Archive for September 24th, 2012
Monday, September 24th, 2012
Submitted by John Aziz of Azizonomics
The Next Industrial Revolution
Large, centrally-directed systems are inherently fragile. Think of the human body; a spontaneous, unexpected blow to the head can kill an otherwise healthy creature; all the healthy cells and tissue in the legs, arms, torso and so forth killed through dependency on the brain’s functionality. Interdependent systems are only ever as strong as their weakest critical link, and very often a critical link can fail through nothing more than bad luck.
Yet the human body does not exist in isolation. Humans as a species are a decentralised network. Each individual may be in himself or herself a fragile, interdependent system, but the wider network of humanity is a robust independent system. One group of humans may die in an avalanche or drown at sea, but their death does not affect the survival of the wider population. The human genome has survived plagues, volcanoes, hurricanes, asteroid impacts and so on through its decentralisation.
In economics, such principles are also applicable. Modern, high-technology civilisation is very centralised and homogenised. Prices and availability are affected by events half way around the world; a war in the middle east, the closure of the Suez Canal or Strait of Hormuz, an earthquake in China, flooding in Thailand, or a tidal wave in Indonesia all have ramifications to global markets, simply because of the interconnectedness of globalisation. The computer I am typing this into is a complex mixture — the cumulative culmination of millions of hours of work, as well as resources and manufacturing processes across the globe. It incorporates tellurium, indium, cobalt, gallium, and manganese mined in Africa. Neodymium mined in China. Plastics forged out of Saudi Crude. Bauxite mined in Brazil. Memory manufactured in Korea, semiconductors forged in Germany, glass made in the United States. And gallons and gallons of oil to ship all the resources and components around the world, ’til they are finally assembled in China, and shipped once again around the world to the consumer. And that manufacturing process stands upon the shoulders of centuries of scientific research, and years of product development, testing, and marketing. It is a huge mesh of interdependent processes. And the disruption of any one of these processes can mean disruption for the system as a whole. The fragility of interconnection is the great hidden danger underlying our modern economic and technological paradigms.
And even if the risks of global trade disruptions do not materialise in the near-term, as the finite supply of oil dwindles in coming years, the costs of constantly shipping so much around and around the world may prove unsustainable.
It is my view that the reality of costlier oil is set over the coming years to spur a new industrial revolution — a very welcome side-effect of which will be increased social and industrial decentralisation. Looming on the horizon are technologies which can decentralise the means of production and the means of energy generation.
3D printers — machines that can assemble molecules into larger pre-designed objects are pioneering a whole new way of making things. This could well rewrite the rules of manufacturing in much the same way as the rise of personal computing discombobulated the traditional world of computing.
3D printers have existed in large-scale industry for years. But at a cost of $100,000 to $1m, few individuals could ever afford one. Fortunately, improved technology and lowered costs are making such machines more viable for home use. Industrial 3D printers now cost from just $15,000, and home versions for little more than $1,000. Obviously, there are still significant hurdles. 3D printing is still a relatively crude technology, so far incapable of producing complex finished goods. And molecular assembly still requires resources to run on — at least until the technology of molecular disassembly becomes viable, allowing for 3D printers to run on, for example, waste. But the potential for more and more individuals to gain the capacity to manufacture at home — thereby reducing dependency on oil and the global trade grid — is a huge incentive to further development. The next Apple or Microsoft could well be the company that develops and brings home-based 3D printing to the wider marketplace by making it simple and accessible and cheap.
Decentralised manufacturing goes hand-in-hand with decentralised energy generation, because manufacturing requires energy input. Microgrids are localised groupings of energy generation that can vary from city-size to individual-size. The latter is gradually becoming more and more economically viable as the costs of solar panels, wind turbines (etc) for energy generation, and lithium and graphene batteries (etc) for home energy storage fall, and efficiencies rise. Although generally connected to a larger national electricity grid, the connection can be disconnected, and a microgrid can function autonomously if the national grid were to fail (for example) as a result of natural disaster or war.
Having access to a robust and independent energy supply and home-manufacturing facilities would be very empowering for individuals and local communities and allow a higher degree of independence from governments and corporations. Home-based microgrids can allow the autonomous and decentralised powering and recharging of not just home appliances like cooking equipment, computers, 3D printers, lights, and food growing equipment, but also electric vehicles and mobile communications equipment. Home-based 3D printing can allow for autonomous and decentralised design and manufacturing of useful tools and equipment.
The choice that we face as individuals and organisations is whether or not we choose to continue to live with the costs and risks of the modern globalised mode of production, or whether we decide to invest in insulating ourselves from some of the dangers. The more individuals and organisations that invest in these technologies that allow us to create robust decentralised energy generation and production systems, the more costs should fall.
Decentralisation has allowed our species to survive and flourish through millions of years of turbulent and unpredictable history. I believe that decentralisation can allow our young civilisation to survive and flourish in the same manner.
Monday, September 24th, 2012
The seemingly inexorable rise of corporate bond ETFs (most specifically HYG and JNK is the high-yield market, and LQD in investment grade) have been discussed at length here as both a ‘new’ factor in the underlying bond market’s technicals (flow) as well as their correlated impact on equity and volatility markets. Goldman Sachs’ credit team delve deep into the impact of these relatively new (and rapidly growing) structures with their greater transparency but considerably higher sensitivities and conclude that not only are they here to stay but the consequences of ETF-inclusion (dramatic outperformance bias relative to non-ETF bonds) are deepening the liquidity divide (and relative-value) of what is already a somewhat sparsely-traded market. Our concern is that, as the divide grows (and liquidity is concentrated in ETF bonds), given the crowding tendency we have witnessed, (even with call constraints at extremes thanks to low interest rates), this is yet another crowded ‘hot potato’ trade hanging like a sword of Damocles over our markets (courtesy of Bernanke’s repression).
Via Goldman Sachs: The “ETF Bid” – A Robust Driver of Bond Returns.
The dramatic growth of credit mutual funds over the past five years has been something of a paradigm shift for the US corporate bond market. According to data from Lipper, IG and HY mutual funds manage roughly $1.3tr and $279bn, respectively, up from $525bn and $126bn at the end of 2007. Even when scaled by the overall size of the US corporate bond market, these figures suggest a bigger ownership share of credit mutual funds. Perhaps more impressive is the growth of corporate bond ETFs, whose size for IG and HY has increased to $105bn and $31bn, respectively, from just $12bn and $288mn at the end 2007.
Despite all-time low yields, the appetite for corporate bonds remains firm, with net inflows to IG and HY mutual funds still running at a robust pace.
Inflows to the HY market have been steady all year with the exception of a brief episode of outflows from mid-May to mid-June, while IG inflows have remained firm, having been positive for all but two weeks this year.
As we often point out, the strength of the inflows is by and large a reflection of sluggish growth, which has maintained a friendly outlook for inflation as well as a challenging outlook for growth expectations, trends we expect to persist.
In the past we have extensively analyzed the price impact of mutual fund flows, showing that fund flows provided a significant boost to bond returns in the early months that followed the crisis and gradually normalized afterwards. In this Credit Line, we focus on the ETF market and use bond-level data to quantify the impact of ETFs on the cross-section of IG bonds returns.
Despite their recent growth, ETFs remain a relatively small subset of the mutual fund complex, but they are of particular interest to us, for two reasons. First, unlike mutual funds, ETFs generally try to track an existing bond index and are thus more transparent in terms of their composition. Second, unlike institutional investors, ETF managers need to be fully invested, and thus need to put money to work “urgently” when inflows increase. Intuitively this should make returns on ETF bond constituents more sensitive to flows.
The ETF factor: Is it really there?
Our primary goal is to determine whether, all else equal, the bid for ETFs has boosted the return on their bond constituents, both in absolute terms and relative to the broad market.
More specifically and using the bond constituents of the iBoxx USD domestic index and its sub-index the LQD IG index, which is tracked by one the largest IG ETFs, we investigate the following questions:
- Controlling for maturities, ratings, sectors and liquidity, how do the bond constituents of the LQD ETF perform relative to those bonds that are not part of the ETF? Put differently, how do two otherwise identical portfolios of bonds, one with ETF constituents and the other with non-ETF constituents, compare in terms of performance.
- To what extent is this relative performance related to ETF flows?
To address the above questions, we use a factor approach and construct hypothetical portfolios, one with only ETF bonds and the other with non-ETF bonds, that have otherwise identical compositions. These portfolios are constructed using the constituents of the iBoxx USD domestic index of which the LQD ETF is a sub-index.
One immediate challenge that such an exercise raises is that our ‘ETF’ factor might be hard to disentangle from a ‘liquidity’ factor. In the extreme case where the ETF only include on-the- run bonds, the ETF factor might just be an arte fact for the on-the-run/off-the-run premium. Partly to address this issue, we include an “on-the-run” dummy variable in our regressions.
Our definition of on-the-run bonds uses the following rule. We group our universe of bonds into three buckets in terms of their original maturity: 1- to 7-year, 7-to 15-year and 30-year and longer. Within each of these buckets and for each issuer, we rank the bonds according to their age. The most recently issued bonds are considered on-the-run while the remaining ones are treated as off-the-run.
Exhibits 5 and 6 plot the cumulative total return and spread change since January 2009 for these two otherwise identical portfolios of ETF and non-ETF bonds. The plot shows that after controlling for maturity, rating, sector and the on-the-run/off-the-run premium, ETF bonds outperformed their non-ETF counterparts from the second half of 2009 to the first quarter of 2011. They subsequently underperformed in the second half of 2011 as the European crisis intensified only to resume their outperformance during the LTRO rally and then more recently following Draghi’s speech in July.
Compared to January 2009 and as shown by Exhibit 6, a monthly rebalanced portfolio of ETF bonds trades 268 bps tighter while an identical portfolio of non-ETF bonds trades 200 bps tighter. This suggests that the bid for ETFs has acted as a tailwind for its bond constituents since the economy turned the corner in the second half of 2009.
Exhibit 7 addresses our second question—the relationship between the relative performance of ETF bonds to ETF flows—showing a simple scatter plot of the monthly return on a long ETF vs. non-ETF bonds against the flow 4-week moving average into IG ETFs.
Our estimates indicate that the correlation is decent with every additional $1 bn worth of weekly average inflows to IG ETFs translating into 60 bp of additional monthly return on a strategy that is long/short two otherwise identical portfolios of ETF and non-ETF bonds.
In sum, the above evidence suggests that fund flows to ETFs are likely to remain an important driver of credit spreads for the foreseeable future.
Monday, September 24th, 2012
A next generation Great Investor who is successfully filling the shoes of the legendary Jean Marie Eveillard at First Eagle Funds. Matthew McLennan, portfolio manager of First Eagle Global, will tell us where in the world he’s finding value now.
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Monday, September 24th, 2012
September 21, 2012
The Schwab Center for Financial Research presents Bond Insights, a bi-weekly analysis of the top stories in today’s bond markets. This issue includes our observations on the Federal Reserve’s announcement of its latest version of quantitative easing (QE3), we discuss bank bonds and if we believe they could present an opportunity for fixed income investors in the current environment, we take a look at the many differences and similarities in the way municipal governments are managing credit challenges and we discuss the impact of low interest rates on bond investments.
“To Infinity and Beyond”
The Federal Reserve’s announcement of its latest version of quantitative easing (QE3) managed to exceed the market’s expectations even though it was widely anticipated. The Fed announced an open-ended bond purchase program of $40 billion per month concentrated entirely in mortgage-backed securities and extended the time period it plans to keep interest rates on hold until mid-2015. Fed Chairman Bernanke made it clear that the committee’s goal is to reduce the unemployment rate, which he called, “a grave concern.” Long-term Treasury bond yields surged to a four-month high on the news. Is this the start of the long-awaited bear market in bonds?
- It is too soon to tell. Rising bond yields are consistent with the market’s response to previous rounds of QE. In the initial phases of QE1 and QE2, bond yields rose as well because investors shifted into riskier assets and out of Treasuries. As the Fed’s bond buying ended however, interest rates drifted lower again as the pace of economic growth and inflation ebbed. With QE3 the Fed is leaving the time frame for bond buying open ended.
- One view on the impact of a third round of asset purchases is… that the Fed’s actions will ignite inflation pressures through the weaker dollar and rising asset prices, sending bond yields higher. Another view is that the bond buying will prove ineffective because the economy’s problem is not a lack of liquidity but a lack of demand. Therefore, interest rates will decline again once it is clear that the economy is not responding to monetary policy.
Market Reaction to Fed Easing
Source: St. Louis Federal Reserve and Bloomberg, monthly data as of September 18, 2012.
- We believe both views have some validity. The previous rounds of quantitative easing were larger on a per-month basis at over $70 billion per month, but the commitment to an indefinite time period may signal that the Fed is willing to tolerate more inflation in exchange for stronger growth. If QE3 results in a weaker dollar, then rising import prices can put upward pressure on the consumer price index (CPI). But rising prices of imported goods, such as oil, may lead consumers to lower consumption in other areas. With weak income growth, demand could remain lackluster and inflation pressures contained.
- It may come down to a matter of timing. Inflation expectations are already rising, but higher inflation may not surface until later when the economy has less excess capacity. That means watching for improvement in labor markets and a pick up in demand while watching inflation expectations.
- In our view, the major risk in current monetary policy is… that the Fed overstays its welcome by pumping too much liquidity into the economy for too long, allowing inflation to become embedded. That is a risk they appear willing to take in exchange for the potential to prevent a renewed recession and/or deflation.
- Bottom line: Whichever view you adhere to, long-term Treasury bond yields at or below the rate of inflation offer very little value beyond diversification, in our view. There is clearly more room for rates to rise than to fall. However, we don’t advise trying to time the interest rate cycle. We continue to favor laddered portfolios where the average duration is in the short-to-intermediate term region. We also believe investors should consider holding high quality bonds for the bulk of their portfolios, limiting the higher-yielding, more aggressive sectors of the market to no more than 20% of the fixed income allocation.
Bank Bonds—Post Downgrades
It’s been almost three months since Moody’s downgraded fifteen global banks on June 21. Although the downgrades had been well-publicized in advance, the degree of downgrades was uncertain. As it turned out, the downgrades were not as severe as markets may have expected. Meanwhile, the stock market has risen, domestic bond yields are higher, and central banks across the globe have taken measures to boost their slowing economies. Given this, how has the financial sector of the bond market fared since the downgrade, and do financial bonds present an opportunity now for fixed income investors in the current environment?
- Financial institution bonds have outperformed other sectors of the bond market. From the date of the downgrades through September 18, the Barclays U.S. Corporate Bond—Financial Institutions Index generated a total return (price change plus interest income) of 4.33%. For the same time period, the industrial and utility sub-sectors of the Barclays U.S. Corporate Bond Index saw total returns of just 1.93% and 1.05%, respectively.
Barclays U.S. Corporate Bond Yields by Sector
Note: Option-adjusted spread (OAS) is the basis point spread relative to Treasuries, net of the cost of any embedded options
Source: Barclays, monthly data as of September 17, 2012.
- Tighter yield spreads are one of the main drivers behind the strong performance. When bonds are perceived to have greater risks they will trade at higher yields relative to bonds with lower credit risk, such as Treasuries, in order to compensate. Yield spreads on financial institution bonds have narrowed since the downgrades. This may seem counterintuitive, but the market may have been expecting deeper downgrades. Only one of the institutions was downgraded by three notches. The rest were smaller. The yield spread of the financial index above the Treasury index dropped from 2.6% the day before the downgrade to 1.8% on September 18. This is the lowest spread since July 2011.
- What has happened to banks since the downgrades? Not much, in our view. From a purely bank-specific point of view, it’s been quiet. Second quarter earnings appeared neither to excite nor disappoint the markets, and aside from the large trading loss at a major bank earlier in the year, domestic banks have done their best to stay out of the headlines. But many macro factors have supported the financial sector. The S&P 500® Index is up over 8% since the downgrades, the Federal Reserve announced another round of quantitative easing, U.S. government bond yields are higher, and the European Central Bank took steps to address its debt crisis. Banks are often considered leveraged plays on an economy and when the central banks provide more liquidity to the economy, riskier segments of the market generally tend to do well. When riskier segments of a market begin to perform well, financials often tend to follow suit.
- But there are still a few unknowns in the financial sector. Although risk premia may have fallen, financial companies still face a number of headwinds, in our view. Financial regulation has yet to be finalized. Without some rules set in stone, many firms will hold off making investment decisions. And the economy can still be described as “sluggish,” which may continue to weigh on corporate earnings. Many banks have been cautious lately about their future earnings, citing earnings growth as one of their main concerns. Although financial firms’ balance sheets may be strengthening, lower earnings growth may affect investor confidence, in our opinion.
- Bottom line: Financial bonds may make sense for investment grade corporate bond investors, but we would caution not to overweight the sector. This can be difficult, as financial institutions make up over 32% of the corporate bond index.
Although financials have generated a positive total return over the past few months, it may be difficult to continue the strong pace. Financial bonds currently offer a higher yield, on average, than their industrial and utility counterparts, but we believe investors should take a diversified approach when buying individual corporate bonds.
California, New York and Illinois Rating and Outlook Changes
We’ve seen several notable rating and outlook changes recently for a handful of large states, including California, New York and Illinois. These rating changes remind us that there are as many differences as similarities in the way municipal governments are managing credit challenges. Even at the state level, it’s not a homogenous market. A key factor to watch is “structural budgetary balance”—whether you’re looking at states or local municipalities. Structurally balanced means that the revenues and expenditures essentially match without the need for one-time cuts that go away later and don’t address long-term challenges.
- California’s A- rating outlook positive from Standard & Poor’s. California is S&P’s lowest-rated U.S. state, at A-. But the agency revised their outlook on the rating to positive from stable in February of this year and affirmed their rating and outlook on September 13. The state’s outlook was revised to positive in part because the legislature successfully passed a timely state budget in June 2012, according to S&P—a feat they’ve had trouble achieving recurrently in prior years. Credit quality also hinges on the sustainability of recent cuts, they say. Will those budget cuts carry over into future years to limit the need for additional cuts if revenues don’t rise? A tax-raising measure (Prop 30) on the fall ballot would also boost revenue and limit the need for $2.5 billion in education cuts. The state legislature also passed reforms in late August to reduce pension contributions for new employees, a factor cited as a positive factor by both S&P and Moody’s. The state plans to sell $1.6 billion in General Obligation (GO) bonds on September 25.
- New York’s AA outlook from S&P is also positive, revised from stable at the end of August. Like California, S&P based their change in outlook on “movement toward structurally balanced budgets in the past two years.” This “structural” alignment of revenues and expenditures is one of the key factors agencies look at when assessing credit quality. The size of the state’s budget deficits have also been shrinking with lower projected “out-year gaps”—a positive for any state, especially if state revenues continue to gradually improve, led (for most states) by income and sales tax.
- Illinois rating downgraded to A from A+ with negative outlook… also by S&P in August. Pension reform, and lack of any “meaningful action” on that front, was the primary reason for S&P’s rating downgrade in late August, according to the agency report. Analysts have often pointed to Illinois—along with California, one of the lowest rated by both S&P and Moody’s—for their relative lack of progress in addressing a sizable unfunded future pension liability (amounting to $82.9 billion at the end of fiscal 2011, with a 43.4% “funded ratio”—meaning the ratio of assets/investments set aside to match the total estimated future pension costs) and lack of progress in containing costs or raising revenues to improve “structural budget performance.” Moody’s affirmed their A2 rating with stable outlook in August, but also cited the failure to enact pension reform as a “credit negative.” We see the same theme: the need to balance revenues and expenditures on an ongoing basis, balancing funding for current and long-term obligations.
*No change in rating or outlook in 2012
**Source: Standard & Poor’s
***Source: Bond Buyer
- Do ratings matter? If you’re skeptical of bond ratings as an indication of credit quality, you’re not alone. Ratings are opinions, not a guarantee of credit quality. But we still see them as a useful tool in monitoring which issuers are making changes to manage long-term budgetary balance. Rating changes may not lead to an immediate change in performance. But right now, investors are already being compensated in the form of higher yields (as shown in the table above.) Over the long-term, however, investors focused on ability to pay—we believe—should focus on issuers with a pattern of managing credit quality. You can find rating reports when searching for individual bonds on schwab.com. Or speak with your Schwab Financial Consultant or a Schwab fixed income specialist.
- Bottom line: For U.S. states, we see ratings as a reminder of the differences in credit quality in the muni market. This includes U.S. states, where credit quality hinges on structural balance between revenues and service obligations.
Interest Rates Are Low—Should You Sell Your Bonds?
If you’ve been holding bonds and bond funds for more than a few years, it’s likely that you have gains in your portfolio. Just in the last two years, ten-year Treasury yields have fallen from nearly 4% in early 2010 to under 2%. And as yields fall, prices rise. With interest rates at low levels, we concede that there isn’t much room for rates to fall further. And if they start to rise, bond prices will fall, erasing paper gains from bonds with higher coupons pricing at premiums now. But selling bonds that have appreciated means losing the income that they generate and replacing that income will be difficult in most cases— without taking more risk. How do you know when its time to sell?
- What’s your goal? If you are looking for total return in your portfolio, then it might be time to take some profits in portions of the fixed income portfolio that appreciated most in price, since it doesn’t appear that bond prices have a lot of upside from here. Certain sectors, in particular long-term bonds, will also experience losses if rates rise. For investors in bond funds, the downside in price can be a particular concern since the net asset value (NAV) of the fund will decline if interest rates rise, all else being equal. Unlike individual bonds, you may not get back the full amount of the principal you’ve invested, depending on when you need the money or need to sell.
- If you sell bonds or bond funds that have appreciated in value, however, you will lose the income that they generate. And replacing that income may mean taking more risk. For income-oriented investors, this is a challenge. For example, if you purchased an investment grade corporate bond with a 5% coupon several years ago, it might be trading 10% or more above its par value. If you sell now and realize that 10% capital gain, then you’ve added to the cash balance in your portfolio. But you’ve taken away the regular 5% coupon as well. The average yield on investment grade bonds is now under 3%, as measured by the Barclays US Corporate Bond Index, so the additional principal you have available to invest may not make up for the reduced income you will receive.
- To get the equivalent yield, you would probably have to invest in lower quality bonds. This may include high yield bonds and other sectors that may not be appropriate for your risk profile. Extending maturities is another way to increase yield, but that adds risk. Long-term bonds with less credit risk, starting with Treasuries, are also the sectors that have appreciated in value the most. Moreover, you will have a capital gain from the sale of your bond, which is taxable. If you are an income-oriented investor, the trade off may not make sense.
- For total return investors, it’s always a good idea to revisit your asset allocation and determine if it’s in line with your long-term goals. If the fixed income portion of your portfolio has risen in value and out of balance with the targeted allocation, it may be a good time to re-balance by selling some bonds or bond funds and re-allocating to other sectors where you may be underinvested. But other investors may hold fixed income investments primarily for the income that they generate, or they are under-allocated to bonds based on their time horizon and tolerance for equity risk. In this case, selling bonds to realize gains will reduce income and may actually increase the risk in the portfolio by pushing into lower credit quality investments or investments with equity risk. When looking at the strategic asset allocation, buy-and-hold investors might also choose to measure the allocation to bonds in terms of the par value rather than the market value.
- Bottom line: If you buy and hold bonds, the gain on your bond portfolio is a temporary reflection of the shift in interest rates—the market’s reflection of the benefit in holding bonds with higher coupons than available at par in the market today. The gain on its own is not necessarily a reason to reallocate away from fixed income or sell individual bonds, in our view. Those gains will gradually decline as the bonds approach maturity. In the meantime, you would realize those gains over time in the form of a higher coupon. The choice to sell, or hold, should depend on your objective—do you prefer income that you might not be able to easily replace, or do you prefer to take gains and then reallocate to other investments that are more in line with a long-term strategic allocation? For help, talk with your Schwab Financial Consultant or a Schwab fixed income specialist.
For other articles, please visit schwab.com/onbonds.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.
Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.
Past performance is no guarantee of future results.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Examples provided are for illustrative purposes only and not intended to show actual investments or to be reflective of results you should expect to attain.
Barclays U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch. This index is part of the U.S. Aggregate.
S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.
Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Monday, September 24th, 2012
by Don Vialoux, Timingthemarket.ca
Economic News This Week
The July Case-Shiller 20 City Home Price Index to be released at 9:00 AM EDT on Tuesday is expected to show a year-over-year gain of 0.8% versus an increase of 0.5% in June.
Canada’s July Retail Sales to be released at 8:30 AM EDT on Tuesday is expected to increase 0.2% versus a 0.4% decline in June.
September Consumer Confidence Index to be released at 10:00 AM EDT on Tuesday is expected to increase to 63.0 from 60.6 in August.
August New Home Sales to be released at 10:00 AM EDT on Wednesday is expected to increase to 380,000 from 372,000 in July.
Weekly Initial Jobless Claims to be released at 8:30 AM EDT on Thursday is expected to ease to 380,000 from 382,000 last week.
August Durable Goods Orders to be released at 8:30 AM EDT on Thursday are expected to drop 5.1% versus a gain of 4.1% in July. Excluding Transportation, Durable Goods Orders are expected to decline 0.3% versus a decline of 0.6% in July.
The third report on real annualized second quarter GDP to be released at 8:30 AM EDT on Thursday is expected to remain unchanged at 1.7%.
August Personal Income to be released at 8:30 AM EDT on Friday is expected to increase 0.2% versus a gain of 0.3% in July. August Personal Spending is expected to increase 0.5% versus a gain of 0.4% in July.
Canada’s July GDP to be released at 8:30 AM EDT is expected to increase 0.1% versus a gain of 0.2% in June.
September Chicago PMI to be released at 9:45 AM EDT on Friday is expected to ease to 52.8 from 53.0.
The September Michigan Sentiment Index to be released at 9:55 AM EDT on Friday is expected to slip to 79.0 from 79.2 in August.
Earnings News This Week
The S&P 500 Index slipped 5.62 points (0.38%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and showing early signs of rolling over (e.g. a fall by RSI below its 70% level on Friday).
Percent of S&P 500 stocks trading above their 50 day moving average slipped last week to 82.00% from 86.20%. Percent is intermediate overbought and rolling over.
Percent of S&P 500 stocks trading above their 200 day moving average fell last week to 77.00% from 81.80%. Percent is intermediate overbought and rolling over.
The ratio of S&P 500 stocks in an uptrend to a downtrend (i.e. the Up/Down ratio) fell last week to (380/78=) 4.87 from 5.22. Twenty six S&P 500 stocks broke resistance and 21 broke support.
Bullish Percent Index for S&P 500 stocks increased last week to 79.40% from 79.00% and remained above its 15 day moving average. The Index remains intermediate overbought.
The Up/Down ratio for TSX Composite stocks slipped last week to (163/52=) 3.13. Twelve stocks broke resistance and thirteen stocks broke support.
Bullish Percent Index for TSX Composite stocks increased last week to 68.70% from 67.89% and remained above its 15 day moving average. The Index remains intermediate overbought.
The TSX Composite Index fell 115.87 points (0.93%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and showing early signs of rolling over (e.g. RSI falling below the 70% level). Strength relative to the S&P 500 Index remains neutral.
Percent of TSX stocks trading above their 50 day moving average fell last week to 67.07% from 71.95%. Percent is intermediate overbought and rolling over.
Percent of TSX stocks trading above their 200 day moving average fell last week to 63.01% from 67.48%. Percent is intermediate overbought and rolling over.
The Dow Jones Industrial Average eased 13.90 points (0.11%) last week. Intermediate trend is up. The Average remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and showing early signs of rolling over (e.g. RSI falling below 70%). Strength relative to the S&P 500 Index remains negative but is showing early signs of change.
Bullish Percent Index for Dow Jones Industrial Average stocks was unchanged last week at 86.67% and remained above its 15 day moving average. The Index remains intermediate overbought.
Bullish Percent Index for NASDAQ Composite Index increased last week to 59.38% to 58.56% and remained above its 15 day moving average. The Index remains intermediate overbought.
The NASDAQ Composite Index slipped 3.99 points (0.13%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and showing signs of rolling over (e.g. RSI falling below 70%). Strength relative to the S&P 500 Index remains positive.
The Russell 2000 Index eased 9.19 points (1.06%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and showing signs of rolling over (e.g. RSI moving below its 70% level and Stochastics moving below its 80% level). Strength relative to the S&P 500 Index remains positive.
The Dow Jones Transportation Average plunged 305.18 points (5.85%) last week. ‘Tis the season! An intermediate downtrend was confirmed on a break below 4,911.83 on Friday. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index remains negative.
The Australia All Ordinaries Composite Index added 20.55 points (0.47%) last week. Intermediate trend changed from down to up on a break above resistance at 4,430.30. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are trending higher. Strength relative to the S&P 500 Index remains negative.
The Nikkei Average fell 49.39 points (0.54%) last week. An intermediate uptrend was confirmed when the Average broke above resistance at 9,222.87. The Average remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are trending higher. Strength relative to the S&P 500 Index remains negative.
The Shanghai Composite Index lost another 97.16 points (5.12%) last week. Intermediate downtrend was confirmed when the Index fell below support at 2,029.05 to reach a three year low. The Index remains below its 20, 50 and 200 day moving averages. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index remains negative.
The London FT Index fell 136.47 points (3.28%), the Frankfurt DAX Index added 39.49 points (0.53%) and the Paris CAC Index dropped 50.86 points (1.42%) last week.
The Athens Index gained 32.77 points (4.41%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought. Strength relative to the S&P 500 Index remains positive.
The U.S. Dollar Index added 0.48 (0.61%) last week. The Index bounced from support at 78.40. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are oversold and showing early signs of bottoming (e.g. Stochastics moving above 20% and RSI moving above 30% on Friday).
The Euro fell 1.51 (1.15%) last week. Intermediate trend is neutral. The Euro remains above its 20 and 50 day moving averages and below its 200 day moving averages. Short term momentum indicators are overbought and showing signs of rolling over (e.g. Stochastics moving below the 80% level and RSI moving below its 70% level on Friday).
The Canadian Dollar eased 0.48 cents U.S. (0.47%) last week. Intermediate trend is up. The Canuck Buck remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and have rolled over (e.g. Stochastics falling below 80%, RSI dropping below 70% and MACD recording a negative cross over.
The Japanese Yen added 0.36 (0.28%) last week. Intermediate trend is up. The Yen remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are neutral after trending lower from an overbought level.
The CRB Index fell 11.94 points (3.72%) last week. Intermediate trend is up. The Index remains above its 50 and 200 day moving averages, but fell below its 20 day moving average. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index has changed from neutral to negative.
Gasoline fell $0.19 per gallon (6.31%) last week. Gasoline fell below support at $2.84 as well as its 20, 50 and 200 day moving averages. Strength relative to the S&P 500 Index has turned from neutral to negative.
Crude Oil fell $5.93 per barrel (5.99%) last week. Intermediate trend changed from up to neutral on a break below support at $93.95. Crude fell below its 20, 50 and 200 day moving averages. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index changed from positive to negative.
Natural Gas fell $0.07 per MBtu (2.36%) last week. Intermediate trend is up. Resistance is at $3.28 and support is at $2.61. Gas remained above its 20, 50 and 200 day moving averages. Short term momentum indicators are neutral. Strength relative to the S&P 500 Index remains neutral/negative.
The S&P Energy Index slipped 10.33 points (1.81%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and have rolled over. Strength relative to the S&P500 Index remains positive. Favourable seasonal influences tend to peak at the end of September.
The Philadelphia Oil Services Index fell 6.78 points (2.81%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators have rolled over from an overbought level. Strength relative to the S&P 500 Index is positive, but showing signs of change.
Gold gained $1.90 per ounce (0.11%) last week. Intermediate trend is up. Gold remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains positive.
The AMEX Gold Bug Index gained another 8.01 points (1.55%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking Strength relative to gold remains positive.
Silver slipped $0.16 per ounce (0.46%) last week. Intermediate trend is up. The stock trades above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to gold remains positive.
Platinum fell $67.40 per ounce (3.96%) last week. Momentum indicators have rolled over from overbought levels. Strength relative to the S&P 500 Index is positive, but changing.
Palladium dropped $21.85 per ounce (3.15%) last week. Short term momentum indicators have rolled over from overbought levels. Strength relative to the S&P 500 changed from positive to neutral.
Copper slipped $0.04 per lb. (1.05%) last week. Intermediate trend is up. Copper remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought. Strength relative to the S&P 500 Index remains positive.
The TSX Global Metals and Mining Index fell 81.29 points (8.15%) last week. Intermediate trend is up. The Index remains above its 20 and 50 day moving averages and below its 200 day moving averages. Short term momentum indicators have rolled over from overbought levels. Strength relative to the S&P 500 Index has returned to a neutral level.
Lumber added $0.41 (0.14%) last week. Intermediate trend is up. Strength relative to the S&P 500 Index remains negative.
The Grain ETN fell $3.20 (5.04%) last week. Units fell below their 20 and 50 day moving averages. Strength relative to the S&P 500 Index changed from neutral to negative.
The Agriculture ETF slipped $0.63 (1.19%) last week. Intermediate trend is up. Units remain above their 20, 50 and 200 day moving averages. Short term momentum indicators are rolling over from overbought levels. Strength relative to the S&P 500 Index remains neutral, but is close to turning positive.
The yield on 10 year Treasuries fell 11 basis points (5.88%) last week. Short term momentum indicators are trending lower from overbought levels.
Conversely, price of the long term Treasury ETF gained $3.25 (2.75%) last week. Price recovered above its 200 day moving average.
The VIX Index fell another 0.53 (3.65%) last week and is testing support at 13.30%.
The weakest period in the year for North American equity markets from September 16th to October 9th is happening again this year. This is the time of year when companies most frequently lower guidance prior to release of third quarter results (i.e. earnings confession season). Lots of examples last week including FedEx, Norfolk Southern and Bed Bath & Beyond! Possibilities of more frequent guidance declines this year are higher than usual. Third quarter year-over-year consensus for Dow Jones Industrial Average companies already calls for a 1.6% decline. Consensus for S&P 500 companies is a decline of 2.7% (down from 2.1% a week ago) despite a 20.2% gain by Apple Computer. Since release of second quarter reports, 80% of S&P 500 companies that changed guidance lowered their guidance. Consensus for TSX 60 companies is an average decline of 7.8%. Despite consensus estimates calling for lower earnings on a year-over-year basis, consensus estimates appear too high and likely will continue to fall prior to release of third quarter results.
Macro events outside of North America also will influence equity markets. A decision by Spain to ask the European Central Bank to purchase Spanish sovereign debt is scheduled on Thursday. The Eurozone consumer confidence index is released on Thursday.
U.S. economic news this week is expected to be mixed. Case-Shiller and Consumer Confidence on Tuesday are potential positive events. Weekly initial jobless claimes, Durable Goods Orders on Thursday and Chicago PMI and Michigan Sentiment on Friday are potential negative events.
Earnings reports this week are not expected to be significant. Focus is on Nike on Thursday.
Historically, North American equity markets have moved lower from mid- September to mid-October during a U.S. Presidential election year (particularly when the polls show a close election as is indicated this year. Thereafter, equity markets have moved higher until at least the beginning of January (The exception was the year 2000 when confirmation of President Bush as President was delayed until January 2001).
Cash on the sidelines is substantial and growing. However, political uncertainties (including the fiscal cliff) preclude major commitments by investors and corporations before the Presidential election.
The Bottom Line
Downside risk in North American equity markets exceeds upside potential in equity markets during the next 2-3 weeks prior to start of the third quarter earnings report season. Thereafter, prospects turn positive. Selected positive seasonal trades such as gold and energy have performed well, but are approaching their end of their period of seasonal strength. Similarly, selected negative seasonal trades such as Transportation and Semiconductors are approaching the end of their seasonal weakness. The time to take profits in these seasonal trades is rapidly approaching. Short term technical indicators will be useful for determining exit points. A new series of seasonal trades will appear as the end of October approaches.
Mark Leibovit on Bloomberg Radio
Following is a link to the interview:
Links to recent volume reversal charts:
Negative Leibovit signal on QCOM
Positive Leibovit signal on CAG
Special Free Services available through www.equityclock.com
Equityclock.com is offering free access to a data base showing seasonal studies on individual stocks and sectors. The data base holds seasonality studies on over 1000 big and moderate cap securities and indices.
To login, simply go to http://www.equityclock.com/charts/
Following is an example:
Energy Sector Seasonal Chart
The latest weekly update on ETFs in Canada to September 21st is available at
Tom Rogers’ Weekly Elliott Wave Blog
Following is a link:
Disclaimer: Comments and opinions offered in this report at www.timingthemarket.ca are for information only. They should not be considered as advice to purchase or to sell mentioned securities. Data offered in this report is believed to be accurate, but is not guaranteed.
Don and Jon Vialoux are research analysts for Horizons Investment Management Inc. All of the views expressed herein are the personal views of the authors and are not necessarily the views of Horizons Investment Management Inc., although any of the recommendations found herein may be reflected in positions or transactions in the various client portfolios managed by Horizons Investment Management Inc
Horizons Seasonal Rotation ETF HAC September 21st 2012
Copyright © Timingthemarket.ca
Monday, September 24th, 2012
by John Hussman, Hussman Funds
Imagine there’s a $100 bill taped to the far corner of the room, near the ceiling and way above your head. You will receive that $100 bill ten years from today. Suppose that you reach your hand out directly in front of you and pay $46.31 today for that future $100. Assuming no credit risk, you have now bargained for an 8% annual return.
Now reach higher, about eye-level, and offer $67.56 for that future $100. You have now bargained for a 4% annual return.
Now reach far above your head, jump as high as you can, and offer $84.49 today for $100 ten years from today. You are now an investor in 10-year Treasury securities, which presently yield 1.7% annually.
Every security on Earth works like this. The higher the price you pay for a given set of expected future cash flows, the lower your prospective future rate of return. Higher prices essentially take from future prospective returns and add to past returns. Conversely, lower prices take from past returns and add to future prospective returns.
At the top of your jump, as you hover like Michael Jordan in mid-air, let’s ask all of the other investors who already hold Treasury securities whether they are “wealthier” because of the elevated price you are paying. At first glance, the obvious answer seems to be yes: each of those investors, individually, could sell their Treasury bond at a price that would enable them to command a greater amount of current output than they could before.
But if you think carefully, you’ll realize that regardless of today’s price, someone will have to hold that security until it delivers $100 a decade from now – no more, no less. So the price change itself does not create aggregate wealth. Unless something happens to materially change that future cash flow, it is not at all clear that elevating current prices makes investors – in aggregate – any wealthier in terms of consumption. While any individual investor could sell the bond in order to consume today (abandoning the reason they had saved in the first place, which was to provide for their future consumption a decade from now), some other investor now has to defer consumption to purchase the bond and hold it to maturity.
An increase in price alters the profile of investment returns by turning prospective future returns into past returns (and vice versa when prices fall), but economic wealth is only created by the generation of additional goods and services (and cash flows from an investment standpoint) that actually emerge in the future. Security prices are a place-holder until the expected future goods, services and cash flows actually arrive. Raising the price that investors pay today for in return for some fixed payment in the future does not create wealth in aggregate.
Any one investor can realize what they count as “wealth” by selling, but only if someone else buys that claim on future goods, services and cash flows. If those things ultimately never arrive, the perceived wealth simply vanishes. In that case, the people who cash out at rich prices certainly get a transfer of wealth from the people who buy at those same rich prices and see their investments vanish, but that does not mean that new wealth was created. Despite the transfer of wealth between sellers who cash out and buyers who hold the bag, security price changes don’t create new aggregate wealth in and of themselves – only increases in goods and services do.
That’s why, when security prices plunge, the lost money doesn’t “go” anywhere or to anyone. It’s air until the goods show up. If a dentist in Poughkeepsie buys a single share of Apple a dime higher than the last guy did, nearly $100 million of market capitalization is suddenly created. Nobody suddenly pumped $100 million into the stock market. One person just paid up a little. All of that is the reason we insist on valuing securities based on the long-term stream of cash flows that we actually expect to be delivered into the hands of investors over time, not based on ephemeral measures like Wall Street’s estimates of next year’s earnings.
Now consider the effect of monetary policy. Suppose that every central bank on Earth is printing money. This may seem like a fine thing when there is so much economic difficulty and credit risk that zero-interest money is willingly absorbed in whatever quantity is produced, but is likely to be inflationary in the back-half of this decade when those cash-seeking motives ease. Alternatively, it will likely lead to significant upward pressure on long-term rates later, as central banks are forced to slash their balance sheets by selling long-term Treasury debt and other assets in order to mop up the liquidity.
Now ask again, if the future cash flows are still the same in nominal terms, and the prospective future price level of goods and services is higher, and the point of saving is to provide for future consumption, are bond market investors actually “wealthier” as a result of all of the manipulation of asset prices? No. To the contrary, they are poorer. In aggregate, the real wealth of fixed-income investors has been assaulted.
One would like to believe that stock market investors will at least be no worse off if inflation eventually emerges in the back half of this decade. After all, inflation would have a tendency to raise future revenues. This is generally true, but historically, inflation has been very hostile to stock prices – particularly during the transition from lower to higher inflation rates – because inflation also raises wages and interest costs, and produces significantly more conservative valuations. Moreover, assuming that government deficits and private savings do not remain in their dismal state indefinitely, we are likely to observe significantly narrower profit margins in the future, compared with present margins, which are about 70% above historical norms (see Too Little to Lock In for the accounting relationships here).
The upshot is simple. The elevated prices of financial assets have already eaten the future. At present, a 10-year investment in U.S. Treasury debt is associated with a prospective total return of just 1.7% annually over the whole of that investment horizon. A 30-year investment will achieve a 2.9% annual total return over three decades. An investment in bonds comprising the Dow Jones Corporate Bond Index will achieve an annual total return of 2.8% annually. We estimate that the S&P 500 is likely to achieve a 10-year average annual total (nominal) return of about 4.1% annually. What has happened here is that the prospect for meaningful future returns has been removed, in order to elevate prices in the present.
Unfortunately, this does not mean that real output will be more plentiful in the future, or that savers who are hoping to provide for the future will be prompted into consuming much more today. Historically, a 1% increase in the value of the stock market is associated with a transitory increase of just 0.03-0.05% in GDP over the following year, quite to the contrary of what Mr. Bernanke wishes the public to believe. As former Fed Chairman Paul Volcker said last week “Another round of QE is understandable, but it will fail to fix the problem. There is so much liquidity in the market that adding more is not going to change the economy.”
That’s particularly important given that we continue to infer that the economy has already entered a recession – something that will probably take several more months to be broadly recognized. We’re seeing fresh lows on the most leading economic component that we infer using unobserved components methods (see the note on extracting economic signals in Do I Feel Lucky?), matching weakness that emerged in late 2000 and late 2007. On a slightly positive note, we don’t yet see the near free-fall in these measures that occurred later in 2001 and 2008 as economic weakness rapidly gained momentum.
As for the financial markets, any single investor interested in present consumption can reasonably count himself or herself as wealthier at this moment, in that higher-risk securities can be sold at elevated prices to others reaching their hands far above their heads, in the belief that they will later find someone who is willing and able to jump higher still. Unfortunately, the tragedy of the commons is that behavior that can be followed by a single individual is not always behavior that can be followed by all individuals taken together.
My impression is that we may not be far off from finding out (once again) what happens when they try.
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.
Our estimates of prospective stock market return/risk were unchanged last week, after reaching the single lowest estimate we’ve observed in a century of market data. As I noted last week, this is not because any single data point is beyond its own historical extremes – valuations were far richer in 2000; overbought conditions were more extensive in 1929 and the late-1990’s; the most extreme bullish sentiment was in January 1977 (immediately rolling into a bear market). The problem is that the combinations of indicators – the syndromes – that we presently identify have repeatedly appeared in subset after subset of historical data, and are uniformly associated with negative market outcomes. Think of it this way – if you throw together a pile of saltpeter, a pile of sulfur, and a pile of charcoal, neither item by itself may be of particular concern, but what you may not realize is that you’re sitting on dynamite.
So we have a strongly negative average outcome on the basis of dozens of individual models or “learners” that comprise our ensemble methods, and at the same time, the disagreement or dispersion between those learners is unusually small. The result is a steeply negative return/risk estimate. As always, this particular instance might turn out differently than the average. Presently, though, we have little basis for that expectation.
Strategic Growth Fund remains fully hedged, and while we continue to carry a staggered-strike put position (which raises the strike price of the put side of our hedges closer to the prevailing level of the market), we have not aggressively raised strikes, and with option volatility (VIX) at just under 14%, the cost and time-decay of that position is just over 1% of assets looking out to next year. Given that we expect an unusually high risk of “tail events” given the extreme negative return/risk estimates we observe, put option premium at a 14% VIX seems strikingly inexpensive. Strategic International remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return carries a duration of about 1.4 years (meaning that a 100 basis point move in Treasury yields would be expected to impact the Fund by about 1.4% on the basis of bond price fluctuations), and on the recent surge in precious metals shares, we have cut our exposure to less than 4% of assets – inflation is likely to be a significant problem in the back-half of this decade, but not without a significant recession, weakness in key commodity consumers like China, credit strains, and other challenges to the “money printing = buy gold” hypothesis first. The Fund also holds a few percent of assets in utility shares, and we closed our foreign currency holdings on the recent surge in the FX markets.
Copyright © Hussman Funds
Monday, September 24th, 2012
The Ramifications of a Robin Hood Tax
September 21, 2012
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
Chief Justice John Marshall, in 1819, once described policymakers’ great influence, remarking, “The power to tax involves the power to destroy.” With rising fiscal deficits and a desperate need to raise revenue, many nations have come up with various tax solutions to raise billions of dollars.
One hotly contested idea in the U.S. and Europe lately, and once advocated by John Maynard Keynes during the Great Depression, is a financial transactions tax imposing a cost on buys and sells of stocks or bonds.
The latest proposal in the U.S. was introduced by Congressman Keith Ellison. His bill would add a tax of 0.5 percent onto the sale of stocks, 0.1 percent on bonds and 0.005 percent on derivatives or other investments. To put this in a buyer’s frame of mind, when an investor purchased $10,000 in stock shares, the financial transactions tax would tack on an additional $50.
Last year Congressman Peter DeFazio proposed a similar act, suggesting a tax imposition of 0.03 percent on financial transactions. The new tax was touted in its ability to raise $350 billion in new revenue over the next nine years, without acknowledgement of the drawbacks it might place on the economic system.
Proponents say a transaction tax would discourage short-term trading, with little effect on long-term investors. Keynes once argued that it would improve market quality by curtailing short-term speculation, according to Daniel Weaver, a professor of finance at Rutgers Business School.
Opposition to a financial transaction tax says the extra cost would undermine liquidity, adversely affect market quality and distort the value of a security. Whereas incentives act as a dose of Lipitor to today’s weak monetary system, unnecessary taxes add cholesterol, delaying a smooth economic recovery, or worse, causing the economic equivalent of a heart attack. In some cases, the Robin Hood deed of “stealing from the rich to help the poor” backfires and ends up negatively affecting all investors.
In his paper analyzing tax law reforms that affect the financial industry, Tulane Law Review Professor Richard T. Page comments on four proposals in the works throughout Europe and the U.S., evaluating them under the guidelines of what makes a “good tax.”
Page writes good taxes should be effective in raising revenues and addressing the U.S. budgetary imbalance. They should reduce undesirable behavior, similar to sin taxes on cigarettes. They should be fair, and finally, they should minimize reductions in desirable behavior. This means a tax should not discourage a desired behavior “to the point that the activity does not take place” because individuals change their behavior or the cost of compliance is expensive or time-consuming.
Page concludes that under these standards, “taxing financial transactions would just be foolish revenge, generating regrettable outcomes.”
For the Center for the Study of Financial Regulation, Rutgers’ Daniel Weaver analyzed the historical precedence of financial transaction taxes by reviewing the results of 11 research papers that looked at the relationship between a security transaction tax and market quality in terms of volatility or volume.
Weaver’s study looks at market quality to answer the following questions: Is a Robin Hood tax effective at reducing volatility and speculative trading? Does it affect volume across equity markets? How are stock prices affected?
Across 28 various security transaction tax (STT) changes in 11 countries, Weaver saw no significant relationship between the tax and volatility. In other words, short-term speculation was not diminished. Weaver’s team also found “an increase in the STT is accompanied by an increase in spreads” and that “volume moves in the opposite direction of the tax change.” He also found that there was a direct relationship between the tax and price impact.
Weaver says, “Taken together, our results suggest that the imposition of an STT will harm market quality.”
Eastern European Fund Portfolio Manager Tim Steinle has been following the correlation between Hungary’s banking system and its financial transaction taxes enacted in 2010. Intended to be a temporary measure for two years to help the country repair its finances, one of the levies included a 0.5 percent tax on banks’ assets.
By March 2011, OTP bank, Hungary’s largest lender, reported that it had a fourth-quarter profit decline of 15 percent. Trouble for the bank continued in the first quarter, with its net profit falling 12 percent year-over-year due to the impact of a special banking tax. Excluding the tax, the profit of OTP would have risen by 4 percent.
It wasn’t only one Hungarian bank that was negatively impacted. Bank credit growth rates across Hungary also plummeted due to the hefty bank levies imposed. In an earlier Investor Alert, we highlighted the chart below in May 2011, which shows a year-over-year credit growth rates across Eastern Europe in May 2011. Hungary’s household and corporate sector credit growth rates were anemic compared to other Eastern European countries.
Could a transaction tax have a similar unintended consequence for American banks? While the jury is still out on that answer, Hungary’s example is a reminder to policymakers to comprehensively consider the rewards of collecting a Robin Hood tax along with the risks.
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Monday, September 24th, 2012
U.S. Equity Market Radar (September 24, 2012)
The S&P 500 Index declined 0.38 percent this week, consolidating in the wake of the Federal Reserve’s decision to conduct open-ended quantitative easing via purchases of mortgage-backed securities and to keep interest rates exceptionally low through mid-2015 to boost employment. This week Japan followed bold policy actions of the European Central Bank and the Fed by expanding its own asset purchase programs to weaken the yen. So far we have observed concerted efforts by G3 countries to further expand the central bank balance sheet in a bid to stimulate economic growth.
- The telecom sector rose 2.4 percent, the best performer, led by prepaid and postpaid wireless operators one week after Apple’s iPhone 5 release. MetroPCS and Sprint Nextel rose 9.4 percent and 7.4 percent, respectively, this week. Sprint’s CEO also predicted wireless industry consolidation in an investment conference.
- The healthcare sector was the second strongest performer this week, advancing 1.83 percent. Gilead Sciences was up 9.31 percent on positive survey reviews of its HIV single-tablet regimen. Tenet Healthcare climbed 7.29 percent on the prospect of improving hospital reimbursement rates from Medicaid.
- MetroPCS was the best performing stock for the week. The company, adding 300,000 LTE subscribers in the last two months, is launching voice over LTE service in all of its 14 markets in 4 to 6 months.
- Cyclical sectors took a breather this week after surging last week in response to the open- ended quantitative easing announcement by the Fed. The financials, energy and materials sectors, the top three performers last week, ended up in the bottom three this week.
- The energy sector declined together with a more than 6 percent retreat in crude oil prices on comments that Saudi Arabia had raised production and speculation of a release in the U.S. strategic petroleum reserve ahead of the presidential election.
- Alpha Natural was the worst performer this week in the S&P 500, falling by more than 15 percent on concerns that the company’s credit ratings may be lowered by Standard & Poor’s due to closure of eight mines and production cuts.
- While debasing the value of their paper currency in the long term, renewed money printing in the developed world may have the ability to send asset prices higher in the near term.
- The market will now shift to earnings preannouncements and the upcoming elections, which could cause some volatility.
Monday, September 24th, 2012
The Economy and Bond Market (September 24, 2012)
Treasury yields rose for a fourth week in a row. Additionally, the benchmark 10-year yield is on the verge of breaking above the technically significant 200-day moving average.
- Existing home sales advanced to their highest level since 2010, according to new data from the National Association of Realtors. The pace of sales jumped 7.8 percent in August to an annual pace of 4.82 million units, eclipsing expectations for a more modest 2.0 percent gain.
- The current account deficit in the U.S. narrowed more than forecast in the second quarter, helped by a pickup in exports and a bigger income surplus. The gap, the broadest measure of international trade because it includes income payments and government transfers, shrank 12 percent to $117.4 billion from $133.6 billion in the prior quarter, a Commerce Department report showed today in Washington.
- The Empire Fed Manufacturing Index came in at its lowest level since April 2009, and was well below expectations. The report confirms the biggest 6 month drop since records began. Manufacturing in the Philadelphia region contracted in August for a fourth consecutive month as orders and employment declined.
- The index of U.S. leading economic indicators fell in August, led by a decline in new orders for manufacturing. The Conference Board’s gauge of the outlook for the next three to six months decreased 0.1 percent after a revised 0.5 percent increase in July, the New York-based group reported today.
- The European Central Bank (ECB) appears ready to implement further QE in the near future to improve financial stability in the region.
- With further weak economic data out of China, odds of additional easing measures continue to move higher.
- Interest rates are likely to remain very low for the foreseeable future.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
- China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.
Monday, September 24th, 2012
Gold Market Radar (September 24, 2012)
For the week, spot gold closed at $1,773.10 up $2.70 per ounce, or 0.15 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 1.75 percent. The U.S. Trade-Weighted Dollar Index gained 0.61 percent for the week.
- Gold prices remained firm, despite several bouts of inter-week profit taking that pushed gold lower at the market open. Sellers only found there were willing buyers to take the price higher upon their exit.
- Gold stocks also put in positive gains for the week with smaller miners and explorers outpacing their senior peers. Junior silver miners also outperformed their senior peers.
- Sales of the U.S. Mint’s American eagle gold coins climbed to 45,000 ounces according to their website. This exceeds the 39,000 ounces sold in August, so there is some pickup in momentum.
- Platinum and palladium prices pulled back this week with the settlement of the Lonmin strike in South Africa.
- Lonmin agreed to as much as a 22 percent hike in wages, marking the single biggest wage spike by a mining company in South Africa.
- Credit default swaps for South African debt surged on the news. The platinum mines were making just enough money to cover maintenance at their operations with nothing left to invest in further mine development.
- Gold Standard Ventures reported another set of exceptional drill results at their Railroad Project’s Bullion Fault Zone. Results included 124 meters of 4.05 grams per tonne, including 16.5 meters of 15.1 grams per tonne. This step-out hole confirms the emergence of a growing high-grade core zone that is still open in all directions according to the company.
- Both Jim Rickards and John Mauldin were recently interviewed on Capital Account by Lauren Lyster. When talking about the U.S. debt problem, Jim Rickards outlined his view on what type of solution the Fed is crafting to solve this problem. He suggested a plan of targeting inflation at 5 percent for 14 years to cut the value of the dollar in half in real terms. China owns $3 trillion of our debt and this would effectively be a $1.5 trillion real wealth transfer from China to the United States. This is the easiest solution to our debt problem and is the most likely choice policy makers will take.
- Ray Dalio, who runs the world’s biggest hedge fund, told CNBC today that Warren Buffett is making a “big mistake” in not holding gold. He stressed that every investor should hold “some degree” of gold in their portfolio.
- Strikes at gold mining operations in South Africa are a concern. Gold Fields has already seen work stoppages at the KDC West operations. In response, the Chamber of Mines which negotiates on behalf of the gold miners is examining the option of bringing the upcoming wage talks forward to address the problem.
- According to analysts we spoke with this week, the fact that Gold Fields is already having problems is reflective of which company may have the least attractive labor relations going into the negotiations.
- As far as AngloGold’s and Harmony’s labor relations stand, Harmony has worked the hardest over the past four years with their employees to understand the economics of mining, and their workforce gets it.