Monday, June 17th, 2013
The Game of Risk
by Jeffrey Saut, Chief Investment Strategist, Raymond James
June 17, 2013
“To be sure, there is no exact definition of what ‘calling’ a market top or bottom involves. In the case of the March 2009 bear market bottom, for example, does ‘calling’ it mean the adviser’s portfolio needs to have moved from being all cash to 100% invested in stocks on the exact day of the bottom? If my analysis had relied on a definition as demanding as this, then it wouldn’t be surprising that no timers called recent market turning points. But my analysis actually relied on a far more relaxed definition: Instead of moving 100% from cash to stocks in the case of a bottom, or 100% the other way in the case of a top, I allowed exposure changes of just ten percentage points to qualify. Furthermore, rather than requiring the change in exposure to occur on the exact day of the market’s top or bottom, I looked at a month-long trading window that began before the market’s juncture and extending a couple of weeks thereafter. Even with these relaxed criteria, however, none of the market timers that the Hulbert Financial Digest has tracked over the last decade were able to call the market tops and bottoms since March 2000. These results add up to perhaps the most important investment lesson of all that: predicting turns in the market is incredibly difficult to do consistently well.”
… Mark Hulbert, MarketWatch (3/10/10)
The above excerpt was penned by Mark Hulbert in an article titled “Fools R Us.” Appropriately, that article ran in a MarketWatch column on the 10-year anniversary of the NASDAQ Composite’s peak of March 10, 2000. Ten years ago the COMP was changing hands around 5132. It is now trading at 3423 for a 13-year loss of some 33.3%. Meanwhile, over that same timeframe, the earnings of the S&P 500 are up 83%, nominal GDP is better by some 57.6%, and interest rates are substantially below where they were back then. If you are a college professor such statistics do not “foot” with your teachings because professors tend to believe stock returns are all about earnings and interest rates. I concur, but would add the caveat, “That is if you live long enough.” As money manager Greg Evans, eponymous captain of Millstone Evans in Boulder Colorado, writes:
“Hey Jeff, I enjoyed your missive on Mr. Market. I use that Warren Buffet allegory quite a bit with clients. One interesting statistic on Berkshire is that its stock price was $38 in 1968 and 8 years later, after trading higher and lower, ended up (again) at $38. Most clients would look at that (performance) and say – it hasn’t done anything for 8 years so I am going to sell. But an astute investor, looking at the underlying growth in book value, would see an average annual growth rate of 14.6% over those 8 years and conclude they should buy more. As to your point that over the long-term stock prices are ultimately determined by their book value, earnings and cash flows, I have often run numbers on stocks over a 25-year time frame to show to clients. For example, Coca-Cola’s stock price in 1983 was $5.10 (midpoint); and, Coke earned $0.30 per share that year. The stock price today is ~$40, and they earned $1.97 last year. That’s about a 15% annualized growth rate on the stock price; and, a ~15% growth rate on earnings – QED.”
Surprisingly, however, if an investor bought Coke shares at their peak price in 1972, over the next 12 years the company compounded earnings at nearly double-digit rates (with only four down quarters), yet said shareholders actually lost money. The reason was “Mr. Market” was unwilling to capitalize that improvement in earnings anywhere near the P/E multiple of 1972. Regrettably, “Mr. Market” is indeed manic depressive, which is why the stock market is truly fear, hope and greed only loosely connected to the business cycle. And that, ladies and gentlemen, is why the successful investor needs to learn how to manage risk. As Benjamin Graham wrote, “The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”
Clearly, Warren Buffet understands this “management of risk” concept for he too has learned when to “play hard” and when not to “play.” Decidedly, his insight to hoard cash, and shun internet stocks, in the late 1990s was brilliant, yet it was greeted with catcalls that “the old man has lost his touch and just doesn’t understand the Internet age.” However, investors benefitted handsomely if they heeded his advice. Enter the aforementioned quote from Mark Hulbert espousing the old market axiom, “It’s TIME in the market, not TIMING the market.” Typically such comments are accompanied with the verbiage, “If you missed the 10 best stock market sessions of the year it kills your returns.” To be sure, over the 25-year period ending on 12/31/2011 the buy and hold investor saw returns of 6.81% per year. But, if you missed the 10 best sessions your annualized return falls to 3.67%. Miss the 20 best and you experienced only a 1.65% yearly gain, and missing the 40 best yields a negative 1.62% return. However, miss the 10 worst days and a prescient investor realized a 10.89% per annum gain, while missing the 40 worst shows annualized returns leaping to a 17.74% – according to a study from Hepburn Capital Management – thus proving the management of “risks” is more important than the management of “returns” (see chart on page 3).
That said, while I too don’t believe anyone can consistently “time” the stock market, I do believe in Dow Theory. Dow Theory is like a roadmap for the “primary trend” of the stock market. Recall, Dow Theory gave you a “sell signal” in September 1999 (albeit three quarters too soon), a “buy signal” in June 2003 (a few months too late), and again a “sell signal” in November 2007 (note, it is not Jeff Saut “calling” the stock market, but Dow Theory). More importantly, the Dow Theory “buy signal” of earlier this year remains in force. Nevertheless, I continue to think we are in a short/intermediate “topping” process. The timing models that have worked so well year to date targeted June 11/12th as the days that a feint to the downside would start. While I had thought the convening of the German Constitutional Court would be the causa proxima, it turned out to be Japan and its statement that it would not increase the monetary stimulus operations. Subsequently, in Friday morning’s verbal strategy comments, I said:
“I think we are going to limp around and then try for the reaction high of 1687. If we don’t make a higher high on that attempt, and turn down from there, then the mid-July swoon I have been targeting will arrive prematurely. However, if we do make a higher high it probably means we are still going up to make a new high into the first or second week of July and then start the swoon. Indeed, I have mixed signals into the end of this week (meaning last week), as well as mixed signals into the beginning of next week (meaning this week). So, it would not surprise me to see the upside action fizzle today (last Friday) and have the market limp around with attempts to sell off into early next week. However, there are much more positive timing point signals coming next week (aka, this week), so my hunch is that the SPX limps for a few sessions and then starts to push higher.”
And while Friday’s Fade (-106 points) wasn’t much of a “limp,” Thursday’s upside action surely fizzled.
The call for this week: Nassim Taleb (trader extraordinaire) has 10 rules. Rule number 8 reads: “Always protect the downside. As pointed out ad nauseum, Black Swans do occur. No matter how much you test, there will be a ‘this time is different’ moment forcing your bank account into oblivion. No matter how confident, always protect the downside.” I agree with Taleb’s comments and therefore always try to “look” down before looking up in an attempt to manage the risk. As for the here and now, as I said on Friday, “It would not surprise me to see the upside action fizzle today (last Friday) and have the market limp around with attempts to sell off into early next week. However, there are much more positive timing point signals coming next week (aka, this week), so my hunch is that the SPX limps for a few sessions and then starts to push higher.” And this morning “higher” is the watchword as last week’s “taper tantrum” is fading on rumors of a softer Fed at this week’s meeting, leaving the preopening S&P 500 futures up about 12 points.
Copyright © Raymond James
Monday, June 17th, 2013
June 14, 2013
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research
- Stocks have seen some selling pressure, while other assets have also reversed course. We believe this is the start of the next phase of investing, with an increase in volatility and more grinding action likely.
- The Federal Reserve continues to prepare the market for its “tapering” of Treasury and/or mortgage-backed securities associated with quantitative easing (QE). This process is likely to be met with continued elevated levels of volatility.
- Emerging markets have had a rough ride, with heightened volatility, and we think it’s likely to persist. Japan’s market and currency action has been stomach-churning recently but we remain optimistic and urge patience, while Europe’s economy may be turning the corner.
Since Chairman Bernanke’s testimony in front of Congress in late May, where “taper” entered the lexicon, we’ve seen a shift in market behavior.
Recent action may be a foreshadowing of action to come as we slowly transition to a more normal economic environment. Gold has retreated over $300, stocks have seen a roughly 3-5% pullback, and we’ve seen the yield on the 10-year Treasury move to its highest level in over a year. Equities are likely to remain more volatile in the near-term. But it is encouraging to note that many of the technical and sentiment conditions that were troubling at the recent market highs have corrected. The AAII bull/bear ratio has moved close to zero—which is a neutral reading; while the Ned Davis Research Daily Trading Sentiment Composite moved from excessive optimism to extreme pessimism. Both are contrarian indicators. Many of the indicators we watch reversed quite quickly, suggesting that further downside may be limited; albeit with heightened volatility.
We don’t believe we’re in store for a large spike higher in yields. Yield-hungry investors may be attracted to the higher yields, but the Federal Reserve doesn’t have much stomach for much higher yields. We continue to suggest caution with regard to certain segments of fixed income; with a focus on higher-quality credit and away from longer-term Treasuries.
Economy not hitting on all cylinders
The Fed will continue to telegraph its tapering plans consistent with incoming economic data. Although the data has been mixed, there are encouraging signs, and we believe improving growth is likely for the second half. The Chicago purchasing managers index (PMI) rose to 58.7 from 49.0; and the Institute for Supply Management (ISM) Non-Manufacturing Survey rose to 53.7 from 53.1, indicating improving conditions in the much larger service side of the economy. But there was softness in manufacturing as the ISM Manufacturing Survey dropped to 49.0, its lowest reading since June 2009. Additionally, within that report, we saw the employment component dip to 50.1 from 52.0.
Services diverging from manufacturing?
Source: FactSet, Institute for Supply Management. As of June 11, 2013.
On the jobs front, ADP reported a relatively soft 135,000 jobs added in the private sector. But the government’s labor report surprised on the upside by reporting a gain of 175,000 jobs. The unemployment rate did uptick to 7.6% from 7.5%—largely due to an increase in the participation rate, which is generally viewed as a positive development. Job growth is improving but likely not yet where the Fed would like to see it at this point in the recovery.
Finally, housing, one of the pillars of support for the economy, may be facing some minor headwinds as the recent rise in yields has also pushed mortgage rates higher by about 80 basis points. We don’t view this as overly concerning, and may in fact result in fence-sitters being spurred into action. In addition, the “real” mortgage rate remains negative thanks to double-digit increases in home prices; a very strong support for housing.
Mortgage rates creeping higher
Source: FactSet, Freddie Mac. As of June 11, 2013.
Does the Fed move sooner rather than later?
We agree with the consensus that September is likely the earliest meeting at which the Fed might announce a tapering of purchases associated with QE. Inflation continues to be quite low and is not yet forcing their hand; however some Fed members have expressed concerns about asset bubbles. Recent action has appeared to remove some of the air from those potential bubbles (such as REITs), giving them some more leeway.
It’s important to remember that tapering is initially likely to be quite modest. The Fed has been clear about its ability to reverse direction if the impact of tapering is detrimental to the economy, and specifically the job market. As long as taping is initiated because of an improving economy—and not rising inflation—it’s’ likely to have a limited negative impact on the stock market, beyond some near-term volatility.
Congress quiet…for now
With other things dominating attention on Capitol Hill, Congress has been less of a market needle-mover recently. We still have a debt ceiling debate to deal with this fall, while corporate and individual tax reform remains on the table. Additionally, the sequester remains in place, with impacts potentially growing as the year winds down. Finally, we are getting closer to the implementation of the Affordable Care Act, which may be at least a near-term drag on economic activity.
Great rotation – out of emerging markets
The discussion over US Fed tapering alerted investors that a reduction of QE could potentially occur in their near-term investment horizon. As a result, risk-based trades that benefitted from what was perceived to be a relatively free lunch from zero interest rate policies (ZIRP), have experienced pressure. Emerging markets (EM), on which we’ve had an underperform rating, have experienced a particularly big hit.
Emerging markets melting down
Source: FactSet, MSCI. As of June 11, 2013. Indexed to 100 as of June 11, 2010.
* A larger/smaller number above 1 denotes greater outperformance/underperformance of the MSCI EM Index relative to the MSCI EAFE Index.
While we have been expressing caution on EM stocks for several months due to slowing growth prospects, the new wrinkle since May 22 is notable weakness in EM currencies and bonds. The risk is that further emerging market currency weakness could create inflationary pressures and reduce the ability for some EM central banks to ease. Additionally, if the US dollar resumes its strength, this could reduce foreign investment flows into emerging market economies and further pressure growth. This is troubling for countries that are dependent on foreign investment due to current account deficits, such as in India, Brazil and Indonesia.
We are maintaining our preference for developed international stock markets over emerging markets due to the continued risks to EM growth. Our negative call on China remains a cornerstone of our view on EM, due to the outsized influence it has on the EM universe. We’ve been expressing our concern about the sustainability of China’s debt-fueled, construction-led growth, and economic data continues to disappoint. Interestingly, China’s Premier Li believes growth remains “relatively high and reasonable,” according to a June 8th statement; but investors view the growth rate differently, as consensus estimates continue to fall. We believe China-related investments will encounter difficulty until investors have confidence about where and how China’s economy stabilizes. Read more Avoid China—Subprime-Like Bubble Brewing, as well as related topics at www.schwab.com/oninternational.
Speed bump in Japan, but story still intact
In recent weeks, volatility has spiked in Japan’s stock and bond markets, as well as for the currency. This comes on the heels of a 76% gain in stocks, 21% fall in the yen, and 29-basis-point drop in Japanese government bond (JGB) 10-year yields from late November to mid-May for the Nikkei and yen; and to April 4 for the low in JGB yields. The volatility in the yen, combined with the Fed taper talk, resulted in some unwinding of the yen “carry trade,” where investors borrow money at low rates in Japan and invest in higher-yielding assets elsewhere. Investors have been forced to sell riskier assets to cover short positions in the yen. Adding to the negativity, early June brought disappointment in the lack of reform details in Prime Minister Abe’s anticipated speech; and little change to Bank of Japan (BoJ) monetary policy.
Despite the extreme volatility, we don’t believe it’s time to panic. The potential for revival in Japan is still in the early stages, with the BoJ’s targeted doubling of the monetary base just beginning. In our opinion, it’s too early to expect changes to monetary policy, and tackling reforms makes more sense after the July 11 parliamentary elections. However, structural reforms are needed for a sustained recovery and will be more difficult than fiscal and monetary stimulus, while remaining a risk for a longer-term move higher for Japanese stocks. Additionally, the Japanese government needs to provide fiscal consolidation plans to maintain the confidence of the bond market.
The economy and corporate profits have begun to improve, with Japan posting the highest gross domestic product (GDP) in the G7 in the first quarter, at 4.1% annualized. Consumer confidence is at a five-year high, wages are starting to rise and consumer spending has rebounded, as discussed in Japan: Land of the Rising Consumer. However, despite the rebound in earnings, business sentiment remains subdued; but continued demand and structural reforms could improve the picture.
We believe Japanese stocks could benefit over a multi-year period, but markets could remain volatile until there is more certainty about economic reforms, and because Japan’s economic data could moderate after a nice rebound.
Eurozone may be bottoming
While the narrative has been of a continued eurozone recession, we believe the eurozone may be in the process of bottoming. The region is receiving relief as policymakers are easing on fiscal austerity, and the fiscal drag in 2013 will likely be less severe than in 2012. Manufacturing PMIs in all nations covered by Markit rose in May for the first time since July 2009; and leading economic indicators in the major economies in the eurozone have been improving or stabilizing in recent months.
Eurozone may be bottoming
Source: FactSet, OECD. As of June 11, 2013.
Additionally, the slowdown in global growth has eased inflation pressures, allowing the European Central Bank (ECB) to cut the benchmark interest rate in May and consider other non-standard measures. As monetary policy works with a lag, changes by the ECB could add to our view that the eurozone could emerge out of recession later in 2013 and maintain recovery in 2014.
That said, there are still risks in the eurozone. In May, Spain’s central bank urged banks to further write down questionable loans by September, with corporate loans joining real estate loans as a concern, with risks most pressing for smaller banks. Yields for government debt globally have recently rebounded, in tandem with the unwind of yield-chasing trades globally on the Fed taper talk, which could pressure countries with more risky outlooks, and a potential bailout for Spain could come back into the discussion. However, a fair amount of bad news has likely already been priced into eurozone stocks, where earnings and valuations for eurozone stocks are depressed and could offer opportunity for investors.
We could be in the beginning stages of an adjustment toward a more “normal” monetary policy environment, with attendant volatility. This once again illustrates the importance of diversification and focusing on long-term goals when investing. We continue to believe the US equity markets are an attractive place for assets and recommend buying on pullbacks to the extent that you need to add to equity exposure. Additionally, continue to exercise caution around fixed income allocations and focus more on the developed markets vs. EM.
The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
Real Gross Domestic Product (GDP) is an inflation-adjusted measure that reflects the value of all goods and services produced in a given year, expressed in base-year prices.
The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
The Institute for Supply Management (ISM) Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms by the Institute of Supply Management. The ISM Non-manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
Manufacturing Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index includes the major indicators of: new orders, inventory levels, production, supplier deliveries and the employment environment.
Ned Davis Research (NDR) Daily Trading Sentiment Composite® shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.
Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.
Past performance is no guarantee of future results.
Investing in sectors may involve a greater degree of risk than investments with broader diversification.
International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
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Monday, June 17th, 2013
by David Rosenberg
Equities are being sought for income, and bonds for capital gains: a fascinating reversal
Stellar performance across most asset classes has been the norm until recently. Equity markets are up sizeably and, in some cases, like the S&P 500 and even the German Dax, have hit fresh all-time highs. Corporate bond markets are still offering decent returns as well, especially when measured against government bonds and cash.
Yet, in the past month, more than 60 per cent of the incoming US economic data have come in below expectations versus 34 per cent above expectations. Two months ago, only 42 per cent of data were disappointing and 53 per cent surprising to the upside.
The consensus was looking for 4 per cent US GDP growth for the first quarter; we got 2.4 per cent instead. Estimates for this quarter are approaching a meagre 1.5 per cent annual rate. So it is safe to say that this latest leg in the risk rally does not have a lot to do with what is happening in the real economy.
Thursday, June 13th, 2013
In 2006, 2007, 2008 and 2009 we saw 10Y bond yields surge into June only to peak and turn lower aggressively; and in 2010, 2011 and 2012 we saw a ‘mini rally’ in yields into June that was not sustained, so, as Citi FX’s Tom Fitzpatrick notes, while we regularly hear the mantra for the Equity market of “Sell in May and go away” maybe we should have one for the Bond market – “Buy in June after the swoon.”
There can be no doubt that the predominant factor in rising yields, increased market volatility, turmoil in emerging markets, rising peripheral European yields etc. over recent weeks has been the Fed but Citi still believes that the mention in the past weeks of “tapering” has been a “Kite flying” exercise by the Fed with the premise being to sell ‘the markets’ on the idea that reducing bond purchases was a “slowing of easing”, a “tinkering” not a tightening.
It appears it is not going according to plan and we believe the Fed has got its answer as to what will happen if they announce tapering and it’s not pretty and unless they back away from this ‘less easing’ path, this policy mistake will have a negative feedback loop in financial markets and the economy leading to the market “easing” again and sending bond yields lower once more.
So the argument from the Fed is that tapering is a slowing of the easing process rather than a tightening process. While mathematically that may be correct consumers do not borrow from mathematicians or for that matter at the “Fed funds rate”
The simple fact of the matter is that starting with the employment numbers in May combined with the tapering rhetoric from the Fed this rate has risen 71 basis (low to high) points since 01 May. If pushing mortgage rates lower is accepted to be a form of unconventional monetary easing (given we are looking to recover out of the greatest housing downturn of this generation) then rising mortgage rates have to be viewed as a tightening.
So to varying degrees we have seen a rising 10 year yield into June in the last 7 years. The most impulsive moves were seen in the four years 2006-2009. Those moves had characteristics more like what we have seen this year and in all cases we saw dramatic moves lower after a surge higher into June. Three of those four surges peaked between 11 and 13 June.
- 2006: 10 year yields surge and hit a peak of 5.25% on 28 June. That level is never again revisited that year and by December the yield had fallen to 4.40%
- 2007: 10 year yields surge and hit a peak of 5.32% on 13 June. That level is never again revisited that year and by November the yield had fallen to 4.05%
- 2008: 10 year yields surge and hit a peak of 4.27% on 13 June. That level is never again revisited that year and by December the yield had fallen to 2.03%
- 2009: 10 year yields surge and hit a peak of 4.00% on 11 June. That level is never again revisited that year and by October the yield had fallen to 3.10%
- 2010: 10 year yields were heading lower but have a short term bounce to peak at 3.42% on 03 June. That level is never again revisited that year and by October the yield had fallen to 2.33%
- 2011: 10 year yields were heading lower but have a short term bounce to peak at 3.22% on 30 June. That level is never again revisited that year and by October the yield had fallen to 1.67%
- 2012: 10 year yields were heading lower but have a short term bounce to peak at 1.73% on 11 June. A new trend low is posted at 1.38% on 25 July. The yield finishes the year at 1.75%
Bottom line the Fed is singing “Everything will be alright” while the market is singing “Hotel California” (You can check out anytime you like but you can never leave.)
Tapering will come, tightening will come but the “patient” is not yet healthy enough to take this shock just yet. To push this prescription at this point risks a relapse.
Wednesday, June 12th, 2013
by Ben Eisen, The Tell Blog
Treasury Inflation-Protected Securities, or TIPS, passed the latest threshold in their dramatic yield rise since the beginning of the year when the 10-year note yield turned positive Monday. The yield has been bouncing around 0%, but the “ask” yield registered at 0.068% around 12:15 p.m., according to Tradeweb.
Monday marks the first time since January 2012 that the 10-year TIPS yield turned positive, Tradeweb data show.
Source: June 12, 2013, MarketWatch
Tuesday, June 11th, 2013
Courtesy of Wolf Richter, www.testosteronepit.com www.amazon.com/author/wolfrichter My friends in the corporate restructuring industry aren’t breaking out the bubbly just yet. But with one eye, they’re gazing wistfully into the distant horizon where they’re seeing the first signs of a glimmer…
Monday, June 10th, 2013
The Economy and Bond Market Radar (June 10, 2013)
Treasury yields moved higher again this week as the employment report on Friday was good enough to keep Fed “tapering” (reducing quantitative easing and the first step on a long road toward tightening monetary policy) fears alive.
- Nonfarm payrolls grew 175,000 in May, modestly ahead of expectations. The unemployment rate ticked higher to 7.6 percent as participation and labor force expanded.
- Retail sales results from individual companies came in a little better than expected, but we will get official government data next week.
- The nonmanufacturing ISM index improved in May, with new orders and output showing an uptick.
- The average 30-year fixed-rate mortgage yield hit 4.07 percent, the highest level in over a year.
- The ISM manufacturing index unexpectedly hit a 4-year low and fell into contraction territory. This was definitely a negative surprise, particularly with recent brisk auto sales.
- April construction spending grew a modest 0.4 percent, well below expectations.
- The Fed continues to remain committed to an extremely accommodative policy.
- Key global central bankers, including the European Central Bank (ECG), Bank of England and the Bank of Japan, are still in easing mode. The Bank of Japan, in particular, is aggressively easing and the ECB recently cut interest rates.
- The recent sell-off in bonds may be an opportunity as growth remains weak and this wouldn’t be the first time the markets got ahead of themselves.
- Inflation in some corners of the globe is getting the attention of policymakers and may be an early indicator for the rest of the world.
- Trade and/or currency “wars” cannot be ruled out which may cause unintended consequences and volatility in the financial markets.
- The recent bond market sell-off may be a “shot across the bow” as the markets reassess the changing macro dynamics.
Tuesday, June 4th, 2013
by William H. Gross, PIMCO
Joseph Schumpeter, the originator of the phrase “creative destruction,” authored a less well-known corollary at some point in the 1930s. “Profit,” he wrote, “is temporary by nature: It will vanish in the subsequent process of competition and adaptation.” And so it has, certainly at the micro level for which his remark was obviously intended. Once proud, seemingly indestructible capitalistic giants have seen their profits fall short of “everlasting” and exhibited a far more ephemeral character. Kodak, Sears, Barnes & Noble, AOL and countless others have been “competed” to near oblivion by advancing technology, more focused management, or evolving business models that had better ideas more “adaptable” to a new age.
Yet capitalism at a macro level must inherently be different than the micro individual businesses which comprise it. Profits in total cannot be temporary or competed away if capitalism as we know it is to survive. Granted, the profit share of annual GDP can increase or decrease over time in its ongoing battle with labor and government for market share. But capitalism without profits is like a beating heart without blood. Not only is it profit’s role to stimulate and rationally distribute new investment (blood) to the economic body, but the profit heart in turn must be fed in order to survive.
And just as profits are critical to the longevity of our capitalistic real economy so too is return or “carry” critical to our financial markets. Without the assumption of “carry,” or return over and above the fixed, if mercurial, yield on an economy’s policy rate (fed funds), then investors would be unwilling to risk financial capital and a capitalistic economy would die for lack of oxygen. The carry or return I speak to is most commonly assumed to be a credit or an equity risk “premium” involving some potential amount of gain or loss to an investor’s principal. Corporate and high yield bonds, stocks, private equity and emerging market investments are financial assets that immediately come to mind. If the “carry” or potential return on these asset classes were no more than the 25 basis points offered by today’s fed funds rate, then who would take the chance? Additionally, however, “carry” on an investor’s bond portfolio can be earned by extending duration and holding longer maturities. It can be collected by selling volatility via an asset’s optionality, or it can be earned by sacrificing liquidity and earning what is known as a liquidity premium. There are numerous ways then to earn “carry,” the combination of which for an entire market of investable assets constitutes a good portion of its “beta” or return relative to the “risk free” rate, all of which may be at risk due to artificial pricing.
This “carry” constitutes the beating heart of our financial markets and ultimately our real economy as well, since profits on paper assets are inextricably linked to profits in the real economy, which are inextricably linked to investment and employment. Without these, the wounded heart dies and shortly thereafter the body. But there comes a point when no matter how much blood is being pumped through the system as it is now, with zero-based policy rates and global quantitative easing programs, that the blood itself may become anemic, oxygen-starved, or even leukemic, with white blood cells destroying more productive red cell counterparts. Our global financial system at the zero-bound is beginning to resemble a leukemia patient with New Age chemotherapy, desperately attempting to cure an economy that requires structural as opposed to monetary solutions. Let me shift from the metaphorical to the specific to make my case.
If “carry” is the oxygen that feeds financial assets then it is clear to all – even to central banks with historical models – that there is a lot less of it now than there used to be. In the bond market – interest rates, risk spreads, volatility and liquidity premiums are all significantly less than they were five years ago during the financial crisis and, in many cases, less than they have ever been in history. Before 2009, the U.S. had never had a policy rate so low, and in the U.K. short-term rates at 50 basis points are now nearly 2% lower than they have ever been, which is a long, long time. Throughout periodic depressions, the Bank of England in the 20th, 19th and even 18th century never dropped short rates below 2%. Add to that of course the New Age chemotherapy called Quantitative Easing (QE) being employed everywhere (and now in double doses at the Bank of Japan,) and you have an “all in”, “whatever it takes” mentality that has successfully lowered longer-term interest rates, risk spreads, volatility and risk premiums to similar extremes. Granted, the astute observer might counter that corporate and high yield risk “spreads” have historically been lower – and they were in 2006/2007 – but never have corporate and high yield bond “yields” been lower. Never has your average B/BB company been able to issue debt at well below 5% and never – which is my point – never have investors received less for the risk they are taking. “Never (as I tweeted recently) have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.”
In the process of reaching and stooping, prices on financial assets have soared and central banks have temporarily averted a debt deflation reminiscent of the Great Depression. Their near-zero-based interest rates and QEs that have lowered carry and risk premiums have stabilized real economies, but not returned them to old normal growth rates. History will likely record that these policies were necessary oxygen generators. But the misunderstood after effects of this chemotherapy may also one day find their way into economic annals or even accepted economic theory. Central banks – including today’s superquant, Kuroda, leading the Bank of Japan – seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment. That theory requires challenge if only because it doesn’t seem to be working very well.
Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk. Granted, some investors may switch from fixed income assets to higher “yielding” stocks, or from domestic to global alternatives, but much of the investment universe is segmented by accounting, demographic or personal risk preferences and only marginal amounts of money appear to shift into what seem to most are slam dunk comparisons, such as Apple stock with a 3% dividend vs. Apple bonds at 1-2% yield levels. Because of historical and demographic asset market segmentation, then, the Fed and other central banks operative model is highly inefficient. Blood is being transfused into the system, but it lacks necessary oxygen.
In addition, there are several other important coagulants that seem to block the financial system’s arteries at zero-bound interest rates and unacceptably narrow “carry” spreads:
- Zero-bound yields deprive savers of their ability to generate income which in turn limits consumption and economic growth.
- Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient “carry” to support employment infrastructures, then personnel layoffs quickly follow. With banks, net interest margins (NIM) are lowered because of “carry” compression, and then nationwide retail branches previously serving as depository magnets are closed one by one. In the U.K. for instance, Britain’s four biggest banks will have eliminated 189,000 jobs by the end of this year compared to peak staffing levels, reports Bloomberg News. Investment banking, insurance, indeed the entire financial industry is now similarly threatened, which is leading to layoffs and the obsolescence of real estate office structures as well which housed a surfeit of employees.
- Zombie corporations are allowed to survive. Reminiscent of the zero-bound carry-less Japanese economy over the past few decades, low interest rates, compressed risk spreads, historically low volatility and ultra-liquidity allow marginal corporations to keep on living. Schumpeter would be shocked at this perversion of capitalism, which is allowing profits to be more than “temporary” at zombie institutions. Real growth is stunted in the process.
- When ROIs or carry in the real economy are too low, corporations resort to financial engineering as opposed to R&D and productive investment. This idea is far too complicated for an Investment Outlook footnote – it deserves expansion in future editions – but in the meantime, look at it this way: Apple has hundreds of billions of cash that is not being invested in future production, but returned via dividends and stock buybacks. Apple is not unique as shown in Chart 1. Western corporations seem focused more on returning capital as opposed to investing it. Low ROIs fostered by central bank policies in financial markets seem to have increasingly negative influences on investment and real growth.
- Credit expansion in the private economy is restricted by an expanding Fed balance sheet and the limits on Treasury “repo.” Again, too complicated for a sidebar Investment Outlook discussion, but the ability of private credit markets to deliver oxygen to the real economy is being hampered because most new Treasuries wind up in the dungeon of the Fed’s balance sheet where they cannot be expanded, lent out and rehypothecated to foster private credit growth. I have previously suggested that the Fed (and other central banks) are where bad bonds go to die. Low yielding Treasuries fit that description and once there, they expire, being no longer available for credit expansion in the private economy.
Well, there is my still incomplete thesis which when summed up would be this: Low yields, low carry, future low expected returns have increasingly negative effects on the real economy. Granted, Chairman Bernanke has frequently admitted as much but cites the hopeful conclusion that once real growth has been restored to “old normal”, then the financial markets can return to those historical levels of yields, carry, volatility and liquidity premiums that investors yearn for. Sacrifice now, he lectures investors, in order to prosper later. Well it’s been five years Mr. Chairman and the real economy has not once over a 12-month period of time grown faster than 2.5%. Perhaps, in addition to a fiscally confused Washington, it’s your policies that may be now part of the problem rather than the solution. Perhaps the beating heart is pumping anemic, even destructively leukemic blood through the system. Perhaps zero-bound interest rates and quantitative easing programs are becoming as much of the problem as the solution. Perhaps when yields, carry and expected returns on financial and real assets become so low, then risk-taking investors turn inward and more conservative as opposed to outward and more risk seeking. Perhaps financial markets and real economic growth are more at risk than your calm demeanor would convey.
Wounded heart you cannot save … you from yourself. More and more debt cannot cure a debt crisis unless it generates real growth. Your beating heart is now arrhythmic and pumping deoxygenated blood. Investors should look for a pacemaker to follow a less risky, lower returning, but more life sustaining path.
The Wounded Heart Speed Read
1) Financial markets require “carry” to pump oxygen to the real economy.
2) Carry is compressed – yields, spreads and volatility are near or at
3) The Fed’s QE plan assumes higher asset prices will revigorate growth.
4) It doesn’t seem to be working.
5) Reduce risk/carry related assets.
William H. Gross
The “risk free” rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return.
A word about risk:
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Monday, June 3rd, 2013
Submitted by Charles Hugh-Smith of OfTwoMinds blog,
Whatever painlessly masks the dysfunction and corruption of the Status Quo will be the policy of choice.
Here’s the challenge the Status Quo monetary and fiscal authorities faced in the 2008 global financial meltdown: how do we maintain the power structure and keep the masses passive while masking the fact that the Status Quo is broken?
The solution: sell bonds to fund benefits to the masses, lower interest rates to zero to keep the explosive rise in fiscal deficits affordable, and rapidly inflate new bubbles in assets that painlessly enrich the top 25% of households who then increase their borrowing and spending, i.e. the “wealth effect.”
Lowering interest rates to zero is a two-fer, as it not only enables the central state to borrow vast sums by selling low-yield bonds, it also drives everyone with financial assets into a desperate search for higher yields in risk assets such as stocks and housing. This herding of capital into risk assets helps inflate the bubbles needed to generate “growth.”
Here’s the beauty of asset bubbles. How do you get trillions of dollars into households without having to borrow the money? You inflate the assets owned by the households: stocks and houses. This magically creates money out of nothing, money that the households can borrow against or sell for cash.
Why not create and distribute cash directly? Two reasons: 1) spreading around trillions of dollars in cash could eventually spark inflation, which would kill the entire project by pushing bond yields higher, and 2) politically, the only cohort the authorities care about are the wealthy who fund the political Elite and the half of the adult populace who votes.
The political calculus is simple: the bottom half of households don’t vote, don’t contribute to political campaigns and don’t have enough income to borrow huge sums of money to enrich the banks. They are thus non-entities in the fiscal-monetary project of maintaining the power structure of the Status Quo.
All the Status Quo needs to do is borrow enough money to fund social programs that keep the masses passive and silent: food stamps, Section 8 housing vouchers, Medicaid, Medicare, Social Security, SSI permanent disability, unemployment, etc.
Unfortunately for the Powers That Be, the cost of placating the rapidly increasing marginalized populace is rising much faster than tax revenues. Here are two charts of interest (source: Kleiner Perkins Caufield Byers 2013 Internet Trends)
The happy story of 2013 is that tax revenues are rising fast while government spending has stopped rising. This is risible, as the same agencies drawing these projections have never forecast a recession or downturn. Taxes rise in bubbles, so no wonder tax revenues are up–and of course, tax rates increased on the margins.
Longer term, Federal expenditures will inexorably rise as the social programs for the elderly absorb 10,000 retiring Baby Boomers a day.
Here’s the problem with bubbles: they pop, despite the best efforts of the fiscal and monetary authorities to keep them inflating forever. And when bubbles pop, assets decline in value. Borrowing, spending and tax revenues all decline.
Near-zero interest rates have problems, too: One, they stripmine pension funds and savers seeking save yields on cash, forcing everyone into risk asset bubbles, where those seeking higher yields are crushed when the bubbles pop, and two, nothing stays low or high forever. Piling up debt at near-zero rates is affordable fun, but when rates rise, the costs of servicing the debt pile skyrocket.
At that point, a feedback loop is set in motion that will bring down the entire system: investors will see fiscal authorities struggling to fund their social programs and pay rapidly rising interest on the vast mountain of government debt, and start wondering if the government will be able to meet its rapidly rising commitments with stagnant tax revenues.
The prudent investor, money manager and pension fund manager will demand a higher risk premium to reflect the possibility that the bond will be repaid with depreciated currency.
That will drive up the interest rate on all future borrowing, which will further stress government obligations which will increase the risk of default or depreciation of the currency, and so on.
The only way to stop this feedback from starting is for the central bank to buy essentially all the bonds sold by the government. This is the path that Japan and the U.S. have taken; both the Bank of Japan and the Federal Reserve are buying government bonds, essentially removing them from the tidal forces of the market with instantly created money.
Are there any limits on the balance sheets of the central banks? Why not transfer $100 trillion to the balance sheet of the Fed? Indeed, this path appears absolutely painless to all involved, and that’s why Japan and the U.S. have pursued this strategy with such gusto.
Whatever painlessly masks the dysfunction and corruption of the Status Quo will be the policy of choice. And right now, that policy is transferring government bonds to the central banks so the fiscal authorities can continue to borrow and blow trillions of dollars rather than restructure their broken financial systems and economies.
The problem with neutering the market to mask systemic dysfunction is that the return on the policy diminishes at the same time that risk is transferred to the entire system. Risk cannot be disappeared, it can only be transferred or hedged. Burying immense debts in the balance sheets of central banks doesn’t make risks disappear, it simply transfers the risk to the entire system.
And when you do that, you get a chart like this:
Anyone who is paying attention to the peculiar gyrations and dislocations in the Japanese bond and currency markets has to wonder if Japan has finally succeeded in entering Phase III, when official credibility and the illusion of central control both crumble.
The beauty of bonds and bubbles is fleeting. The fiscal and monetary authorities are claiming the beauty of bonds and bubbles is ageless, thanks to their magic; but no amount of false data and trickery can possibly eliminate the systemic risk piling up behind the rickety facade of illusory control.
Monday, June 3rd, 2013
The Economy and Bond Market Radar (June 3, 2013)
Treasury yields moved sharply higher this week as the bond sell off that began early this month continued. Fears of the Federal Reserve “tapering” (reducing QE and the first step on a long road toward tightening monetary policy) continued and investors are focusing on the potential end in a multi decade bull market for bonds.
- Consumer confidence rose to a five-year high as both current and future expectations improved. The University of Michigan’s Confidence Index also rose in May.
- Existing home values rose 10.9 percent in the twelve months ending in March, the biggest gain since 2006.
- The Chicago Purchasing Manager Index rose to the highest level in a year and well into expansion territory, which bodes well for next week’s national ISM report.
- The total number of mortgage applications, according to the Mortgage Bankers Association, filed in the U.S. last week fell 8.8 percent from the prior week. This was the third week in a row of large declines in mortgage activity due to rising interest rates.
- Personal income and spending in April came in below expectations as income was flat and spending was down.
- Brazil unexpectedly raised interest rates by 50 basis points this week to fight inflation even with weaker than expected economic growth.
- The Fed continues to remain committed to an extremely accommodative policy.
- Key global central bankers are still in easing mode such as the European Central Bank (ECB), Bank of England and the Bank of Japan. The Bank of Japan, in particular, is aggressively easing currently and the ECB recently cut interest rates.
- Inflation in some corners of the globe is getting the attention of policy makers and may be an early indicator for the rest of the world.
- Trade and/or currency wars cannot be ruled out which may cause unintended consequences and volatility in the financial markets.