Archive for October 17th, 2012
Canada’s Household Debt Approaches US Bubble Levels plus Inane Housing Comments From Canadian Economist
Wednesday, October 17th, 2012
by Michael Shedlock, Global Economic Trends Analysis
Shortly after the peak in the US housing bubble, Americans’ household debt-to-income ratio reached 170 per cent.
For comparison purposes, Canadian household debt-to-income is now at 163 per cent, according to Statistics Canada.
Canadians’ debt-to-income ratio has soared to 163 per cent, much higher than previously believed, according to revised Statistics Canada figures.
The household debt level has increased 1.8 per cent in the second quarter, bringing it to a similar level seen in the United States before the housing bust and the 2008 financial crisis.
Statistics Canada said the new figures are the result of a revised method used to measure household net worth, which is more in line with international accounting standards. Non-profit institutions have been removed from the household category to get a better representation of family finances.
While the latest figures are troubling, RBC Chief Economist Craig Wright says they shouldn’t necessarily trigger alarm bells.
The Canadian household debt “doesn’t strictly compare with the U.S.,” he told CTV’s Power Play Monday.
About 70 per cent of household credit is mortgage-related, Wright said, but new data suggests housing markets across Canada, except in Vancouver, are cooling off.
The Canadian Real Estate Association said Monday that sales of existing homes fell 15.1 per cent in September from a year ago, although last month’s numbers were slightly higher than in August.
“So as we move forward we hope (the debt) ratio will stabilize,” Wright said.
Inane Housing Comments From Wright
Those comments from Wright are quite amazing. The more leverage one has in housing, the more susceptible personal finances and the economy will be to a sustained downturn in that area.
What really takes the cake however, is Wright’s “hope (the debt) ratio will stabilize” in spite of falling home prices.
In a recession (and one is on the way if not started), layoffs will increase and income will drop. Housing prices and the stock market will both take a hit as well. Thus, debt-to-income ratios will rise and net worth will plunge. Canadians should expect a double whammy.
Mike “Mish” Shedlock
Copyright © http://globaleconomicanalysis.blogspot.com
Wednesday, October 17th, 2012
by Don Vialoux
Upcoming US Events for Today:
- Housing Starts for September will be released at 8:30am. The market expects 765K versus 758K previous. Permits are expected to show 810K versus 801K previous.
- Weekly Crude Inventories will be released at 10:30am.
Upcoming International Events for Today:
- Bank of England Minutes will be released at 4:30am EST.
- Great Britain Jobless Claims Change for September will be released at 4:30am EST. The market expects 0 (unchanged) versus a decline of 15,000 previous.
- China GDP for the Third Quarter will be released at 10:00pm EST. The market expects a year-over-year increase of 7.4% versus an increase of 7.6% previous.
Equity markets surged higher on Tuesday, boosted by earnings optimism, industrial production numbers that beat expectations, and comments pertaining to aid for Spain. Concern over earnings is showing signs of alleviating as more companies are beating expectations than missing. Goldman Sachs, Johnson & Johnson, Mattel, and United Health are among the companies that reported better than expected results on Tuesday. Still, the reaction to results is very much mixed with stocks either trading firmly higher or lower, keeping investors cautious as we enter the some of the busiest days for earnings season next week. Companies reporting today include Abbott Laboratories, Bank of America, Halliburton, Pepsico, Textron, American Express, and eBay.
Also fueling growth in risk assets on Tuesday was a report that two German lawmakers said the country is open to credit aid for Spain ahead a summit of European Union leaders on Thursday. The Euro surged on the remarks, trading higher by almost 1%, putting pressure on the US Dollar in the process. The US Dollar index is now trading back below its 20-day moving average, rolling over from an apparent short-term double top pattern. Firm support is evident on the charts at 78.60, marking this a significant hurdle to overcome in the currency’s push toward lower levels. Seasonal tendencies for the US Dollar remain flat to positive in October and November.
We’ve reached an interesting juncture for Dow Theory as the Transports finally show signs of outperformance over recent days. The chart of the Dow Transports relative to the Dow Jones Industrial Average shows that the recent outperformance has pushed the relative price action back to the intermediate-term declining trendline as the transports finally make a push to regain lost ground compared to other indices. The transports have been lagging for the bulk of the year as the industry reflects the struggling fundamental condition of the worldwide economy. Recent strength in the Baltic Dry Index following a bounce near an area of support is optimistic for the industry going into the end of the year. Transportation stocks enter a period of seasonal strength in the month of October, running through to May as cyclical stocks gain during the favourable six month period for equities.
Sentiment on Tuesday, as gauged by the put-call ratio, ended bullish at 0.81. The ratio continues to trade below the recent rising trend channel, suggesting a change in sentiment away from the pessimistic tone that dominated markets coming into earnings season. Over the next two weeks, earnings report releases will be plentiful with almost 1500 companies providing quarterly results. Seasonal tendencies suggest a brief pullback somewhere in between this core period in the reporting cycle as reports are digested. As positive seasonal tendencies attempt to gain a firm footing, volatility over the coming weeks is expected as investors continue to receive earnings reports and speculation grows over which candidate will win the the role of the President.
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
Horizons Seasonal Rotation ETF (TSX:HAC)
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Wednesday, October 17th, 2012
Change is inevitable, but the recent pace and magnitude of economic change has left many investors disoriented, to say the least. Perhaps most importantly, it’s unlikely we’ll revert back to a more familiar environment any time soon. It’s my belief that the sooner investors accept this new world order and view their portfolios through this lens, the better off they’ll be.
To gain an understanding of just how far we’ve come, let’s take a look at the many ways in which the economic and investment landscape has evolved over the past five years:
- Slower growth
From the end of World War II through 2008, the US economy expanded by roughly 3.4% a year. Since exiting the recession in 2009, growth has averaged 2.1%, with personal consumption particularly weak.
- More volatile growth
Not only has growth been weaker, it has become more erratic. In the United States, the volatility of quarterly changes in industrial production is four times higher than it was back in late 2007. Nor is this just a US phenomenon; current economic volatility is also near a record high in Europe.
- More volatile inflation
Economic volatility is also rising in other areas. The volatility of US inflation – measured by the standard deviation of monthly changes – is twice as high as it was in early 2005.
- Negative real rates
Even so called “risk free” assets, like Treasury Bills, typically produce a return above the rate of inflation. However, since 2010 short-term interest rates have been consistently negative. With the Fed determined to keep short-term rates anchored at zero, real rates are likely to remain negative for the foreseeable future.
- Bloated central bank balance sheets
The Federal Reserve’s balance sheet has risen from $800 billion in the summer of 2008 to approximately $3 trillion today. The ECB and Bank of England have followed a similar path. The wide-spread adoption of unconventional monetary policy makes the future path of money supply growth and inflation highly uncertain.
What has caused these changes, and how long are they likely to last? My own view is that the world is still in the early stages of reversing a four-decade long credit binge. For example, between 1952 and 2008 US households enjoyed 56 years of uninterrupted credit expansion. In other words, prior to Q2 of 2008 there was not a single quarter when household debt contracted.
Obviously, things have changed since then. While the consumer and financial sectors have been deleveraging for four years, given the duration and magnitude of the credit expansion, this process is likely to take even more time to unwind.
In addition, while the household and financial sectors have at least begun the deleveraging process, other parts of the economy continue to add to the imbalances. The fiscal position in Europe and the United States has deteriorated dramatically since the financial crisis – Japan had a head start. And while you would not know it from watching sovereign bond yields, few nations have witnessed as rapid a decline in their current account as the United States. Federal debt held by the public has doubled in five years, from roughly $5 trillion in 2007 to nearly $11 trillion today.
Given all of this, it is very hard to envision the world going back to the way it was anytime soon. For investors this means that investment process and philosophy need to be geared to the current environment, rather than the way the world was. In my next post on this topic, I’ll outline 3 strategies for doing just that.
[i] Economists routinely refer to Treasuries as being “risk free”, in order to provide a base against which the risk of other debt can be measured. However, an investment in a Treasury ETF or Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
Wednesday, October 17th, 2012
This is a follow up to Timely Portfolio’s interesting post estimating how an investment in 10-year US Treasuries (constant maturity, similar to IEF) might perform in an extreme theoretical scenario where 10-year yields fall to 0% in one month (h/t The Whole Street).
The following chart is taken from Timely’s post showing the return on 10-year Treasuries (constant maturity) since 1954. That tiny red line represents yields falling to 0% by the end of this month, which would result in about a 17% one month return.
In this follow up I’ll show how that 17% return might differ if the drop to 0% happens over the course of the next one year, two years, etc.
Here I’ve shown the annualized and total return of our hypothetical 10-year constant maturity investment (similar to IEF) if yields fall from the September average of 1.72% down to 0% over the course of the next 1 year, 2 years, etc.
I assumed that the decrease in yield was linear. In other words, change in yield this month = (1.72% / # of months in test * -1).
Note how the longer it takes to get to 0%, the greater the total return (because investors are enjoying that ever dwindling UST yield over a longer period of time), but the smaller the annualized return (because the immediate benefit of falling yields on prices are also stretched over a longer period of time).
In a sense, these numbers represent a theoretical best case scenario for 10-year UST funds over the near term (well not entirely, yields could stay the same until the very last month of the test and then plummet to zero which would result in an even higher return, but now we’re getting really unrealistic).
Of course, studying 10-year yields falling all the way down to 0% might not be very helpful. Timely also talks about how Japan’s 10-year yields briefly touched a low point of 0.47%.
What if we assumed that 0.47% was also our low point? Here is the same test, with yields falling from 1.72% to 0.47% over the next X years.
Not much commentary to add here. The blogosphere is doing a fine job spelling doom and gloom for Treasuries without me (as they have been for at least a couple of years now).
This of course has all sorts of implications for tactical asset allocation type programs, but that’s something I’m still mulling around in me noggin’ and the subject of a future post.
Just one last comment – if you are of the mindset that Treasury fund returns will be subpar from here, that doesn’t mean that they’re necessarily without purpose. UST has been one of the few asset classes that have (mostly) maintained low to negative correlation with equity-like assets in recent history, and they may continue to be useful as a way to minimize portfolio volatility.
Copyright © MarketSci Blog
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Wednesday, October 17th, 2012
by Peter Tchir, TF Market Advisors
The First Real QE Day Trading Pattern
Yesterday’s stock action reminded me a lot of 2010 after QE2. We saw stocks gap higher on the open, then grind higher throughout the day, with a final surge into the close. That to me was a defining pattern of the rally in 2010. Yesterday was really the first time we’ve seen it since QE3 was announced. We have had some big days. We have had some sell-offs, but we have faded or bounced into the close, but this distinct “QE” pattern hadn’t occurred. At least not is such a striking way.
I remain bearish, more so now that stocks have climbed to 1,455 but yesterday’s movement is concerning. I tend not to change views based solely price action (at least not to conform to the momentum) but yesterday’s move does make me wonder if we have moved into some 2010 like QE rally. I don’t think so, but I am watching this closely.
A Credit Line For Spain
Markets are reacting positively to the stories that Spain will receive credit lines and OMT. Spanish stocks are up over 5% this week. While this isn’t bad news, it isn’t new news and isn’t going to change much.
We don’t know the details on either OMT or what the ESM line of credit but if they follow the IMF’s guidelines, the rate is likely to be between 2.5% and 3% all-in, which is where the Spanish 2 year is right now 2.78%. The market has anticipated this ever since the OMT announcement. We have bounced around but as far as I can tell, it is very well priced in and I wouldn’t expect any intervention to bring rates much lower than this.
Conditionality will remain an issue and the curve will steepen as investors are constantly left in fear that the government will fail and the EU support will be pulled, or changed.
GS and Citi
Goldman crushed it on earnings, yet the stock was down. Citi had the sudden resignation of its CEO and the stock was up. I understand the rationale, but I think had you been told that information ahead of time, the natural reaction would have been to expect the opposite moves. It just enhances the view that this is all about positioning.
So I remain bearish and I think the surge since 11 am on Monday is not justified, and investors are overly bullish on what is really old news, but the movement yesterday is worrisome from the short or underinvested side if it really is the all-clear to get into QE rally mode.
Copyright © TF Market Advisors
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Wednesday, October 17th, 2012
The Absolute Return Letter
When Career Risk Reigns
I concluded last month’s Absolute Return Letter by suggesting that only when policy makers begin to address the underlying root causes that lie underneath the current crisis will we be able to leave the problems of the past few years behind us.
What I didn’t say, but probably should have said, was that an almost universal lack of appetite amongst policy makers on both sides of the Atlantic to deal with those root causes will ensure that the crisis will rumble on for quite some time to come. To paraphrase John Mauldin, politicians are like teenagers. They opt for the difficult choice only when all other options have been explored.
So far, only Greece has reached that point. The Spanish are probably next in line. And there will be many more countries forced to make tough decisions before this crisis is well and truly over.
This has repercussions for asset allocation and portfolio construction. The credit crisis, now into its sixth year1, has changed the investment landscape on two important fronts. Investors have had to get accustomed to low return expectations – not something that comes naturally to Homo sapiens – and they have had to adapt to what is often referred to as the high correlation environment.
Why MPT doesn’t work
Let’s begin with a quick recap of what the credit crisis has done to Modern Portfolio Theory (MPT). If you google “MPT”, Wikipedia will tell you that it is “a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset.”
That’s all very well, provided asset classes behave the way Harry Markowitz assumed they would, when he produced his first paper on MPT back in 1952. The reality, however, has been very different in the post crisis environment. I have run a simple correlation analysis to illustrate the problem (see chart 1).
The 2000-03 bear market was massive. It followed an 18 year bull market which gave us valuations this world has never seen before. When the bubble finally burst, stock prices around the world fell like a stone. MPT followers still did relatively well, though, as other asset classes offered investors at least partial protection.
In chart 1 below I have compared correlations during the 2000-03 period (bright blue) with correlations in the current environment (dark blue). As you can see, with one or two exceptions, correlations are generally much higher now.
Now, you could quite reasonably confine this observation to the ‘academically interesting but why should I care?’ category, if it wasn’t for the fact that most investors around the world continue to manage money in a way that is deeply rooted in the MPT school of thought even when facts suggest that a different approach to asset allocation and portfolio construction is warranted.
Nowadays, only a handful of sovereign bonds are considered safe haven assets. Pretty much all other asset classes are now deemed risk assets and they move more or less in tandem. Even gold looks and smells like a risk asset these days.
Take another look at chart 1. In the 2000-03 bear market commodities were an excellent diversifier against equity market risk with the two asset classes being virtually uncorrelated (+0.05). Nowadays, the two are highly correlated (+0.69). It follows that we are not only in a low return environment at present, as evidenced by the paltry return on equities since the end of the secular bull market in early 2000, but we can’t rely on the ability to diversify risk either.
Now, perhaps I should define risk. In traditional investment management parlour, risk is usually synonymous with volatility risk. One could make the argument that volatility risk is a risk that most investors could and should ignore (provided no leverage is used) and that only one element of risk really matters – that of the permanent loss of capital.
Whilst theoretically correct, the reason you cannot ignore volatility risk is that it profoundly influences investor behaviour. Few investors have the nerve to stay put when a financial storm gathers momentum.
Part of the problem is that investors generally have unrealistic expectations. Andrea Frazzini, David Kabiller and Lasse Pedersen published an interesting paper a while ago called Buffett’s Alpha (you can find it here) which is packed with interesting observations. I quote from their conclusion:
“Buffett’s performance is outstanding as the best among all stocks and mutual funds that have existed for at least 30 years. Nevertheless, his Sharpe ratio of 0.76 might be lower than many investors imagine. While optimistic asset managers often claim to be able to achieve Sharpe ratios above 1 or 2, long-term investors might do well by setting a realistic performance goal and bracing themselves for the tough periods that even Buffett has experienced.”
For those of you not familiar with the concept of Sharpe ratios, it measures the excess return (over and above the risk free rate of return) for every unit of volatility. The U.S stock market’s Sharpe ratio is about 0.39. In other words, Buffett has delivered a Sharpe ratio nearly twice the market average. Few would disagree that Warren Buffett is the stand-out investor of our generation. If the supreme talent can ‘only’ deliver a Sharpe ratio of 0.76, what is it that make professional money managers step forward again and again and promise2 their investors the prospect of Sharpe ratios of 1 or higher?
The proof is in the pudding, as they say, and I am afraid that in this particular case, the pudding is well past its sell by date. The most recent study I have been able to find on Sharpe ratios was conducted by Blackstar Funds back in 2009 on 555 actively reporting commodity traders – also known as CTAs or managed futures managers (chart 2). Commodity traders are interesting to study because they have the longest track record of any alternative investment strategy, allowing us to distinguish between luck and skill.
Chart 2 offers a solid piece of humble pie for a notoriously over-optimistic fraternity of money managers. When the reporting period is limited to 5 years or less, plenty of managers can claim to have a Sharpe ratio in excess of 1 (even a broken clock is right twice a day). Only a few manage to keep it above 1 for longer than 5 years, and after 10 years there are virtually none left. The lesson? Luck plays no small part in the short to medium term but reality gradually catches up with the lucky ones. Buffett is still the best!
Do EMs offer a solution?
Responding to low growth expectations in the U.S. and Europe, investors have been allocating increasing amounts of capital in recent years to emerging markets, expecting that the higher growth in those countries will lead to superior returns. There is only one problem with this strategy; there is no evidence whatsoever to support the thesis that high GDP growth leads to superior stock market performance.
Elroy Dimson, Paul Marsh and Mike Staunton of London Business School did a study back in early 2010, covering 83 countries over four decades3, with the results being published in the 2010 version of the Credit Suisse Global Investment Returns Yearbook. They found little or no support for the idea that economic growth drives stock market performance (chart 3).
More specifically, during the decade of the 1970s (the grey dots in chart 3) the correlation across 23 countries was 0.61. In the 1980s (light blue) there was a correlation across 33 countries of 0.33. In the 1990s (dark blue), the correlation across 44 countries was actually negative (–0.14) and finally, in the 2000s (red), the correlation across 83 countries was 0.22.
When pooling all observations in chart 3, the correlation between GDP growth and stock market performance comes out at 0.12. The R-squared is about 1%, suggesting that 99% of the variability in equity returns is associated with factors other than changes in GDP. You can find the entire study here.
So, with economic prospects in Europe and the U.S. likely to remain subdued, with risk assets remaining highly correlated and with emerging markets not necessarily offering a way out for investors, what can you do to generate a respectable return on your capital whilst appropriately diversifying risk?
Misallocation of capital
I have been an observer of financial markets, and of those who operate within the markets, for almost 30 years. I have never before experienced investors paying more attention to career risk than they do at present. A preoccupation with career risk changes behavioural patterns. Decisions become more defensive, and sometimes less rational. (Before I offend too many of our readers, perhaps I should point out that what may be a dim-witted decision from an investment point of view is not necessarily irrational from a career perspective.)
According to the latest data from Hedge Fund Research, there were $70 billion of net inflows in to the hedge fund industry in 2011. $50 billion of those went to funds with more than $5 billion under management. This is a staggering statistic considering there is a wealth of research documenting that smaller managers consistently outperform their larger peers. I suppose nobody was ever fired for investing in IBM (sigh).
The misallocation of capital can also be driven by factors beyond the control of the individual. The UK pension industry is a case in point. With 84% of UK defined benefit schemes now under water, and with liabilities exceeding assets by over £300 billion4, the UK pensions regulator, the plan sponsors and the pension consultants all apply considerable pressure on the pension trustees who are often lay people not equipped to deal with complex situations such as a credit crisis. One result is an exodus from riskier equity investments into supposedly lower risk bonds (chart 4). We shall see who has the last laugh.
At a time where UK P/E multiples are near 30-year lows, and UK gilts are trading at record low yields, capital flows should, if investors behave rationally, move in precisely the opposite direction – away from bonds into equities.
The illiquidity premium
The illiquidity premium is the excess return investors demand for holding an illiquid investment over a liquid investment of the same kind. The illiquidity premium can move within a very wide range and is usually highest during times of distress. The credit crisis has resulted in a dramatic fall in the appetite for illiquid investments which has caused the illiquidity premium to increase substantially more recently.
At the same time as the appetite for illiquid investments has been falling, opportunities have been on the rise. Banks all over Europe have been reducing their loan books with small and medium sized companies suffering the most as a result.
This has given rise to a new industry where pension funds and other long term investors provide capital to facilitate lending outside the traditional banking system. Given what is around the corner for the banks in terms of new and tighter capital requirements, this industry will grow to be much larger over the next decade.
However, new data from the ECB suggest that European banks’ balance sheets are actually larger than ever (chart 5) so, on the whole, banks have merely shifted the balance sheet composition away from lending towards speculative investments funded cheaply through the ECB.
In other words, the European banking industry has become one massive hedge fund taking a punt on the ability of European sovereigns to service their debt. All of this will have to be unwound at some stage, suggesting that the deleveraging process in Europe’s banking sector is far from over.
Assuming that European banks eventually must bring the leverage down to U.S. levels or thereabouts, total assets in the European banking industry must be reduced from around $45 trillion today to less than half that number. Not only will that be painful but it could also cause the illiquidity premium to rise further.
The savvy investor will seek to take advantage of these inefficiencies and allocate his capital where others don’t go. In the long run, that is likely to be a winning strategy.
Convergence vs. divergence
Our friends at Altegris published an interesting white paper back in July on what they aptly have named Convergent vs. Divergent Investment Strategies (you can find the paper on www.altegris.com or here). Convergent strategies are the usual suspects – traditional long-only strategies as well as a number of alternative strategies that are all highly correlated.
Divergent strategies, on the other hand (and I quote) “… aim to profit when fundamental valuations are ignored by the market. These strategies – of which managed futures are the prime example – seek to identify and exploit price dislocations, often exemplified by serial price movement that reflects changing market themes and investor sentiment.”
The paper concludes – and I wholeheartedly agree – that investors need to inject divergent investment strategies, such as commodity traders, into their portfolios if they wish to protect themselves against large draw-downs during market distress5.
Alexander Ineichen at Ineichen Research and Management reached a similar conclusion when he published a paper earlier this year called Diversification? What diversification? Looking at 20 so-called financial accidents since 1980, Ineichen found that, of all the alternative investment strategies that he looked into, managed futures did by far the best job in terms of protecting portfolios in difficult times (chart 6a). Interestingly, managed futures have also done better than gold on that account. Having exposure to a diversified portfolio of hedge funds may have reduced the volatility somewhat, but losses during the drawdown periods were still significant (chart 6b).
Valuation matters According to a recent study by the (friendly) geeks at SocGen Cross Asset Research, the average holding period for U.S. stocks is down to about 22 seconds (sic). Even if we cleanse the numbers for high frequency and other computer generated trades, there is no question that the average holding period for stocks continues to shorten. It is part and parcel of the risk-on / risk-off mentality which prevails at the moment.
However, all research into the art of equity investing suggests that the best results are obtained through long term investing. It is in fact not complicated at all. Invest when the market trades below 10 times earnings. Sit on the portfolio for 10 years and, voila, you are well positioned to earn double digit annual returns (chart 7). Well, that is if history offers any guidance to future returns, which it doesn’t according to my legal counsel. We shall see.
The first problem with such an investment strategy for a professional investor is that it may not work for the first 2, 3 or even 5 years and, by the time it does, his career in the industry may be well and truly over. It is that career risk rearing its ugly head again.
The second problem relates to the confusion between P/E ratios at the aggregate market level and P/E ratios on individual stocks. The research we have conducted into this suggests that buying the lowest P/E stocks is not necessarily a winning strategy whereas buying the overall market when it is cheap very much is (long term).
The implication of chart 7 is that if you can identify the stock markets that trade at rock bottom P/E ratios relative to their historical range, you are probably on to the long term winners. The study behind chart 7 was conducted exclusively on U.S. stocks, but similar studies elsewhere suggest that it is a global phenomenon.
Now, with that in mind, which markets are currently cheap and which ones are not? Not surprisingly, the markets everyone loves to hate are the cheapest relative to their historical P/E range (Greece, Italy, Austria, Japan and Portugal in that order), whereas the ones everyone has fallen in love with are the most expensive (Thailand, Malaysia, Indonesia, Chile and South Africa in that order). However, I note with some comfort that no stock market in the world appears to be ridiculously overpriced at present on this measure.
Value or Growth?
Taking the equity discussion one step further, one of the longest standing debates amongst equity portfolio managers is whether to populate your portfolio with value or growth stocks. However, recent research seems to suggest that there is a third way which is far superior to the other two investment styles.
Our friends at SocGen have recently published the result of some extensive work they have conducted on the subject which suggests that investors should focus neither on growth nor on value but on quality instead. Quality is obviously a subjective term but so is value or, for that matter, growth. The approach taken by SocGen emphasizes the quality of the balance sheet and, in particular, the company’s ability to sustain its dividend policy. After all, dividends have been the main source of equity returns over time (chart 8). We just happily forgot about that during the happy bull days of 1982-2000.
SocGen has tested their approach over a very long period of time and the results are impressive (chart 9). They are simply impossible to ignore. Whether the strategy can be sustained over longer periods of time remains to be seen, but I have noted that quality outperformed both value and growth in the 2003-07 bull market. In other words, it doesn’t appear just to be a post crisis phenomenon.
There is actually one approach to asset allocation I have not yet mentioned. In an environment such as this, where the mood swings can be sudden and quite violent, one can build a strong case for a much more dynamic approach to asset allocation.
Internally we operate with two layers of asset allocation – one for the long term (strategic asset allocation) and one for the short term (tactical asset allocation). The regular changes in sentiment do not affect our strategic asset allocation decisions but they certainly influence our tactical decisions. We use a mix of sentiment indicators and technical indicators to drive these decisions.
That’s pretty much it for this month. These are tricky times, and one must adapt; however, with a more creative approach it is indeed possible to structure portfolios that are not only likely to generate a respectable return, but they can also be designed in a way that enhances the downside protection materially. If you wish to discuss any of these ideas in more detail, feel free to call or email us.
Niels C. Jensen
4 October 2012
Copyright © 2002-2012 Absolute Return Partners LLP. All rights reserved.
1 Counting from the collapse of the Bear Stearns structured credit funds in June-July 2007.
2 We are not supposed to make promises in our industry, yet I have had numerous ‘run-ins’ with professional portfolio managers over the years claiming they could deliver a sustainable Sharpe ratio in excess of 1. Going forward, I will make a habit of asking them what they think the Sharpe ratio of Warren Buffett has been over the past 30 years. They will almost certainly overestimate the actual number.
3 Not all countries in the study had total return data available for the entire 1970-2009 period, hence the different number of countries analysed in each of the four decades.
4 Source: Morgan Stanley
5 Please note that commodity traders (managed future funds) follow a fundamentally different strategy from the commodity long-only strategy referred to in chart 1.
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Wednesday, October 17th, 2012
October 17, 2012
by Axel Merk, Merk Funds
Doubling down on QE3, the Federal Reserve (Fed) Chairman Bernanke tells China and Brazil: allow your currencies to appreciate. One does not need to be a rocket scientist to conclude that Bernanke wants the U.S. dollar to fall. Is it merely a war of words, or an actual war? Who is winning the war?
The cheapest Fed policy is one where a Fed official utters a few words and the markets move. Rate cuts are more expensive; even more so are emergency rate cuts and the printing of billions, then trillions of dollars. As such, the Fed’s communication strategy may be considered part of a war of words. Indeed, the commitment to keep interest rates low through mid 2015 may be part of that category. But quantitative easing goes beyond words: QE3, as it was announced last month, is the Fed’s third round of quantitative easing, a program in which the Fed is engaging in an open-ended program to purchase Mortgage Backed Securities (MBS). To pay for such purchases, money is created through the strokes of a keyboard: the Fed credits banks with “cash” in payment for MBS, replacing MBS on bank balance sheets with Fed checking accounts. Through the rules of fractional reserve banking, this cash can be multiplied on to create new loans and expand the broader money supply. The money used for the QE purchases is created out of thin air, not literally printed, although even Bernanke has referred to this process as printing money to illustrate the mechanics.
Why call it a war? It was Brazil’s finance minister Guido Mantega that first coined the term, accusing Bernanke of starting a currency war. Here’s the issue: like any other asset, currencies are valued based on supply and demand. When money is printed, all else equal, supply increases, causing a currency to decline in value. In real life, the only constant is change, allowing policy makers to come up with complex explanations as to why printing money does not equate to debasing a currency. But even if intentions may have a different primary focus, our assessment is that a central bank that engages in quantitative easing wants to weaken its currency. It becomes a war because someone’s weak currency is someone else’s strong currency, with the “winner” being the country with the weaker currency. The logic being a weaker currency promotes net exports and GDP growth. If the dollar is debased through expansionary monetary policy, there is upward pressure on other currencies. Those other countries like to export to the U.S. and feel squeezed by U.S. monetary policy. Given that politicians the world over never like to blame themselves for any shortcomings, the focus of international policy makers quickly becomes the Fed’s monetary largesse.
Bernanke speaking at an IMF sponsored seminar in Tokyo pointed to the other side of the coin: if China, Brazil and others don’t like his policies because they create inflation back home, they should allow their currencies to appreciate. But these countries are reluctant as stronger currencies lead to a tougher export environment.
Now keep in mind that it is always easier to debase a currency than to strengthen it. Switzerland, the previously perceived safe haven by many investors, has taken the lead. Using a central bank’s balance sheet as a proxy for the amount of money that has been printed, the Swiss National Bank’s printing press has surpassed that of the Federal Reserve considering relative growth since August 2008. Again note that no real money has been directly printed in these programs; also note that some activities, such as the sterilization of bond purchases by the European Central Bank, cause a central bank balance sheet to grow, even if sterilization reflects a “mopping up” of liquidity:
Japan has warned about intervening in the markets on multiple occasions, but the size of the Japanese economy as well as the lack of political will make an intentional debasement more difficult. Indeed, the Japanese did their money printing in the 1990s, but forgot we had a financial crisis in recent years.
Bernanke does acknowledge the concerns of emerging markets, but argues they are blown out of proportion. He elaborates that undervaluation and unwanted capital inflows are linked: allow your currencies to appreciate (versus the dollar) and you won’t have to be afraid of excessive capital inflows, inflation and asset bubbles. Ultimately, and importantly, Bernanke says the Fed will continue its course, suggesting that it will strengthen the U.S. economic recovery; and by extension, strengthen the global economy.
Let’s look at the issue from the viewpoint of emerging markets: policy makers like to promote economic growth, among other methods, through a cheap exchange rate, up to a certain point. They don’t want too much inflation or too many side effects. Historically, they manage these side effects with administrative tools. However, taking China as an example, taming price pressure through, say, price controls, has not been very effective. We believe that’s a good thing, as China would otherwise experience product shortages akin to what the Soviet Union experienced. Conversely, however, China must employ a broader policy brush to contain inflationary pressures. We believe – and Bernanke appears to agree – currency appreciation is one of the more effective tools.
So how will this currency war unfold? The ultimate winner may well be gold. But as the chart above shows, it’s not simply a race to the bottom. If one considers what type of economy can stomach a stronger currency, our analysis shows an economy competing on value rather than price has more pricing power and therefore the greater ability to handle it. Vietnam mostly competes on price; as such, the country has, more than once, engaged in competitive devaluation. At the other end of the spectrum in emerging markets may be China: having allowed its low-end industries to move to lower cost countries, China increasingly competes on value. Within Asia, we believe the more advanced economies have the best potential to allow their currencies to appreciate. It’s not surprising to us that China’s Renminbi just recently reached a 19-year high versus the dollar.
What we have little sympathy for is an advanced economy, e.g. the U.S., competing on price. We very much doubt the day will come when we export sneakers to Vietnam. As such, a weak dollar only provides the illusion of strength with exports temporarily boosted. Yet the potential side effects, from inflation to the sale of assets to foreign investors with strong currencies, may not be worth the risk.
Please register to join us as we discuss winners and losers of the unfolding currency wars in our Webinar this Thursday, October 18, 2012. Please also sign up to our newsletter to be informed as we discuss global dynamics and their impact on gold and currencies.
Axel Merk is President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds.
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