Equity Implications for a Modest-Return World

Monday, July 30th, 2012

by Andrew Pyne, PIMCO

• Equity valuations appear reasonable, but volatility is likely to remain elevated amid slowing global economic growth and macroeconomic risks.
• As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value.
• Investors should consider increasing exposure to emerging markets, deploying downside-risk and volatility-mitigation, emphasizing dividends and focusing on active share.

PIMCO’s secular outlook calls for slowing global economic growth, a world that is still multi-speed, and unresolved macroeconomic risks that are likely to result in continued heightened volatility. While our view on the economy is a cautious one, overall equity valuations appear reasonable, and corporate fundamentals, as measured by earnings, margins and balance sheets, are relatively attractive. The outlook for equities, then, can be expressed as a tug of war between these macro headwinds and micro fundamentals.

What does this mean for equities, which are still the dominant risk in investor portfolios? Overall, we believe that continued policy confusion and economic fundamentals that are trending in a negative direction will create headwinds. As the developed world continues to delever, we expect global equities to experience a modest-return environment.

Challenges and solutions

The clear implication is that this creates a challenge for investors. Most investors historically have relied on equities to help achieve their target portfolio returns. In this environment, though, beta is unlikely to deliver the returns required. We believe that investors should consider the following:

• Increase exposure to faster-growing economies. Many portfolios should be more global with higher allocations to emerging markets.
• Incorporate downside-risk and volatility-mitigation to address the higher probabilities of negative macro events.
• Emphasize dividends, which will likely be a more important component of equity total returns.
• Take greater active risk and focus on active share. In a modest-return world, if beta doesn’t get the job done, then alpha may be a significant percentage of an investor’s equity returns.

Multi-speed world

The key risk to the global economy is Europe, which given significant structural challenges and policy uncertainty is facing prolonged subdued growth and the risk of recession. Why then do we suggest equity portfolios be more global? The answer lies partly in the way equities have traditionally been categorized. Companies are often classified by their country of domicile, but we think they are better defined by their end-markets. Despite significant risks at home, many European multinationals have meaningful exposure to emerging markets. If we find businesses with stable cash flows, high dividend yields, strong end-market growth – and with valuations that discount home-market risks – these can be attractive investment opportunities.

In addition, we believe most investors, particularly those with a home-market bias, would benefit from increased direct exposure to emerging markets. While emerging markets are certainly not immune to the struggles of the developed world, emerging markets and developed markets face very different economic scenarios. We expect emerging markets to continue to gain share of global GDP, but most investors are still underweight the asset class. We expect emerging markets to account for more than 50% of global GDP in purchasing power parity terms over the next three to five years. They already are about a third of global equity market caps. Yet emerging market equities represent only about 7% of the average investor’s portfolio.

Managing macro risks

Our second suggestion is to prioritize downside- and volatility-mitigation in equity portfolios. Correlations among stocks have increased meaningfully over the past few years; they’ve tended to spike around negative macro events and decrease as uncertainty subsides (see Figure 1). This suggests that the “risk-on/risk-off” sentiment that drives stock prices is often governed by macro news flows, not company fundamentals.

There are two takeaways for investors. The first is that macro does impact stock prices, and so while equity investing has traditionally been thought of as a bottom-up endeavor, we believe managers need to consider both bottom-up and top-down views as part of their research process.

The second takeaway is that because there are unresolved macro risks, investors must recognize that, given the way returns compound over time, protecting on the downside could be a critical contributor to long-term returns. Part of the solution may be increasing allocations to active mandates from passive. Although investors could lose more with an active approach, by definition traditional indexes will capture 100% of down-market performance.

We believe protecting on the downside requires a very active approach. Strategies including low-volatility and dividend-focused investing, tail-risk hedging, and flexibility to short stocks or raise cash, may result in improved risk mitigation compared with a passive strategy.

Dividend income

Dividend income, a significant portion of historical equity returns, is likely to be even more important in an environment of slower growth. Of course, if we were expecting broad multiple expansion and strong global growth – as we saw in the ‘80s and ‘90s – then the message simply would be “buy equities and enjoy the ride.” As Figure 2 shows, however, dividends often have been a substantial portion of total equity performance during periods of modest returns. While many investors’ assumptions and expectations for equities were formed by the 20-year bull market of the ‘80s and ‘90s, the ‘40s, ‘60s and ‘70s may be more instructive for the period ahead.

We also believe the opportunity for dividend-paying stocks is more of a global story than a U.S. one. Given demand from U.S. investors for income, traditional dividend-paying sectors in the U.S. – telecom, utilities, Real Estate Investment Trusts (REITs), and Master Limited Partnerships (MLPs) – are generally quite expensive, whereas select non-U.S. equities, including emerging markets, remain attractive sources of yield.

Essential alpha

Two points outlined above – the notion that macroeconomic news flow influences stock prices and the expectation for modest returns – each reinforce the importance of alpha in helping investors achieve their goals. As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value. The key is to be highly selective, identifying the long-term winners even as the markets are indiscriminate in the short term.

For many investors, the importance of alpha should prompt a reconsideration of the mix of passive and active equity allocations. At the very least, we believe investors should ensure that their active managers are truly active, with high active share a prerequisite for inclusion in their portfolio (please see Equity Investing: From Style Box to Global Unconstrained, May 2012).

Revisiting equity portfolios

In an environment of fatter tails, there is always the possibility of a right-tail event. Enactment of comprehensive and bipartisan policies to address structural problems in developed markets, for example, would be welcome news and would likely lead to broad multiple expansion and higher returns in the equity markets. However, absent such developments, economic fundamentals suggest more modest returns.

Many investor portfolios may not be positioned for a lower-return world, particularly those that were structured during a higher-return equity environment. We believe investors would be well served to take a fresh look at their equity allocations. If beta will not suffice, then investors should work to ensure their portfolios have the characteristics needed to succeed.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

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. Outlook and strategies are subject to change without notice.

The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The S&P 90 (prior to 1957) was a value-weighted index based on 90 stocks. It is not possible to invest directly in an unmanaged index.

This material contains the 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. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

©2012, PIMCO.

Tags: Active Share, Balance Sheets, Downside Risk, Economic Fundamentals, Emerging Markets, Global Economic Growth, Global Equities, Headwinds, Impo, Mitigation, Negative Direction, PIMCO, Policy Confusion, Portfolio Returns, Pyne, Target, Tug Of War, Valuations, Value Investors, Volatility
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Three Years and Counting (Kashkari)

Thursday, June 14th, 2012

• In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.
• As heightened volatility persists, many equity investors remain on the sidelines. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.
• We believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term. Equity investors should continue to focus on
  higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

We recently concluded our Secular Forum, an annual event in which PIMCO investment professionals from around the world discuss and debate our three- to five-year outlook for the global economy and financial markets. The Secular Forum process demands that we focus on the long term and imposes a discipline on us that we believe makes us better stewards of our clients’ capital.

Mohamed A. El-Erian published a summary of our conclusions from the Forum, titled Policy Confusions and Inflection Points. And my portfolio manager colleagues are participating in a series of interviews discussing these conclusions.

My goal here is to discuss what our revised Secular Outlook means for equity investors. But first I think it is important to take a moment to review conclusions from prior Secular Forums and objectively consider what has actually happened in the intervening periods. What have we gotten right? What has surprised us?

In the spring of 2009, with the U.S. economy and financial markets still reeling from the financial crisis, PIMCO conducted its annual Secular Forum right on schedule. It was during this time that PIMCO first applied the term New Normal to its updated outlook for the global economy. It is important to note that I wasn’t at PIMCO at the time – I was still at the Treasury helping to fight the financial crisis. I only joined PIMCO six months after I left government.

As government officials consumed with trying to stabilize the global financial system, my colleagues and I were much more concerned about surviving the next few days or weeks than thinking about the next three to five years. It is noteworthy that an investment management firm had the poise to stop to think about the longer-term outlook during that stressful time.

The New Normal called for long-term deleveraging that would lead to lower growth than society had been accustomed to. It called for more modest investment returns across asset classes, as the leveraging of the economy reversed course. It called for increased regulation and reduced globalization. Most importantly, it said there would be no V-shaped recovery that is typically seen after a recession. It would be a long, hard adjustment period with sustained high unemployment. It also called for a transition of stress from private balance sheets to sovereign balance sheets.

These trends, unfortunately for societies, have played out as my PIMCO colleagues forecasted. I also observe that implicit in their forecast was the assumption that policymakers would be successful in stabilizing the financial system and preventing a collapse. In hindsight, they seem to have been more confident than we in government were at the time. I am glad they were right.

While this may seem self-congratulatory for me to pat my PIMCO colleagues on the back, as I noted above, I wasn’t at PIMCO at the time. I am just observing, with the benefit of hindsight, what has actually happened.

While PIMCO’s New Normal call has proven remarkably accurate, its implications for equities were less clear. PIMCO did not forecast that central banks would employ unprecedented aggressive monetary policy via quantitative easing with the specific goal of pushing up the prices of risk assets in an attempt to stimulate economic activity. The QEs have been effective in pushing up equities (see Chart 1 below) and staving off deflation, though the effect on real GDP is less clear. In addition, the New Normal did not forecast record corporate profits that many companies have enjoyed, especially large multinationals. In the past three years, equities have rallied more than the underlying economic fundamentals would have predicted on the back of extraordinary monetary policy activism and strong corporate earnings.

In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.

Chart 2 shows the VIX, or volatility index of the S&P 500 Index, over the past 10 years. You can see three fairly clear periods: “old normal,” financial crisis and New Normal. As the crisis has spread from corporate to sovereign balance sheets and from the U.S. to Europe, sentiment has repeatedly swung from fear to greed and back to fear, triggering wild swings in equity markets.

Many investors, both individuals and institutions, were truly shocked by the losses they experienced during the financial crisis: The S&P 500 fell 38% in 2008. After years of gains, many people couldn’t believe their nest eggs were being destroyed. This experience has left many investors both scared and scarred – and as heightened volatility persists, many equity investors remain on the sidelines.

Our updated Secular Outlook calls for a continuation of the deleveraging we’ve experienced for the past few years. Slow real economic growth in America of 1% to 2%, a likely recession in the eurozone stemming from the ongoing debt crisis, and – and this is really important – slowing growth in the emerging markets of 5%, down from 6% previously. Remember, emerging markets have powered the global economy for the past few years; the U.S. will have to carry more of that load now. But with more moderate overall global economic growth in the next three to five years, markets will be more vulnerable to shocks.

The volatility that equity markets have experienced in the last few years is also likely to continue for the foreseeable future. The crisis in Europe will take years to resolve in part because policymakers there are trying to simultaneously achieve multiple, often-divergent objectives: 1) preserve basic eurozone stability, 2) keep pressure on fiscal authorities to make hard choices and 3) keep inflation in check. These multiple objectives prevent them from taking final, decisive action to quell the crisis. Our base case outlook is continued spurts of crisis and volatility coming out of Europe. These policy and macro factors will likely continue to overwhelm company-specific factors in the short term.

Many investors aren’t sure what to do – where to turn for “safe” investment returns in light of this volatility. As I regularly meet with clients and financial advisors, I repeatedly hear a few questions about how to navigate these choppy equity markets that are worth discussing here:

Given the volatility of the New Normal, why should I invest in equities at all? Why shouldn’t I just sit in cash and wait it out?
Unfortunately the final end-state for the global economy following this debt-induced crisis is unclear. If the global economy faces deflation, sitting in cash or fixed income instruments will probably be the best option. Purchasing power will increase as prices fall. While a deflationary scenario is not impossible, it is the least likely outcome given central banks’ actions to date. More likely is a moderate inflation scenario. Sitting in cash in such a scenario will see purchasing power degrade due to inflation. Equities should perform well in a moderate inflation scenario. This is our highest likelihood outcome.

A high inflation scenario can’t be ruled out either. It is possible that central banks could lose control of inflation expectations. In such a scenario cash and bonds will likely perform the worst, with equities next. Real assets and commodities would likely perform best, because prices for those assets should rise with inflation.

Because of the uncertainty regarding the end-state of the global economy and the fact that the only scenario in our view where cash performs well is the least likely, deflationary scenario, sitting on the sidelines is unfortunately not a good option for those who have future liabilities they need to meet. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.

Given our outlook that moderate inflation is the outcome with the highest long-term probability, we believe equities should be a meaningful part of a diversified investment portfolio. Equity investors should continue to focus on higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

My clients just can’t take the equity market pullbacks. What should I do as a financial advisor?
Many clients are in this situation. From May 2002 to May 2007, during the old normal, the S&P 500 experienced a 5% correction from a recent high five times, or on average of once per year, and a 10% correction four times. In the three New Normal years from May 2009 to May 2012, the S&P 500 experienced seven 5% corrections, more than twice as often, and a 10% correction three times. This increased downside volatility not only has direct financial implications for clients, but also has indirect effects that are important too: The emotional swings are scaring clients into sitting on the sidelines. As discussed above, this could prove very costly if central banks are successful in engineering moderate inflation, let alone high inflation.

We believe clients and advisors should focus on strategies that can be used to manage downside volatility. There are a number of ways to pursue this: 1) Buying higher-quality companies and those with strong balance sheets, because they tend to be more resilient against shocks, according to our research. 2) Buying companies at deep discounts to their intrinsic value. 3) Buying companies offering more immediate return on investment through dividends. 4) Actively hedging the portfolio, with tail risk hedging (which refers to taking a defensive position against extreme market shocks), or other means. 5) Investing in multi-asset solutions that provide diversification and include equities, fixed income securities and commodities in one vehicle.

Is passive or active management better in this environment?
We believe there is a place in client portfolios for both passive and active management. Each has advantages. Passive management tends to be cheaper than active management. But with each pull back in the equity markets, a passive strategy should fall in lock-step with the market. Passive index replication, by definition, has no downside protection against market moves. If clients are alarmed about market corrections, passive management won’t help them. A related point that I have written about previously (Teaching to the Test – September 2011) is that many managers associate index investing with taking less risk. Index investing is taking no benchmark risk, but clients are still taking risk – as the S&P 500’s 38% loss in 2008 so painfully reminds us.

We believe active management should aim to provide clients with a better experience. That means enabling clients to participate in much of the growth, appreciation and income potential provided by a vibrant equity market, while also actively managing against major pullbacks associated with macroeconomic shocks that we’ve been experiencing over the last few years. Achieving this – capturing most of the upside while limiting the downside – isn’t easy. It requires both deep company-specific analysis and a strong top-down, macroeconomic framework. And we believe it requires investing globally to take advantage of the best possible risk-adjusted return opportunities wherever they are. Limiting the downside likely requires giving up some upside in a rally – and in this environment especially – we think that’s probably a good tradeoff. It would be great to be able to limit the downside without sacrificing any upside. Unfortunately that’s not realistic – but we believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term.

Although markets are again focused on risks from Europe right now, sentiment will likely swing back to “risk on” again, and people will wonder what all the fuss was about. And then at some point it will swing back to “risk off.” Equity investing in this environment isn’t easy or for the faint of heart. With long-term risks of global inflation, sitting on the sideline isn’t an option for many people. We think the right approach is to focus on the right companies and to be willing to give up a little upside, while working hard to protect the downside. Call it the New Normal of equity investing: Three years and counting.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

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 long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.

This material contains the 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 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. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.

Copyright © PIMCO

Tags: Asset Classes, Attractive Returns, Balance Sheets, Confusions, Downside, Equity Investors, Erian, Financial Markets, Global Economy, Growth Markets, Inflection Points, Investment Approach, Investment Professionals, Low Interest Rates, Market Volatility, Portfolio Manager, Quality Companies, Sidelines, Stewards, Term Equity
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One Sided Balance Sheet and Solvenquidity (Tchir)

Wednesday, June 13th, 2012

One Sided Balance Sheets

I’m seeing a lot of negative headlines about how much more debt Spain is adding. How much subordination there is going to be for existing creditors. That is in spite of a lack of detail. I’m not here to cheerlead this deal, but at the same time, falling prey to the easy headlines is dangerous.

No one seems to be talking about the “asset” side of this program. The FROB will borrow money and it will buy assets. The proceeds from either repayment or sale of those assets would be used to pay back FROB’s borrowing. If everything FROB buys is worthless, than yes, the Kingdom of Spain will owe a lot of money under those guarantees. If the FROB made great investments, all the debt could be repaid by the investment and no claim ever made under the guarantee.

Once again, the answer is likely to be in between. The U.S. has done okay on TARP. Since the U.S. forced some of the better banks to take on money, the recovery/repayment rate is artificially high but at least worth looking at. The IMF involvement is a good sign here. If Spain was completely in control of investing FROB’s money, I would quickly assume the assets would wind up with no value. That might be unfair to Spain, but I would not for a second trust them to make decent investments with the FROB money. The IMF, I will grudgingly admit, does seem to actually try and run numbers and make sane decisions. They seem less likely to lose all the FROB money.

When I see everyone talking about all the great points of the deal, I will reconsider my view, but right now, I see simple headlines and negative reactions to those simplistic headlines. I don’t see this deal as a game changer on its own, but I don’t think it is as bad as some are pitching it right now, and more importantly, am very scared as a potential bear that there are more ideas and programs in the global pipeline.

Solvenquidity

Solvency and Liquidity are usually two different concepts.

A “liquidity” problem is when a solid borrower who for some reason cannot get access to money at a particular point in time. There is usually some reason that the company cannot borrow, and it has less to do with the creditworthiness of the borrower than on the market as a whole.

A “solvency” problem is when a creditor is so weak, overleveraged, that they have no way to borrow because they are on the verge of default.

Typically those two situations are different. If some entity tried to address a solvency problem by lending more and more, they could do that, but eventually they would run out of money as the market would stop lending to them. If A is a horrible credit, B can choose to lend to B so long as B has money. If B is willing to lend cheaply and in ever increasing size, A can continue to avoid default. It is the doubling down on an unlimited table theory in blackjack. In the real world, B will start having trouble getting money to lend to A because its creditors will see how stupid it is behaving. That mechanism is what separates solvency from liquidity.

What happens when the lender can print its own limitless supply of money? If you can print money and are willing to continue to print money you can use liquidity to avoid solvency for a very long time. I don’t condone that. I think it is horrible in the long run. I think we should have let more entities go bankrupt, starting with Bear Stearns back in 2008, and Greece in 2010, but for whatever reason the politicians have been petrified to do that.

Will they finally step up and let failure and bloated balance sheets run their course? I hope so, but I doubt it. I think we will see more activity, and for all the talk that you can’t solve a solvency issue with liquidity, you are right, but sadly a lender with virtually unlimited access to cheap money (since he prints it) can provide enough liquidity to address solvency for a long time. The end result is likely to be ugly, but that doesn’t mean the central bankers won’t try.

Tags: Assets, Balance Sheet, Balance Sheets, Creditors, Different Concepts, Frob, Global Pipeline, Guarantees, Imf Involvement, Kingdom Of Spain, Liquidi, liquidity, Negative Headlines, Prey, Proceeds, Repayment Rate, Solvency, Spite, Subordination, Tarp
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What Record Low 10-year Rates Tell Us About the Toxic Effects of Permanent Zero

Thursday, May 31st, 2012

 
by Edward Harrison, Credit Writedowns

On Twitter the latest buzz is about the US ten-year government bond hitting a record low of 1.6713%. Some are amazed that the world of ‘financial repression’ where long-term yields are lower than consumer price inflation can go on and on without a hiccup. Well don’t be. Long-term interest rates are a series of future short-term rates. If the central bank is telling you that zero rates are practically permanent i.e. permanent zero, wouldn’t you expect the term structure to eventually flatten? That’s what has happened, folks – just as in Japan.

So what does this mean for you and me? Well, first of all, what’s your savings account statement saying? Is it telling you you can spend a lot more because you are flush with interest income or is it telling you you better save more if you expect to retire without having to live on cat food? Here’s another question: does this bode well for consumption or ill? Clearly, it bodes ill via the interest income channel but it could bode well if you and I leverage up a bit as debt service costs are down. And that is the point of low rates, by the way.

The Fed is squeezing interest rates down to levels where you see private portfolio preference shifts, a euphemism for the risk seeking return mentality that arises from artificially low real fixed income returns and that forces up risk assets. But this can only go one for so long.

See, eventually there will be another recession and the question should be what happens to all those toxic assets on bank balance sheets. What happens if new loans go sour too? If you recall, US FDIC-insured institutions recorded $35 billion in Q1 2012 accounting gains. But the quality of those accounting gains was dubious. Here’s the key line to note:

Lower provisions for loan losses and higher noninterest income were responsible for most of the year-over-year improvement in earnings.

That means FDIC insured institutions are under-provisioning and earning money through non-lending channels. These institutions are taxpayer guaranteed by the FDIC because they take deposits and lend that money in support of economic activity. Yet, what the FDIC is telling you is that institutions are not earning money through the traditional interest income channel which is the source of their FDIC guarantee. And that’s as you should expect in a permanent zero environment.

After all, that’s what regulatory forbearance is all about, by the way. The S&L crisis is a prime example:

So what happened in the S&L crisis is that in the early 1980s American banks got slammed by Volcker’s high interest rates. Lending long and borrowing short meant that they were losing money as short rates skyrocketed. What’s more is that the S&L model was busted by money market funds which competed with the S&L’s low cost deposit funding base. The fix was what is known as regulatory forbearance, which is a fancy way of saying regulators looked the other way as insolvent banks continued to operate as if they were solvent.The thinking here was that giving the banks a bit of time to “earn” their way back into solvency would keep the 1980-1982 crisis from becoming another Great Depression. There was no Great Depression in 1982. But S&L executives ended up loading up on risky high yield assets, knowing that it was a heads-I-win tails-you-lose situation since their banks were already insolvent. Many like Charles Keating turned to fraud and looting, what criminologist and law professor Bill Black calls control fraud.

So, what we should expect going into the next downturn is an environment in which banks have much less net interest margin as the yield curve is as flat as a pancake due to permanent zero. As the downturn takes form, risk assets will be selling off and loans will be souring such that the sources of accounting gains today will turn to sources of accounting losses. And then the worry again will be about bank solvency. When I see record low yields in the United States, that’s what I am seeing.

About Edward Harrison

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

Copyright © http://www.creditwritedowns.com

Tags: Balance Sheets, Bank Balance, Cat Food, Consumer Price Inflation, Debt Service Costs, Edward Harrison, Financial Repression, Fixed Income, Government Bond, Hiccup, Interest Income, Key Line, Loan Losses, Private Portfolio, Savings Account, Term Interest, Term Structure, Term Yields, Toxic Effects, Zero Rates
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NYSE Short Interest Rises to 2012 Highs

Thursday, May 10th, 2012

On the surface, the fact that NYSE short interest was just reported today to have risen to 13.1 billion shares as of April 30 could be troubling for the bears, as this just happens to be the highest short interest number of 2012. Indeed, an increase in short interest into a centrally-planned market is always disturbing, as it opens up stocks to the kinds of baseless short covering melt ups that simply have some HFT algo going on a stop hunt as their source, that we have seen in the past several weeks. Naturally, it would be far easier to be short a market in which Ben Bernanke managed to eradicate all other bears, especially when considering that a year ago the Short Interest as of April 30 was virtually identical.

However, courtesy of some recent discoveries by Bloomberg, we now know that his very pedestrian way of looking at short exposure is simply naive, as it ignores all the synthetic means that hedge funds truly express their position these days, mostly in attempts to avoid observation, and to magnify their balance sheets in any way possible. In other words: epic abuse of leverage, but not simply on the books, but through repos, Total Return Swaps, and various other shadow “shadow” P&L enhancement techniques. To wit from Bloomberg:

Citadel Advisors LLC and Millennium Management LLC said their assets soared ninefold when tallied under a new rule that requires hedge funds to disclose investments financed through borrowings.

 

Citadel, run by Ken Griffin out of Chicago, reported $115.2 billion of regulatory assets in a March 30 filing with the U.S. Securities and Exchange Commission, compared with $12.6 billion of net assets. Millennium, founded by Israel Englander, disclosed comparable figures of $119 billion and $13.5 billion as of year-end.

…

 

In short sales, investors borrow assets to sell them in anticipation that they can be repurchased at a lower price later and they can pocket the difference. Hedging includes the purchase of offsetting positions to limit risk in a trade.

 

While some fund managers only gave information on their gross assets, 31 of the 50 largest also disclosed their net assets in a separate section known as the client brochure. For these advisers, gross assets of $949 billion were more than double their net assets of $422 billion.

 

That indicates hedge funds may be using as much leverage as they did prior to the 2008 financial crisis. On average, hedge funds held total assets that were double their net capital as recently as 2007, said Daniel Celeghin, a partner at Casey Quirk & Associates LLC, a Darien, Connecticut, adviser to asset managers.

 

Not all of the difference between net and gross assets may be explained by leverage, because the SEC’s gross number also includes proprietary stakes that money managers hold in their own funds as well as assets that don’t get charged a management fee. The SEC’s calculating method can lead to double counting of assets at funds, such as Citadel, that include multiple entities.

 

“If you are heavily levered, obviously that will result in you having a larger gross asset number,” said Gary Kaminsky, a principal in the business advisory services group at Rothstein Kass, a Roseland, New Jersey, accounting firm that audits hedge funds. That’s because, under the SEC approach, “all that matters is what’s on the asset side of the balance sheet,” Kaminsky said.

 

Hedge funds are relying less on margin loans from prime brokers, the securities firms that provide credit and facilitate trading, and more on repurchase agreements, leveraged exchange- traded funds, and derivatives such as total return swaps, according to Josh Galper, the managing principal at Finadium LLC, a Concord, Massachusetts, investment research and consulting firm.

 

“Leverage is down across the board from the perspective of borrowing from a prime broker,” Galper said in a telephone interview. “It’s tough to measure how much embedded leverage funds are using.”

In other words, while the chart above is useful generically, the reality is that a true picture of outright bullish or bearish appearance is now impossible to be gleaned courtesy of precisely the same synthetic instruments that nearly destroyed the financial system in the fall of 2008. Funds will do anything in their power to systematically boost their leverage at the gross level, while leaving their net leverage appear innocuous, and then spin how gross is not net, even as their Prime Brokers onboard all the risk: after all who bails them out if things go wrong? Why, you do.

And who benefits if they are right? Here’s who, together with an AUM breakdown based on the old and new methodology:

Tags: Anticipation, Balance Sheets, Bloomberg, Borrowings, Citadel Run, Comparable Figures, Enhancement Techniques, Hedge Funds, Hft, Israel Englander, Ken Griffin, Millennium Management, Net Assets, Nyse Short Interest, Recent Discoveries, Regulatory Assets, Return Swaps, Securities And Exchange Commission, Ups, Year End
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Can Stocks Avoid Another Bear in Spring?

Thursday, May 3rd, 2012

Can Stocks Avoid Another Bear in Spring?

by Francis Gannon, Royce Funds

After back-to-back double-digit return quarters, the equity markets paused in April. Uncertainty and volatility returned on renewed concerns about a slowdown in economic growth in the United States and China, and the never-ending debt crisis in Europe. Interestingly, these are the same issues that unsettled investors during the spring of 2010 and 2011, and there remains widespread fear that this year could play out the same way. After falling close to 30% in the first quarter, the CBOE Volatility Index (VIX) spiked 20% and the Russell 2000 Index fell -1.54% during April.

Many investors remain spooked by the last two cruel Aprils. They can easily recall how well stocks, especially small-caps, did during the early months of the past two years, only to peak in 2010 on April 23 before dropping 20.3% through July 6, 2010, and then peaking on April 29, 2011 before plunging 29.1% through October 3, 2011.

Whatever the combined reasons for the change in the market’s fortunes, we have been struck by the consistently optimistic tone we are hearing from corporate managements following first-quarter earnings. From our perspective, while many are once again questioning the sustainability of earnings and fear that peak margins are at hand in the face of renewed economic concerns, we think there is a long way to go.

It’s probably not surprising that, lost among today’s uncertain macro headlines and the seemingly endless fear of equities falling (as measured by sustained actively managed equity mutual fund outflows), is the reality that high-quality smaller companies not only have strong balance sheets, but also continue to expand in what can only be described as an anemic economic growth environment.

While popular opinion seems to be calling for margins to reverse, we have been hearing about continued productivity gains, expanding profit margins, and sound capital allocation in many of our recent conversations with corporate management teams. In fact, for many companies, the spread between the cost of capital and return on capital has never been wider, which should continue to drive capital formation and therefore growth and margin expansion.

Remarkably, small-cap operating margins remain significantly below prior peaks, and there is ample room for continued expansion. According to Chip Miller of UBS, “S&P SmallCap 600 operating margins are roughly 180 basis points—or 20%—below last cycle’s high.” To be sure, smaller-company margins in general have been solid, but we think they have room to improve.

The immediate issue, then, is whether or not the market can avoid a third consecutive bearish spring. Will the third time be the charm? For the moment, the market is caught in a tug of war between better first-quarter corporate earnings and a string of disappointing economic news. Could this be the beginning of another economic growth scare and equity correction? We are not sure. We do know, however, that corrections happen. From our perspective, they are part of the small-cap landscape and occur on a regular basis. They are neither unusual nor unprecedented.

“Price corrections serve an important function
in our investment process, allowing for the accumulation
of well-run companies at attractive prices.
After all, total return is a function of entry price.”

Using the Russell 2000 as an example, the small-cap index has experienced 18 downturns of 10% or more since its 1979 inception, including the most recent one in 2011. While calendar-year declines have occurred about every third or fourth year, downturns of 10% or more have happened about every other year. Without a doubt they are unpleasant, but in our view they remain a key component in building higher long-term returns.

Price corrections serve an important function in our investment process, allowing for the accumulation of well-run companies at attractive prices. After all, total return is a function of entry price.

We have always believed in the old adage that “great companies create their own success,” which is especially true today as many smaller companies position and prepare for better economic times in the not too distant future. It is also true, from our perspective, that there is an abundance of high-quality small-caps trading at a discount not only to their fellow small-caps but to their larger-cap siblings as well.

Stay tuned…
FDG

Important Disclosure Information

Francis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor’s based on market size, liquidity and industry grouping, among other factors. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The S&P 600 is an index that covers roughly the small-cap range of stocks selected by Standard & Poor’s based on market size, liquidity and industry grouping, among other factors.

Tags: April 29, Balance Sheets, Capital Allocation, Cboe Volatility Index, Debt Crisis, Economic Concerns, Endless Fear, Fortunes, Francis Gannon, Growth Environment, Optimistic Tone, Popular Opinion, Productivity Gains, Profit Margins, Quarter Earnings, Royce Funds, Russell 2000 Index, Slowdown, Small Caps, Smaller Companies
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Is the Fed Promoting Recovery or Desperation? (Hussman)

Monday, April 9th, 2012

On Friday, the Department of Labor reported that March non-farm payrolls increased by 120,000, falling well short of consensus expectations in excess of 200,000. For our part, we continue to expect a deterioration in observable economic variables, with weakness that emerges gradually and then accelerates toward mid-year. On the payroll front, our present expectation is that April job creation will deteriorate toward zero or negative levels.

Immediately after the payroll number was released, CNBC shot out a news story titled “Disappointing Jobs Report Revives Talk of Fed Easing.” Of course it does, because this remains a market dependent on sugar. And with little doubt the Fed will eventually deliver it – perhaps following a market plunge of 25% or more – but with little doubt nonetheless, because like the indulgent parent of a spoiled toddler, the FOMC can’t stand to see Wall Street throw a tantrum without reaching for a lollipop.

If the Fed indeed steps in with an additional round of QE, a few distinctions may be helpful. First, regardless of Fed actions, and even in the past few years, the market has invariably suffered significant losses following the emergence of the “overvalued, overbought, overbullish, rising-yields” syndrome that we presently observe. In contrast, the main window where it has not paid to “fight the Fed,” so to speak, has been the period coming off of oversold lows. That’s primarily the window where financials, cyclicals, materials, and garbage stocks with highly leveraged balance sheets have outperformed. Regardless of the fact that QE has had no durable economic benefits (more on that below), and does little but to repeatedly lay fresh wallpaper over the rotting edifice that is the global banking system, the main effect of QE has been to provide temporary support for the most speculative corners of the financial market after they have been pummeled.

Strategically, then, we concede that there is some latitude to ease back on defensiveness between the point where QE induces an early improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an “overvalued, overbought, overbullish, rising-yields” syndrome is established. But once that syndrome is established, it is unwise to ignore it, and a defensive stance becomes essential (as we saw separately in 2010 and 2011, not to mention at most major market tops over history). Meanwhile, it is unwise to believe that additional rounds of QE will do much to help the economy in any event, as its primary effect is merely to drive investors into speculative investments by starving them of safer yields.

There is a very well-defined theoretical and empirical relationship between the monetary base and targets like short-term interest rates and monetary velocity (see Sixteen Cents: Pushing the Unstable Limits of Monetary Policy), but investors should note that the response of the stock market and other financial assets to quantitative easing is far more based on superstition than on structure. We can observe, for example, that drowning the financial markets in zero-interest assets has tended to lower the yields (and therefore raise the prices) of higher-risk, longer-duration assets, but that response is dependent on a certain form of myopia. Specifically, investors either have to assume that they can safely speculate until some particular date arrives on the calendar and they can all take their profits simultaneously, or they have to ignore the tendency for low prospective long-term returns to go hand in hand with quite negative prospective intermediate-term returns. For that reason, any “QE indicator” we might develop (as several people have requested) would likely be spurious and not very robust going forward, even though one might be back-fitted to the data. A better approach, as noted above, is to take a signal from market action and trend-following measures, but emphatically to also impose several alternate exit criteria – including for example a deterioration of those measures, or the establishment of an overvalued, overbought, overbullish, rising-yields syndrome. I remain convinced that investors who simply have blind faith that QE is reliably bullish in and of itself, or can be trusted to limit losses, will have their heads handed to them.

How QE “works”

Keep in mind that the U.S. banking system has trillions of dollars sitting in idle deposits with the Fed already. Quantitative easing simply does not relieve any constraint that is binding on the economy. Rather, QE is a method by which the Fed hoards longer-duration, higher-yielding securities like U.S. Treasury bonds and replaces them with cash that bears zero interest. At every moment in time, somebody has to hold that paper. The only way for the holder to seek a higher return is to trade it for a more speculative asset, in which case whoever sells the speculative asset then has to hold the cash. The process stops when all speculative assets are finally priced so richly and precariously that the people holding the cash have no further incentive to chase the speculative assets, and are simply willing to hold idle, zero-interest cash balances.

Why does the Fed want this? Simple. Chairman Bernanke believes that by creating a bubble in speculative assets, people will “feel” wealthier and keep consuming – regardless of the fact that real incomes are stagnant and debt burdens are already intolerable, and despite the fact that there is extremely weak evidence for any such “wealth effect” in the historical record. Undoubtedly, it would be difficult for Bernanke to refrain from these reckless policies when everyone is crying “do something!” But the willingness to tolerate short-term criticism in the interest of long-term benefit is part of what separates leadership from cowardice.

Given the bubbling concerns among various FOMC members about inflation risk, the next round of QE is likely to be “sterilized.” Essentially, the Fed would buy Treasury bonds from banks, and would pay for them with newly created cash, but the Fed would then borrow those funds back from banks, holding them as idle deposits with the Federal Reserve. By definition, the additional “liquidity” created by a sterilized round of QE would not be available for new lending (as if there aren’t enough idle reserves in the banking system already). So again, the main goal is to increase the outstanding stock of zero- and low-interest assets in the economy, in order to lower the yields and increase the prices of more speculative investments.

Now, if you think carefully about this, you’ll recognize that the U.S. government is still running a deficit of more than 8% of GDP, so the Treasury will have to issue more than a trillion dollars of new debt in the coming year anyway. Given that banks already hold trillions of dollars in idle balances, the Treasury could have the identical effect of an additional round of QE simply by issuing a larger portion of the new debt as very short-term T-bills, which also yield next to nothing. So why bother doing this as “quantitative easing” when the Treasury could just change the maturity profile of the new debt all by itself?

Well, for one, the Treasury securities are issued on the open market. The Fed typically pre-announces which issues it will buy, allowing the banks that act as primary dealers to essentially front-run: buying the newly issued debt from the Treasury in expectation of getting a higher price from the Fed. So doing all of this as QE has the benefit of handing the banks a nice trading profit. Second, the Fed has an awful lot of Treasury debt on its balance sheet, which is leveraged about 50-to-1 against its own capital. By purchasing Treasury securities and creating zero-interest cash (or low-interest reserves), the Fed essentially earns a spread that can cover any shortfall it might experience if it is ever forced to unwind its position and sell any of those securities at a loss. It’s true that if the Fed earns any surplus interest, it has to go back to the Treasury, but the surplus rendered back to the Treasury is only what remains after a night on the town in the Fed’s balance sheet.

Finally, the reason for doing QE through the Fed (rather than simply changing the maturity profile of the new Treasury debt) is that Wall Street – at least – believes that the Emperor is actually wearing clothes. Despite the fact that the main effect of QE is to boost speculation and release brief bursts of pent-up demand, both which immediately soften when the policies are suspended, this recurring pattern is still unclear to many investors and analysts. As long as that delusion persists, we can expect the Fed to periodically exploit it.

Ignore that the side-effect of this delusion is the misallocation of capital toward speculative assets in the belief that the Fed has set a “put option” under the markets. Forget that savings are discouraged, bad lending decisions are rescued, incentives and economic signals are distorted, and the accumulation of productive capital is disabled. We have the most creative, entrepreneurial nation on the planet, but our policy makers are intent on preventing debt restructuring and misallocating scarce capital. As a result, they continue to compromise long-term growth in favor of temporary bouts of short-term speculation.

What about recent employment gains?

But wait. How can we say that quantitative easing has such weak effects on the economy when we’ve clearly enjoyed a significant amount of job creation since mid-2009? Isn’t that clear evidence that Fed policy is working?

Well, that depends on what one means by “working.”

Last week, we observed “Real income declined month-over-month in the latest report, which is very much at odds with the job creation figures unless that job creation reflects extraordinarily low-paying jobs. Real disposable income growth has now dropped to just 0.3% year-over-year, which is lower than the rate that is typically observed even in recessions.” It wasn’t quite clear what was going on until I read a comment by David Rosenberg, who noted that much of the recent growth in payrolls has been in “55 years and over” cohort. Suddenly, 2 and 2 became 4.

If you dig into the payroll data, the picture that emerges is breathtaking. Since the recession “ended” in June 2009, total non-farm payrolls in the U.S. have grown by 1.84 million jobs. However, if we look at workers 55 years of age and over, we find that employment in that group has increased by 2.96 million jobs. In contrast, employment among workers under age 55 has actually contracted by 1.12 million jobs. Even over the past year, the vast majority of job creation has been in the 55-and-over group, while employment has been sluggish for all other workers, and has already turned down.

For most of history prior to the late-1990′s, employment growth in the 55-and-over cohort was a fairly small and stable segment of total employment growth. Undoubtedly, part of the recent increase has simply been a change in the classification of existing workers as they’ve aged (1945 + 55 = 2000, so the we would have expected to see some gradual bulge in this bracket since 2000 due to aging baby boomers). But the shift is too large to be explained simply by reclassification. Something more troubling has been underway.

Beginning first with Alan Greenspan, and then with Ben Bernanke, the Fed has increasingly pursued policies of suppressing interest rates, even driving real interest rates to negative levels after inflation. Combine this with the bursting of two Fed-enabled (if not Fed-induced) bubbles – one in stocks and one in housing, and the over-55 cohort has suffered an assault on its financial security: a difficult trifecta that includes the loss of interest income, the loss of portfolio value, and the loss of home equity. All of these have combined to provoke a delay in retirement plans and a need for these individuals to re-enter the labor force.

In short, what we’ve observed in the employment figures is not recovery, but desperation. Having starved savers of interest income, and having repeatedly subjected investors to Fed-induced financial bubbles that create volatility without durable returns, the Fed has successfully provoked job growth of the obligatory, low-wage variety. Over the past year, the majority of this growth has been in the 55-and-over cohort, while growth has turned down among other workers. Meanwhile, overall labor force participation continues to fall as discouraged workers leave the labor force entirely, which is the primary reason the unemployment rate has declined. All of this reflects not health, but despair, and explains why real disposable income has grown by only 0.3% over the past year.

Economic Notes

It’s important to recognize that our concerns about the stock market here are independent of our economic concerns, in that the “Angry Army of Aunt Minnies” we’ve recently observed are associated with very negative average market outcomes regardless of economic conditions. Even in the past few years, the emergence of these conditions has invariably been followed by declines that have wiped out all of the intervening gains since the earliest signal was observed.

As noted above, even in the event of another round of quantitative easing, the particular window to ease back on a defensive position would be between the point where QE induces an improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an “overvalued, overbought, overbullish, rising-yields” syndrome is established. To ignore the syndromes we observe at present, in the hope that the hope of QE will be sufficient to limit market risk, is a strategy that would not have been successful even in recent years.

Still, though our present market concerns are independent of economic concerns, they are also reinforced by those economic concerns. We’ve reviewed various lines of evidence, from leading indicators to “unobserved components models,” and I continue to view the coming weeks as a likely minefield of economic disappointments. The issue here remains the distinction between leading, coincident and lagging measures of the economy. As I’ve noted before, a tendency toward positive economic surprises over this period would improve the underlying economic state that we infer from observable data, but here and now, the most leading components remain clearly negative. The concerns are also clearly compounded by the uniform deterioration in economic measures in Europe, China and India, among other regions. The charts below convey the general situation.

Over the weekend, the New York Times published a good article (Some Dreary Forecasts from Recovery Skeptics) that summarized the concerns of a number of economic observers, placing Lakshman Achuthan of the ECRI and me into the classification of “perma-bears.” Actually, with respect to the economy, I’m pleased to be in good company, and don’t greatly object to the “perma-bear” label in that I continue to believe major underlying economic problems have merely been kicked down the road and remain unresolved (primarily an overhang of unserviceable debt, which continues to need restructuring, and which will leave the global economy prone to recurring crises until that happens).

I also periodically get the “perma-bear” label with respect to my views on the financial markets. While I do believe that stocks have been generally overvalued since the late-1990′s (a view that is supported by the predictably dismal overall total returns on stocks since that time), I do think that some observers misclassify the 2009-early 2010 period as being a reflection of our standard investment strategy instead of what it was – a period when we suspended risk taking until we were confident that we had adequately stress-tested our methods against Depression-era data. That may seem like a distinction without a difference, but the difference is that for most periods since 2000, our present investment methods would do very little differently than we actually did in practice (though there are of course a few moderate differences due to various refinements and ongoing research). The 2009-early 2010 period is distinct in that it is not at all indicative of the hedge position that can be expected of our strategy in future market cycles, even under identical conditions and evidence. The fact that we removed about 70% of our hedges in 2002 (when our projection for 10-year S&P 500 total returns was not much more compelling than what it is today), should be some evidence of that.

Financial markets fluctuate, and prospective returns change. We will undoubtedly have ample opportunities to accept financial risk in expectation of reasonable returns, and if history is any guide, those opportunities will emerge well before our economic problems are behind us. What concerns me here is the refusal of investors to even recognize those problems; the army of hostile syndromes we observe in both financial and economic data; the blind faith that simply changing the mix of Treasury debt and bank reserves can produce growth and put a floor under speculative assets; the near-complete denial of ongoing debt strains; and heavily bullish sentiment that Investors Intelligence correctly notes is now in “territory associated with market tops.”

Market Climate

As of last week, the Market Climate for stocks remained characterized by a hostile “overvalued, overbought, overbullish, rising-yields” syndrome, and a variety of other hostile syndromes that I’ve reviewed in recent comments. Strategic Growth and Strategic International Fund remain tightly hedged here. Strategic Dividend Value has a hedge equal to about 50% of the value of its holdings – its most hedged stance. Strategic Total Return continues to have a duration of just under 3 years, and a small percent of assets in utility shares and foreign currencies. We raised our exposure in precious metals shares to just over 4% on last week’s price weakness, but there too, our stance remains decidedly conservative at present.

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Tags: Balance Sheets, Banking System, Cnbc, Consensus Expectations, Cyclicals, Department Of Labor, Desperation, Economic Benefits, Economic Variables, Edifice, Fomc, Global Banking, Hussman, Job Creation, Lollipop, Lows, Market Plunge, Non Farm Payrolls, Payroll Number, Qe, Tantrum
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“The Boredom Discount”: Why Greater Risk Does Not Lead To Greater Return

Thursday, April 5th, 2012

In his latest piece, Dylan Grice comes very close to explaining some of the more irrational, manic, aspects of modern capital markets. Appropriately coming after the recent mania with the $640 million Mega Millions Jackpot (which as we described is nothing but the government taking advantage of personal gullibility and effectively acting as a tax on the poor), the SocGen strategists effectively succeeded in debunking some of the flawed assumptions embedded in the efficient risk frontier, and points out that just because something has greater risk, does not mean it will generate a higher return. Quite the contrary. After analyzing returns of low (boring) and high beta (big upside opportunity, big risk) stocks, he finds that “higher quality stocks carry the sort of lower risk which is supposed to attract a low return, we’ve consistently found them to be higher return. Quality stocks, in other words, seems to possess that attribute most desirable to the long-term investor: systematic undervaluation.”

Reread the last quote as it has huge implications for all those who, self-professed, scramble after high beta momentum stock, and allegedly make gobs of money. Chances are most of them are lying. But how does one explain this fundamental discrepancy between textbook finance and reality? Simple – think lottery, and the fact that humans are inherently flawed, greedy animals, always seeking shortcuts to wealth, fame and power. In Grice’s words, “Antti Iimanen’s idea that ‘high risk’ securities attract a “lottery ticket” premium is closer to being right than wrong. We also think that the same psychological tendency that overvalues lottery tickets undervalues quality stocks, as their robust business models and solid balance sheets do tend to be quite boring. [Hence the boredom discount]. So our best guess at the moment is that the mispricing of quality is indeed systematic. It reflects something permanent (our psychological hardwiring) rather than something transient (the fads of macroeconomic theory).”

In other words, just like 3 people shared the winning prize from the Mega Millions jackpot and tens of millions ended up empty handed, so chasing after high beta will, over time, lead to ruin. And in this case, one can’t blame the Fed or any other central planners. It also explains the exponential blow off mania phases so evident in every bubble… up until the realization that the latest fad is nothing but another get rich quick scheme with nothing backing it, and driven more by herd mentality than rational thought. To paraphrase Cassius: “”The fault, dear Brutus, is not in our stars, But in ourselves.”

The one SocGen chart that proves Grice’s point with clinical precision:

The implications of this finding also undermine the entire efficient markets hypothesis: in essence, the corollary is that “high risk” in the market is systematically overvalued by all those who assume that just because it is high risk, it will generate greater returns, when empirical evidence shows time and time again that it won’t. The same as playing the lottery at 176 million to one odds. And yet people keep doing it. Until the risky stock blows up in your face. After all: it is risky for a reason! There are those who naturally benefit from this bias, such as all those who are willing to take advantage of the “lottery” mania to issue risky securities to a public which is inherently unable to distinguish inherent bias from objective observation, and overvalue risk, while undervaluing safety.

Grice explains further:

A common finding in experiments is that people prefer, say, a guaranteed $90 to a 95% chance of $100. In other words, a near-certain bet correctly valued $95 will tend to be worth significantly less to most people. We undervalue near-certain outcomes. Yet this is exactly the world in  which low beta/high quality stocks live. Cast your eyes down a screen of low beta stocks and you’ll find yourself looking at food retailers, tobacco companies and regulated utilities. Forget the possibility of outsized returns in a few months. Last year was pretty much the same as the one before, and this year will probably be much the same as next … probably …

 

The next chart shows the difference between the objective probabilities and the decision weights from the previous chart. It shows the over-valuation of possibilities and the undervaluation of near-certainties. And if high beta/low quality stocks live in the world of possible triple-digit returns, attracting lottery ticket overvaluations, low beta/high quality stocks live in the world of near certainty, attracting the boredom discount.

Of course, for this thinking to be correct we, like the guys at GMO, are making the assumption that the lower quality elements of the stock market are effectively more speculative. They are vehicles for trading with, not investing in. If that’s close to the mark, therefore, we’d expect to see more activity in the high beta/lower quality names. The following chart shows exactly such a tendency, with estimated holding period for low beta (fifth quintile) portfolios to be almost three times higher than for high beta (top quintile) ones.

The most common question we get when we recommend quality is whether or not its past outperformance has been simply because it started out cheap, or because there’s something more going on. The possibility effect creates excitement. The near-certainty effect is a slightly anxious boredom. And we’re hardwired to overvalue excitement and undervalue boredom. So I think it’s the latter – because there is something more going on.

 

So we still have a bias towards quality in the stock market, and we think you should too.

And while we all know that Grice is 100% right, and in the long run risk does not pay off, that animalistic, irrational part of the brain will keep on telling you to buy AAPL call options at $500, $600, $1,000, $10,000 etc, because “it may make you rich.” Sure: so can the Mega Millions. Realistically, will it? Absolutely not.

Tags: Assumptions, Balance Sheets, Best Guess, Boredom, Business Models, Capital Markets, Debunking, Discrepancy, Grice, Gullibility, High Risk, Lottery Ticket, Mega Millions, Momentum Stock, Quality Stocks, Risk Stocks, Robust Business, Strategists, Term Investor, Ticket Premium
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Frontrunning: March 26, 2012

Monday, March 26th, 2012

• BOJ Crosses Rubicon With Desperate Monetary Policy, Hirano Says (Bloomberg)
• Europe’s bailout bazooka is proving to be a toy gun (FT)
• Monti Signals Spanish Euro Risk as EU to Bolster Firewall (FT)
• Merkel set to allow firewall to rise (FT)
• Banks set to cut $1tn from balance sheets (FT)
• Supreme Court weighs historic healthcare law (Reuters)
• Spain PM denied symbolic austerity boost in local vote (Reuters)
• Anti-war movement stirs in Israel (FT)
• Obama to Ask China to Toughen Korea Line (WSJ)
• Pimco’s Gross Says Fed May ‘Hint’ at QE3 at April Meeting (Bloomberg)
• How to ensure stimulus today, austerity tomorrow (FT)
• Merkel’s Party Wins Saarland State in Show of Crisis Backing (Bloomberg)

Overnight Media Summary:

FT

MERKEL SET TO ALLOW FIREWALL TO RISE

Germany is poised to bow to international pressure and allow a temporary increase in the euro zone’s financial “firewall” this week, to prevent the crisis in the region’s periphery spreading to other member states.

BANKS SET TO CUT $1 TRILLION FROM BALANCE SHEETS

Investment banks are to shrink their balance sheets by another $1 trillion or up to 7 percent globally within the next two years, says a report that foresees a shake-up of market share in the industry.

HEDGE FUNDS FACE HIGHER TRADING COSTS

Leading prime brokerages are preparing to hit clients with across-the-board increases in the cost of trading, which could dry up liquidity and cause niche global markets to shut down.

BIRDS EYE IGLO PUT UP FOR SALE BY PERMIRA

Birds Eye Iglo, the frozen foods business bought out of Unilever by Permira, is joining the shopping trolley of food assets up for sale.

UBS TO OFFER ORCEL FULL BACKING

UBS is gearing up to use its balance sheet heft to back its new co-head of investment banking as the Swiss group steps up efforts to revive its status in the market.

LLOYDS’ DEAL FACES BUYOUT OPPOSITION

Two private equity firms are looking for ways to block Lloyds Banking Group’s sale of their loans to a Bain Capital arm, according to a person familiar with the matter.

LUXEMBOURG FACES EU RAP ON INVESTMENT RULES

Luxembourg, the main home for one of Europe’s most popular investment products, is to be singled out as a regulatory weak link in an unusually undiplomatic European Commission proposal.

US REGULATOR POINTS FINGER OVER FREDDIE AND FANNIE

The U.S. regulator overseeing state-controlled home loan financiers Fannie Mae and Freddie Mac has said the companies are being pushed to accept losses to keep big U.S. banks from writing down their holdings.

OUTGOING FSA ENFORCER SAYS WATCHDOGS NEED MORE BITE

UK financial watchdogs should step up penalties and tackle a wider range of fraud cases to make sure the London’s financial district continues to take the law seriously, Margaret Cole, a top Financial Services Authority official, has urged as she prepares to leave for the private sector.

UK’S ROYAL MAIL TO DELIVER IPO IN 2013

Britain’s coalition government aims to begin the privatisation of Royal Mail by selling or floating at least part of it in autumn 2013 if the state-owned postal operator’s finances continue to improve.

SPAIN’S CAIXABANK SET TO BID FOR CIVICA

Caixabank, the listed arm of the Barcelona-based savings bank La Caixa, is poised to announce a bid as early as Monday to take over its smaller rival Banca Civica in the latest move to restructure Spain’s financial sector, according to executives from both banks.

SWEDISH OIL GROUP SVENSKA UP FOR SALE

Mohammed Hussein al-Amoudi, the Saudi billionaire, has put Swedish oil explorer Svenska Petroleum up for sale in a deal that could raise $2 billion.

IAG WEIGHS ITS NORTH ATLANTIC OPTIONS

The owner of British Airways, IAG, is close to appointing an adviser to help safeguard its north Atlantic joint venture with American Airlines.

Canada

THE GLOBE AND MAIL

- Thomas Mulcair has taken control of the New Democrats in the same way that Stephen Harper took control of the Conservatives: by appealing to the party membership in the face of opposition from the old guard.

- It’s hard to believe that a single provincial budget could be more important to the Canadian economy than Thursday’s long-awaited federal budget.

But Ontario is in a bind. Growth is stuck in low gear as the province struggles with high unemployment, and challenges in its key manufacturing sector.

Reports in the business section:

- The McCains and Sobeys, two powerful business families with deep roots in rural Atlantic Canada, are joining forces for the first time in an investment venture, SeaFort Capital Inc.

- A major labour disruption has been averted for at least two more days after Toronto’s largest civic employees’ union reluctantly agreed to send the Ford administration’s final offer to a ratification vote Wednesday.

- When Thorsten Heins took over as CEO of BlackBerry maker Research In Motion Ltd from long-time co-chiefs Mike Lazaridis and Jim Balsillie in January, he inherited a stumbling giant. Heins will oversee his first quarter as RIM’s CEO this Thursday when fiscal fourth-quarter results are released.

NATIONAL POST

- Canada’s largest medical regulator is proposing an end to the age-old tradition of licences that give physicians almost unfettered freedom, as it steps up its drive to restrict doctors from dabbling in areas where they lack the proper skills.

- Prime Minister Stephen Harper acknowledged the potential difficulties in securing a trade deal with Japan, and admitted some sectors of the economy will be viewing the launch of trade talks with some hesitation.

WSJ

* Distrust of the government’s handling of money matters has turned Zimbabwe into a nation of hoarders. The grubby graying American dollars on Zimbabwe’s streets — including bountiful supplies of $2 bills — attest to a robust cash economy that largely bypasses the country’s banks.

* U.S. businesses see slowing sales growth in China this year, while nearly half rate the nation’s economic slowdown as a top risk factor.

* Yahoo said it would appoint three new independent directors to its board in April, as the Internet company aims to complete an overhaul of its board and leadership while avoiding a proxy fight with an unhappy large shareholder.

* Some of the world’s largest insurance companies are gearing up to compete for ING Groep NV’s Asian life insurance arm, potentially creating a bidding war that could reach $6 billion for what is considered a good franchise in the world’s fastest-growing insurance market.

* An experimental Merck & Co anticlotting drug proved effective in a study at preventing heart attacks for patients with heart disease, but the cost was a sharp increase in the risk of significant bleeding.

NYT

* Testifying recently in a lawsuit that is unrelated to Copper River’s closing, its chief maintained that actions taken in the fall of 2008 by Goldman Sachs had done irreparable damage to his fund.

* Jon Corzine, the former chief executive of MF Global , was told during the brokerage firm’s final day of business that a crucial transfer of $175 million came from the firm’s own money – not from a customer account, according to an internal e-mail.

* Despite a very public setback for BATS Global Markets on Friday, the future of stock trading still looks to be one dominated by rapid-fire computerized trading platforms.

* Computer software giant, Microsoft, won a court order to enter two Web hosting facilities last week in a war against so-called botnets that scour the Internet for personal data to steal and exploit.

* As Congress begins work this week on legislation to shore up the finances of the debt-ridden post office, companies representing a cross-section of American business are spending millions of dollars lobbying lawmakers to oppose or support various proposals to keep the agency afloat.

* Acorn Media says it is now the second-largest distributor of British programming on DVD in North America, second only to the BBC.

* CASH Music is part of a growing number of behind-the-scenes companies that handle business tasks like marketing and merchandising that used to be the domain of record labels.

European Economic Update:

• Finland PPI 1.2% m/m 2.2% y/y. Previous 1.0% m/m 1.8% y/y.
• Germany IFO – Business Climate 109.8 – higher than expected. Consensus 109.6. Previous 109.7.
• Italy Consumer Confidence Indicator s.a. 96.8 – higher than expected. Consensus 93.5. Previous 94.4.

Tags: Austerity, Bailout, Balance Sheets, Banking Group, Birds Eye, Canadian, Canadian Market, Euro Zone, Foods Business, Frozen Foods, Group Steps, Healthcare Law, Hirano, Investment Banks, PIMCO, Private Equity Firms, Qe3, S Gross, Shopping Trolley, Swiss Group, Toy Gun, War Movement
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Marc Faber: The Perils of Money Printing’s Unintended Consequences

Saturday, March 17th, 2012

 
 

 
 
Marc Faber does not mince words. He believes that the money printing policies of the Federal Reserve and its sister central banks around the globe have put the world’s currencies on an inexorable, accelerating, inflationary down slope.

The dangers of money printing are many, in his eyes. But in particular, he worries about the unintended consequences it subjects the populace to. Beyond currency devaluation, it creates malinvestment that leads to asset bubbles that wreak havoc when they burst. And even more nefarious, money printing disproportionately punishes the lower classes, resulting in volatile social and political tensions.

It’s no surprise, then, that he’s feeling particularly defensive these days. While he generally advises those looking to protect their purchasing power to invest capital in precious metals and the equity markets (the rationale being that inflation should hurt equity prices less than bond prices), he warns that equities appear overbought at this time.

On Inflation

First of all, I do not believe that the central banks around the world will ever, and I repeat ever, reduce their balance sheets. They’ve gone the path of money printing, and once you choose that path you’re in it and you have to print more money. If you start to print, it has the biggest impact. Then you print more — it has a lesser impact, unless you increase the rate of money printing very significantly. And, the third money-printing has even less impact. And the problem is like the Fed: They printed money because they wanted to lift the housing market, but the housing market is the only asset that didn’t go up substantially. In general, I think that the purchasing power of money has diminished very significantly over the last ten, twenty, thirty years, and will continue to do so. So being in cash and government bonds is not a protection against this depreciation in the value of money.

On His Love for Central Bankers

Basically the US had a significant increase in the average household income in real terms from the late 1940s to essentially the mid-1960s. And then inflation began to bite, and real income growth slowed down. Then came the 1980s, and in order not to disappoint the household-income recipients, you essentially printed money and had a huge debt expansion. So if you have an economic system and you suddenly grow your debt at a very high rate, it’s like an injection of a stimulant of steroids. So the economy grew at a relatively fast pace, but built on additional debt. And this obviously cannot go on forever, and when it comes to an end, you have a problem. But the Fed had never paid any attention. The Fed is about the worst economic forecaster you can imagine. They are academics. They never go to a local pub. They never go shopping — or they lie. But basically they are a bunch of people who never worked a single day in their lives. They’re not businessmen that have to balance the books, earn some money by selling goods, and pay the expenditures. They get paid by the government. And so these people have no clue about the economy. And, so what happens is they never paid any attention to excessive credit growth — and let me remind you, between 2000 and 2007, credit growth was five times the growth of the economy in nominal terms. In other words, in order to create one dollar of GDP, you had to borrow another five dollars from the credit market. Now this came to an end in 2008. Now the Fed never having paid any attention to credit growth, they realized if we have a credit-addicted economy and credit growth slows down, we have to print money. So that’s what they did. But believe me, it doesn’t take a rocket scientist to see that if you print money you don’t create prosperity. Otherwise, every country would be unbelievably rich, because every country would print money and be happy thereafter.

On the Unintended Consequences of Money Printing

In the short term, it has been working to some extent, in the sense that equity prices are up and interest rates are down. And, so companies can issue bonds at extremely low rates. But every money-printing exercise in the world leads to unintended consequences at a later point. And this is the important issue to remember. We don’t know yet for sure what the unintended consequences are. We know one unintended consequence, and this is that the middle class and the lower classes of society, say 50% of the US, has rather been hurt by the increase in the quantity of money in the sense that commodity prices in particular food and energy have gone up very substantially. And, since below 50% of income recipients in the US spend a lot, a much larger portion of their income on food and energy than, say, the 10% richest people in America and highest income earners, they have been hurt by monetary policy. In addition, the lower income groups, if they have savings, traditionally they keep them in safe deposits and in cash because they don’t have much money to invest in the first place. So the increase in the value of the S&P hasn’t helped them, but it helped the 5% or 10% or 1% of the population that owns equities. So it’s created a wider wealth inequality, and that is a negative from a society point of view.

Click the play button below to listen to Chris’ interview with Marc Faber (runtime 40m:45s):

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Tags: Balance Sheets, Banke, Bond Prices, Central Banks, Currency Devaluation, Depreciation, Federal Reserve, Government Bonds, Havoc, Housing Market, Marc Faber, Money Printing, Perils, Political Tensions, Populace, precious metals, Printing Policies, Purchasing Power Of Money, Thirty Years, Unintended Consequences, Value Of Money
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