,” while the new model from Apple (AAPL) sells about 8 million units in the last three months of 2012. Assume the average selling price for the new models is about $600. (True, people who get the new phone as part of a calling plan pay less than the sticker price, but the sale gets reported to the government for what it would have cost on a stand-alone basis.)
- Out of that $600, about $200 is the imported cost, leaving $400 as the value captured in the U.S. Multiply $400 times 8 million and you get a pop of $3.2 billion, which is enough to boost the annualized growth rate of the economy by one-third of a percentage point. Feroli, the bank’s chief U.S. economist, expects the U.S. economy to grow at an annual rate of about 2 percent in the fourth quarter, and says the iPhone will “limit the downside risk” to that projection.
- “This estimate seems fairly large, and for that reason should be treated skeptically,” writes Feroli in a research note titled “Can one little phone impact GDP?” But he says the projection fits with what happened when the iPhone 4S, a less ballyhooed product, was released last October. “Overall retail sales that month significantly outperformed expectations,” he writes, and “online sales and computer and software sales … had their largest monthly increase on record.”
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Tuesday, September 11th, 2012
by Mark W. Riepe, Schwab Center for Financial Research
What’s an investor to do in the face of a soft domestic economy and an uncertain outlook abroad? Kathy Jones, Schwab’s fixed income strategist, and Michelle Gibley, Schwab’s director of international research, shared their thoughts with Mark Riepe.
The US economy
Q (Mark Riepe): What should we make of Friday’s US unemployment numbers?
Kathy Jones: The unemployment report was a disappointment. The numbers indicate that economic growth is soft and employment growth is stagnating in the United States. The bond market, which had sold off in response to the earlier good news out of Europe, rebounded on the unemployment report. The figures seem to indicate the likelihood of continued low inflation.
- The number of jobs increased by only 96,000 in August, less than the 130,000 jobs anticipated and well below the more than 200,000 jobs indicated by the ADP survey. The previous two months were also revised downward, taking away another 41,000 jobs.
- The underlying figures were soft as well. The workweek declined by 0.1 hour to 34.4 hours, average hourly earnings were flat for the month and are up only 1.7% year to year, and factory payrolls declined by 15,000.
- Although the unemployment rate declined to 8.1% from 8.3%, that was only due to a drop in the size of the labor force. In fact, the labor-force participation rate fell to a 31-year low of 63.5%. The unemployment rate has been greater than 8% since February 2009, the longest stretch above 8% since 1948.
Q: Could unemployment data influence the Fed’s decisions on further stimulus?
KJ: The Fed considers unemployment figures to be very important, since the goal of full employment is part of the Federal Open Market Committee’s mandate. But we think a single number is not likely to alter its view significantly. We think the Fed was already poised to provide more stimulus based on recent statements focusing on the sluggish pace of US economic growth as well as downside risks from Europe and the approaching “fiscal cliff” of possible higher taxes and spending cuts in the United States early next year.
In the minutes of the July Fed meeting, the Fed stated that easing would be warranted unless the incoming data pointed to “a substantial and sustainable strengthening in the pace of economic recovery.” Fed Chairman Ben Bernanke followed those statements with a recent speech in Jackson Hole that defended the Fed’s extraordinary policy moves over the past few years and pointed to the benefits of quantitative easing. We believe more policy initiatives are likely from the Fed.
Q: Could a quantitative easing plan by the Fed be tied to an employment target of some kind?
KJ: We think the Fed will probably try to avoid targeting a level of unemployment because it limits its room to maneuver by making policy too formulaic. Moreover, there’s a lot of statistical “noise” in the employment figures from month to month, and the figures are often heavily revised later on. Nonetheless, it seems clear that the Fed believes unemployment greater than 8% is too high and that it isn’t a structural problem, i.e., a mismatch between skills and the labor force, but instead is due to weak economic growth.
Q: Would the Fed’s most effective stimulus tool be a promise to hold down rates for a longer period?
KJ: Holding rates down even longer is one possibility and could be an effective tool. It’s one of the easier policy options to implement, and it may also be one of the least controversial moves the Fed could make at this point (although it would likely still be criticized by some).
The Fed will release revised economic and interest-rate projections at this week’s meeting, and it’s possible that it could extend its expectation for rates to remain low into 2015; however, that would be based on input from the various members of the Federal Open Market Committee.
Fixed income investing
Q. How can investors go about building a fixed income portfolio these days?
KJ: We believe a few basic strategies could help investors in the current low-interest-rate environment:
- Stay invested. Earning income even at low rates is better than sitting in cash with money that isn’t needed to meet near-term expenses. It’s unpredictable when the interest-rate environment is going to change, but few would have guessed in 2008 that yields would still be this low in 2012. In our opinion, it could take a while before interest rates rise substantially.
- We generally favor laddered bond portfolios to help manage interest-rate risk, targeting an intermediate-term average duration (a calculation used to estimate how a change in interest rates will affect the price of a bond or bond portfolio1) of about five to seven years, depending on an investor’s risk tolerance and when the money is needed.
- The fixed income core of the portfolio should be high-quality bonds, such as a mix of US Treasuries and investment-grade corporate and municipal bonds. For added diversification and income, we suggest putting up to 20% of the fixed income portion of a portfolio in more-aggressive strategies such as high-yield bonds, preferred securities or emerging-market bonds, provided that investors are comfortable with the added risks.
- Higher-coupon bonds can also be a good strategy to consider in a low-interest-rate environment. The added income can help reduce the volatility of the bond when rates do rise. Investors need to keep in mind that they’ll pay higher prices for higher coupons, all else being equal.
- Some allocation to inflation-linked bonds such as Treasury Inflation-Protected Securities (TIPS) can be a way to help protect against inflation longer term.
Q: Does the European Central Bank’s (ECB) bond-buying program make investing in European bonds any safer?
KJ: We do not see a favorable risk/reward in European bonds. The countries considered safer have yields that are too low to take currency risk, while the countries with higher yields are still risky in our view. The bond-buying program doesn’t address some of the problems in the European banking system or boost the amount of credit available to the economy.
The plan would lower the quality of the ECB’s balance sheet. The bank removed the credit requirement for sovereign bonds used as collateral, which could mean deterioration in the credit quality of the central bank’s balance sheet over the long term. The announcement did help bring down yields in European bond markets such as Spain and Italy, where there are concerns about those countries being able to finance their debt.
The plan entails the ECB buying short-term bonds in countries with elevated yields if the countries apply for help and accept the terms that the EU lays out, which are largely aimed at cutting spending and making structural reforms.
The ECB indicated that the bond buying would be “unlimited,” but it also indicated that the market intervention would be sterilized, meaning that it will drain reserves by the same amount that it injects into the market.
On the positive side, the plan sends a signal that Europe is working on its problems and it should buy fiscally troubled countries some time to address their underlying economic problems. It also shows a commitment to the common European currency.
However, the ECB’s move doesn’t guarantee that long-term rates will remain low, nor does it eliminate the possibility that another country (beyond Greece) may need to restructure its debt. It also doesn’t appear to do anything to boost economic growth, a key underlying problem for resolving some of the region’s deficits.
Michelle Gibley: The ECB laid out the technical aspects of a sovereign-bond purchase program for Outright Monetary Transactions. The ECB justified the program by citing market dysfunction over concerns about the viability of the euro.
The plan requires participating countries to first officially ask for assistance and commit to deficit-reduction targets and structural economic reforms (known as conditionality). To the extent warranted by monetary policy, the ECB may buy the debt of these countries in unlimited amounts, up to three years in maturity, on secondary markets. Purchases will be “sterilized,” meaning that injections of liquidity are offset by withdrawals via ECB issuance of short-term debt.
We view the plan positively because it differs from past actions. Insisting on conditionality is a positive as it keeps pressure on countries; the ECB’s purchases won’t be given seniority status; the break-up of the euro may be less in question (though not a zero probability); and the plan is stronger in our view because the ECB is acting as a buyer of last resort.
Challenges do remain. Eurozone banks need more capital; economies are struggling; and the euro faces longer-term risks, such as the need to move toward a banking union. Countries need to stay the course, which will be difficult.
Q: There’s an important decision expected this week from Germany’s Constitutional Court on the eurozone rescue fund. What’s at stake and what’s the significance?
MG: The German Constitutional Court is examining the legality of the permanent bailout fund (known as the European Stability Mechanism, or ESM) and Germany’s involvement in the eurozone fiscal compact. The court is involved because, according to German law, the country needs to maintain control over its fiscal budget and can’t be forced into long-term financing of the debts of other countries.
Many court watchers expect a positive ruling, which would allow the ESM to proceed, but the ruling is likely to be accompanied by conditions for the use of the ESM. For the temporary EFSF fund, the court attached the condition that the German parliament would vote each time the EFSF would be used. Other conditions could include limiting the ESM from increasing in size or turning into a bank holding company.
The court, however, could rule that the ESM is illegal, potentially resulting in turmoil throughout global financial markets because policy makers would have to go back to the drawing board to find a way to provide longer-term access to bailout funding.
Q: What other events in Europe should investors be watching for in the months ahead?
MG: Several events in September and October could inject risk into markets, but the ECB’s Outright Monetary Transactions plan could cushion the downside because the central bank appears willing to be a lender of last resort.
Independent audits of Spanish bank capital needs are expected in September. Spain’s credit rating is under review by Moody’s Investors Service and Standard & Poor’s, with a decision expected before winter. Spain’s debt could be downgraded to below investment grade.
Spain’s funding needs pick up in late October. As the auctions to refinance existing debt approach, market pressure could increase and force Spain to make a decision. We believe there’s incentive for Spain to ask for aid before the credit rating reviews and the auctions in late October, but Spain doesn’t necessarily require aid at this point.
Greece could still exit the euro, but not yet. Policy makers are indicating that they’re willing to negotiate, with a report due later in September from the commission overseeing the debt crisis and a decision on the next quarterly disbursement due in October. Fortunately, the ECB’s willingness to be a lender of last resort has, in our opinion, reduced the risks of contagion to other countries if Greece does exit the euro.
Q: What’s the overall outlook for Europe right now and what should investors do with eurozone stocks?
MG: We recently upgraded our view on eurozone stocks to neutral from underperform, as we believe the ECB’s plan is a significant positive step that reduces extreme downside risks and due to significant underperformance by eurozone stocks over the past two years. While a large catch-up rally is possible, we believe challenges could limit the ability of eurozone stocks to outperform over the medium term.
We believe weightings in line with long-term asset allocations are appropriate for both eurozone stocks and, as an extension, the overall international asset class, due to the large weight of the region in the MSCI EAFE Index, which measures stock performance in developed markets outside the United States and Canada.
Performance over the medium term could be hindered, however, because challenges remain. Eurozone banks need more capital, economic growth will likely be subpar and longer-term risks to the euro remain, such as the need to move toward a European banking union. Additionally, countries need to stay the course, which will be challenging. A caveat: The German Constitutional Court ruling on Sept. 12 could change the outlook if the court rules that the ESM is illegal.
Q: Which individual European countries may present some positive near-term investing opportunities?
MG: While low-quality stocks in peripheral European countries may post the strongest rebound, we prefer staying with quality names in core countries, as we expect heightened risk to continue in peripheral countries. Within the eurozone stock index, the core countries of France and Germany have the highest weighting.
Germany has a relatively strong economy as well as an export sector that produces specialized goods and has solid brands, which puts it in a strong competitive position. During the second-quarter earnings season, 73% of companies in Germany’s DAX Index beat sales estimates and 72% beat earnings estimates, indicating expectations may be low. Germany’s stock market, however, has a high weight in cyclically exposed, export-oriented sectors (industrials, materials and energy) of 40%, meaning that it’s still dependent on factors outside of the German domestic economy that move with swings in the business cycle.
France’s economy has been more resilient than expected, but leading indicators suggest that it could still enter recession. Additionally, President François Hollande has proposed policies that appear anti-business and anti-competitive in nature. There may be opportunities in individual stocks, however, as many French companies in the consumer discretionary sector have strong global brands.
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1. Duration assumes a 1% change in the interest rate. For example, if a bond has a duration of eight and the yield to maturity for the bond moves by 1%, then the bond’s price is expected to go up or down by 8%. Does not consider the effects on price of any stated call features or other redemption provisions.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Fixed-income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications, and other factors.
High yield bonds are subject to greater credit risk, default risk and liquidity risk.
Investments in foreign assets may incur greater risks than domestic investments. Investing in emerging markets may accentuate these risks.
Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed-market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The EAFE captures about 85% of the investable developed-markets universe excluding the United States and Canada. The index has been calculated since 31 December 1969, making it the oldest truly international stock index.
The DAX (Deutscher Aktien IndeX, or German stock index) consists of the 30 largest German companies in terms of order book volume and market capitalization trading on the Frankfurt Stock Exchange.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
Tuesday, September 11th, 2012
by Mark Hanna, Market Montage
For those around at the time one can remember hedge fund manager David Tepper famously said in 2010 before QE2 you can’t lose – either the economy improves and stocks go up, or the Fed steps in and stocks go up. You are hearing the same language lately – for example this morning it was either the labor data would improve and stocks would like that or the labor data would not improve and the Fed will step in. Certainly a “have your cake and eat it too”. Lost in the shuffle was a warning by semi bellweather Intel (INTC) on guidance – a severe one. This might explain why the semis have acted so poorly the past few weeks and frankly all summer aside for the few weeks after Draghi told us he would fix everything in late July. So in a span of a few days transport bellweather Fedex and semi bellweather Intel have warned – and yet the market chugs along since the central banks have everything under control.
As I keep saying this is a very different market than how it used to work. And I will also repeat that if the Fed does “unlimited QE” as has been rumored it will be a mistake in the long run. The reason is part and parcel of this smoke and mirrors trick is QE as a psychological experiment – each time it comes or is threatened every short runs for cover and people pile into stocks. Under the theory that stocks must go up in QE eras. Well in “unlimited” QE there is eventually going to be a serious correction of 10% or more – while QE is happening. So what will those who propose stocks can only go sideways or up (with tiny corrections) believe in then? It will be an emperor without clothes moment. And the psychology of the “warm embrace” and “central bank put” will be damaged severely. Something to watch later this year and into 2013 if “unlimited” QE heads our way.
Here is the video from Sept 2010:
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Tuesday, September 11th, 2012
by Jeffrey Saut, Chief Investment Strategist, Raymond James
September 10, 2012
“It was the rally that left many fund managers behind. Stocks jumped nearly 10% over the summer, defying the expectations of many hedge – and mutual – fund managers who had bet on a decline. They saw a multitude of headwinds from Europe’s woes to the slowing U.S. economy and sluggish corporate earnings. Now, those defensive fund managers are facing what’s known in Wall Street lingo as the “pain trade”; having to buy stocks just to avoid being left in the dust. The longer stocks hold the summer’s gains, the more deeply the pain could be felt, forcing fund managers to start buying. That, in turn, could give stock prices another leg up and potentially generate a virtuous circle for the stock market and even more pain for those on the defensive. ‘A lot of people were waiting for the next big selloff and it never materialized,’ said Dan Greenhaus, chief global strategist at brokerage firm BTIG. ‘There’s going to be that pressure to try and play catch-up and not just merely play along but to gain some outperformance’.”
… Tom Lauricella, The Wall Street Journal (9/7/12)
In last week’s verbal strategy comments I suggested participants study the chart pattern of the S&P 500 (SPX/1437.92) and then think about what it would feel like if you were an underinvested portfolio manager (PM), or even worse a hedge fund that is massively short of stocks betting on a big decline. The concurrent performance anxiety would be legend because not only would you have performance risk, but also bonus risk and ultimately job risk. Accordingly, I have been opining that stocks were likely going break above the April highs (1420 – 1422) and then trade higher toward the 1450 – 1477 zone driven by what Dan Greenhaus said, “that pressure to try and play catch-up and not just merely play along but to gain some outperformance.” Of course that performance pressure is magnified with end of the third quarter “report cards” due for PMs, followed by fiscal year-end, as many PMs close their books at the end of October.
Last week the performance pressure increased noticeably when the SPX and the NASDAQ Composite Index both traded out to new reaction highs. In the NASDAQ’s case it “tagged” its highest level since 2000! While that is good news, it should be noted that the Financials are still 58.8% from their all-time highs, Telecom Services are 54.8% from their all-time highs, and Technology is 49.6% away. Still, the SPX has registered a topside breakout from one of the longest, and tightest, trading ranges in decades. Interestingly, in each of the four other instances this pattern has occurred the SPX has rallied an additional 2% – 5%. In the current case that would imply a rally to somewhere between 1445 and 1473, which is consistent with my longstanding target zone of 1450 – 1477. It would also be consistent with the historical chart pattern for the SPX in an election year that my friends at the invaluable Bespoke organization identified months ago (see chart on page 3). Accordingly, I would look for some kind of trading “top” this week and next followed by a decline into mid/late October that should sink the “footings” for the fabled year-end rally.
Speaking to Friday’s bleak employment report, as our economist Dr. Scott Brown writes:
“Not good. Payrolls rose less than expected in August and the two previous months were revised down. There were a few extenuating factors (such as seasonal adjustment in autos, which boosted July manufacturing at the expense of August), but not enough of these to offset the overall disappointment. The payroll figures aren’t terrible (we’re still adding jobs), but they are clearly disappointing. The unemployment rate dropped, but that was due largely to individuals leaving the labor force. I wouldn’t read much into that. The household figure components are notoriously volatile. The August FOMC meeting minutes showed that many policymakers felt that ‘additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery’ and Bernanke, in his Jackson Hole speech, noted that ‘the stagnation of the labor market in particular is a grave concern.’ Clearly, this report does not indicate ‘substantial and sustainable’ improvement, and the labor market outlook is weaker than it appeared just seven days ago. Hence, the odds of further Fed action are a lot higher. Extending the forward guidance (pushing out the date for which Fed officials expected short-term interest rates to remain ‘exceptionally low’) should be an easy decision for the Fed. Whether to undertake additional asset purchases (QE3) is still an open question. There are pluses and minuses. However, the August job market report should push the odds above 50%.”
Also in the “not good” camp was last week’s ISM Manufacturing report, which at 49.6 was the third month in a row below the magical 50.0 level and the lowest reading since August 2009. Somewhat offsetting that number was the ISM Non-Manufacturing report that came in stronger than expected at 53.7 versus the estimated 52.5. Combining the two reports leaves us with an overall reading of 53.2 that is still suggestive of no recession on the horizon. The softening economic numbers renewed hopes of another quantitative easing (QE) with an attendant lift in the equity markets. However, last week’s rally on QE3 hopes should have come as no surprise because gold, the ultimate indicator for QE3, has been telegraphing another QE for more than three weeks. Indeed, gold has risen from $1592 per ounce to last Friday’s close of $1740.
The other big news of last week was Thursday’s announcement by the ECB President Marion Draghi on how he is going to deal with Euroquake’s debt debacle. Simply stated, Mr. Draghi called for outright monetary transactions of government bonds in countries that needed help; he also declared that the ECB would NOT have seniority over other investors. That announcement left the yield on Spain’s two-year sovereign debt at 2.67% versus 6.57% last July. It also caused Spain’s equity index (IBEX) to rally roughly 5% and close above its 50-day moving average for the first time in more than a year. Obviously, the ECB news lifted all the world’s equity markets with the SPX gaining 2.23% for the week. In fact, all of the domestic indices I monitor were higher on the week with the strongest showing coming from the year-to-date lagging indexes like the Russell 2000 that gained 3.72%. In past missives I have postulated that when “they” start running the laggards a trading top would not be too far behind. I continue to feel that way.
The call for this week: I have been treating the June 4th “low” as THE “low” on a daily/intermediate-term basis. That said, the election year cycle suggests a “high” is due this month with a pullback into mid/late-October that sinks the footings for the year-end rally. The catalyst for a decline should surface this week out of either the Fed meeting or the German constitutional court meeting. In any event, a near-term trading top is due.
Copyright © Raymond James
Tuesday, September 11th, 2012
by John Hussman, Hussman Funds
For investors who don’t rely much on historical research, evidence, or memory, the exuberance of the market here is undoubtedly enticing, while a strongly defensive position might seem unbearably at odds with prevailing conditions. For investors who do rely on historical research, evidence, and memory, prevailing conditions offer little choice but to maintain a strongly defensive position. Moreover, the evidence is so strong and familiar from a historical perspective that a defensive position should be fairly comfortable despite the near-term enthusiasm of investors.
There are few times in history when the S&P 500 has been within 1% or less of its upper Bollinger band (two standard deviations above the 20-period moving average) on daily, weekly and monthly resolutions; coupled with a Shiller P/E in excess of 18 – the present multiple is actually 22.3; coupled with advisory bullishness above 47% and bearishness below 27% – the actual figures are 51% and 24.5% respectively; with the S&P 500 at a 4-year high and more than 8% above its 52-week moving average; and coupled, for good measure, with decelerating market internals, so that the advance-decline line at least deteriorated relative to its 13-week moving average compared with 6-months prior, or actually broke that average during the preceding month. This set of conditions is observationally equivalent to a variety of other extreme syndromes of overvalued, overbought, overbullish conditions that we’ve reported over time. Once that syndrome becomes extreme – as it has here – and you get any sort of meaningful “divergence” (rising interest rates, deteriorating internals, etc), the result is a virtual Who’s Who of awful times to invest.
Consider the chronicle of these instances in recent decades: August and December 1972, shortly before a bull market peak that would see the S&P 500 lose half of its value over the next two years; August 1987, just before the market lost a third of its value over the next 20 weeks; April and July 1998, which would see the market lose 20% within a few months; a minor instance in July 1999 which would see the market lose just over 10% over the next 12 weeks, and following a recovery, another instance in March 2000 that would be followed by a collapse of more than 50% into 2002; April and July 2007, which would be followed by a collapse of more than 50% in the S&P 500, and today.
The prior instances were sometimes followed by immediate market losses, and were sometimes characterized by extended top formations – which produce a sort of complacency as investors say “see, the market may be elevated and investors may be over-bullish, but the market is so resilient that it’s ignoring all that, so there’s no reason to worry.” Ultimately, however, the subsequent plunges wiped out far more return than investors achieved by remaining invested once conditions became so extreme. We are in familiar territory, but that territory generally marks the mouth of a vortex.
Based on ensemble methods that capture a century of evidence – from Depression-era data, through the New Deal, World War, the Great Society, the electronics boom, the energy crisis, stagflation, the great moderation, the dot-com bubble, the tech crash, the housing bubble, the credit crisis, and even the more recent period of massive central bank interventions – our estimates of prospective market return/risk have been negative since April 2010 and have remained negative even as new data has arrived. Since early March, those estimates have plunged into the most negative 0.5% of historical instances.
It’s worth noting that the S&P 500 posted a negative total return between April 2010 and November of last year. Of course, the market has also enjoyed a risk-on mode since then. Through Friday, the S&P 500 has achieved a total return of nearly 25% since our return/risk estimates turned negative in early 2010. Defensiveness has clearly been taxing in that respect. But this doesn’t remove the question of whether the market’s recent gains are durable, much less whether they will be extended. Corporate insiders certainly don’t seem to think so – their sales have tripled since July, to a rate of six shares sold for each share purchased.
Far from being some novel “new era” environment, present conditions – rich valuations, overbought trends, lopsided bullishness, heavy insider sales, and lagging market internals – are part of a historical syndrome that is very familiar in the sense that we’ve repeatedly seen it prior to the worst market declines on record. But as the chronicle above should make clear, this doesn’t make our short-term experience any easier, because these conditions can emerge, go dormant for a few months while the market retreats modestly, and then reappear as the market registers a marginal new high. The ultimate outcome has historically been spectacularly bad, but it still takes patience and discipline to stay on the sidelines during late-stage, high-risk advances. Of course, the present instance may turn out differently than every prior instance has – it’s just that we have no basis to expect that outcome.
The most interesting feature of last week’s “decision” by the European Central Bank was the continued eagerness of investors to hear what they want to hear, rather than what is actually said. With little doubt, what investors think they heard was that the ECB has finally decided to launch a new program by which it will begin purchasing Italian and Spanish debt in unlimited – unlimited – amounts, putting an emphatic end to European debt strains, and decisively ensuring the future unity of the Euro.
Here is what the European Central Bank actually said:
“A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.”
If you wondered why Angela Merkel and the whole of Germany was not immediately up in arms, it is because prior to transactions by the ECB, the receiving country would have to submit to an adjustment program, ideally involving the IMF. This is nothing like what Spain has been asking for, which is for the ECB to make unconditional purchases. To benefit from the proposed OMT program, these countries have to subordinate their fiscal policy to outside conditionality.
What if they don’t?
“The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.”
But assuming these countries accept the adjustment programs, at least they can be assured that the ECB will buy their debt in unlimited amounts, can’t they?
“No ex ante quantitative limits are set on the size of Outright Monetary Transactions.”
Read carefully – the ECB did not promise “unlimited” financing. Rather, it refused to specify an amount in advance (ex-ante), because it doesn’t want the markets to look at some inadequately small and fixed number and begin to speculate against the ECB as soon as that particular number is approached. By refusing to set a specific amount in advance, Draghi said in his press conference that he wanted the policy to be perceived as fully effective. But perception substitutes for reality only for so long. If Merkel, Monti and Rajoy were stranded on a mountaintop and Merkel was the only one with a bag of muesli, she might offer some to the other two without specifying an amount in advance, but there’s no doubt she’d be slapping it out of their hands if things got out of control.
Finally, “The liquidity created through Outright Monetary Transactions will be fully sterilised.”
This last provision is likely to both calm Germans and inflame them. Sterilization means that for every euro of Spanish or Italian bonds the ECB buys (creating new euros in the process), it will drain euros by selling some other security – most likely bonds of Germany, Holland, Finland, or other stronger European nations. This will help to calm Germans because it indicates that the overall supply of euros will not expand. It will also inflame them, however, because the existing stock of euros will now have been created to provide fiscal support to Spain, Italy and other troubled countries, while Germany, Holland, Finland and stronger countries will not have benefited at all from the money creation.
It will be interesting how this plays on September 12, when the German Constitutional Court is set to decide on the legality of the European bailout funds, the EFSF and the ESM (technically, the Court will rule on an injunction against even passing it into law, but will not formally rule on constitutionality until possibly next year). My expectation is that they will rule that these mechanisms are in fact allowable and consistent with the German Constitution. Where it gets interesting is whether they will rule that it is allowable to leverage these mechanisms or operate with a banking license (which would make Germany’s existing contribution “capital” that could be wiped out, leaving Germany on the hook for much, much larger amounts – which essentially cedes fiscal authority from the German people to the ESM). I suspect that there is a fair chance that the Court will add language in their ruling to reject that possibility, which may force the idea of a “big bazooka” back to square one. We’ll see.
Here in the U.S., Friday’s August employment report was surprisingly weak relative to Wall Street’s expectations, though hundreds of thousands of workers abandoned the labor force, which allowed the unemployment rate to decline. Relative to our own expectations, the figure was elevated, as I expect that the August employment figure will ultimately be revised to a negative reading. This would be consistent with revisions that we’ve seen around prior recession starting points.
For example, if you look at the originally reported data for May through August 1990, you’ll see 480,000 total jobs created (see the October 1990 vintage in Archival Federal Reserve Economic Data). But if you look at the revised data as it stands today, you’ll see a loss of 81,000 jobs for the same period. Look at January through April 2001, at the start of that recession. The vintage data shows a total gain of 105,000 jobs during those months, while the revised data now shows a loss of 262,000 jobs. Fast forward to February through May 2008, and though you’ll actually see an originally-reported job loss during that period of 248,000 jobs, the revised figures are still dismal in comparison, now reported at a loss of 577,000 jobs for the same period. As other good economic analysts have recognized, economic time series tend to be revised after-the-fact, with upward revisions in periods just before the recession begins, and downward revisions in periods just after the recession begins. I continue to believe that the U.S. joined an unfolding global recession, most probably in June of this year.
Ahead to QE3. A week ago, The Wall Street Journal ran a piece by Jon Hilsenrath titled Will Fed Act Again? Sizing Up Potential Costs. The article reviewed concerns about additional quantitative easing, noting that inflation has remained muted and the dollar has remained firm. Both of those outcomes were presented as evidence counter to Fed Governor Charles Plosser’s concern that “Without appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available… the inflation rate is likely to rise to levels that most would consider unacceptable.”
There is strong evidence to suggest that this is little but false comfort. While we don’t expect material inflationary pressures until the back-half of this decade, the Federal Reserve has increasingly placed itself into a position that will be nearly impossible to disgorge without enormous disruption. Specifically, the U.S. economy could not achieve a non-inflationary increase in Treasury bill yields to even 2% without requiring a nearly 50% reduction in the Federal Reserve’s balance sheet.
This point is easily demonstrated in data from 1947 to the present. The relationship between short-term interest rates and the amount of monetary base per dollar of nominal GDP is very robust, and is widely recognized as the “liquidity preference” curve. We are already way out on the flat part of this curve. Note that Treasury bill yields have never been at even 2% except when there was less than 10 cents of base money per dollar of nominal GDP. There are only 3 ways to get there from the current 18 cents – dramatically cut the balance sheet, keep interest rates near zero for the next decade (assuming nominal GDP growth of 5% annually), or accept much higher rates of inflation than most would consider acceptable.
Moreover, with a portfolio duration that we now estimate at about 8 years, historically low yields on Treasury securities, and a Fed balance sheet currently leveraged about 53-to-1 against the Fed’s own capital, an increase in long-term yields of anything more than 20 basis points a year would produce capital losses sufficient to wipe out interest income, making the Fed effectively insolvent, and turning monetary policy into fiscal policy.
On the subject of Fed leverage, it is one thing to purchase long-dated bonds when yields are high. It is another to purchase them when yields are at record lows and very small yield changes are capable of wiping out all interest income and leaving the Fed in a loss position when it is already levered 53-to-1 (2.9 trillion of assets on 54.6 billion of capital, according to the Fed’s consolidated balance sheet). At a 10-year Treasury yield of just 1.6% and a portfolio duration of about 8 years (meaning that a 100 basis point move causes a change of about 8% in the value of the securities held by the Fed), it takes an interest rate increase of only about 20 basis points (1.6/8) to wipe out a year of interest on the portfolio held by the Fed and push it into capital losses. It would then take another 24 basis points to wipe out all of the capital on the Fed’s balance sheet. Of course, they don’t mark the balance sheet to market. So the public might not be aware of those losses, but that would only mean that we would have an insolvent Fed printing money on an extra-Constitutional basis to fund its own balance sheet losses instead of public spending.
Based on a report from UBS (h/t ZeroHedge), the Federal Reserve now holds all but $650 billion of outstanding 10-30 year Treasury securities, with UBS warning “a large, fixed size QE program could cause liquidity to tank”, with a similar outcome in the event that the Fed pursues mortgage-backed securities instead. A couple of years ago, Bernanke asserted in a 60 minutes interview that “We could raise interest rates in 15 minutes if we have to. So there is really no problem in raising interest rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.” Really? Tell that to Paul Volcker, who had to deal with enormous inflation at unemployment rates even higher and a monetary base dramatically smaller than we observe at present.
The Fed now holds virtually no Treasury debt of maturity of less than 3 years, as Operation Twist and other efforts have been designed to force investors to choke on short-dated paper yielding next to nothing, in hopes of forcing them into riskier securities. The chart below shows the distribution of Fed holdings (dark bars) versus private sector holdings of Treasury debt, at various maturities. Of course, in equilibrium, someone still has to hold the short-dated Treasury securities, in addition to about $2.7 trillion in zero-interest cash and bank reserves, until those securities, currency, and reserves are retired. To believe that an unwinding of the Fed’s present balance sheet would not be disruptive is full-metal make-believe.
Good economic policy acts to relieve some binding constraint on the economy. How does the Fed argue that base money is a binding constraint? At present, there are trillions of dollars held as idle reserves on bank balance sheets. While a “portfolio balance” perspective may well suggest that additional zero-interest reserves will force more investors into risky assets at the margin (which has been most effective after significant market declines over the prior 6-month period), so what? There is no historical evidence that changes in stock market value have a significant effect on GDP. Indeed, a 1% change in stock market value is associated with a change of only 0.03-0.05% in GDP, largely because individuals consume off of their expectation of “permanent income”, not off of transitory changes in volatile securities.
In regard to why inflation has remained low, a useful way to see the relationship between the monetary base, interest rates, GDP and inflation is the “exchange equation”: MV = PQ, where M is base money, V is velocity, P is prices, and Q is real output. As is evident from the liquidity preference chart, base velocity (PQ/M) is tightly related to short-term interest rates. In fact, as long as short-term interest rates fall in response to increases in the monetary base, those increases have virtually no effect on real output, but instead translate almost directly into declines in velocity. Again, some data from 1947 to the present:
If the decline in velocity exactly offsets the increase in base money, inflation is not going to explode overnight. But this happy outcome is brought to you by the passive response of short-term interest rates and the willingness of the public to accumulate zero-interest assets, which is in turn the result of strong and legitimate concerns about credit risk, default risk, and economic weakness. But remove any of those factors, or allow any other exogenous upward pressure on short-term interest rates, and the result will be upward pressure on velocity. Barring enormous rates of real GDP growth, the only way to counter that, as the first chart suggests, will be through either massive (and potentially disruptive) contraction of the Federal Reserve’s balance sheet, or acceptance of undesirable rates of inflation.
As hedge funds often discover, and JP Morgan recently learned, it is very easy to get into a position that later turns out to be nearly impossible to exit smoothly. A significant reduction in the Fed’s balance sheet is unlikely to be achieved at long-term interest rates nearly where they are now, which implies capital losses on the Fed account, which implies that in contemplating a further round of quantitative easing, the Federal Reserve is effectively contemplating a fiscal policy action.
Unfortunately, they’re likely to do it anyway.
From an investment perspective, it’s important to consider the potential effect of additional quantitative easing. As I noted several weeks ago (see What if the Fed Throws a QE3 and Nobody Comes?), the effect of prior rounds of quantitative easing both in the U.S. and abroad has generally been limited to little more than a recovery of the loss that the stock market sustained over the prior 6-month period. Presently, the S&P 500 is at a 4-year high, valuations are rich on the basis of normalized earnings, and advisory sentiment exceeds 50% bulls – over twice the number of bearish advisors according to Investors Intelligence. In recent years, each round of QE emerged closely on the heels of a significant market loss that produced a spike in risk premiums. In that environment, expanding the stock of zero-interest rate assets had the effect of bringing those risk premiums back down to those observed over the prior 6-months or so, and more recent interventions have shown diminishing returns. At present, risk-premiums are already depressed and there is no 6-month loss to recover.
In short, even the evidence of the past several years does not support the automatic assumption that stock prices will advance in the event of another round of QE at present levels. With little doubt, the market is likely to enjoy some immediate cheer from that sort of move, particularly if the Fed refrains from providing a specific ex-ante limit on its purchases – allowing investors to rejoice in the perception that the Fed had launched “unlimited” QE. Still, that cheer may be short-lived. If we examine the way that QE actually operates, and how and why risk premiums have responded to prior rounds, it is entirely unclear that a further round will have much effect beyond an initial spike of enthusiasm. That is, unless one adopts a superstitious faith that stocks will rise in response to QE, since QE makes stocks rise, because QE equals stocks rising, with no further analysis needed.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
As of Friday, our estimates of prospective return/risk in the stock market remain in the most negative 0.5% of historical instances. Notably, the S&P 500 is within 1% of its upper Bollinger band (two standard deviations above its 20-period moving average) on daily, weekly and monthly resolutions. According to Investors Intelligence, bullish advisors outnumber bearish advisors by more than two-to-one (51% vs. 24.5% respectively), and corporate insiders are selling stock at a pace of six shares sold for every share purchased.
On the valuation front, profit margins remain elevated and the ratio of corporate profits to GDP is nearly 70% above its historical norm, and as a result, price/earnings multiples that are based on near-term earnings estimates are elevated, but do not seem extreme. But stocks are not a claim on one year of earnings – they are a claim on a very long-term stream of cash flows that will actually be delivered to investors over time. On the basis of normalized earnings, we estimate a 10-year prospective total return for the S&P 500 of less than 4.5% nominal. The Shiller P/E is presently 22.3, which is in the richest 5% of all historical data prior to the late-1990’s bubble. While this multiple may not seem extreme relative to the data of the past 13 years or so, it should be remembered that stocks have lagged Treasury bill yields during this period, and the market has experienced two separate plunges in excess of 50% each, precisely because valuations have been so rich.
The market conditions we observe at present are very familiar from the standpoint of historical data, matching those that have appeared prior to the most violent market declines on record (e.g. 1973-74, 1987, 2000-2002, 2007-2009). That is no assurance that market losses will be swift, as some of those instances included extended tops characterized by some amount of “churn” and exhaustion before failing. Indeed, even the historical record of these instances is not an assurance that stocks will decline at all in the present case. It’s just that we have no other basis to form expectations about prospective return and risk except to understand how valuations, market action, sentiment and other factors have converged to drive market returns over history.
In any event, we are creatures of discipline, and I strongly believe that our discipline is well-suited to achieve our investment objectives over the complete bull-bear market cycle, despite what will inevitably include shorter-term frustrations. Meanwhile, long-time readers of these weekly comments may be somewhat relieved that going forward, I’ll simply refer to our 2012 Annual Report to elaborate on why the recent cycle has been an outlier, compared with the full-cycle performance that we achieved prior to 2009, and that I expect in future cycles.
There will be periods where a few of our large holdings get hit (as we saw on Friday) despite the fact that our stock selection has strongly outperformed the S&P 500 over time. There will be periods where we are defensive in an advancing market because we face familiar sets of market conditions that have been devastating for investors, as we do now. But what matters to our strategy, and what produces strong risk-adjusted returns over the complete market cycle, is the habit of accepting greater risk in conditions where risk has generally been well-rewarded, and avoiding risk in conditions where risk has generally been punished. We are now in a very familiar environment that has regularly punished risk-taking severely, if not immediately.
Strategic Growth remains fully hedged, with just over 1% of assets invested in additional option time premium to raise the strike prices of the put option side of our hedge, looking out to the end of the year. Strategic International remains fully hedged. Strategic Dividend Value remains hedged at 50% of the value of its stock holdings – its most defensive position. In Strategic Total Return, we used recent bond market strength to cut our portfolio duration to 1.4 years (meaning that a 100 basis point change in interest rates would be expected to affect the portfolio by about 1.4% on the basis of bond price changes), and we cut our exposure in precious metals shares to about 6% of assets, as the prospect for open monetary spigots is likely to be far more limited than investors seem to expect, and global economic activity is slowing rapidly, now including China and other presumed economic bulwarks. Our return/risk estimates remain positive in that sector, but have become much more muted in response to the recent price advance and other factors. The Fund continues to hold small allocations in utility shares and foreign currencies.
Copyright © Hussman Funds
Tuesday, September 11th, 2012
Guest post submitted by John Aziz of Azizonomics
The Contrarian Indicator Of The Decade?
Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
Sir John Templeton
Buy the fear, sell the greed. Since bottoming-out in 2009 markets have seen an uptrend in equity prices:
Now it seems like the euphoria is setting in. And in perfectly, deliciously ironic time, as shares of AIG — the behemoth at the heart of the 2008 crash — are returning to the market. Because reintroducing bailed-out companies to the market worked well last time didn’t it?
Markets are down a hair today, but the theme of the morning is clear: Uber-bullishness. Everywhere.
This is the most unanimously bullish moment we can recall since the crisis began.
Note that this comes as US indices are all within a hair of multi-year highs, and the NASDAQ returns to levels not seen since late 2000.
Big macro hedge funds, who have been famously flat-footed this year, are now positioned for a continued rally.
Bank of America’s Mary Ann Bartels:
Macros bought the NASDAQ 100 to a net long for the first time since June, continued to buy the S&P 500 and commodities, increased EM & EAFE exposures, sold USD and 10-year Treasuries. In addition, macros reduced large cap preference.
J.P. Morgan’s Jan Loeys:
We think the positive environment for risk assets can and will last over the next 3-6 months. And this is not because of a strong economy, as we foresee below potential global growth over the next year and are below consensus expectations. Overall, we continue to see data that signal that world growth is in a bottoming process.
SocGen’s Sebastian Galy:
The market decided rose tinted glasses were not enough, put on its dark shades and hit the nightlife.
And the uber-bullishness is based on what? Hopium. Hope that the Fed will unleash QE3, or nominal GDP level targeting and buy, buy, buy — because what the market really needs right now is more bond flippers, right? Hope that Europeans have finally gotten their act together in respect to buying up periphery debt to create a ceiling on borrowing costs. Hope that this time is different in China, and that throwing a huge splash of stimulus cash at infrastructure will soften the landing.
But in the midst of all that hopium, let’s consider at least that quantitative easing hasn’t really reduced unemployment — and that Japan is still mired in a liquidity trap even after twenty years of printing. Let’s not forget that there is still a huge crushing weight of old debt weighing down on the world. Let’s not forget that the prospect of war in the middle east still hangs over the world (and oil). Let’s not forget that the iron ore bubble is bursting. Let’s not forget that a severe drought (as well as stupid ethanol subsidies) have raised food prices, and that food price spikes often produce downturns. Let’s not forget the increasing tension in the pacific between the United States and China (because the last time the world was in a global depression, it ended in a global conflict).
It would be unwise for me to predict an imminent severe downturn — after all markets are irrational and can stay irrational far longer than people can often stay solvent. But this could very well be the final blow-out top before the hopium wears off, and reality kicks in. Buying the fear and selling the greed usually works.
Tuesday, September 11th, 2012
Bill Gross may be credited with inventing the term ‘the New Normal‘, although his recommendation to purchase gold above all other asset classes, something which only fringe blogs such as this one have been saying is the best trade (in terms of return, Sharpe Ratio, and the ability to sleep soundly) for the past three and a half years, he is sure to be increasingly ostracized by the establishment, and told to take all his newfangled idioms with him in his exile to less than serious people land. Which takes us to David Rosenberg, who today revisits his own definition of the New Normal. And it, too, is just as applicable as that of the Pimco boss: “The new normal is that the economy doesn’t drive markets any more.” Short and sweet, although it also is up for debate whether the economy ever drove the markets in the first place. But that would open up a whole new conspiratorial can of worms, and is a discussion best saved for after Ben Bernanke decides to save the “housing market” by buying more hundreds of billions in MBS and lowering mortgage yields further, even though mortgage rates already are at record lows (something that mortgage applications apparently couldn’t care less about as we showed last week), while “avoiding” to do everything in his power to boost the S&P, which recently was at 5 year highs, and certainly “avoiding” to listen to Chuck Schumer telling him to do his CTRL+P job, and “get to work” guaranteeing Schumer’s donors have another whopper of a bonus season.
From Gluskin Sheff:
THE NEW NORMAL REVISITED
Markets are going in the opposite direction of the world economy if you’re positioned fundamentally, you’re positioned against these clowns.
John Burbank, Passport Capital, ECB Bazooka Faces Pefipherai Tests. page 12 of the weekend FT
What’s extraordinary is that the euro is rallying almost because the ultimate taboo of central banking is being violated, the proactive financing of fiscal imbalances through the central bank balance sheet Before this all other QE was to further monetary policy when the interest rate lever had been exhausted. Here it’s financing a government deficit because the market won’t is the ECB going to be a fiscal inquisitor or enabler?
Louis Bacon. Moore Capital (same article)
Indeed, the data and the markets have gone their separate ways just about everywhere on the planet because of this ever-rising threat of additional policy stimulus (see Optimism over Central Banks Lifts Risky Assets on page 11 of the weekend FT). Shorts are getting squeezed as a result. Wednesday is a key day from that perspective … the consensus is now widespread that the Fed will announce a $600 billion QE extension, likely in MBS.
Who would have thought that in a week that saw such an awful pair of data from two critical reports like ISM and nonfarm payrolls that the S&P 500 would have managed to rally 2_2% and the Nasdaq hit a new 12-year high? Not even the main earnings development, Intel cutting its sales guidance, could elicit much of a market reaction.
Page M3 of Barron’s (The Trader) cites three reasons for the extended bullish sentiment last week_
1. An electrifying speech by former President Bill Clinton.
2. Mario Draghi pronounced the euro to be “irreversible- and laid out a plan to stabilize beleaguered euro-zone nations_
3. China did its part for the markets Friday when it announced a plan to spend $157 billion on 60 different infrastructi ire projects.
Clinton. Draghi. China.
The horrible employment data? That showed up in the tenth paragraph (imagine zero job growth outside of three sectors- leisure, professional services and health/education).
The new normal is that the economy doesn’t drive markets any more.
The correlations today are tighter with yield spreads between Spain and Germany (the overall positive tone globally coincided with Spanish 10-year yields sliding below 6% for the first time since May alongside a 20 basis point jump in German bund yields … this has become the pulse for financial market confidence in general). In fact, we ran correlations between daily changes in 10-year spreads and in the S&P 500 level and found that the correlation has gone from -13% from 2000-2011 to -33% since 2011 (2011 to now, meaning widening in spreads is associated with negative returns on the S&P500 and that inverse relationship has been magnified nearly three-fold in the past two years).