Archive for September 13th, 2012
Thursday, September 13th, 2012
Over at Bespoke Premium we just published our September Dividend Screen, which highlights the yields and ex-dates for every dividend paying stock in the Russell 3,000. From the report, we pulled the highest yielding S&P 500 stocks going ex-dividend over the next month and ran them through our popular trading range screen, which allows you to quickly analyze each stock’s recent momentum and overbought/oversold levels.
Windstream (WIN) is the highest yielding S&P 500 stock going ex over the next month at 9.35%, followed by Verizon (VZ), Safeway (SWY) and DTE Energy (DTE). Other notables on the list include Philip Morris Intl (PM), Staples (SPLS), Merck (MRK), General Electric (GE), Dell (DELL), Cisco (CSCO) and Deere (DE).
Windstream is the highest yielder on the list, but it’s also the most overbought at the moment, so an entry at these levels is not favorable. Stocks that may be worth taking a look at are the ones trading in neutral or oversold territory that have seen upside momentum over the last week.
(Remember, to receive a dividend, you have to own the stock at the close on the day before the ex-dividend date.)
Copyright © Bespoke Investment Group
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Thursday, September 13th, 2012
On Uncertain Ground
September 11, 2012
by Howard Marks, Chairman, Oaktree Capital
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The world seems more uncertain today than at any other time in my life. That’s a simple sentence but one with significant implications. And it’s not just me. Here’s what The New York Times said on August 12 in an article about John Bogle, the founder of Vanguard:
“It’s urgent that people wake up,” he says. This is the worst time for investors that he has ever seen – and after 60 years in the business, that’s saying a lot. . . . “The economy has clouds hovering over it,” Mr. Bogle says. “And the financial system has been damaged. The risk of a black-swan event – of something unlikely but apocalyptic – is small, but it’s real.”
I’m going to devote this memo to the uncertainty in the world and the investment environment and then offer my take on the appropriate strategy response. This will require me to touch on a large number of topics, but I will try to dwell less than usual on each of them. If after reading this memo you find yourself hungry for more, you might go back to “What Worries Me” (August 28, 2008) and “The Long View” (January 9, 2009).
The Macro-Economic Setting
It’s my belief that we’re going to see relatively sluggish economic growth in the U.S. for a prolonged period of time. My expectations for other developed nations, given their specific issues, are even less positive. (This is a good time for my typical reminder that I am not an economist, and far from all of my observations would be supported by that fraternity. And please note that one of the key tenets of Oaktree’s investment philosophy dictates that our investing will not be governed by macro forecasts. We say it’s one thing to have an opinion on the macro, but something very different to act as if it’s correct. I urge you to consider adopting a similar attitude toward all macro forecasts, especially mine.)
Around 2008 or ’09, I had a visit from a senator looking – surprise! – for a campaign contribution. I suppose to make conversation, he asked if I could assure him we were headed for a vigorous recovery. “Forget vigorous,” I told him. “I’m hoping for lackluster.” I haven’t changed my tune.
There’s a very human tendency to think things will stay as they are, and if they change, that they’ll revert to what we’re used to. Most people think of economic growth as the norm; after all, that’s been the general rule during our lifetimes. In fact, the global economy has grown nicely for hundreds of years. That’s something “everyone knows.” But how many people think about where economic growth comes from, and whether it’s naturally occurring and inevitable?
Economic growth doesn’t just happen. Its vigor depends on a combination of population gains, a conducive infrastructure, positive aspiration and profit motive, advances in technology and productivity, and benign exogenous developments. In many ways and to varying degrees, I think the future for these things in the U.S. is less good than it was in the past. The birthrate is down; our infrastructure is out of date; it’s uncertain whether technology can add as much to productivity in the future as it has in the recent past (but perhaps it always is); and mobility up the income curve has stagnated.
I think a lot about the role of deficit spending and credit. In the forty or so years leading up to the crisis of 2008, consumers could grow their spending faster than their incomes because of the increasing availability of credit (and their increasing willingness to make use of it). Likewise, generous capital markets greatly facilitated deficit spending on the part of governments. Economic units around the world were able to spend money they didn’t have and thus buy things they couldn’t afford. This made a big contribution to economic growth, but few people recognized the negative implications: increased leverage, increased dependency on the continued generosity of the capital markets, and thus increased precariousness. In other words, unwise behavior in the short run led directly to problems in the long run. This is a normal aspect of the economic process.
Few debtors can tap the capital markets today to the same extent they could five or ten years ago. In a radical turn of events, lenders now appear to care about borrowers’ ability to repay, and they find some of their customers less than creditworthy. Since almost no borrowers actually have the ability to pay off their debts, this has led to credit difficulties ranging from home foreclosures, to municipal bankruptcies in the U.S., to debt crises in peripheral Europe.
American consumers seem to have concluded that they should owe less (or have found that they can’t borrow as much). For whatever reason, the savings rate has risen, suggesting a decline in the propensity to spend all one makes and more. All around the world, there’s movement on the part of borrowers – sometimes voluntary and sometimes involuntary – toward austerity (reducing the excess of spending over incomes) or even delevering (spending less than you make and using the surplus to pay down debt).
These trends are healthy for individual borrowers’ balance sheets, but they imply reduced consumption and thus are negative for GDP growth. If everyone does these things at the same time, the results can be quite contractionary. Regardless of how you look at it, less use of consumer credit implies less economic growth.
The other specific element that gives me pause relates to confidence. Psychology plays a huge role – perhaps a dominant and self-fulfilling one – in influencing economic growth. In short, if people think things will be good in the future, they’ll spend and invest, and things will be good. But if they turn pessimistic regarding the future and go into their shells, refusing to spend and invest, growth will slow down.
Consumers were traumatized by the crisis of 2008: laid off, forced out of their houses, made poorer by market declines, and denied credit. Those who didn’t feel these influences directly were still pounded by headlines trumpeting economic weakness, the collapse of financial institutions, the need for bailouts, and malfeasance in the banking and mortgage industries. It could require significant healing before these influences abate.
Much of an economy’s resilience comes from what economists call “animal spirits”: the bullishness that drives things upward when people’s innate optimism, acquisitiveness and tendency to forget harsh lessons are sparked by some bits of good economic news. Right now, with animal spirits largely in hibernation, a reversal of the crisis’s trauma may not come easy. But that doesn’t mean there won’t be one. The U.S. consumer has a tendency to surprise on the upside.
Business investment plays a key role in economic recovery. When managers conclude that consumers are about to resume spending after a downturn, they hire workers and invest in new equipment in order to meet the increased demand they believe is coming. Yet the current recovery has seen little in this regard. I think the prevailing attitude has been, “Let’s see how far we can stretch our current capacity before spending to expand it.” Or as I heard on the radio the other day, in a report on productivity gains, “Businesses continue to do more with less.” Thus companies have built cash hoards, not productive capacity.
Much of this has been attributed to uncertainty on the part of executives concerning the business environment. In contrast to the preceding 28 years of pro-business and pro-free market administrations under Presidents Reagan, Bush, Clinton and Bush, today many business people detect antipathy – or, at minimum, indifference – on the part of the Obama administration, in which the private sector is little represented. In addition, there is uncertainty and anxiety regarding the outlook for the economy, regulation and taxes. All of these things have deterred expansion.
Thursday, September 13th, 2012
by William Smead, Smead Capital Management
Our long-time readers are aware that we are stingy when it comes to trading and big believers of keeping trading costs low at Smead Capital Management. Despite these natural inclinations, we do try to keep the pulse of sentiment in the US stock market. The old adage used to be that in the short run your stock movements were 70 percent market-related (beta), 20 percent industry-related (sector attribution) and 10 percent company-related (stock picking). In the long run (3-5 years), we assume the numbers were exactly the opposite, 70 percent company- related, 20 percent industry-related and 10 percent market-related. Therefore, long-duration investors like us focused almost exclusively on company selection (which we do), since it affected our long-term track record and wealth creation the most.
Despite these disciplines, we do follow sentiment indicators and try to conclude what the masses are up to in the marketplace. In our view, these sentiment indicators are useful at extremes and can even be helpful to long-duration owners and buyers of common stock. Since the bear market low of March 2009, we have observed a huge new factor in sentiment indicator usefulness.
We wrote a missive a couple of years ago and we talked about how people are participating with one foot out the door. Our theory has been that heavy use of indexing and ETF investing, coupled with wide-asset allocation and tactical work in those arenas, has altered what the traditional sentiment indicators mean. Our belief in the bull market in US stocks has been positively affected by the near total lack of belief the largest pools of money have in the US stock market. They might get somewhat invested in it from time to time, but they have over-emphasized the most pessimistic S & P 500 sectors like energy, basic materials, heavy industrials and consumer staples, all the sectors which would benefit from the world economy outperforming the US. In other words, long US stocks and bearish on the US economy and future.
Here are a few examples that might be helpful. First, at the high in the S&P 500 index in 2010, 2011 and 2012, bullish sentiment reached a level of around three bulls for each bear in the Investor’s Intelligence weekly survey. Each reading led to a painful mid-year correction. Neither time did bullish sentiment reach 60 percent, which we view as a historically meaningful signal for declines of 20 percent or greater. Since institutional and individual investors appear to have a very small part of their overall portfolio in long-only US large cap stocks and are instead heavily committed to wide-asset allocation, do these sentiment numbers mean as much as they used to? Should you reduce exposure to US common stocks as a long-duration investor in an era of loneliness and US equity de-emphasis because of historically effective sentiment indicators?
Second, the American Association of Individual Investors (AAII) weekly poll is another useful sentiment indicator. We were astounded recently when the S&P 500 was up nearly 10 percent for the year and the AAII voters were bearish by a ratio of two to one! We haven’t given you the worst part of the story. We spoke at a regional meeting of the National Association of Investment Clubs, which is affiliated with the American Association of Individual Investors. They told us the membership is down over 40% in the last four years. You almost have to add those folks to the bearish category. Throw in 38 consecutive months of Lipper analysis indicating net liquidation of US equity mutual funds and you wonder if the sentiment polls can accurately compare today with years gone by.
Third, the CFTC reported over the weekend that money managers have more net long bets on oil in the week ended September 4th as they did the week ended May 1st of this year. In our opinion, this should especially scare oil investors. The net long exposure in early May was at over $106 per barrel and September 4th was at $96 per barrel. Any technician gets very nervous at lower peaks on worse sentiment. We believe very few institutions, almost no registered investment advisors and very few financial advisors had any participation in commodity futures contracts 10-12 years ago. With more participants than ever in history and more capital committed than ever, we believe these sentiment stats from the CFTC should scare every oil optimist to death. It is the dead opposite of the AAII polling circumstance in our view.
Lastly, one anecdotal piece of sentiment was provided over the weekend. China appears to us at SCM to be six months into a four-year recession/depression. We believe they badly need it to clean their economy of severe imbalances, fraud and bad loans in the banking system. We view where they are today to where the US was in the 1870′s when the four-year depression in our economy was triggered by over-building the western railroad system on money borrowed from Europe. Numerous US companies like FedEx (FDX), Cummins (CM) and Intel (INTC) have warned of the affects a hard landing in China could have on their business. All it took last week was the announcement of new government controlled-fixed asset investment stimulus on the part of Chinese government to trigger a four-percent rally in the Shanghai Composite. It also caused the President of Caterpillar (CAT) to declare over the weekend that the new stimulus from China would cause business to pick up for CAT in China in early 2013.
Why is this so important? Caterpillar is one of the companies we use as an example of representing the risk associated with “suckling on China’s economic boom”. They bought Bucyrus International near the top in investor enthusiasm for coal, gold and just about everything pulled out of the ground. When you helped people dig up the ground, we think you should get nervous when things have never gone better in the history of your company and industry. Our point is this; so many people are twisted up in the BRIC trade that bullish sentiment is effectively on steroids. More people are interested and participating in emerging markets and commodity-related stocks, bonds and commodities than ever before and we believe any smart contrarian should be doubly skeptical.
In conclusion, we at SCM are assuming low overall interest in US large cap stocks should be included when thinking about sentiment indicators. Our belief is that historically foolish enthusiasm and participation in all things BRIC-trade related should be avoided based on sentiment alone.
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 mentioned above 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
Thursday, September 13th, 2012
By now everyone knows that the WSJ’s Jon Hilsenrath is spoon-Fed information directly by the Fed. Even the Fed. Which is why everyone expected the Fed to ease last time around per yet another Hilsenrath leak, only to be largely disappointed, invoking the term Hilsen-wrath.
Sure enough, it took the market only a few hours to convince itself that “no easing now only means more easing tomorrow”, and sure enough everyone looked to the August, then September FOMC meetings as the inevitable moment when something will finally come out.
So far nothing has, as the Fed, like the ECB, have merely jawboned, since both know the second the “news” is out there, it will be sold in stocks, if not so much in gold as Citi explained earlier.
Regardless, the conventional wisdom expectation now is that tomorrow the Fed will do a piecemeal, open-ended QE program, with set economic thresholds that if unmet will force Bernanke to keep hitting CTRL-P until such time as Goldman is finally satisfied with their bonuses or unemployment drops for real, not BS participation rate reasons, whichever comes first.
As expected, this is what Hilsenrath ‘says’ to expect tomorrow, less than two months from the election, in a move that will be roundly interpreted as highly political, and one which as Paul Ryan noted earlier, will seek to redirect from Obama’s economic failures, and also potentially to save Bernanke’s seat as Romney has hinted on several occasions he would fire Bernanke if elected. Here is what else the Hilsenrumor says.
In the past, it has announced programs with big numbers and fixed completion dates — like a $1.25 trillion mortgage-buying program that stretched 12 months through March 2010 and a $600 billion Treasury bond-buying program that stretched eight months through June 2011.
The activist wing of Fed officials, which support aggressive responses to high unemployment, want a large and open-ended commitment to bond buying. For instance, the Fed could announce it would buy at least a certain amount of bonds over a specified time period and signal they could buy more later if the economy doesn’t pick up.
Announcing an opening allotment over several months would blunt the ability of Fed policy hawks, who are skeptical of easing actions, to quickly call for the program to end. The hawks don’t want another round of QE, but if there is going to be one, they would want a small up-front commitment to bond buying and the opportunity to pull the plug on the program if the economy picks up quickly.
A four-month opening allotment would get the Fed past the election and through a Dec. 11-12 policy meeting, at which point it could consider whether to continue. A five month commitment could get it to a January press conference and another round of forecast updates. A seven-month opening allotment would get it through the first quarter of 2013 and to a March 19-20 policy meeting. If it decides to make decisions on a meeting-by-meeting basis, the next meeting is Oct. 23-24, two weeks before the election.
It’s hard to say how big a program the Fed would launch, here are some guideposts:
- The Fed is already purchasing $45 billion in long-term Treasury securities every month through the Operation Twist program and it plans to buy a total of $267 billion by year-end. That marks the lower bound of what Fed purchases will be for the rest of the year.
- If the Fed doubles the size of its current program by matching Treasury purchases with mortgage purchases, that would get its monthly purchases to $90 billion.
- Its controversial QEII program launched in November 2010 was smaller at $75 billion per month.
- Its first round of mortgage and Treasury purchases took place largely in 2009 and was designed to be immense to address the financial crisis. It amounted to more than $140 billion per month, an amount that seems likely to be far beyond the ambitions of what Fed officials are prepared to do now.
–WHAT TO DO WITH TWIST: Officials must decide what to do about the “Operation Twist” program if they launch a new bond-buying program. The Fed is funding the Twist purchases with money it gets by selling short-term Treasury securities. The Fed has two options:
- It could suspend the Twist program and replace it with a new bond-buying program in which it buys both Treasury securities and mortgage-backed securities, and funds those purchases with money that the Fed prints — rather than with proceeds from short-term securities sales. This would be more like the QE programs the Fed launched in March 2009 and November 2010.
- The Fed could continue the Twist program and launch a mortgage-bond-buying program by its side in which it buys mortgage bonds with newly printed money but continues to fund long-term Treasury purchases with sales of short-term securities.
In either case, the Fed would be launching a program which it considers to be more powerful than Operation Twist alone. One question for officials is which of these two complex approaches would be easiest to explain to the public? Another is which approach entails less risk of public backlash? Many critics worry that the Fed’s money printing will someday cause inflation or another financial bubble. Many officials don’t agree, but they’re sensitive to the argument. The second option would involve less money printing and might help to blunt that criticism.
–COMMUNICATION: How the Fed describes its impetus for action, and its criteria for even more in the future, could matter a lot. Is it responding to a darkening outlook? Or has it decided to take more aggressive action because its patience with slow growth and high unemployment is running out and it has a new commitment to changing that?
If it emphasizes the former, it might just depress investors, households and businesses more and backfire. If it emphasizes new resolve, it could spur the public to change behavior in ways that lead to more economic growth but also risk more inflation.
Fed officials have long believed that their communications about monetary policy and the economy are as important as the actions they take, but they’ve struggled to strike the right message.
In a widely debated paper presented at the Fed’s Jackson Hole meeting last month, Columbia University economist Michael Woodford argued that the Fed should signal more strongly that it is committed to an easy money policy until the economy meets benchmarks for more output. The Fed seems to be moving tentatively in this direction. Its discussion about open-ended bond buying is one potential example.
Another: Minutes of the July 31-Aug. 1 policy meeting showed officials considered offering a new assurance that short-term interest rates will stay low even after the recovery progresses.
–WHETHER TO LOWER ANOTHER RATE: The Fed now pays banks 0.25% interest on reserves they keep with the central bank. The Fed could reduce the rate it pays on reserves that aren’t required of banks (known as excess reserves) a little bit to try to give banks more impetus to lend. However many officials are reluctant to do so because they’re afraid pushing the rate any lower would disrupt short-term lending markets. It’s unclear whether the Fed will do anything on this front, especially with so many other hard decisions on the table.
Thursday, September 13th, 2012
Spain needs external financial support – a view that is now clearly held by the consensus. A swift and smooth move by Spain to request external support is needed to validate the recent improvement in market sentiment towards Spain (and an improvement in financial markets more broadly). Mr Draghi’s announcement of the ECB’s new Outright Monetary Transactions (OMT) scheme offers a vehicle for that support. Goldman believes that the Spanish authorities now need to get on board the vehicle by requesting EFSF support.
Goldman Sachs: Tensions With Spain Set To Increase, Sooner Or Later
Spain’s larger size implies that this external support needs to be more flexible than was the case for Greece, Ireland and Portugal. This flexibility is what the ECB’s OMT scheme provides: the ECB’s balance sheet can be used to purchase short-dated sovereign debt when a country has accepted the conditionality that accompanies a request for parallel support from the EFSF.
Yet the effectiveness of the ECB’s initiative requires governments to act responsibly: both over the longer term in making the fundamental reforms to meet the conditions set by the EFSF and in the shorter term by moving smoothly to accept EFSF conditionality.
We had previously expected Spain to make a request for EFSF support at the Eurogroup meeting at the end of this week. This has proved overly optimistic and we therefore revise our view. While a later formal request to the EFSF ahead of Spain’s end-October redemptions should prove sufficient to contain re-emergence of intense market pressures, some disruptions cannot be ruled out. And while Spain is seen to prevaricate on the basis of domestic political concerns, German public and political opinion can become further inflamed. With German sentiment already sensitive to announcements, seeking protection in the form of tighter conditionality may only make Spain more reluctant to request help and therefore intensify the difficulty.
Near-term and medium-term risks becoming evident
Beyond the weak economic fundamentals that imply Spain will ultimately require further external support, the main risk currently stemming from Spain is that the government loses the incentive to reform if it is guaranteed that the ECB will purchase its debt.
- Near-term risk – current deliberations over Spain’s agreement to conditionality suggest Spain is willing to push to the limit the market’s tolerance for a slower transition to EFSF support.
- Medium-term risk – even when Spain is subject to conditionality within an EFSF programme, the imperfect nature of monitoring could tempt Spain to exploit the ECB’s preparedness to buy its debt.
In European Economics Daily ‘The ECB’s new measures: Bridging and/or breaking Europe’s ‘red line’’, we forecast that Spain would submit a formal request for external support at this week’s Eurogroup meeting. That request would then be followed in the second half of September with broader agreement on EFSF support with other Euro area member states. We also noted an alternative view where Spain delays seeking EFSF support so as to meet domestic political constraints. On account of signs of that reluctance – against a background of improved market conditions – we believe that the risk of this delay is materialising. Other interpretations of the delay are possible: Spain may be delaying on account of the publication of bank-by-bank stress tests at the end of September. Nonetheless, we are revising our view of the base case.
We also highlight, however, that the timing of any formal request will depend on market tensions, which in the past have proved a forcing mechanism for (often overdue) political action. We continue to believe that Spain will need to submit a request for EFSF support before its redemptions on October 29 and 31.
While – as we have seen in the case of Greece – various forms of cash management allow Spain to avoid a hard ‘cash flow’ constraint should support not be in place prior to the October redemptions, we would see a failure to deliver the anticipated programme request by then as disruptive.
Beyond the near term, a problem with incentives
As we have pointed out in the past, we continue to believe that a move by Spain to require EFSF/ESM support will ultimately prove inevitable. This suggests that the more substantial risk is the medium-term risk of a more awkward relationship developing between Spain and the broader Euro area. Based not merely on the latest signals from Spain but also on the incentives we have noted above, we believe this risk applies. Applying conditionality is always difficult in practice – still more so when a country has a large primary deficit, as Spain does, and can be perceived as taking undue advantage of central bank financing.
Beyond Spain, beyond the near term
Looking beyond Spain – specifically to Germany – brings together the two factors we have highlighted:
- The risk of a near-term delay in Spain’s request for EFSF owing to a reluctance to be submitted to conditionality.
- The ‘moral hazard’ risk that Spain slackens in its efforts to meet conditionality once external support is sought. We do not expect major changes to Spain’s current reform programme, although there is a risk of additional structural reforms being requested, particularly if Spain delays further.
The opposition seen in Germany in response to Mr Draghi’s preparedness to buy sovereign debt implies that current posturing in Spain will not wear well with the politics of signing a Memorandum of Understanding in Germany. The more the Spanish administration indulges domestic political interests and is perceived to be taking undue advantage of external support, the more explicit conditionality is likely to be demanded. This would add to any existing tensions, given Spain’s opposition to conditionality. This is disappointing partly because it is avoidable if Spain were to accept the external support on the terms currently available.
Spain will have the opportunity in the coming weeks and months to demonstrate that it wishes to avoid these incipient risks. But we continue to believe that some of the incentives created by Mr Draghi’s preparedness to act could prove difficult to resist.
Thursday, September 13th, 2012
May we suggest a Twitter version of today’s FOMC statement: “Don’t worry, be happy! ” – No, the economic outlook hasn’t improved. In fact, the Fed may want you to take a valium to stomach the ride ahead. Alternatively, if you don’t get mollified by the Fed’s “communication strategy”, you may want to consider taking action to protect the purchasing power of your hard earned dollars.
Here’s the challenge: the Federal Reserve (Fed) wants to keep interest rates low across the yield curve (from short-term to long-term rates) to aid the economic recovery. But good economic data might send the bond market into a tailspin, i.e. raise long-term rates and thus cause massive headwinds to the economic recovery. We got a taste of how quickly the bond market can sell off earlier this year when the economy appeared to pick up some steam. Higher interest rates would further encourage the major deleveraging that market forces still warrant, not a desirable scenario from our understanding of Fed Chairman Bernanke’s thinking.
Engaging in further rounds of asset purchases (“Quantitative Easing”, “QE3″, “QEn+1″) may alleviate some of those upward pressures on interest rates, but the moment a program is announced, the market prices it in and looks ahead, threatening to mitigate any lasting impact of QEn+1. Picture the Fed as trying to hold a carrot in front of the donkey, well, market, to make us believe another stimulus is coming, without actually giving it. That way, the Fed can print less money to achieve its goals. The Fed calls it communication strategy.
Some have suggested a more open-ended approach to asset purchases. But that would likely come with some sort of guidance as to when to stop it, such as when a certain level of unemployment or nominal growth is reached. Given that everything Bernanke has done has been signaled well ahead of time (the blogosphere is full of the “best kept secret”, the likelihood of more QE), introducing a completely new concept is rather un-Bernanke-ish. You may not agree with Bernanke, but as an investor please don’t act surprised.
In recently released FOMC minutes, the Fed tells us that it might communicate to the market that rates may remain low even as the economy recovers. Bingo! We have long argued that Bernanke considered the early monetary tightening during the Great Depression as a grave mistake, as it undid all the “progress” that had been achieved. But more to the point, the Fed needs to get our attention away from the economy. By keeping the link to the economy, the Fed will always struggle to keep the upper hand on the bond market. So forget about the carrot: we need valium, not carrots. By communicating with the market that rates will remain low independent of how the economy might perform, the bond market just might not be selling off as aggressively as economic growth picks up.
That’s exactly the path we believe the Fed is going to go down. It will be interesting, however, to see what the Fed’s explanation will be. We doubt they will use the valium analogy. Some Fed watchers would like to see a nominal GDP target or something similar, but don’t bet your donkey on Bernanke going that far.
The basic challenge is – and we are interpreting here as we don’t think the Fed or any central banker in office would ever frame it this way: the Fed wants to have inflation, wants to move the price level higher to bail out home owners, wants to push up nominal wages, and wants to push up nominal GDP to make the debt burden more bearable. But the Fed doesn’t want the market to price in inflation, as that would push interest rates up.
That’s why we may be heading ever more into the “Land of Make-Believe.” But as investors enjoy their valium, the U.S. dollar is at risk of melting away under their feet. Drugged up, we are too busy laughing at Greece and doling out advice to Europe to notice that our “don’t worry, be happy” approach might lead to rather unhappy purchasing power. If you think you are above the fray, let me just ask whether you have watched the euro in recent months? As of late, that perceived weakling of a currency appears to be giving the greenback a run for its money. We are not suggesting that investors dump their U.S. dollars and exchange them all for euros. However, we would like to encourage investors to consider embracing currency risk, for example through a managed basket of currencies, as a way to manage the risk posed to the purchasing power of the U.S. dollar. Adding currency exposure to a portfolio may have valuable diversification benefits.
Some sympathize with the ever greater complexity of monetary activism around the world. But it’s really rather simple: there’s too much debt in the world. To deal with the debt, countries may deflate, default or inflate. In the US, we have what both Bernanke and his predecessor Greenspan have called the printing press; as such, so their argument goes, the U.S. dollar is safe – in nominal terms at least. Greece is not capable of procuring valium, which creates a different set of challenges. But stop pitying Greece and consider taking action to protect your purchasing power at home.
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President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds