Archive for September 17th, 2012
Monday, September 17th, 2012
David Rosenberg, Gluskin Sheff: BernanQE Plays With A New Deck
It would be glib to ask “well, wasn’t QE3 priced in?”
What the Fed did was actually much more than QE3. Call it QE3-plus… a gift that will now keep on giving. No maximum. No time limit. The Fed also lowered the bar on what it will take, going forward, for even more intervention.
The Fed announced that it will buy $40 billion per month in MBS (together with the on-going Operation Twist program, this brings total asset purchases to around $85 billion monthly through year-end), but the press statement contained an open-ended commitment to QE until labour market conditions not only improve, but do so ‘substantially”. This is a radical shift.
Before, the QEs had an explicit maximum limit in magnitude duration. That is no longer the case — $40 billion in MBS buying month in, month out, perhaps until such time that the Fed owns the entire market (the Fed already has $843 billion of Agency MBS on its balance sheet as it is — if this is truly Japan and it takes another ten years for the economy to improve “substantially”, the Fed will end up owning the entire market).
Prior QEs seemed predicated on relapses in economic growth (or at least no follow-through). This was the case with QE1 in March 2009, QE2 in November 2010 and Operation Twist just over a year ago. Now the economy has to strengthen dramatically and if it doesn’t – the Fed is clearly targeting the jobs market and specifically on the unemployment rate here – then the spectre of even more balance sheet expansion will remain fully intact. We could soon be attaching Roman numerals to future QE actions (January 31st 2014 is Bernanke’s last day as Fed Chairman and that is a loooong way away).
The payroll data always move the market but now more than ever and the Fed’s explicit goal of generating “substantial” improvement in the jobs market will ensure that this ‘bad news is good news’ psychology will remain fully intact (why the stock market so easily managed to shrug off last week’s data – this new normal of bad news being good news is now going to be more fully entrenched for the market). And with the Fed targeting mortgages, it is clear that it views housing as the transmission mechanism for its objective of strengthening the jobs market. So each housing indicator going forward is also going to very likely elicit a stronger market reaction than normal – remember, because the stock market is addicted to QE, weak data can still be expected to be supportive. A notable improvement in the data will be even more supportive because the Fed will still keep the hope alive of more QE even if economic conditions get better.
I have to stress this but anything less than “substantial” is just not going to cut it for the Fed – I don’t know how that is defined numerically, but if the economy and specifically the jobs market does not go gangbusters, more QE can be expected. And it won’t always be in MBS – the Fed came right out and said that it will also “undertake additional asset purchases and employ other tools as appropriate until such improvement is achieved in the context of price stability”.
That reference to “price stability” is a bit comical because in the prior rounds of unconventional stimulus: market-based inflation expectations (from the TIPS market) were sub-2% and falling. Going into today’s meeting, they were 2.6% and rising. This, for a central bank that spent an inordinate amount of time talking about how important it was to prevent inflation expectations from becoming unhinged when it was busy tightening policy in the 2004-2006 rate-hiking cycle. The times, they are a changin’ (in other words, the price stability objective has a big fat R.I.P. on its tombstone). This is why gold swung from a moderate decline to a huge gain yesterday afternoon, and the DXY is breaking. It is clear that out of its dual mandate, a lower unemployment rate right now clearly trumps any concern over higher inflation expectations (whether justified or not).
Equities have ripped to the upside. Commodities are bid. Gold has broken out. The U.S. dollar is sliding. Yet the bond market refuses to buy in. The yield on the 10-year note has remained stable through this entire dramatic response to QE3 (and pledges for more). The Fed announced that it was buying mortgage-backed securities, not Treasuries, so it is curious as to why the bond market is not selling off dramatically. I can count numerous Fed meeting days when the stock market rallied sizably and bonds sold off alongside the reflationary view. I recall all too well the June 26, 2003 FOMC meeting when the Fed cut rates for the last time in that cycle and told the market it was on its own because the economic clouds had finally parted. The Dow ran up more than 100 points from the intra-day low that session and the 10-year note yield jumped 17 basis points, basically ratifying the view of the equity market at the time. But this time around, the Treasury market remains the odd man out on this new pro-growth view evident in the pricing of other asset classes. For any perma-bull out there, Mr. Bond is like having a mosquito in your ear on the putting green.
So from a markets standpoint, let’s talk about what all this means.
- The Fed is setting us up for more risk-on/risk-off volatility. Long-short strategies or relative value strategies are perfectly appropriate.
- The Fed extended the period of ultra low policy rates through to mid-2015 (one FOMC member is at 20161) from the end of 2014, which will nurture a low yield environment even further. Not only that, but the Fed said that “a highly accommodative stance of monetary policy will remain appropriate fora considerable time after the economic recovery strengthens” which means that even if growth miraculously manages to accelerate earlier than expected, the Fed is not going to begin raising rates. The age of “pre-emptive” tightening is long gone. This nurturing of a low policy rate environment for years to come will continue to underpin the income (dividend) theme in the stock market.
- The fact that the Fed is embarking on an even more aggressive course with inflation expectations on the rise should be viewed constructively for gold and other precious metals (and gold mining stocks).
- The Treasury market is like the brake lights on a car – we need to acknowledge that it is not signalling better growth ahead. Screen for earnings visibility and less cyclicality. Bonds usually have the economy right.
- Corporate bonds should be a beneficiary as the Fed continues to anchor a low interest cost environment and as such, correspondingly keep debt- servicing charges and default risks at bay.
I don’t think this latest Fed action does anything more for the economy than the previous rounds did. It’s just an added reminder of how screwed up the economy really is and that the U.S. is much closer to resembling Japan of the past two decades than is generally recognized. Maybe in the central bank world of the “counterfactual” these QEs prevent a worse outcome but the most radical easing in monetary policy ever recorded has not stopped this post-bubble-bust American economy from posting its weakest recovery ever whether measured in real, nominal or per capita terms.
The economy is saddled with too much debt, a shortage of skills, bloated government, an uncertain tax rate outlook, the costs associated with Obamacare, banking sector re-regulation and a spreading European recession. Home prices may have revived of late, but there are still an amazing 22% of debt-ridden homeowners who are upside-down on their mortgage. Monetary policy is best equipped to deal with the vagaries of the business cycle but is a blunt way to deal with deep structural, fiscal and regulatory hurdles. QE has done squat for the economy and I don’t expect that to change. Even the Fed cut its 2012 real GDP growth projection for this year to 1.85% from 2.15% – for a year when typically growth is closer to 4% – and so the bump-up in 2013 to 2.75% from 2.5% has to be viewed in that context (in fact, it would seem as though for all the bluster, the level of real GDP is actually lower now at the end of next year compared to the pre-QE3 forecast… maybe this is what the Treasury market has latched on to).
It would seem as though the Fed’s macro models have a massive coefficient for the ‘wealth effect’ factor. The wealth effect may well stimulate economic activity at the bottom of an inventory or a normal business cycle. But this factor is really irrelevant at the trough of a balance sheet/delivering recession. The economy is suffering from a shortage of aggregate demand. Full stop. Perhaps most importantly, in order for the Fed’s action to have a lasting impact on the direction of the equity market, it must foster at least some significant belief that the action will lead to self-sustaining economic expansion. The scars of real family median income declining for two years in a row – the Fed’s action in a perverse way perpetuates this by forcing essential basic material prices higher – and an unprecedented five-year decline in household net worth are lingering, and exerting far more powerful dampening effect on spending and confidence than the Fed’s repeated attempts to generate risk-taking behaviour.
To the extent that the Fed is at least temporarily successful in nurturing a risk-on trade for portfolio managers, the reality is that changing the relative prices of assets does not create demand.
It just perpetuates the inequality that is building up in the country, and while this is not a headline maker, it is a real long term risk for the health of the country, from a social stability perspective as well.
Monday, September 17th, 2012
What will it take to rebuild investor confidence? Financial Thought Leader David Darst, Chief Investment Strategist at Morgan Stanley Smith Barney, will discuss the positive signs he’s seeing in the U.S. and global markets and why investors should start to trust the markets.
Consuelo Mack WealthTrack – September 14, 2012
CONSUELO MACK: This week on WealthTrack, what will it take to rebuild damaged investor confidence? Financial Thought Leader David Darst, Morgan Stanley’s Chief Investment Strategist, shows us the steps to take to build a stronger and more secure financial house. David Darst is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Is the cult of equity dying, as bond king Bill Gross recently opined in his monthly investment outlook? Gross runs the world’s largest and one of its most successful bond funds, the PIMCO Total Return Fund and is one of the country’s most influential investors and prognosticators. As Gross’ chart, “Stocks For The Really Long Run” shows, stocks, with their 6.6% annualized inflation adjusted returns, have vastly outperformed bonds and cash over the last one hundred years; a fact chronicled by Wharton professor Jeremy Siegel in his investment classic, Stocks for the Long Run . Gross maintains this track record is unsustainable for a number of reasons, not the least of which is PIMCO’s expectation that the economy will grow at a much slower pace for the foreseeable future. Under PIMCO’s now famous “new normal” forecast, real GDP should crawl along at 1-2% a year versus the historical average of 3.5% in the post-war era.
Many investors seem to agree that the cult of equity is dying. Investors have been pulling money out of stock mutual funds for years. As independent research firm Bianco Research reports and its chart of cash flows into U.S. stock mutual funds shows, “investors correctly started selling domestic equity mutual funds on an annual basis in mid-2007… in fact, in the months ending May 2012, net new cash flow out of these funds set a record at $193.93 billion.” You sure wouldn’t think so looking at how the markets have performed this year though. Stock markets across the world have rallied, led by the U.S. Professional investors are much more bullish than individuals are about the ability of the Federal Reserve and the European Central Bank among others to boost growth and stimulate demand.
Put this week’s WealthTrack guest in the optimist’s camp, with some caveats and measured advice for investors. He is Financial Thought Leader, David Darst, Chief Investment Strategist at Morgan Stanley, where he criss-crosses the globe advising clients. He is also an acknowledged expert in asset allocation and a prolific author. Among his most recent books is a best seller, The Little Book that Saves Your Assets , which I highly recommend. I began the interview by asking David, given recent events, why should investors trust the financial markets.
DAVID DARST: Well, I think the basic reason is that we trust America, the United States of America. America is certainly a country that’s had its ups and downs. We’ve been through the Depression, we’ve been through world wars, we’ve been through great conflicts that were not of world war scale, but they’ve been significant for our heroes and heroines. But I have great faith in the people, the deep-keeled strength of this nation to keep this nation in balance. This nation is the destiny, this nation is the hope of this world.
And why should Americans trust in the financial system? We will get it right. No family is perfect. Marriages have problems. Your kids have problems. Everybody has problems. It’s not the problems- it’s how do we deal with problems? I was recently having lunch with someone and she said it’s not what baggage you have, it is how you deal with the baggage you have, and I think this is baggage- these scandals, the trading, the high frequency trading, the flash crashes. These are things, this American ideal, this American history, and it’s 100% correct, we move to basically… we love problems. We go with the problems and we solve them. Do we do it overnight? No.
And I also have faith in the basic people who do the work in this country, and who do the work in this financial system, that they will do the right thing. Do you have bad eggs? Read the Old Testament. There’s thousands of stories in there of people … one guy kills his brother because the smoke goes up to heaven and his doesn’t. But does that mean we have to stop the Bible in Genesis right there, Cain and Abel? No. And we’re going to have people who make mistakes. We’re going to have pilots who… we’re going to have planes that crash, we’re going to have systems that crash, but I think this whole American ideal is that we will work to fix this.
CONSUELO MACK: So what has been fixed that you think that we can feel better about the fact that we are addressing our issues?
DAVID DARST: Consuelo, number one is public awareness. A show like yours educates people. It is not a high frequency trading show. It is the antidote. You and I have talked about this. It is a show of thoughtfulness, of reflection, of appropriateness, of judiciousness. And I believe what has been fixed is there’s much greater public awareness of these things, and they are now on the agenda. They are not hidden. They are not something that we’re blissfully ignorant of. What has been fixed? People, the SEC, the NASDAQ, people are aware of some of the big egregious errors; the word egregious comes from egrex- in Latin, out of the flock. These things that have been outliers, have been recognized as such, and we are going like the good shepherd to bring that thing back like Rin Tin Tin and Lassie, and bring them back into the fold.
CONSUELO MACK: So let’s talk about what’s changed as far as when you’re talking to clients and advising them on their investments, because many people feel that the markets have fundamentally changed. You mentioned the flash crash, for instance. The fact is that we have had, in the last five or six years, or ten years, we’ve had two back-to-back market declines of 50% or more.
DAVID DARST: Well said.
CONSUELO MACK: So there’s tremendous volatility in the markets right now. It feels like the very nature of the markets have changed, that computers are in charge and the humans are not. So, what has changed and how do we adapt to it to get the kinds of returns that we want from the market?
DAVID DARST: What has changed is in 1876 somebody dropped acid on himself in Boston, Massachusetts and said, “Watson, come here, I need you.” And Alexander Graham Bell, Watson came running in, and we had the telephone and we were able to have information travel through the distance and now it’s sped up to almost instantaneous speed of light. What has changed is the speed at which things are being thrown at us, and we have to become a little bit more nimble, we have to pay a little bit more attention. You and I have discussed you had to drive, you have to drive occasionally with both hands on the steering wheel, wear a seat belt and pay attention to the road. This is not autopilot.
CONSUELO MACK: And you said it’s not a cruise control market, but it hasn’t been in quite a while. So if it’s not cruise control, I mean, you know, do I have to be a Grand Prix driver in order to navigate the market, in which case–
DAVID DARST: Stay within your lanes, stay down the middle of the highway, and if it says “Don’t Pass” don’t pass. And what I mean by that is, what’s changed is the speed. What has not changed in 10,000 years since they began drawing images at Lascaux, Spain and Altamira, okay, over there in those caves– what’s not changed is the things that frighten us are still the things that frighten us and the things that get us excited and greedy are still the same things. Human nature has not changed. The world has changed. I tell all of our financial advisors, our clients, the world as we know it is not the world today that we did know it. It is the end of the world as we know it, Consuelo, is not the end of the world. We have three big changes: demographics, technology and globalization. And the technology piece is what you’re putting your finger on, and that has changed, no question about it.
That having been said, the things… Buffet says when people are greedy then you have to basically stand back. When people are fearful, then you’ve got to force yourself. And I think one of the great things of this show is that you give this long-term perspective, and when things get sold down, our philosophy, number one, asset protection is paramount. The key second word of our philosophy is the word protection; secondly is correlations are critical. You want to have asset classes that zig when others zag so that you’re calm and you are like a surgeon operating on your own relative. You have ice water in your veins, and that’s given to you by assets that do well when others aren’t doing well.
CONSUELO MACK: And the non-correlated assets continue to be non-correlated.
DAVID DARST: Those are cash. Those are managed futures. Those are precious metals. Those are inflation index securities which you have been a pioneer on in your show.
CONSUELO MACK: Let’s go back to some of the fundamental changes, and you mentioned demographics. A lot of people don’t pay as much attention to the aging baby boomers, which made such a huge difference in the market rallies of the ’80s and ’90s and so …
DAVID DARST: It was like a religion. They told us to buy stocks and hold them.
CONSUELO MACK: Right. There’s a major reason why stocks went up, because the baby boomers were a huge consumer, huge stimulative factor. They are now aging, so their patterns are going to change. How much of a drag or a headwind is that going to be on market returns for the next 20 years?
DAVID DARST: Consuelo, I think many of the baby boomers are going to want their portfolios to be more stable and they’re going to want them to generate more income. Those are a couple of givens . Professor Siegel and, you know …
CONSUELO MACK: Jeremy Siegel, right, Wharton.
DAVID DARST: Jeremy Siegel at Wharton. Professor Siegel, in his first book, I remember the last chapter said the U.S. companies are going to be so good and so global that many of these rich emerging markets, people in Indonesia, people in Taiwan, people in China, are going to want to buy stocks of these American global gorillas. I thought, how crazy. Now, 15 years later after is first edition, he was brilliant with that statement. I don’t even know if he realized totally that these young people are going to look for companies they trust, going back to your first point, they’re going to look for companies whose accounting they know, they’re going to look for companies that have been around 160, 170, 180 years. You take companies that are in the consumer products area that have global footprints, these people touch these products every day and they’re going to want to own shares of these. And so I think we have another wave of buyers…
CONSUELO MACK: A global wave of buyers buying these multinational…
DAVID DARST: Global wave of buyers of U.S. companies and European and Canadian and U.K. companies that have good accountings, that have good accounting systems, good managements, that have a global mindset and a global… these companies…
CONSUELO MACK: Are you seeing that happening now? Where is the demand coming from? I thought it was coming from…
DAVID DARST: I just got back from Brazil, as you know. You go to Brazil and you see people coming to investor presentations, you see questions that indicate that the middle class is growing all over the world. The 1700s were about the deposition of monarchies. The 1800s were about getting rid of slavery. The 1900s were about the eradication of fascism, totalitarianism and Communism. This century now that we’re entering is going to be about, number one, the emancipation and the no more oppression of women, globally. And they are savers, and they are household maintainers, along with their spouses, along with their partners, and they are going to buy stocks and they’re going to buy things they trust and they’re going to buy the products of the companies they trust, and they’re going to buy stocks of those companies.
CONSUELO MACK: So what are you telling your clients? How are we getting through this transition and do we have to adjust… during these kind of transitions there’s so much displacement in transitional periods, I mean do we have to adjust our investment expectations? Do we have to adjust our portfolios to new asset allocation, use different sectors? Tell us how we adjust to survive.
DAVID DARST: First of all is diversification. You’ve preached this, I have preached this. You want to basically have a bunch of assets that are non-correlated, good quality assets. Take baby steps. I see people that come in and they get disgusted and they want to change the entire décor of their house. Listen, change the house one room at a time. Focus on, are your equities of high quality, global companies that have free cash flow generation, that have dividend-friendly policy, shareholder-friendly policies, and managements that are trustworthy and are doing things to expand the global footprint? That’s one.
CONSUELO MACK: So David, a lot of people say that’s a very crowded trade, they’re expensive now, especially the global gorilla type of stocks that have a total return, they’re paying regular dividends. That’s the … the criticism is that that stuff is really expensive now. What’s your view?
DAVID DARST: Breathing is a crowded trade. Does that mean I have to hold my breath? Running out of a movie theater when the building is on fire is a crowded trade. Does that mean I have to be contrary? There’s a time to be contrarian. I’m going back to Ecclesiastes. You’ve heard me talk about Ecclesiastes. In there, it says there’s a time for being part of the crowd and there’s a time for standing away from the crowd. And right now, if I saw these valuations, the valuation of the U.S. stock market had come down from 33 to around 12. Has it stopped? Could it go down to six or seven? Of course it could. That’s usually the long-term bottom. But in 2000, and you remember it very well, 2000 the stock market PE was 33 times earnings. It’s come down in dribs and drabs, because the market’s done nothing over these 12 years, to a PE of 12. Therefore, you want to basically own some of these companies that have good valuations.
CONSUELO MACK: So let’s talk about some of the positive things that you’re seeing where there are investment opportunities. So one of them is energy.
DAVID DARST: One of them is energy, Consuelo. I think there’s legitimate concern over fracking. Are we going to be protective of the water? And this is something that this generation demands in a way that our generation was only beginning to, but they really draw the line and say we need confirmation that this drilling is so far below that, that it’s impossible to taint the water…
CONSUELO MACK: To pollute the water supply.
DAVID DARST: And we want our water, we want our air to be clean, and I think there are so many countries in the world, including the number two economy in the world after the United States now, China, they would love to have clean air and clean water. And we, I think, set a standard. So one is in the area of energy. Another one is in the area of water. We have water, but we also have, even in this drought condition year that we’ve just finished, we have filtration, we have desalination techniques, and those are two of the areas that folks in your investment mindset need to be look at is water, not just bottled water. Bottled water is a soft drink, what you need is filtration, you need irrigation, and you need desalination.
CONSUELO MACK: What’s on the radar screen of you, an investor, shorter term- the election, what’s at stake?
DAVID DARST: What’s at stake, Consuelo is the United States’ view towards capital, the United States’ view towards regulation, the United States’ view towards the spending and debt limits. Those are the four things: regulation, capital… listen, these big companies, 80 to 90% of their profits are abroad. They can’t bring them back here. It’s simple, your seven year old niece could put this on a postcard and send it to 1600 Pennsylvania Avenue and say give them a break on the taxes if they hire people and build things here. Let me tell you, Airbus is pulling Boeing. What is that? They’re going to build airplanes in the south part of the United States because they have hardworking, disciplined, non-unionized workers, who work in a country where things get crazy, we depreciate the currency a little bit externally to make the thing competitive, and they don’t have that in Europe.
CONSUELO MACK: What are you telling your clients how to deal with the crisis in the Eurozone?
DAVID DARST: Europe, everybody wants to put it down and says it’s nothing but a big Disneyland over there and it’s people having espresso in the piazza all afternoon. No, Europe is German companies, Europe is Danish companies, Europe is Swedish companies, Europe is Italian leather manufacturers that are not even listed in the telephone book. The Economist magazine said the strongest person in Europe was the Italian manufacturer with less than 15 people because they don’t have to register. Ninety percent of women’s leather glove, to date-
Vietnam, Philippines, Bangladesh, okay, Sri Lanka, they’re not made in Asia- 90% of women’s leather gloves in the world are made in Naples, Italy, but Consuelo, there’s not one glove manufacturer listed in the telephone book. It’s all done off the books.
CONSUELO MACK: So what are the investment opportunities in Europe?
DAVID DARST: I think you’ve got some of these phenomenal European companies, these healthcare companies, the dividends on these Swiss, giant pharma companies, the dividends on the French giant pharma company, the U.K., the dividends are five, six, seven percent.
CONSUELO MACK: So these are, again, global gorillas.
DAVID DARST: These are global gorillas. You have some of these German powerhouse manufacturing companies, the big multi-industry companies. Buffett bought into these reinsurance companies in Switzerland and in Germany, and they are conservative, and they have tremendous bookkeeping and they have tremendous risk control. Nobody said a word about these great reinsurance companies. So Europe has tremendous opportunities. Am I going to sit here on your show and tell people to buy the European banks? Not now, because people still don’t know what’s inside their balance sheets.
CONSUELO MACK: So David, one of the other questions that a lot of your clients are asking you is- again, these are the baby boomer clients- in a low yield world, where can we go for income? So what are you telling them?
DAVID DARST: We say take a little, have a sprinkling of real estate investment trusts. They’ve done well this year, Consuelo. The domestic ones recently were up as much as 13, 14%. People were looking for yield. The international ones, which don’t get mentioned on your program a lot, but there are indices that follow them, and there are funds that track these international real estate investment trusts, those things are up 24%.
CONSUELO MACK: So everything has a price so…
DAVID DARST: That’s income. Secondly is master limited partnerships. We’ve talked about these on your show. These are energy infrastructure. They’re pipelines, they are oil storage facilities. They are not downstream, which is refining and marketing, where we buy our gasoline. They’re not upstream, which is drilling for oil. They call this midstream, okay, master limited partnerships is… Congress, in 1961, created real estate investment trusts. In 1987, they created master limited partnerships to encourage national investment in this infrastructure, and to build out the midstream aspect of the energy industry. That’s yield oriented. So you say, where do you go for yield? You want to go with the healthcare sector. Those things are yielding four, five, six percent.
CONSUELO MACK: These are big drug companies?
DAVID DARST: Your telephone companies and your Canadian, the big Canadian giants, Consuelo, you want to own some of those. You want to own your big U.S. carriers, and your biggest Canadian carrier. These yield 4.5, five percent. Those are generous yields that can be maintained, so there’s where you want to be looking for yield these days.
CONSUELO MACK: One Investment for a long-term diversified portfolio- what should we all own some of?
DAVID DARST: Johnson & Johnson is a company of 126 years.
CONSUELO MACK: It’s had some problems.
DAVID DARST: It’s had some problems. They’ve had some recalls, some product recalls, they’ve had some manufacturing issues. This is one of the great ethical companies of all time. They’ve just installed a new chairman succeeding Bill Weldon, who did a good job. They’ve installed on April 12th of this year, Alex Gorsky. He’s a U.S. Military Academy grad, he’s a native of Michigan, he’s one of five kids, he was posted in Greece, he was posted in Hawaii. He then went to work as a salesman for J&J, and 28 years later he’s the CEO. What is he doing? In short, they are basically taking their global footprint and now going to expand it. You take companies that are the biggest consumer products companies in the U.S. They are about 34% emerging markets. You take the big beverage companies, okay, your big cola companies, they are about 50% emerging markets; you take the biggest toothpaste companies that we have, they are 50% in emerging markets.
CONSUELO MACK: Johnson & Johnson?
DAVID DARST: Johnson & Johnson is only 20% in emerging markets. They have a gross margin, that’s sales less cost of goods sold, of 70%. Their revenues this past year were $70 billion, their earnings were 20%, after taxes, $14 billion. They have $12 of debt, they have $70 billion of equity.
CONSUELO MACK: And the dividend policy is…
DAVID DARST: Dividend is 3.5% and a tendency to grow the dividend over time. We think this is a classic example, and I am thrilled that it’s cheap. They can earn $5. It sells for 13 times earnings. It’s towards the low end of its historical multiple. That’s the kind of company that’s emblematic of the themes that we’ve been discussing that we think will give you along, a good return to buy in, it’s just cheap valuation.
CONSUELO MACK: David Darst, Morgan Stanley. Thank you so much for joining us on WealthTrack, as always.
DAVID DARST: Thank you for having me. Nice to be with you.
CONSUELO MACK: At the end of every WealthTrack, we try to leave you with one suggestion to help you build and protect your wealth over the long term. This week I am taking some advice from PIMCO’s star bond manager Bill Gross, whom I quoted in the beginning of the program. This week’s Action Point comes right from Bill. It is: balance your asset mix according to your age. Gross advises “own more stocks if you are young, but more bonds if you are in your 60’s or older” as he is. It also fits nicely into a core part of David Darst’s strategy, which is to be broadly diversified with portfolio protection in mind.
I hope you can join us next week. I am going to sit down with a next generation Great Investor, Matthew McLennan, successor to legendary portfolio manager Jean Marie Eveillard, at the First Eagle Funds. If you would like to watch this program again, please go to our website, wealthtrack.com. It will be available as streaming video or a podcast no later than Sunday night. You can also see additional interviews with WealthTrack guests in our new and improved WealthTrack Extra feature. And that concludes this edition of WealthTrack. Thank you for watching. Have a great weekend and make the week ahead a profitable and a productive one.
Monday, September 17th, 2012
by Don Vialoux, Timingthemarket.ca
Upcoming US Events for Today:
- The Empire Manufacturing Survey for September will be released at 8:30am. The market expects –2.00 versus –5.85 previous.
Upcoming International Events for Today:
- The Reserve Bank of Australia Board Minutes for September will be released at 9:30pm EST.
Markets edged higher on Friday, still buoyed by the euphoria that was created following the Fed’s announcement of a new quantitative easing program on Thursday. Equities and commodities have received a significant boost over the past two sessions as inflation expectations jump. The Treasury Inflation Protected ETF (TIP) is trading at the highest level since inception of the fund. The US Five Year Breakeven rate at around 2.37% has set new year-to-date highs and is reaching towards the highest levels since the recession began. And the recent PPI and CPI reports showed the largest month over month increase since the first half of 2009. The statement from the FOMC on Thursday noted that “the Committee anticipates that inflation over the medium term likely would run at or below its 2-percent objective.” It’s safe to say that the Fed’s primary mandate of price stability is under threat. As inflation creeps higher, the cost of goods will encompass a greater portion of the income of consumers, threatening discretionary purchases at a very crucial time in the calendar year, the Christmas season. The end result of this additional stimulus package could prove to be more detrimental to the economy, and in turn employment, should the trend inflation continue. Remember, effects of inflation are immediate while employment and wage increases that could potentially will result take much longer to be realized, which makes the threat of a poor fourth quarter that much more real. Oil prices on Friday shot up above $100 a barrel for the first time since the beginning of May and according to an article published at Zerohedge.com “for the first time in history, national average gas prices for the 2nd week of September were over $4.00.” Food prices are already creeping higher as a result of the summer’s drought and now metal prices are breaking out. Decreased purchasing power is not exactly the economic boost that the Fed desires.
Higher inflation expectations are also proving to be detrimental to bond yields. The yield on the 30-year treasury bond broke out above resistance on Friday as investors seek a higher real rate of return. The short-term trend of bond yields has confirmed a positive trend, acting in opposition to the Fed’s desire to keep interest rates low. The Fed stated on Thursday that their action “should put downward pressure on longer term interest rates, support mortgage markets, and to help make broader financial conditions more accommodative.” The Fed could be in serious trouble.
Fortunately, for equity and commodity investors, prices are moving higher as the US dollar becomes devalued. Equity benchmarks, such as the S&P 500 Index, are now the most stretched to the upside since the middle of March this year, just prior to the the Spring pullback. Technical indicators, such as stochastics and RSI, are firmly within overbought territory, which could lead to buyer exhaustion as marginal buyers fail to find value within the markets. Conversely, the US Dollar is extremely stretched to the downside, presently the most oversold since May of 2011. The currency bottomed shortly thereafter that year, placing pressure on equity and commodity markets for the months to follow. The degree to which these asset classes are stretched increases the probability of a near-term pullback, likely to correspond to the seasonal weakness in equity markets that runs into the month of October. Area of support for the S&P 500 upon a pullback falls between a range bound by the 50-day moving average, presently at 1392, and the 20-day moving average, presently at 1420. Conversely, resistance for the US Dollar index runs back to the recent breakdown point at 81. Each of these levels would be logical points to retest to confirm the breakout in equities and the breakdown in the Dollar, ideally alleviating stretched technical indicators and replenishing upside momentum into the end of the year.
Overall, despite near-term expectations of a pullback, the trend in equity markets remains firmly positive. Technical Sell signals have evaded equity markets since the start of June, warranting a hold mentality, even through the recent uncertainties.
Breadth is showing considerable signs of improving after spending much of the summer within a declining trend. The S&P 500 Equally Weighted index is now outperforming the capitalization weighted index. And the NASDAQ cumulative advance decline line is starting to trend positive after a summer full of declines.
Risk sentiment has rebounded. Cyclicals are outperforming defensives, a characteristic of a bullish market. Riskier small cap stocks are outperforming lower beta large caps. And Copper (also known as Doctor Copper due to its predictive capabilities of market direction) is starting to outperform equity benchmarks as well as commodity benchmarks.
Volume has also returned to equity markets with Friday showing the largest volume day for the S&P 500 since the middle of March. The Cumulative NYSE Advance-Decline Volume line for the NYSE is pushing towards the highs of the year having broken out above a level of resistance within the last couple of weeks.
Each of these bullish characteristics gives no reason to suspect the positive trend in equity markets will end anytime soon, despite any short-term weakness. A significant negative catalyst would be required to derail the present positive trend. Economic fundamentals, although negatively diverging from equity prices, are not yet proving to be a risk to the trend. Increased inflation expectations and a devaluation of the US Dollar is likely to keep a bid in equities and commodities through year-end, driving equities higher during the seasonally strong fourth quarter. Next hurdle for the markets to contend with is earnings, which could initiate short-term concern, allowing equity markets to pullback between now and mid-October. FedEx and Oracle, two economic bellwethers, will report earnings this week.
Sentiment on Friday, as gauged by the put-call ratio, ended overly bullish at 0.69. This is the lowest level since the days prior to the 2011 plunge in equity markets during the month of August. The ratio is screaming complacency, a typical precursor to equity market declines. The VIX is also rebounding off of a long-term level of support, also a leading indicator of equity market weakness ahead. And the short Interest in the S&P 500 ETF (SPY) is holding around the lowest levels in years. Equity investors are presently underexposed to protective positions and overly exposed to risk assets, tipping the boat too far in one direction. A pullback is required to correct the uneven tilt.
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
- Closing Market Value: $12.57 (unchanged)
- Closing NAV/Unit: $12.58 (up 0.11%)
|2012 Year-to-Date||Since Inception (Nov 19, 2009)|
* performance calculated on Closing NAV/Unit as provided by custodian
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Monday, September 17th, 2012
by John Hussman, Hussman Funds
As of Friday, our estimates of prospective return/risk for the S&P 500 have dropped to the single lowest point we’ve observed in a century of data. There is no way to view this as something other than a warning, but it’s also a warning that I don’t want to overstate. This is an extreme data point, but there has been no abrupt change; no sudden event; no major catalyst. We are no more defensive today than we were a week ago, because conditions have been in the most negative 0.5% of the data for months. This is just the most negative return/risk estimate we’ve seen. It is what it is.
Since we estimate prospective return/risk on a blended horizon of 2-weeks to 18 months, we are not making a statement about the very long-term, but only about intermediate-term horizons (prospective long-term returns have certainly been worse at some points, such as 2000). As always, our estimates represent the average historical outcome that is associated with a given set of conditions, and they don’t ensure that any particular instance will match that average. So while present conditions have been followed by extraordinarily poor market outcomes on average, there’s no assurance that this instance can’t diverge from typical outcomes. Investors should ignore my concerns here if they believe that the proper way to invest is to bet that this time is different.
In March of this year, our estimates dropped into the worst 2% of historical observations, and fell to the lowest 0.5% of all observations by April. Note that the only way to achieve an extremely overbought market is for prices to move up through less extreme overbought conditions, without consequence. Likewise, the only way for market conditions to become as extreme as they are at present was for the market to advance despite progressively worsening conditions, without consequence. So we have been wrong, and uncomfortably so, during this advance. The bet of investors, of course, is that global central banks can provide a panacea against the consequences of the rich valuations and excessive debt burdens that those same central banks are responsible for encouraging. Again, investors should ignore my concerns here if they believe that present market levels do not adequately reflect and discount those hopes, or are convinced that these hopes are sufficient to negate other historical evidence.
In saying that our prospective return/risk estimates are more negative than at any point in history, it is important to note what we are not saying. We are not saying that stocks are more overvalued than they have ever been. That distinction belongs to the 2000 market peak. While sensitive measures of new orders and economic activity are falling worldwide, and we believe that corporate profit margins have been held at unsustainable levels only as a result of unsustainable government deficits and low savings rates (which are all related through an accounting identity) this is still far from the worst economy in history. That distinction belongs to the Great Depression. We are also not saying that this is the most cyclically overbought market in history. Those distinctions belong to 1929 and the late-1990’s. Emphatically, we are not saying that investors can look at the worst intermediate-term losses in market history, and expect the next one to be worse – individual market fluctuations have a modest predictable component and a large random component, and can only hope to estimate the predictable component. Rather, what we observe here is a preponderance of negative indications that we’ve never observed in such uniform agreement.
Essentially, our return/risk projections are based on an ensemble of dozens of individual models, each capturing the factors that best distinguish favorable and unfavorable return/risk outcomes across widely different random samples of data. We’ve found that this approach performs well in generalizing to new, out-of-sample data, while more traditional stand-alone approaches are often less reliable in new or unseen data (which is why our “two-data sets problem” in 2009 was so challenging). No other point in history has generated such a preponderance of negative prospective returns from so many of these individual “learners” – which is an indication that present conditions have been uniformly hostile to market returns in random sample after random sample across a century of widely different market environments, regardless of how one divides up the record.
[Geek's Note: Ensemble methods are similar to other useful noise-reduction and signal-extraction methods that use the convergence of signals from multiple “sensors” to reduce the effect of random noise. In our economic analysis, the sensors are individual economic series having varying leading/coincident/lagging relationships; in our work in autism genomics, the sensors are independent samples of genomic data; in ensemble methods, the sensors are individually trained classifiers known as base learners, each which captures a different segment of evidence. A good ensemble is made up of base learners that are all generally good, but err in different parts of the data set, so that the collection of learners suppresses the individual errors, enriches the true unobserved signal, and generalizes well to new data.]
Despite the uniformity of negative signals we presently observe, I can’t say with certainty that this particular instance will produce negative market outcomes, or that we won’t find ourselves at odds with a speculative, richly valued, overbought, overbullish but still-advancing market. But even setting aside our particular methods, we have a very mature market advance, at a high Shiller P/E, atop nearly every upper Bollinger band (two standard deviations above the 20-period average at daily, weekly, and monthly resolutions), in an environment of lopsided bullishness. All of this should make bells go off for anyone familiar with market history. Of all the investment adages that are being embraced as reasons to accept market risk, somehow the phrase “buy low, sell high” is conspicuously absent. I expect that this will prove to be a crucial error for investors. In all of the present ebullience about quantitative easing with no ex-ante amount (which I’ll again point out is far different than “unlimited” QE), the market conditions we observe at present have been consistently associated with negative outcomes throughout history.
The chart below shows the S&P 500 since 1928, with blue bars identifying points where 1) the Shiller P/E exceeded 18; 2) the S&P 500 was above its upper Bollinger bands on daily, weekly and monthly resolutions; 3) the percentage of advisory bulls exceeded 45%, with bears less than 27% (sentiment data prior to 1960 is imputed based on the strong post-war relationship between sentiment and measures of price momentum), and; 4) the 10-year Treasury yield exceeded its average over the prior 6-month period. This set of criteria is one of many observationally equivalent ways to define an “overvalued, overbought, overbullish, rising-yields” environment.
As I have emphasized in numerous recent market comments, different definitions will capture slightly different instances, but with the notable exception of an instance in 1997 during the internet bubble (which was followed by further gains – though the S&P 500 was actually lower by 2009), those instances have invariably been biased toward awful subsequent market outcomes, with stocks usually substantially lower even years later. Note that the graph is on log-scale, so large percentage losses – such as the 1987 crash when the market lost a third of its value – may look deceptively small. That said, the market losses did not always begin immediately, which is important for investors to keep in mind. This is certainly not the only syndrome of evidence that concerns us, but it demonstrates why we are reluctant to accept market risk here.
Meanwhile, it is probably worth marking down September 13, 12:30 PM Eastern, S&P 500 1438 as the point when the Fed finally went all-in, much to our relief – allowing the market to presume unlimited QE, and removing the constant anticipation that the Fed would draw the last arrow from its quiver to kill off every prudent element of our economic system. As Bernanke noted at his press conference, the Fed has been down to two main tools given that interest rates are effectively zero: “balance sheet action, and of course, we can restructure those – change those in various ways. The other type of tool is communication tools. And we could – we continue to work on how to best communicate with the public.” So the Fed has now left itself with nothing but talk.
We continue to view QE as being of no real economic benefit, and though it has clearly affected financial markets, QE has typically boosted the stock market by little more than the amount it has lost over the prior 6 month period. That’s another way of saying that I doubt the Fed’s actions will be of much durable effect here at all. As I noted in July, the probable upside benefit to QE3 was likely to be limited to the upper Bollinger band of the S&P 500 on weekly and monthly resolutions. And here we are.
The S&P 500 now sits atop its upper Bollinger bands (two standard deviations above its 20-period moving average) at daily, weekly and monthly resolutions. Further progress requires the market to sustain these strenuously overbought conditions. Investment advisors are now bullish by a margin of greater than two-to-one, and the pace of selling by corporate insiders has tripled since July to a rate of six shares sold for every share purchased. We now estimate a prospective 10-year total return for the S&P 500 at less than 4% annually in nominal terms, while the Shiller P/E based on normalized earnings is in the richest 3% of historical readings prior to the late-1990’s market bubble (it is worth remembering that even with the recent advance, the S&P 500 has still achieved total returns less than Treasury bill yields for over 13 years because of that bubble).
Last week, we observed a syndrome of evidence that matches only a handful of market extremes in history, including August-December 1972, August 1987, April-July 1998, July 1999, and March 2000, and April-July 2007. Investors with a good sense of market history will recognize all of those instances as points from which subsequent outcomes were steeply negative, even if stocks held up or advanced moderately over the short-run. With regard to the potential for steeply negative outcomes, we find that when we look across history, conditions similar to the present have been “enriched” with steep declines – another way of saying that the negative tail of the distribution is very fat here.
For example, if we break our estimates of prospective market return/risk into five quintiles or “buckets”, present estimates are clearly in the most negative bucket. Historically, 31% of instances in that worst bucket have been followed by a market decline of at least 10% over the following 6 month period, while 41% of all 10% market declines (occurring within a 6-month period) have started from instances in that bucket. In other words, while the lowest quintile captures 20% of the historical data, that bucket captures 10% market corrections more than twice as often as one would expect if those 10% declines were randomly distributed across market conditions. Similarly, the periods in the lowest quintile of prospective return/risk capture 45% of all 15% market declines that have occurred within a 6-month window, 54% of all 20% market declines, 69% of all 30% declines, and 87% of all declines of 35% or more (what would commonly be considered “crashes”).
In short, saying that our estimates of prospective return/risk are negative does not indicate that the market will or must plunge. Rather, it says that the average outcome has been quite negative, and the likelihood of extreme “tail events” is vastly enriched compared with more typical conditions throughout history. In this environment, market exposure has typically been far more costly than it has been beneficial, and investment opportunities have generally emerged after a period of market losses. Despite the market’s recent derision for stable “core growth” stocks, in favor of materials, cyclicals, financials and speculative growth, I continue to expect a value-conscious stock-selection approach to outperform the major indices over time. That has certainly been our experience from the standpoint of individual stocks. Meanwhile, given an overbought S&P 500 that has breached nearly every short- and long-term upper Bollinger band, coupled with rich valuations on the basis of normalized fundamentals and an extremely negative market return/risk profile by our estimates, I see neither short-term speculative merit nor long-term investment merit in general market exposure here.
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 last week, or estimates of prospective return/risk have moved to the lowest level we have observed in nearly a century of market history. These estimates reflect a blended horizon from 2-weeks to about 18 months, and indicates that market conditions similar to the present have been associated with unfavorable market outcomes in dozens of subsets of historical data. Strategic Growth Fund remains fully hedged, with our put option strikes raised within about 5% of present market levels, at additional put option premium amounting to about 1% of assets looking out to year-end. Strategic International remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return continues to carry a duration of about 1.4 years, about 6% of assets in precious metals shares, and a few percent in utility shares and foreign currencies.
It has certainly been frustrating to remain defensive in a market that has scaled higher as our measures of market conditions have deteriorated from the most negative 2% of historical instances in early-March, to the most negative 0.5% of instances in recent weeks, to the most negative single instance we can identify. And while our stock selection approach has significantly outperformed the major indices since the inception of Strategic Growth Fund, the enthusiasm over the notion of “unlimited” quantitative easing has favored materials, cyclicals, resource stocks, and speculative growth, which we tend to avoid in large doses. Previous episodes favoring these “risk-on” sectors have been temporary, and I don’t expect that this will be an exception.
Last week, we received a very good question – “How much does the market have to decline before you become constructive?” The answer is that good investment opportunities following a period of rich valuations usually emerge in two steps. In the first step, prices decline enough for valuations to move out of an extreme range, and hostile indicator syndromes (e. g. “overvalued, overbought, overbullish”) dissipate. In the second step, our measures of market action improve – which is driven largely by uniformity of market internals (breadth, sector performance, etc.) and can occur very early in an advance, as we saw in 2003. Even in an overvalued market, the presence of favorable market internals and trend-following measures and the absence of hostile indicator syndromes is usually enough to produce a positive expected return/risk profile. The problem since April 2010 (the last time our present ensemble methods would have been materially constructive) is that we’ve seen a constant round of “hot potato” from overvalued, overbought, overbullish conditions to steep declines and unfavorable market action, and then an immediate resumption of overvalued, overbought, overbullish conditions the moment that trend-following measures have sufficiently improved. The declines have left no leeway for valuations to increase without also restoring historically dangerous conditions.
While the Shiller P/E is over 22.5 here and anything above about 18 is generally problematic from the standpoint of long-term returns, we can tolerate rich valuations provided that favorable market internals and trend-following measures are present, and hostile indicator syndromes are absent. The bulk of historical bull market advances have featured that combination.
At present, a market decline of about 20% would raise our estimate of 10-year prospective returns to somewhere around 6.5% annually, which is still below-average but not intolerable. Even a smaller decline would still allow a constructive investment stance. In both cases, we would require our measures of market action to be positive: favorable trend-following measures and market internals, without hostile indicator syndromes. The problem with a shallow decline is that a constructive position would probably not be sustained for long because overbought conditions or other negative factors could emerge fairly quickly – which is what we’ve repeatedly observed since 2010.
Undoubtedly, the most favorable outcome would entail a market loss deeply in excess of 20% followed by an improvement in market internals – which is the typical way that a market cycle is completed. That would allow a good deal of latitude for the market to advance without shifting back to an overvalued, overbought, overbullish condition or some other hostile syndrome. We certainly don’t need stocks to become undervalued in order to establish a constructive position, nor do we require valuations to normalize in one fell swoop. A large improvement in valuations would be desirable, but a smaller improvement would be adequate provided that we can clear the abysmal set of conditions that we presently observe.
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