Groundhog Day: Will September’s Sell-off Repeat?

Tuesday, August 21st, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

Come September investors might feel as if they are trapped in their own version of Groundhog Day. Last year, the Dow dropped 6% in September. Given the month’s consistently negative bias and lingering headline risks, there is a reasonable chance markets will come under pressure again this year.

While investors often pay too much attention to the calendar, September is the notable exception. Looking at data on the Dow Jones Industrial Average, which stretches back to 1896, September has historically been the worst month of the year, with an average return of slightly worse than negative 1%. This is the only month of the year for which the seasonal bias is so great as to be considered statistically significant.

The tendency for markets to fall in September is also evident when you look at the win rate – how often equities move higher. The win rate in September is barely 40%, versus nearly 60% for the other 11-months. Finally, this phenomenon is not limited to the United States. September has historically been the worst month of the year in a number of European markets – including Germany and the United Kingdom, as well as in Japan.

In addition to a negative seasonal bias, there are three other reasons to be concerned about the headline risk to the markets in the coming weeks:

• On September 12, the German Constitutional Court will rule on the constitutionality of the European Stability Mechanism (ESM). Investors currently expect a favorable ruling, so any other outcome is likely to be disruptive.
• The Netherlands holds an election, also on September 12. This is risky for markets as the outcome may very well be a fragmented government, which will call into question the commitment of the Dutch to further fiscal integration and their support for the southern European countries.
• Closer to home, the US Federal Reserve will begin two days of deliberation on September 12 about the economy and monetary policy. Many investors are still expecting, or at least hoping for, an extension of the Fed’s quantitative easing program, but there is considerable scope for disappointment should the central bank stand pat.

In addition to headline risk, there has been a growing complacency in global equity markets. This trend is particularly evident when looking at implied volatility, or the VIX Index. In mid-August the VIX went below 15, well below its long-term average. While there are several technical reasons that the VIX is this low, it should still concern investors. A low VIX reading indicates weak demand for put protection, suggesting that investors are not particularly concerned with downside protection. Previous readings in this vicinity – in March of 2012 and the spring of 2011 – coincided with short-term tops.

How should investors position their portfolios? While I still prefer equities over the long-term, this is probably a reasonable time to consider trimming back on positions and looking for instruments that offer the potential for downside protection. One way to achieve this is to re-allocate from a cap-weighted exposure into a minimum volatility fund, or other instruments which tend to have a lower market beta.

For investors looking for global exposure, I like the iShares MSCI ACWI Index Fund (NYSEARCA:ACWI), the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA:ACWV), or the iShares S&P Global 100 Index Fund (NYSEARCA:IOO).

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

The author is long IOO.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Minimum volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.
Index returns are for illustrative purposes only. Indexes are unmanaged and one cannot invest directly in an index.

Tags: Chief Investment Strategist, Constitutionality, Deliberation, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, European Markets, European Stability, Federal Reserve, German Constitutional Court, Groundhog Day, Investors, Koesterich, Month Of The Year, Negative Bias, Netherlands, Phenomenon, Russ, Southern European Countries, Tendency, Us Federal Reserve
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The Magic of Compound Interest (Saut)

Tuesday, August 21st, 2012

“The Magic of Compound Interest”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

August 20, 2012

There was a king who held a chess tournament among the peasants and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a single kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third – and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels, or enough, if each kernel is a quarter-inch long (which it may not be; I’ve never seen wheat in its pre-english-muffin form), to stretch to the sun and back 391,320 times. That was nothing more than one kernel’s compounding at 100 percent per square for 64 squares.

… “Money Angels” by Andrew Tobias

When compound interest works in your favor, it is a blessing. But when it works against you, it is a curse. Just ask Washington Mutual, or General Motors. More recently ask Greece, whose “debt chickens” have come home to roost. For example, Greece’s 10-year sovereign note sported a yield of around 5% back in 2010. Subsequently, it soared to more than 30% earlier this year, and currently changes hands around 24%. When yields are double-digits the power of compound interest working against the borrower is awesome. Consider the following example from the same book by Andrew Tobias illustrating the term of interest and return on interest:

Say you borrowed $1,000 from a friend and paid it back at the rate of $100 a month for a year. What rate of interest would that be? A lot of bright people will answer 20 percent. After all, you borrowed $1,000 and paid back $1,200, so what else could it be? Forty percent? No [it’s] more. If you’d had use of the full $1,000 for a year, then $200 would, indeed, have constituted 20 percent interest. But you had full use of it for only the first month, at the end of which you began paying it back. By the end of the tenth month, far from having use of $1,000, you no longer had use of ANY of the money. So you were paying $200 in the last two months of the year for the right to have used an average of $550 for each of the first ten [months]. That comes to a bit more than a 41.25 percent effective rate of interest. (Trust me).

I revisit this compound interest theme this morning because the recent rise in interest rates has been one of the most important events that have occurred over the past few weeks. The rate rise is important because this week the U.S. Debt Clock will cross above $16 trillion (excluding off balance sheet items), and if we stay on the same debt course by 2015 the U.S. will have accumulated $20 trillion in debt. Accordingly, the increase in the 10-year T’note’s yield, from 1.38% on July 24th to last week’s high of 1.86%, is significant. Consider this, by 2015, if our debt is at $20 trillion, an aggregate yield on that debt of 2.5% means the cost of servicing the debt is roughly $500 billion per year. At a yield of 5% our debt service cost would be $1 trillion; and at 10%, the yearly debt service would be $2 trillion, or nearly all of the $2.3 trillion our government receives in revenues! Unsurprisingly, most of the folks I talk to inside the D.C. Beltway realize we are on an unsustainable path; and that’s why I think no matter who is elected in November my sense is we are going to get smarter policy makers, more practical policy, and more productivity out of government. Currently few believe this is possible, but if you look at what’s happening at the grassroots level there are a lot of good things happening on both the “left” and the “right.” One entity that appears to embrace this more positive scenario is Mr. Market.

Indeed, while there are some pundits commenting on the recent increase in interest rates, there is NOBODY expounding on the fact that the S&P 500 Total Return Index is probing new all-time highs (see chart on page 3). To be sure, I am aware of all the bearish arguments swirling down the canyons of Wall Street, but the bears continue to misunderstand there is not a linear relationship between the fundamentals and the movement of the markets. Manifestly, it takes a massive deflationary shock, like what we experienced in 2008, to cause a waterfall decline in stock prices; and, I just don’t see that on the horizon. Actually, I think the rise in interest rates is more about the improving economic backdrop and the inflation that should accompany it. As the invaluable Bank Credit Analyst organization wrote back in 2007:

The history of the U.S. is characterized by a long-run increase in indebtedness, punctuated by occasional financial crises and subsequent policy reflation. The sub-prime blow-up is the latest installment in this ongoing Debt Supercycle story. During each crisis, there are always fears that conventional reflation will no longer work, implying the economy and markets face a catastrophic debt unwinding. Such fears have always proved unfounded, and the current episode is no exception. A combination of Fed rate cuts, fiscal easing, and a lower dollar will eventually trigger another upleg in the Debt Supercycle, and a new round of leverage and financial excesses. The objects of speculation are likely to be global, particularly emerging markets and resource related assets. The Supercycle will end if foreign investors ever turn their back on U.S. assets, triggering capital flight out of the dollar and robbing U.S. authorities of any room to maneuver. This will not happen any time soon.

“Not any time soon,” says the Bank Credit Analyst and I agree, which is why my mantra has been, “You can get cautious, but do not get bearish!” Importantly, I have likened the March 2009 “low” to the nominal price low of December 1974, which was the “print low” of the 1966 – 1982 wide-swinging, trading range stock market. Further, I have suggested the October 4, 2011 “undercut low” might be the equivalent of the “valuation low” of August 1982 before the 1982 – 2000 secular bull market began. Whether we are now into a new secular bull market is questionable, but secular “bull” markets typically arise when valuations are parsimonious, the economy is a mess, politics are leaning to the left, and individual investors have abandoned stocks. If that sounds familiar, it should for that is precisely the environment we have had for awhile.

Over the longer-term I will let Mr. Market tell us if we are in a secular bull market. As for the here and now, I have been treating the June 4th low as THE daily/intermediate-term cycle low. More recently, I opined that while the S&P 500 (SPX/1418.16) may pause, or pull back, around the 1400 level, but that any pullback should be shallow with the real bull/bear battle coming at the April highs of 1420 – 1422. And, that is where we were late last week. Typically the initial assault on a key resistance level like 1420 fails. It tends to take two or three attempts before a key level is surmounted. For example, the Reuters/Jeffries CRB Commodity Index (@CR/303.48) made a reaction high on May 1, 2012 at 307.95. Subsequently, it has tried to better that high on July 19th, August 9th, and is currently trying for the third time to close above its May 1st high (see chart on page 3). My sense is this time it makes it because triple tops rarely hold. That view is reinforced by the recent sell-off in the Dollar Index (@DX/82.54), which closed below its 50-day moving average on Friday. If the U.S. dollar keeps falling it should put the wind at the back of the CRB, as well as gold, which is also trying to break out above a triple top around $1630.

The call for this week: The S&P 500 Total Return Index (&SPXT/2469.00) is trying to break out to new all-time highs, as can be seen in the chart on the next page. It may also be pointing the way for the S&P 500 because if the SPX can decisively break out above its April highs of 1420 – 1422 it potentially brings into view targets above 1500. And while it is doubtful the SPX can breakout above those “highs” on its first try, I think it will indeed eventually break out. Of course, the grind higher from the June 4th low has been accompanied by total disbelief among individual and professional investors. That is reflected not only in the flow of funds by individual investors out of equity-centric mutual funds, but in the latest Commitment of Traders report that shows the “pros” have been caught heavily on the short side into a rising equity market. So the fuse is burning and I think it is just a matter of time until the SPX travels above 1422.

Click here to enlarge

Click here to enlarge

Copyright © Raymond James

Tags: Andrew Tobias, Chess Tournament, Chickens, Chief Investment Strategist, Curse, Double Digits, English Muffin, General Motors, Humility, jeffrey saut, Kernel Of Wheat, Kernels, Million Trillion, Peasant, Peasants, Power Of Compound Interest, Rate Of Interest, Raymond James, Saut, Squares, Washington Mutual
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Young Americans: The Death of Equities May be Exaggerated

Tuesday, August 21st, 2012

August 20, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• PIMCO founder Bill Gross believes the “cult of equity is dying” … let me take the other side.
• Mutual-fund flows suggest that we may have lost a generation of investors.
• However, demographics suggest there may be another generation that could be the stock market’s savior.

Rumors of the death of equities may be greatly exaggerated. Bill Gross, founder of PIMCO, recently wrote that the “cult of equity is dying,” and of course it generated a furor of interest. In a separate Tweet, Mr. Gross noted that disillusion with stocks “might be a generational thing.” I have great respect for Bill and was very fortunate to share the stage with him at the opening of last year’s Schwab IMPACT conference. He was no more optimistic then than he is now and several media outlets that covered the conference called me the “optimistic ying to his pessimistic yang.”

Bill’s recent comments didn’t do much more than repeat the view he’s held for some time. I remember reading back in February 2009 an interview he did with Forbes Magazine in which he opined, “…things will never be the same. Risk taking has been destroyed and any animal spirits must come from Washington. Global growth rates—low, low, low—asset classes will be readjusted for that outlook. That is—stocks will be more of a subordinated income vehicle as opposed to a ‘stocks for the long run’ growth vehicle.”

Not just a lost decade … a lost “baker’s dozen”

Needless to say, the timing of those comments was not ideal as the stock market bottomed the following month and has since doubled. This missive is by no means an attempt to discredit Bill or his views, as there’s a lot of truth to what troubles him. Frankly, they’re the same truths that continue to plague the psyche of the majority of individual investors that are indeed shunning stocks as if the recent lost decade (or, more precisely, lost “baker’s dozen” given that the S&P 500 index is presently at levels equivalent to where it traded back in 1999) will be repeated.

I know that this opinion may elicit many of the same comments I’ve heard following other contrarian views I’ve expressed over the past three years—that I’m yet another “perma-bull” with blinders masking long-term structural problems that will forever plague stocks. First, I’m not a market timer, but I’m also not a perma-bull. Long-time clients may recall we were decidedly pessimistic about the outlook for both the economy and stock market leading into the 2007 top and didn’t turn optimistic until the spring of 2009.

I remain optimistic longer-term, albeit it with near-term concerns due to the obvious pressures still with us thanks to the ongoing eurozone crisis, the looming US fiscal cliff and related election uncertainty, and slowing global growth. But it’s the longer term that’s the focus of today’s report.

Being a contrarian

I’m never a contrarian just to be contrarian, but sometimes tacking against the winds of the market and investor psychology can be amply rewarded. Stock market sentiment has always been driven by what the market has done in the past, not by a fundamentally based consideration of what might lie ahead.

Short-term sentiment measures will always ebb and flow with market action, but most longer-term sentiment measures show a level of despair about stocks unmatched in the post-World War II era. One need look no further than mutual-fund flows: the chart below shows a $1.4 trillion spread between bond-fund inflows and stock-fund outflows—a spread unmatched in history.

An Unprecedented Show of Risk Aversion

Source: FactSet, Investment Company Institute, as of June 30, 2012.

A wave of shocks

The inflows to bond funds are easy to explain given strong returns (until recently). But they’re also characteristic of aging Baby Boomers’ risk aversion and reactions to a veritable wave of shocks to both the system and investors’ psyche, including, but not limited to:

• The lost decade (or as previously mentioned, the lost “baker’s dozen”)
• The dramatic decline in the stock market from 2007 to 2009
• Periods of unprecedented market volatility
• The 2010 “flash crash”
• The growing dominance of high-frequency trading and its effect on market behavior
• The 270-point average daily Dow swing in 2011′s August-November span related to Standard & Poor’s downgrade of US debt and the debt-ceiling debacle
• Facebook’s disastrous initial public offering and subsequent price performance
• JP Morgan’s huge trading loss earlier this year
• Another Ponzi scheme in the form of Peregrine Financial Group (and related attempted suicide by its founder), coming on the heels of the Bernie Madoff and Allen Stanford scandals
• The “LIBORgate” rate-setting scandal

The bottom line is that the demise of interest in stock investing by many individual investors is in very large part due to a total lack of trust in the transparency and fairness of the market. This is understandable.

I often get asked whether there’s any hope for the market longer-term if individual investors remain on the sidelines. History may be a guide. As noted by The Leuthold Group this spring, there were two stock market climbs the public missed. The first was the advance from 1974 to 1980, which lasted more than six years and amounted to a 120% gain for the S&P 500, and a multiple of that gain in small-cap stocks. However, US-focused mutual funds enjoyed net inflows in only 15 months during this run. The shallow bear market of 1976-1977 likely shook out many would-be buyers … and contrarians might note the high of that entire move coincided with the first sizable month of net inflows.

More recently, during the current cyclical bull market (since March 2009) there have been two sharp declines in both mid-2010 and mid-2011. They probably served the same purpose as the 1976-1977 decline—scaring off many retail investors just as they were finally preparing to tiptoe back in. It’s hard to fathom that a majority of individual investors could remain sidelined in the face of a continued strong rally in stocks, but the late 1970s showed that it can happen.

Back to demographics and the “Millennials”

In history, few forces have been as strong behind stock returns as demographic trends: movements in population, age, gender and employment status, among others. Much focus has been on Baby Boomers, especially as they begin to retire, and their effect on markets in the future. Yes, they’re now more risk-averse than ever, and this is not likely to change. But what about a key generation behind them?

Those born after 1980 are generally considered “Millennials,” but I prefer the description “Echo Boomers,” as they represent many of the children of Baby Boomers. Millennials are often characterized as having less financial savvy and weaker job prospects than their Boomer parents. The result is an impression of a generation equally as disenfranchised from the stock market as the Baby Boomers.

However, I think many may be underestimating the positive impact this generation may have on investing trends. I recently read an interesting report on the subject by Turner Investments in which it noted that the Millennials are “digital natives”—the first generation raised with technologies such as personal computers, the Internet and smartphones that prior generations had to adapt to later in life.

My two children (ages 12 and 16) can’t fathom that I had to rely on libraries, books, encyclopedias and a typewriter when I was a college student. But they’re part of a generation that’s become completely reliant on “new” technologies. Eight of 10 of Millennials sleep with their cell phones in reach (count my kids in the 20% that don’t, though they would if we let them).

The Millennials are highly educated: About 40% of college-age Millennials are enrolled in higher education—the greatest percentage in US history. Yes, some of that’s a result of the rough economic ride they’ve been on over the past decade or so. They’ve had to suffer two economic/market crises since 2000, starting with the bursting of the technology bubble and followed by the bursting of the housing bubble and the attendant financial crisis. The dearth of jobs has hit the generation particularly hard. About a third of 18-29 year olds are unemployed, under-employed or simply out of the work force.

Don’t underestimate the Millennials

Turner offers seven reasons why the financial prospects of Millennials may be much better than is popularly supposed and why Millennials may “bring about a Great Bull Market of the 21^st Century”:

1. The Millennial generation is huge at more than 85 million—even larger than the Baby Boomers’ 81 million. It wasn’t until Boomers were in their 30s that they began to truly make their presence felt in the stock market. The great bull market of the last century was the result. My additional perspective: vehicles like 401(k)s make it easier and more “automatic” for this cohort to invest.
2. Millennials’ financial struggles thus far are actually fairly typical of early adult life: paying for education, finding a first job, relocating, buying a first house and learning the vocational ropes.
3. Macroeconomic headwinds facing Millennials—notably high unemployment and depressed housing—are likely to be temporary. My additional perspective: housing has likely already found its bottom and household formation has jumped significantly since its lows.
4. Baby Boomers once faced similar macroeconomic headwinds (during the late 1970s and early 1980s), but were still able to subsequently invest in stocks and drive the market to new highs during their peak earning years.
5. Despite all of their financial troubles, Millennials are savers and are already investing in stocks. Twenty-something investors have more stocks in their 401(k) accounts today than their counterparts did a decade ago, according to the Investment Company Institute. About 80% of 20-somethings had devoted at least 60% of their 401(k)s to stocks in 2010 (the latest year of data) versus 70% in 2000.
6. Millennials tend to be optimists and are more willing to take risks relative to their parents’ generation. About 29% of all entrepreneurs are Millennials, according to the Kaufman Foundation, suggesting an appetite for risk.
7. Millennials are putting emerging nations in a demographic sweet spot. The ratio of workers to the total populace in East Asia rose from 47% in 1975 to 64% in 2010. In Latin America the ratio rose from 44% to 56%, and in South Asia it rose from 45% to 55%. A sizable new class of investors is surfacing around the globe.

Food for thought.

Important Disclosures

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.

Copyright © Charles Schwab and Company

Tags: Animal Spirits, Asset Classes, Bill Gross, Charles Schwab, Chief Investment Strategist, Disillusion, Forbes Magazine, Founder Bill, Furor, Global Growth, Impact Conference, Individual Investors, Liz Ann, Media Outlets, Missive, Mutual Fund Flows, Risk Taking, Senior Vice President, Tweet, Young Americans
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The Fundamental Case for the 20,000 Dow

Tuesday, August 14th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

While some people deem stocks expensive relative to 10-year trailing earnings, we take a forward-looking approach. It starts with the premise that the stock market is not a casino and stock prices are not pulled out of thin air: they reflect the intrinsic value of companies’ future earnings.

Let’s start with basics. Stocks represent an ownership claim on a share of company earnings. Hence, stock prices reflect (imperfectly, of course) the value of companies’ current earnings and potential earnings growth. In computing the expected returns for stocks, what matters is the starting price, earnings, dividends (the portion of earnings distributed to shareholders), earnings growth and changes in P/E. As you might expect, low starting prices, high earnings and dividends, high growth, and P/E expansion are all good for future stock returns.

The models we use when investing are complex, but a simple argument makes the point. The expected return for a Treasury bond held to maturity is equal to its yield. Similarly, the expected return for a stock equals its earnings per share (EPS) divided by its price—its earnings yield—if the company has no growth prospects and therefore returns all of its earnings to shareholders. If the company does have growth prospects, it would retain some of its earnings to fund growth. In that case, the expected return equals the dividend yield plus dividend growth. If the company pays out a constant share of earnings as dividends, dividend growth equals earnings growth.

Let’s apply this framework to the S&P 500 Index’s price level of about 1,300. Consensus forecasts call for the index to have $104 in earnings per share this year. If the companies in the index didn’t xpect any growth, they would pay out all their earnings as dividends, and earnings and dividends wouldn’t grow. The S&P 500’s dividend yield would be 8%, as the first row of the display below shows.

If the P/E remained unchanged, the total return would also be 8%, but both the S&P 500 and the Dow would stay at their current level. While a flat index price might be disappointing, we think most investors today would probably welcome an 8% return on investment.

Of course, the companies in the S&P 500 do retain a portion of their earnings to finance growth, so the index’s dividend yield is slightly above 2%, rather than 8%, as the second row of the display shows. What kind of earnings growth should we assume?

What About Growth?

Historically, earnings and the stock market have grown with the economy over time, although they can diverge for several years at a stretch, particularly if market euphoria drives stock prices to very high multiples of earnings or if gloom drives stock prices to low multiples. Nominal US GDP, which includes inflation, has grown 7% a year on average since 1947—and so have the S&P 500’s earnings and price. (GDP growth is more commonly quoted in real, or inflation-adjusted, terms. We use nominal growth here to match data for earnings growth and the stock market.)

The three key variables that drive both economic growth and earnings growth over the long term are inflation (which increases the nominal value of economic output), population growth (which boosts the number of people consuming and producing goods) and productivity (which increases the output per person or per unit of capital).

Inflation is widely expected to average about 3% over the long term; population growth, to average about 1%; and productivity, to continue to rise about 2% per year. Since 3% + 1% + 2% = 6%, 6% is a plausible long-term economic growth forecast; it is actually below both the postwar average and the International Monetary Fund’s projections for the next five years.*

So let’s assume 6% economic and earnings growth. With a constant dividend payout ratio, this would lead to 6% dividend growth. Eventually, this growth rate would probably make investors less gloomy, and the market would rise from its current low level of 12.5 times earnings.

If the S&P 500’s P/E rose to 15—halfway back to its average of 17.6 since 1970—the index’s expected return would be 9% per year. At that rate, the S&P 500 would reach 2,000 in five years. The Dow, which typically trades at about 10 times the S&P 500, would reach 20,000 in about five years.

But as discussed above, the market should arguably be trading at an above-average multiple, since bond yields are so low. If the S&P 500’s P/E rises to 20 times earnings as sustained growth in a low-interest-rate environment makes investors more confident, the Dow could reprice to 20,000 immediately, as the third row of the display shows.

Since most investors today would probably welcome an 8% or 9% return for the next five to 10 years (let alone an immediate market revaluation), the current limited appetite for stocks suggests that investors don’t believe in these scenarios. Most likely, they don’t believe in the consensus forecast of $104 in earnings per share this year or 6% economic growth. So let’s examine the implications for stock returns of lower earnings and slower economic growth.

What If Earnings Fall or GDP Growth Slows?

Many people expect earnings to decline because margins are far higher than usual. If corporate spending picks up from the unusually low levels of recent years, margins would fall, and that could drive down earnings.

We think it’s reasonable to expect margins to decline somewhat—although not necessarily to their historical average. But for the sake of argument, let’s look at what would happen if margins declined from 9.5% today to their long-term average of about 6.75%.

Even in this scenario, the S&P 500 would reach 2,000 and the Dow would reach 20,000 in about 10 years. Applied to current revenues, 6.75% margins would reduce S&P 500 earnings by about 30%—to $74, as the fourth row of the display shows.

While there would likely be a severe market pullback initially, if normal economic growth resumed and P/E ratios normalized, the S&P 500 would have a 5% total return and reach 2,000 in 10 years.

But the global economy is now weak, and the European sovereign-debt crisis could end up being a drag on economic growth for years. What if Europe and theUSenter a lengthy period of disinflation? That’s possible, particularly if policymakers are unsuccessful at addressing the world’s serious macroeconomic problems.

So let’s perform a stress test and assume inflation of only 1%, population growth of 1% and no productivity growth at all. That would give us nominal GDP growth of just 2%. A recent survey of professional forecasters said there’s less than a 10% chance that economic growth will be that slow over the next three years.**

What would these dismal economic forecasts imply about future earnings growth and stock returns? If we assume the S&P 500 earns $74 per share this year, 2% growth would still get us to a 4% annualized market return if the market P/E ultimately returns to average, as the fifth row of the display shows. At that rate, it would take 20 years for the S&P 500 to reach 2,000 and the Dow to reach 20,000. Such returns are hardly enticing, but they are still likely to exceed bonds.

Of course, stock-market returns could be worse than 8% (or 4%), particularly in the short term. S&P 500 earnings could fall below $74, and anxiety could cause market valuations to drop even further below normal; both happened in early 2009. Other market shocks are also possible. For example, very high inflation with slow growth could cause price-to-earnings multiples to contract.

But market returns could also be better. Our stress test incorporated draconian assumptions—a 30% drop in earnings plus no productivity growth at all, a very rare occurrence over a 10-year period. Human ingenuity has led to remarkably persistent and steady productivity growth in the postwar period. In recent years, new technology and globalization have driven productivity growth. In the future, these trends and others not yet imagined are likely to continue to drive it.

Faced with uncertainty and traumatized by losses in recent years, investors who are avoiding stocks appear to be assuming that the worst outcomes are highly likely to occur. Or, perhaps, they’ve just lost their stomach for market volatility and are prizing near-term stability over potential long-term gains.

In my next post, I will compare the likely range of outcomes for stocks and bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Alliancebernstein, Chief Investment Strategist, Company Earnings, Consensus Forecasts, Dividend Growth, Dividend Yield, Dividends, Earnings Growth, Earnings Per Share, Future Stock, Growth Prospects, Intrinsic Value, Premise, Price Earnings, Shareholders, Stock Market, Stock Prices, Stock Returns, Thin Air, Treasury Bond
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Invest with the Best?! (Saut)

Tuesday, August 14th, 2012

Invest with the Best?!

by Jeffrey Saut, Chief Investment Strategist, Raymond James

August 13, 2012

“Finding the best person or the best organization to invest your money is one of the most important financial decisions you’ll ever make. It’s also one of the toughest. The right manager for someone else may not be the right manager for you, nor can you reasonably expect to find many objective, or even reliable, sources to help you narrow your choices. You will be bombarded with figures, charts, and statistics that seek to sell you on each adviser’s services … the sad fact is that too often you cannot even believe what has been presented to you.”

… Claude N. Rosenberg, Jr.

I have been a “fan” of the astute Mr. Rosenberg ever since hearing him speak back in the 1970s. Many will remember him as the founder of the San Francisco-based money management firm that used to bear his name, Rosenberg Capital Management, before changing its moniker to RCM Capital Management. Others will remember him as the author of numerous books on financial matters, one of which was Investing with the Best, which holds the above quote and deals with the daunting task of selecting an investment manager. Given the plethora of investment managers, each with their own investment philosophy and style, picking a manager is difficult. That’s why many individuals’ selection process consists of nothing more than looking at a portfolio manager’s track record for the past few years. We think such a simplistic approach is a mistake.

Apparently, Jeremy Grantham, eponymous captain of the money management firm Grantham, Mayo, Van Otterloo & Co., agrees. To reprise some of his thoughts: “Ninety percent of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (i.e., growth, value, foreign vs. domestic, etc.). Since opportunities by style regress, past performance tends to be negatively correlated with future relative performance. Therefore, managers are often harder to pick than stocks. Clients have to choose between fact (past performance) and the conflicting marketing claims of various managers. As sensible businessmen, clients usually feel they have to go with the past facts. They therefore rotate into previously strong styles, which regress [to the mean], dooming most active clients to failure.”

This is where Raymond James’ Asset Management Services (AMS), as well as our Mutual Fund Research Department, can help. As unbiased intermediaries, these departments are committed to aiding clients in the hiring of an investment manager who most closely aligns the manager/mutual fund with the client’s views on the various markets, as well as their risk tolerance. To this point, I journeyed to the cooler climes of Boston last week to escape the Florida heat, speak at a national conference, and visit with over 20 portfolio managers (PMs). My first visit was with the folks at Pioneer Funds where I met with Marco Pirondini (Head of Equities) and his team, as well as Ken Taubes (Chief Investment Officer). I have spoken with Ken a number of times and find his wisdom both on stocks and bonds to be invaluable. Because of his long tenure as a bond manager, I was surprised when he opined that interest rates should bottom between now and year end. Given that “higher interest rate” view, I was particularly interested in speaking with Jonathan Sharkey who manages the Pioneer Floating Rate Fund (FLARX/$6.88) and the Multi-Asset Ultrashort Income Fund (MAFRX/$10.04). In a rising rate environment these two funds should fair pretty well. I discussed Jon’s investment style/strategy over dinner and found it to be closely aligned with mine. I was also interested in the Pioneer Research Fund (PATMX/$10.64) and will be vetting it, along with other Pioneer funds, over the coming months.

After a few more meetings with hedge funds that afternoon, I spent most of Wednesday with Fidelity. My first meeting was with Jurrien Timmer, co-portfolio manager along with Andrew Dierdorf, of the Fidelity Global Strategies Fund (FDYSX /$9.18). To me, FDYSX is tantamount to a global macro fund because it can “go anywhere” and “do anything.” That means it can invest in just about everything. Moreover, I like the fact that the fund has a technical analysis overlay to it, as well as a tactical leaning, since tactical is what has been working in this manic depressant market. Next was Charles Myers, captain of the Fidelity Small Cap Value fund (FCPVX/$15.27). Chuck told me that while he is really good at picking stocks, he is less confident with his market timing and sector selection abilities. Accordingly, he spends his days looking for good companies and thinking about portfolio construction. Indeed, he adds value to the investment equation through portfolio construction. He does run a concentrated portfolio (~70 names) and does adjust his turnover rate to take advantage of when the markets are more dynamic.

Fidelity Select Health Care Fund (FSPHX/$136.14) is managed by Edward Yoon and has provided very good risk adjusted returns over time. My meeting with him was informative as he thinks insurance companies and PBMs are part of the healthcare solution. Strategically, Eddie thinks the healthcare system has never let customers know what things cost, but that’s changing because employers are moving healthcare risks from their balance sheets to the employee’s balance sheet. This should be a boom for companies that provide consumers with the ability to analyze price competition between vendors. He also suggested there is going to be a shift from public to privatized Medicare. A couple of names he mentioned covered by our fundamental analysts were: Cerner (CERN/$71.12/Outperform) and Nuance (NUAN/$23.53/Strong Buy). My last meeting was with Steve Wymer, who told me the S&P 500 investment style is too conservative for a growth fund and the Nasdaq Composite Index is too aggressive, so he runs The Fidelity Advisor Growth Opportunity Fund (FAGOX/$40.87) somewhere in between. He thinks we are somewhere in the mid-cycle of a recovery provided Euroquake doesn’t derail us. Dinner Wednesday was with the good folks from Fidelity.

The next morning I arrived at MFS, which is an active global asset manager that employs a uniquely collaborative approach to build better insights for our clients. Their investment approach has three core elements: integrated research, global collaboration, and active risk management. Of course, “risk management” is a big thing with me for the essence of portfolio management is the management of risk, not the management of returns. My meeting was with Jim Swanson (Chief Investment Strategist) and eight PMs/analysts. Jim began by stating that people he meets in everyday life talk about how bad the stock market is. He then “closed” that comment by noting the S&P 500 is up nearly 12% YTD, while the NASDAQ Composite is better by ~16%. Moreover, when you impact those returns for the almost non-existent inflation, the “real” returns are awesome. The rest of the conversation was about the topics du jour (government, Euroquake, the fiscal cliff, etc.). Regrettably, I did not have the time to meet with my friend Thomas Melendez, who manages my favorite international fund, MFS International Diversified Fund (MDIDX/$13.27), or the PM of the MFS New Discovery Fund (MNDAX/$20.15), but that will happen next trip.

My final meeting was with Putnam to reconnect with Bill Kohli, portfolio manager of the Putnam Diversified Income Trust (PDINX/$7.65) that has so often been featured in these comments. It is one of only two bond funds I have featured over the years because I think PDINX is positioned for a higher interest rate environment. The fund has a 5.8% yield with zero duration. The fund employs 70 – 80 different strategies to pursue a diverse range of opportunities. For example, the fund is “long” non-agency RBMS (Residential Mortgage Backed Securities), but hedges that position with agency IOs (Interest Only). Hence, to lose money on those positions would require home prices to collapse over 50% from their already depressed prices. And then there was David Glancy and his Putnam Equity Spectrum Fund (PYSAX/$28.04). Hereto David thinks a lot about portfolio construction and combines stocks, bonds, bank loans, convertibles, opportunistic short-selling, and cash to produce returns. To this cash point, I was taught early in this business that cash is indeed an asset class for to assume the investment “opportunity sets” that are available today are as good as those presented next week, next month or next quarter is naive; and, you need to have some cash to take advantage of those opportunities. Evidently David thinks that as well because his cash position has varied from 44.4% in 2Q09, to 14.8% in 3Q10. David loves stocks and I could talk individual companies with him for hours. As always, all of these mutual funds should be vetted before purchase.

As for the stock market, not much really happened in my absence as the D-J Industrials (INDU/13207.95) experienced their tightest weekly trading range since January 2007. Of course, that was not the case a year ago when our sovereign debt was downgraded and equities collapsed 6.66% (the mark of the devil as well as the intraday low of March 6, 2009 where the new bull market began). Indeed, what a difference a year makes. Nevertheless, the rotation away from the defensive sectors and into Materials (+2.83%), Energy (+2.34%), and Technology (+2.10%) is an interesting observation because when the defensive sectors lead it is not indicative of a healthy and sustainable rally. Said rotation reinforces my belief that the upside breakout above the 1360 – 1366 level is for real and suggests we are finally setting up for another push to the upside. The real battle should be waged at the April highs of 1422. That said, the rally that began on June 4th has left ALL of the macro sectors overbought in the short term. It has also left the SPX at the top of the parallel chart channel (read: resistance) referenced in last Monday’s letter. Consequently, a pause or pullback attempt is not out of the question. Support remains in that 1360 – 1366 zone for the SPX.

The call for this week: The good: stocks are hanging in pretty well after an 11% rally from the June 4th low, earnings are still beating estimates by ~60%, earnings revisions are rising again, economic reports are strengthening, European equities have rallied while their sovereign yields have declined, the SPX continues to track the typical election pattern (see chart from the sagacious Bespoke organization), and there was a rare “buy signal” from the Bob Farrell sentiment indicator. The bad: all sectors are overbought, companies are beating revenues estimates by only 48.3%, the number of new highs is shrinking, upside momentum has waned, we are at the top of a parallel channel in the SPX chart. The ugly: forward earnings guidance is negative by 5.5%, the presidential election rhetoric is getting nastier, commercial hedgers have moved close to their most extreme short position in years, the Volatility index (VIX/14.74) is below 15 (read: no fear), gasoline had its largest two-week rise this year (+$0.18), and the list extends. Nevertheless, I think this is the pause that refreshes and not the start of a big decline.

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Copyright © Raymond James

Tags: Capital Management, Chief Investment Strategist, Claude N Rosenberg, Daunting Task, David Rosenberg, Ebb And Flow, Financial Decisions, Gluskin Sheff, Grantham Mayo Van Otterloo, Investment Manager, Investment Managers, Investment Philosophy, Investment Style, jeffrey saut, Money Management Firm, Moniker, oil, Portfolio Manager, Raymond James, Relative Performance, Reliable Sources, Rosenberg, Rosie, Sad Fact, Saut, Simplistic Approach
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Yogi Berra? (Saut)

Tuesday, August 7th, 2012

by Jeffrey Saut, Chief Investment Strategist, Raymond James

“Yogi Berra”
August 6, 2012

“It’s hard to make predictions, especially about the future.”… Yogi Berra

To be sure, “It’s hard to make predictions, especially about the future,” and last week was no exception. I began the week, as stated in Monday’s missive, noting that there would be a trifecta of potentially market moving news events. The first was the two-day FOMC meeting where I thought the Fed would change its policy statement with a lean toward more accommodation. My reasoning was that the Fed would appear too political by waiting until the September meeting, just a few short weeks before the election. WRONG; and that was pointed out to me in spades on Thursday because while Wednesday’s “no change” policy announcement only produced a stutter step for the S&P 500 (SPX/1390.99), by Thursday the SPX swooned. Indeed, by mid-session the SPX had shed more than 20 points from Wednesday’s closing price (1375), and in the process tagged its intraday low of 1354. By the close, however, the index had recouped about half of those intraday losses, ending the sloppy session at 1365. Actually, Thursday’s late in the day recovery was yet another surprise to me because hereto my early week prediction was there would be no surprise from the European Central Bank meeting. But, a surprise it was with Mario Draghi unwilling to make good on his previous week’s market moving statement that, “Within our mandate, the ECB is willing to do whatever it takes to preserve the euro and, believe me, it will be enough.”

WRONG; and I had to suffer through that night’s, and early Friday morning’s, parade of pundits talking about how bad the employment number might be. Such musings should have had a dilatory effect on the preopening futures, but that wasn’t the case as a number of other rumors swirled down the canyon of Wall Street with positive implications. Still, everyone awaited the numba’! And as stated in Thursday’s verbal strategy comments, I had no idea as to what the number was going to be given the wide dispersion of previous reports; yet, my sense was it was going to be close to consensus. WRONG again because Friday’s number was much better than expected with nonfarm payrolls rising to 163,000 versus the median forecast of +100,000. Lost in the euphoria, however, was that the unemployment rate rose from 8.216% to 8.253%.

So it was three “strikes” and “out” for me and my predictions last week. About the only thing I got right was saying in Thursday morning’s verbal strategy comments that any pullback should be contained in the 1360 -1366 zone so often mentioned in these comments; and contained it was, with Thursday’s close of 1365. Given Friday’s surprise number, the SPX sprinted to its highest closing price since May 3rd and reinforced my more bullish stance of the past few weeks (as opposed to my previous trading range, but not bearish, stance). Friday’s Fling took the SPX up to the top of a parallel channel, as can be seen in the chart on page 3 from the astute Bespoke organization. If it can break out above that channel, last April’s reaction high of 1422 should be the next objective.

Regrettably, a strong earnings season has not been the driver of the upside breakout. Verily, of the 1,702 companies that have reported, the earnings beat ratio stands at 59.9%, well behind the S&P 500’s beat rate of 67.3% (376 companies have reported). Meanwhile, the revenue beat rate stands at only 48.2%. Yet by far the most troubling metric is the company’s forward earnings guidance, which is currently negative. Despite that forward guidance, the bottom up consensus earnings estimates for the SPX remain around $102 for this year and near $115 for 2013. If those estimates are anywhere near the mark, it means the SPX is trading at 13.6x this year’s estimates, and at 12x next year’s estimates, with concurrent earnings yields (earnings ÷ price) of 7.3% and 8.3%, respectively. Using the yield on the 10-year Treasury Note of 1.6% as your risk free rate of return produces what an analyst terms an equity risk premium of 6.7% basis next year’s estimates (earnings yield 8.5% – 1.6% risk free return = 6.9% equity risk premium, or ERP). Investopedia defines an ERP as:

“The excess return that an individual stock, or the overall stock market, provides over a risk-free rate [of return]. This excess return compensates investors for taking on the relatively higher risk of the equity market.”

QED, investors are being “compensated” by 6.7% (ERP) to own the SPX instead of the 10-year T’note.

While the aforementioned valuations are not as parsimonious as they were at last year’s October 4th undercut low (we were very bullish), they are still pretty inexpensive, offering the long-term investor a decent risk/reward ratio when combined with the SPX’s 1.9% dividend yield. Yet, I understand investors’ reluctance to commit capital since it seems like the trading of the “headline” < i>du jour is creating too much volatility. Interestingly, one vehicle that attempts to damp down some of that volatility is the PowerShares S&P 500 Low Volatility ETF (SPLV/$28.05), which consists of the 100 stocks in the S&P 500 with the lowest realized volatility over the trailing 12 months. This ETF currently yields 2.9%; as always, details should be checked before purchase.

Another strategy that has been working for the past few quarters has been to consider companies that have beaten quarterly earnings estimates, as well as revenue estimates, and guided forward estimates higher. Some names from the Raymond James research universe that have recently met these three criteria, are favorably rated by our fundamental analysts, and have “greened up” on indicators, like the SPX chart on page 3 shows, include: BioMed Realty Trust (BMR/$18.76/Outperform); Extra Space Storage (EXR/$33.45/Outperform); Kimco Realty (KIM/$19.94/Outperform); Power-One (PWER/$5.13/Outperform); Post Properties (PPS/$51.23/Strong Buy); and Wabtec (WAB/$78.38/Outperform).

The call for this week: As a sidebar, be sure to look at this month’s edition of < i>Gleanings for further insights from our economist, technical analyst, and my additional thoughts. As far as the stock market, last Friday’s rally extended the upside breakout by the SPX above the often mentioned 1360 – 1366 zone; and at this point, that breakout looks sustainable. The rally has also broken the index above the “neckline” of what a technical analyst would term a reverse head and shoulders bottoming pattern (read: bullishly). That said, the rally has left the SPX at the top of the parallel channel previously mentioned, as well as leaving every macro sector I follow pretty overbought in the short term. Also of note is that while the D-J industrials, the S&P 500, and the D-J Utilities bettered their June reaction highs, the S&P 400 MidCap, the S&P 600 SmallCap, the NASDAQ Composite, the Russell 2000, and the Value Line Arithmetic Index did not (read: potential non-confirmation). Still, the stock market’s internal energy continues to look strong, my proprietary indicators have been “green” on the S&P 500 for six weeks (see chart on page 3), the Dollar Index got crushed on Friday (lower dollar means the “risk trade” is back on), short interest on the NYSE is high, the equity markets survived a potential “flash crash” from the Knight Capital (KCG/$4.05/Market Perform) fallout, the recent investor sentiment figures were about as negative as they ever get, the public liquidated another $2.7 billion of domestic equity mutual funds last week (the highest weekly redemption of the year), the Spanish market rallied 7.41% on Friday, well y’all get the idea. Recently participants have been conditioned to sell each marginal breakout to a new reaction high because it has been followed by a pullback. I am not so sure this breakout plays that way. Indeed, I expect at least a test of the April highs (1422) over the next few weeks before a corrective phase begins.

P.S. – I will be in Boston all week spending time with portfolio managers, seeing accounts, and speaking at a conference. I will try and do my verbal strategy comments, but they are likely going to be abbreviated.

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Tags: Chief Investment Strategist, ECB, Friday Morning, Futures, jeffrey saut, Mandate, Mario, Missive, Musings, Numba, oil, Policy Announcement, Pundits, Raymond James, S Market, Saut, Spades, Spx, Stutter Step, Trifecta, Wall Street, Yogi Berra
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Mythbusting: How Elections Affect Markets

Friday, August 3rd, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

Elections do matter for the markets, but not necessarily for the reasons that investors tend to believe. Ahead of the US presidential election in November, I’m going to attempt to debunk some of the common myths surrounding markets and elections:

Myth #1: Party affiliation matters when it comes to market returns.

There is little to no evidence to support the fact that the winning candidate’s party makes a difference to markets. Over the past century, which party occupies the White House has had no discernible or consistent impact on US equity markets. Since 1900, when a Democrat has been in the White House, the average return for the Dow Jones Industrial Average has been around 8.5%; for Republicans the average is around 6% (neither average includes dividends). When you adjust those averages for the market’s volatility, the numbers are statistically the same. In other words, the party affiliation of the president has had no consistent influence on stock market performance, though many investors still believe this.

Myth #2: Divided government is good for the financial markets.

Following the halcyon days of the 1990s, many investors have come to believe this myth. While divided government was certainly good for markets in the 1990s, that seems to have been an anomaly. The 1990s were unusual and were a function of many factors, including a secular drop in interest rates, a productivity surge, and the taming of inflation. Unfortunately, conditions are very different today.

Looking at the last century of data, there is no evidence that divided government produces better returns. In fact, in the past equities appear to have actually done better when one party has controlled both Congress and the White House, though the numbers backing this better performance aren’t statistically significant and should be taken with more than a grain of salt.

What Does Matter: Policy

None of the above implies that the outcome of this election is irrelevant for financial markets. While politicians cannot fix much of what ails the global economy, sensible economic policy would help mitigate the damage. There is also quite a bit that politicians can do to make matters worse. In short, as I write in my new Market Perspectives piece, the election will matter a great deal.

There are a number of issues, both long and short-term, which can only be solved in Washington. The absence of progress will likely worsen the economic malaise and in the case of the fiscal cliff push, the United States back into recession. On the other hand, real progress on taxes and entitlements could remove at least some of the headwinds holding back growth.

Both the fiscal cliff and the entitlements issue are extremely important to the capital markets. Evidence that we’re not doing everything we can to resolve them is likely to push stocks lower and volatility higher. To state the obvious, should we allow this to occur it would be a game changer for US financial markets.

If we wake up on the morning of November 7 with continued divided government and no consensus on reform and then no consensus is reached before the fiscal cliff hits in January, investors may want to consider opting for these five portfolio moves:

1.) Less equity exposure

2.) A higher allocation to defensive sectors like consumer staples and healthcare, accessible through the iShares S&P Global Consumer Staples Sector Index Fund (NYSEARCA: KXI) and the iShares S&P Global Healthcare Sector Index Fund (NYSEARCA: IXJ).

3.) Less credit exposure in the fixed income section of their portfolios

4.) A smaller allocation to commodities

5.) A higher weight to dollar-denominated assets

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.

Copyright © iShares

Tags: 1990s, Anomaly, Chief Investment Strategist, Common Myths, Democrat, Dividends, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Financial Markets, Grain Of Salt, Halcyon Days, inflation, Ishares, Koesterich, Myth 2, Party Affiliation, Russ, Stock Market Performance, Us Presidential Election, Volatility
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Housing: Good Vibrations (Sonders)

Thursday, August 2nd, 2012

July 30, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Household formations are moving higher but housing completions aren’t keeping pace.
• Real mortgage rates plunge into negative territory.
• Key housing market index indicates continued sales (and pricing) recovery.

I’ve penned quite a few reports dedicated to housing over the past six years or so, the most recent being my “Rock Bottom” report in January of this year. I’ve also incorporated many of the charts I track into recent Market Snapshots videos. It’s time for an update.

First, I wear no blinders hiding the truth that the recovery in housing is not yet “healthy” relative to history. The housing market will continue to be hampered by anemic job growth, “underwater” homeowners and the foreclosure pipeline. But the forces of demographics and supply/demand imbalances have begun to register their weight and the data has done a great job of reinforcing our message from earlier this year.
Laws of supply and demand
Current conditions in the economics of housing reflect a considerable imbalance between supply and demand. Many chapters have been written about the supply part of the imbalance (i.e., overbuilding), but less ink has been spilled on the role of weak demand specific to declining household formations in since 2007. The National Association of Home Builders’ (NAHB) HousingEconomics.com division concludes that two-thirds of excess vacant housing units in the existing housing stock can be attributed to a steep decline in demand during the recession.

Household formations (e.g., adult children leaving parents’ households, singles leaving shared housing arrangements, etc.) are the largest component of demand for additions to the housing stock. These new households are accommodated by additions to the housing stock when vacancy rates are low, and are absorbed into the existing stock when vacancy rates are high. There’s a strong trend component to growth in the number of households, but formations are influenced by economic conditions—rising during good times and declining during bad times.

In the history of the data, the biggest declines in household formations occurred around recessions and bear markets. The 2010 drop in formations set a modern-day record, as seen in the chart below.
Boomerang Kids Moving Out of Parents’ Homes

Source: ISI Group, US Census Bureau, as of 2011. Household formations are calculated as the difference in households this year versus the past year.

A large gap is now developing as household formations surge from their recent base, while home completions lag behind. HousingEconomics.com suggests that a considerable portion of the excess housing supply (NY Fed president William Dudley recently estimated three million units) is due to a steep decline in demand related to economic conditions, rather than overbuilding. This has important implications: if excess housing supply was “pure” supply (i.e., assuming no pent-up demand), then recovery would take as long as it would take for demographic forces to catch up with supply. But, given that the excess supply embodies pent-up demand, then the recovery in housing will probably unfold more quickly than many believe.

Whether measured in terms of months’ supply or as a percentage of the working population, inventories of homes for sale have fallen dramatically since their peak. Inventories of single-family homes are down 24% from a year ago—the largest annual drop in at least 30 years, leaving inventories at roughly the historic levels that preceded the housing bubble. The number of homes for sale normalized for potential buyers (working age population) is now at a record low. This helps to explain the recent weaker home sales reports, which brought a few housing bears back out of hibernation. Existing home sales fell more than 5% in June to the lowest level in eight months. But, the prior month was revised up nicely and sales remain up more than 4% from a year ago. Looking deeper, the National Association of Realtors noted the decline in June was due to “tight supplies of affordable homes, limiting first-time buyers.” Another good sign is that despite weaker sales, median existing home prices shot up, reaching their highest level since September 2008. Real median home prices are up over 5% on a year-over-year trend basis, which is the most since March 2006, before the bubble burst.

Mortgage rates … get real!

Home prices are important for the obvious reasons, but also as an input into what I think is one of the most important housing metrics—the real mortgage rate. We’ve seen plenty of good news on the nominal mortgage rate front. The nominal 30-year fixed mortgage rate is now a record low 3.5%, but the “real” mortgage rate is even lower—in fact, it recently went negative.

Many long-time readers know that I pay more attention to the real mortgage rate (RMR) than the nominal mortgage rate. Just like real gross domestic product (GDP) is the difference between nominal GDP and inflation, the RMR is the difference between the nominal mortgage rate and the rate of appreciation (or depreciation) in median home prices. Why should we look at it this way? It’s not only the rate at which we’re borrowing that matters, but what’s happening to the price of the asset we’re borrowing to buy. See the chart below, which tracks the RMR back to the early 1970s.

Real Mortgage Rates Plunging

Source: FactSet, Federal Reserve, National Association of Realtors, National Bureau of Economic Research (NBER), as of June, 2012.

At the peak in the bubble, RMRs were -11% (6% nominal mortgage rate minus 17% appreciation rate). Fast-forward to the trough of the housing bust and RMRs had surged to 22% (5% nominal mortgage rate minus a 17% depreciation rate). No wonder the bubble burst: who would want to borrow at any rate to buy a rapidly depreciating asset? But today, RMRs are back in negative territory. It makes sense again to borrow to buy a house since home prices are now appreciating at a rate higher than the mortgage rate.

Surging housing market index

The NAHB/Wells Fargo Housing Market Index (HMI) is one of the most watched housing metrics and is based on a monthly survey of the National Association of Home Builders’ members. It gauges builder confidence about the single-family housing market and is a weighted average of market conditions for current new home sales, sales expectations for the next six months, and traffic from prospective buyers. As you can see in the chart below, there has historically been a tight relationship between the HMI and total home sales; and the latest jump is “forecasting” more sales to come.

Housing Market Index Suggests Higher Sales

Source: FactSet, National Association of Home Builders (NAHB), National Association of Realtors, US Census Bureau. NAHB Housing Index as of July, 2012. Total Home Sales (existing and new) as of June, 2012.

As an aside, I recently discovered (thanks to Wolfe Trahan) the relationship charted below, which compares the HMI (advanced 21 months) to the fed funds rate (which has effectively been zero since late 2008). Historically the two have been highly correlated. This should not serve as any kind of “warning” that the Fed will be raising rates sooner than it’s telegraphed (late 2014)—the Fed is making decisions on more than just trends in housing—but it will be something I am tracking.

Will Housing’s Recovery Alter Fed Policy?

Source: FactSet, Wolfe Trahan & Co., as of July 30, 2012.
Echo boomers to the rescue
I recently read the “State of the Nation’s Housing” report by the Joint Center for Housing Studies of Harvard University. In it was a discussion of demographics and I’ll conclude with some of their most interesting observations. “Assuming the economic recovery is sustained in the next few years, the growth and aging of the current population alone—including the entrance of the echo boomers into adulthood—should support the addition of about one million new households per year over the next decade.” The report also suggested adding at least another 180,000 to that estimate from immigration. Due to these demographic trends, it’s a decent bet that demand will continue to revive, even if job growth remains weak.

One of the concluding comments from the report was its most compelling: “The good news for housing production is that this new generation already outnumbers that of the baby boomers at the same ages. With even a modest lift from immigration, the echo boom generation will grow even larger as its members move into the prime household formation years.”
Important Disclosures

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.

Copyright © Charles Schwab & Co., Inc.

Tags: Adult Children, Blinders, Charles Schwab, Chief Investment Strategist, Completions, Good Vibrations, Housing Market, Keeping Pace, Laws Of Supply And Demand, Liz Ann, Market Index, Market Snapshots, Mortgage Rates, Nahb, National Association Of Home Builders, Negative Territory, Rock Bottom, Senior Vice President, Steep Decline, Vacancy Rates
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Are Investors Worried About the Right Risk?

Monday, July 30th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

Individual and institutional investors alike have been shifting their capital from stocks to cash and bonds at a rapid rate in recent years, despite extraordinarily low interest rates. But if investors stop to weigh the importance of two different types of risk, they’ll see they still need stocks.

It’s tempting to give up on stocks after more than a decade of high volatility and low returns from stocks—and lower volatility with higher returns from bonds. But we think that 10 years from now, investors who do so will wish they had stayed in stocks—or added to them.

That’s not to say we think investors don’t need bonds. Despite extremely low current yields, we think bonds should still play their usual roles in the portfolios of most long-term investors: providing income, preserving capital and providing protection in times of stock-market distress (because bond prices tend to rise at such times). Bonds will be especially important if the market outcomes are at the extreme low end of our forecast range of potential outcomes.

But most investors are likely to need stocks to feel confident that they will have enough to live on, despite the high volatility of recent years. Remember that volatility isn’t the only type of risk. There’s also shortfall risk: not having enough money to meet your spending requirements. Investors must weigh both types of risk when making strategic asset-allocation decisions.

If you’re just thinking about market volatility, bond-oriented portfolios may look very appealing, especially today. We estimate there is less than a 2% chance that a portfolio with a 20% allocation to stocks and an 80% allocation to bonds will suffer a 20% peak-to-trough loss at some point over the next 10 years, compared with the 15% chance of such a loss for a portfolio with 60% in stocks (Display, left), as the left side of the display below shows. But if you’re just thinking about shortfall risk, a portfolio with 60% in stocks looks more attractive (Display, right).

We estimate that a 65-year-old retired couple planning to withdraw only 3% of their portfolio, grown with inflation, has a 12% chance of running out of money if they invest in the portfolio with 60% in stocks. That may not sound great, but it is materially better than the 24% odds of running out of money if they invest in a portfolio with 20% in stocks.

Today, uncertain macroeconomic conditions make large stock-market drops more likely than usual, and very low bond yields provide a thinner cushion. As a result, market risk can’t easily be avoided. And trying to avoid market risk is not a good strategy if it increases shortfall risk too much. A 20% loss is certainly painful, but it doesn’t hurt as much as running out of all of your money. Many investors who are currently focused on market volatility should be paying at least as much attention to shortfall risk.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

The Bernstein Wealth Forecasting System,^SM driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Copyright © AllianceBernstein

Tags: Asset Allocation Decisions, Bond Prices, Bonds, Chief Investment Strategist, Current Yields, Enough Money, Institutional Investors, Low Interest Rates, Market Outcomes, Market Volatility, Portfolios, Rapid Rate, Seth, Shortfall, Stock Market, Stocks, Strategic Asset Allocation, Term Investors, Trough
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Treading Water (Sonders)

Monday, July 30th, 2012

July 27, 2012

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

Key Points

• Volume has been low and stocks have managed to drift higher, despite some volatile days; but conviction appears to be lacking. We seem to be biding time until the action heats back up as summer winds down, but market-moving events can happen at any time.
• The US economy continues to slow and Fed Chairman Bernanke had a relatively dour outlook before Congress. But it appears things would have to get worse before another round of easing is initiated; the effectiveness of which we continue to question.
• Yields in Spain and Italy indicate action may be needed sooner rather than later, but we did get positive remarks by the ECB, which led to market rallies and a big drop in yields, providing a measure of hope. Meanwhile, Chinese growth has been hit by the global economic slowdown but their lack of transparency means getting a good read is difficult.

In contrast to the athletes in the Olympics that are laser-focused on moving forward and achieving their objectives, markets seem to be caught in a sort of summer malaise. Volume has been depressed and sentiment surveys show retail investor skepticism at high levels-despite stock market performance being relatively decent this year, with the S&P 500′s 8.5% gain through July 20 the best showing to this point in the year since 2000 (thanks to Wolfe Trahan & Co. Portfolio Strategy). But with policymakers lacking the discipline and focus of Olympic athletes (the understatement of the year), and continuing publicity hits to the financial sector, we can’t blame investors for their doubts; and determining what direction the next major move will likely be more difficult than usual. Whenever you get politicians and the courts involved in the financial picture, predictions become even more difficult than usual, and that’s saying something!

In this frustrating, unpredictable environment, we find it helpful to take a step back. Asset allocation continues to be important and investors need to pay attention to their distribution of money relative to their time horizon and risk tolerance. In this environment, investors ignore their portfolios at their peril as things can and likely will change quickly. We are unlikely to see any resolution to the fiscal cliff before the election and the eurozone crisis remains on tenuous footing; notwithstanding Mario Draghi’s encouraging comments (discussed below). But if you look out the five years that we suggest is an appropriate time horizon for equities, it’s difficult to imagine that we’ll still be dealing with these same issues. And US equities remain quite cheap based on historical measures and recently hit a cyclical high in terms of relative performance to most other global equity markets. Our view that the US market will be the best relative performer through at least the balance of 2012 has not changed.

Economy keeping its head above water—barely

The US economic picture continues pointing toward still (barely) positive but slowing growth. Somewhat concerning, however, was the third-consecutive negative reading on retail sales, the Philly Fed Index remaining in negative territory, and the Index of Leading Economic Indicators declining by 0.3% last month.

LEI paints a disappointing portrait

Source: FactSet, U.S. Conference Board. As of July 24, 2012.

However, there continue to be positive offsets that did not exist in either of the past two years when we also dealt with growth scares—dominant among them is the recovery in housing. We’ve seen steady improvement over the course of the year; but housing is now less than 3% of US gross domestic product (GDP) after hitting a high of over 6% at the peak in the bubble. The National Association of Home Builders (NAHB) Index rose 6 points to 35, still below the 50 mark that would denote a growing housing market, but the best reading since March 2007. Additionally, housing starts rose 6.9% to the highest level since October 2008.

Housing now contributing positively?

Source: FactSet, U.S. Census Bureau. As of July 24, 2012.

And although existing home sales posted a decline of 5.4%, the National Association of Realtors noted that the fall was attributable to inventory tightness, something that we haven’t heard in a while. In fact, there is now just a 6.6 month supply of existing homes for sale, versus 9.1 months a year ago. We’re not trumpeting the all-clear signal yet, but it appears to us that housing is now a help and not a hindrance to economic growth.

Additional support for our “muddle through” view comes from various other areas such as the Empire Manufacturing Index getting a modest bump to 7.4, industrial production expanding by 0.4%, and jobless claims remaining comfortably below 400,000. We are also through the bulk of earnings season and bottom-line results, while not spectacular, were largely better than reduced expectations. However, top-line growth was somewhat disappointing but consistent with the low level of nominal GDP growth.

Policy frustration grows

Unfortunately, much of the frustration expressed during earnings season was directed toward Washington. Politics has thrust itself into the middle of both the markets and the economy and cannot be ignored. Corporate executives are increasingly pointing toward the uncertainty surrounding regulation and tax policy as reasons that they were unwilling to take the risk of expanding their business or hiring new workers. And while companies often take shots at Washington, the difference this time around is the unanimity in the desires of executives. While each would likely have their own view on what the ultimate outcome would look like, the bottom line for the vast majority of them is that they need a bottom line. Businesses can adjust to a variety of circumstances—that’s one thing that has made America what it is—but they need to know the rules of the game. Unfortunately, Washington’s dysfunction and the typical antics in an election year suggest limited resolutions to what presently ails confidence and hiring.

Last week’s outrage was to hear a sitting Senator tell the Chairman of the Federal Reserve—after hearing again that the best thing for economic growth would be responsibly addressing the fiscal cliff—that the Fed better “get to work” because Congress was hopelessly deadlocked. And while Bernanke said the Fed is prepared to act again if necessary, our belief is that there is little they can do at this point to have a real impact on the economy.

Europe’s cliff draws nearer

Europe has leaned more toward collectivist fiscal policies than the US, which has helped to contribute to the ongoing debt crisis as governments have spent and promised beyond their means. At some point, bills have to be paid, and without strong incentives to take risks and expand business, payers start to dwindle while payees increase.

Currently, policymakers are again treading water but summer doldrums are noticeable in the peripheral sovereign bond auctions in Europe, where the few buyers that are showing up are demanding higher rates, particularly for Spanish and Italian government debt.

The risks for Spain remain high, with regional government debt and deficits the new concern du jour. Despite the 17 regional governments being major contributors to the 2011 deficit slip, the Spanish central government has been unable to control their spending due to strong cultural and historical adherence to regional autonomy. Regional government spending is significant, as they control education, health and social services, accounting for 50% of total government spending. The buyers’ strike for Spanish debt is intensified for regional governments, where the 10-year debt yield for the region of Catalonia exceeded 14% in June and the region of Valencia had to pay a punitive 6.8% six-month yield to roll over 500 million euros of debt in May.

As a result, yet another bailout fund has been created; this time for Spain’s regional governments, which Spain insists will not increase its borrowing burden. When adding to bank capital needs that were revised higher and deficit targets which were adjusted larger, investors are skeptical. This lack of confidence has resulted in Spanish government short-term yields spiking nearly as high as long-term rates, a sign of market stress, although we did see a marked pullback following the Draghi comments.

Spain’s stress gauge volatile

Source: FactSet, Tullett Prebon. As of July 26, 2012.

With Spain’s average maturity of 6.4 years resulting in a 4.1% average interest rate, rates may need to stay elevated longer before a bailout is necessary, but more forceful action is needed to contain the situation. The reason is that the size of Spain’s economy and government bond market is around double the combined size of those of Greece, Portugal and Ireland, and Spain’s problems have increasingly ensnared Italy.

Meanwhile, eurozone bailout funds are still impotent, with the temporary European Financial Stability Facility (EFSF) lacking sufficient funds, the permanent European Stability Mechanism (ESM) on hold for a ruling by the German Constitutional Court in September, and the European Central Bank (ECB) is not yet using monetary measures to solve what they view a fiscal problem. Despite recent comments by ECB President Mario Draghi indicating they would do “whatever it takes to preserve the euro,” actions are still lacking and their ability to implement substantial plans is likely severely constrained by their mandate and the continuing disagreements among member nations. While the market rallied on the comments and reminds us that sharp rallies are possible on potential positive movement, words have become less meaningful and more decisive action is needed.

We’ve said in the past that the situation is rife for outbreaks of market volatility, as we continue to see. Moody’s Investor Service apparently concurs, downgrading the outlooks for the AAA-rated nations of Germany, the Netherlands and Luxembourg. It was due in part to the rising risk of future liabilities, because policymaker’s “continued reactive and gradualist” response will “very likely be associated with a series of shocks, which are likely to rise in magnitude the longer the crisis persists.”

We’ve believed it would take severe market instability, nearing the edge of the precipice, before more forceful actions would be taken. The flattening of the Spanish yield curve indicates more forceful actions are drawing closer, with the ECB the institution able to respond most quickly. Granting the ESM a banking license could create large firepower, but Draghi said in July that this could risk the ECB’s credibility by behaving outside its mandate—seemingly conflicting with the above statement of unconditional support. Other “non-standard” measures such as restarting the Securities Market Program (SMP) for sovereign bond purchases were not discussed at the ECB’s July policy meeting, but traders are on the lookout for a change in the ECB’s stance.

Germany remains resistant to endlessly fund peripheral country problems, as it is responsible for the largest share of potential future liabilities. With Greece’s problems remaining, a Greek exit from the euro is not out of question. Conversely, there have been increasingly vocal suggestions that Germany leave the euro. While this is easier said than done and any action would have attendant costs, the ultimate decision is political, and therefore difficult to forecast.

All of the wrangling does have an outcome we can foresee—likely continued economic suppression in the eurozone; as uncertainty halts investment and spending, and a hobbled banking sector hampers lending. Additionally, the rollercoaster of investor sentiment is likely to remain, and we continue to believe European stocks will underperform most other global markets.

Chinese economic data manipulated?

China’s lack of transparency breeds speculation about where the economy is headed. Attention has focused on a significant slowdown in electricity production and consumption, which have fallen to single-digit rates in recent months, while gross domestic product (GDP) has slowed more modestly.

China’s electricity deviation historically “normal”

Source: FactSet, National Bureau of Statistics of China. As of July 24, 2012.

Electricity production has deviated from GDP in the past, not only in China, but also in other major economies, including the United States. This statistic is volatile and it is important to note that one of China’s major long-term initiatives has been to lower its energy usage per unit of GDP, and that energy-intensive industrial sectors have slowed more than the overall economy.

Positively, HBSC’s initial manufacturing purchasing manager index (PMI) for July rose to a five-month high of 49.5, driven by gains in production and export order components. We are skeptical China’s economy has yet to significantly accelerate, believing growth in China will slow further in the third quarter, but remain above a hard landing. Conversely, the Street is still grappling with the slowdown, forecasting a turn higher in third quarter growth 8.2% from 7.6% in the second quarter. A pick-up in fiscal and monetary stimulus is likely needed for China’s economy to reaccelerate, and the government thus far has been disappointingly slow and measured on this front.

With the desire to keep social unrest at bay, employment trends are likely closely monitored by Chinese officials. While not yet at a crisis level, the faster rate of contraction in employment indicated in the HSBC report, and comments from consumer-goods maker Jarden about a “halt” in wage inflation momentum, may indicate stepped up stimulus measures could be on the immediate horizon.

Spiking corn prices have ignited concern about food prices, in particular for emerging markets where the food component in consumer price inflation (CPI) indexes is two-to-five times larger than in developed markets, which could limit growth and continued easing by emerging market central banks. We are monitoring the situation, but aren’t yet ready to declare a lasting and broad increase in overall food prices, with prices of the important staple of rice still subdued. Read more international research at www.schwab.com/oninternational.

So what?

With such a conglomeration of concerns, investors can be tempted to throw up their hands in frustration and seek the perceived safety of a nice, comfortable mattress. However, as we saw with the Draghi comments, sharp equity rallies are possible and we believe at some time in the not-too-distant future resolutions to the two major issues—the eurozone crisis and the fiscal cliff—will emerge, setting the stage for a renewed sustainable move. Waiting until it occurs carries risks just as staying invested does, so we urge investors to maintain a diversified portfolio with a bit more exposure to the US side of the ledger at the expense of some European exposure. Valuations are attractive and sentiment is very pessimistic—a contrarian indicator. For tactical investors we would suggest adding to equities during pullbacks and trimming outsized positions during any fierce rallies.

This commentary originally appeared at Schwab.com

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: 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 MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

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 contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Tags: BRICs, Charles Schwab, Chief Investment Strategist, Chinese Growth, ECB, Fed Chairman Bernanke, Financial Sector, Getting A Good Read, Global Economic Slowdown, Liz Ann, Olympic Athletes, Portfolio Strategy, Research Key, Retail Investor, Sector Analysis, Senior Vice President, Stock Market Performance, Summer Winds, Trahan, Treading Water, Understatement Of The Year
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