Tuesday, July 10th, 2012
by Frank Holmes, CEO, CIO, U.S. Global Investors
Manufacturing around the world weakened in June, according to the JP Morgan Global Manufacturing Purchasing Managers’ Index (PMI). Its reading of 48.9 was the lowest in three years and the first dip below 50 since September 2011. The current reading is also below the three-month moving average for the second month in a row. As you can see on the chart, PMI crossed below the three-month in May.
While Europe, China and the U.S. were primarily responsible for the slowed activity, we believe the trend is your friend. In April, global PMI crossed above the three-month moving average, and historically, when a “cross-above” has happened, it’s signaled higher prices for many commodities. Take a look at the chart below which shows the following:
Ninety percent of the time, copper rose 10 percent over the following three months. Eighty-five percent of the time, West Texas Intermediate oil has also increased. Its median three-month change has been an increase of 11 percent.
Materials and energy were also positively affected, with modest results: When the PMI crosses above the three-month average, 70 percent of the time, the S&P 500 Materials Index rose, with a median return of about 3 percent. The S&P 500 Energy Index had a median three-month return of about 5 percent, with an 80 percent chance of the three-month change being positive.
Using history as a guide, this suggests that by the end of July, we could see strength in these commodities and energy and materials stocks. Although volatility and uncertainty rule the markets these days, we believe that the world’s central bankers are taking note of slowed activity and will act if deemed necessary.
The trend is your friend only if your portfolio is “resourceful” enough to benefit. Read the Financial Planning article, which showed how U.S. Global Investors’ Global Resources Fund strengthened a diversified portfolio over the past 10 years. Read the article.
Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.
Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries.
Diversification does not protect an investor from market risks and does not assure a profit.
All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.
The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The S&P 500 Energy Index is a capitalization-weighted index that tracks the companies in the energy sector as a subset of the S&P 500. The S&P 500 Materials Index is a capitalization-weighted index that tracks the companies in the material sector as a subset of the S&P 500.
Tags: Amp, Commodities, Copper, Diversified Portfolio, Energy Index, Financial Planning, Frank Holmes, Global Resources, Jp Morgan, Moving Average, Nbsp, Pmi, Purchasing Managers Index, Resources Fund, S Central, Three Months, U S Global Investors, Uncertainty, Volatility, West Texas Intermediate
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Thursday, June 7th, 2012
All preferred shares are not created equal.
Rate reset preferred shares offer an attractive alternative.
by Stephane Ruah, Richardson GMP Limited
I am often asked by clients to explain the difference between the various preferred shares available in the marketplace. There are so many types of products available, each with special features that investors should know about as they are investing their hard earned money.
In this article, we will demystify rate reset preferred shares: what are they and how they can help build a well-diversified portfolio.
What are rate reset preferred shares?
A typical preferred share will pay a fixed dividend in perpetuity, while rate reset preferred shares will pay a fixed dividend for a specific predetermined time, usually five years, then recalibrate. At the reset date, provided the issuer does not call the preferred share for the issue price, investors can elect to either take the Government of Canada 5-year rate plus a fixed spread, or opt for a floating rate that offers the 3-month T-bill yield plus a spread.
For example, company ABC issues a preferred at $25 that pays 5% with a reset clause of 2.5%. This means that in five years, on the anniversary of the initial date established, ABC can recall it at $25. Alternatively, ABC may choose to roll it out for an additional period of time, usually five years, and reset the new rate to the five-year Government of Canada bond yield plus the reset clause. If the five-year yields are 3%, the new rate for company ABC will be 3% + 2.5%, or 5.5%.
These shares are attractive to investors as they offer a tax advantage over buying bonds. Although the dividends are fixed, as with a bond coupon, they are taxed at a preferential rate over interest payments, leaving you with more money in your pocket.
When considering reset preferred shares, it is important to keep in mind that they are not guaranteed like a GIC. If the issuer experiences poor business conditions leading to financial difficulty, preferred shares can significantly erode in value and even become worthless. Therefore, it is important to invest in solid companies with a consistent track record of paying dividends, especially in turbulent economic times.
Today, interest rates are at historic lows with rates on cash and cash equivalents being less than the rate of inflation. In this type of environment, rate reset preferred shares offer a very good alternative as resets have the potential to increase their dividends as rates rise.
Do you have questions about rate reset preferred shares or other fixed income investment solutions? Please feel free to contact me directly.
Stephane Ruah is Director, Wealth Management and Investment Advisor at Richardson GMP Limited, Canada’s largest independent wealth management firm. He provides exclusive and innovative investment services to successful families and entrepreneurs and can be reached at 514.288.4018 or Stephane.Ruah@RichardsonGMP.com and you may subscribe to our free bi-weekly newsletter at http://www.thermgroup.ca.
The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.
Tags: Bond Yield, Business Conditions, Company Abc, Diversified Portfolio, Dividend, Dividends, Gic, Government Of Canada, Hard Earned Money, Interest Payments, Money In Your Pocket, Period Of Time, Perpetuity, Poor Business, Preferential Rate, Preferred Share, Preferred Shares, Ruah, Stephane, Tax Advantage
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Monday, June 4th, 2012
June 1, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., and
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research
- Equities have pulled back and are flirting with correction (-10%) territory. We believed this was a needed process, and remain modestly optimistic that economic data will rebound and the market will eventually resume its move higher over the next several months.
- The Federal Reserve has made clear that it stands ready to act should the US economy deteriorate, or the European debt crisis escalate, but we remain skeptical. The more important issue in our view is how the coming “fiscal cliff” is addressed.
- The European crisis continues to escalate and we are recommending that investors underweight European equities. Hopes of a sustainable solution in the near term are virtually nonexistent, while contagion fears are rising. China’s growth has slowed but the country has tools at its disposal and we believe a soft-landing is the most likely scenario.
Frustrating! That’s one of the most common words we hear from investors as they look at the current environment. Fixed income yields remain historically low, money market returns are nonexistent, international markets have various ills, and the domestic economy is muddling along—not a great list to choose from.
As uncertainty has grown, we are again reminded how important having a diversified portfolio can be. Day-to-day moves can be influenced by innumerable factors that are rarely predictable, and even over several months, markets can be influenced by exogenous events that are nearly impossible to appropriately factor into pricing models. For example, at what discount should equity markets trade if Greece exits the eurozone? We don’t know if it will happen, when it might happen, how it will happen, or what the ultimate financial impacts may be. We don’t know if there will be a relief rally or a sharp downturn on further uncertainty—both arguments can be made. And, of course, the market could move in the exact opposite direction if an agreement to keep Greece in the coalition is reached and viewed as credible by investors. As detailed below, risks in the eurozone have risen to the point that we are now recommending investors underweight European equities, which results in an underweighting of developed international, and use that cash to move to a potentially more defensive posture by investing in highly-rated US equities.
We continue to see signs, however, that many investors are overexposed to investments viewed as “safe.” Highly-rated fixed income instruments continue to see near-record inflows and cash appears to be heavily weighted in many investors’ portfolios. This “return of capital rather than return on capital” mentality, however, has its own dangers. By holding an outsized amount of a portfolio in these instruments that are paying next-to-nothing in yield, investors are virtually locking in losses of purchasing power at even a low inflation rate of 2-3%. To achieve investing goals over the longer-term, we believe investors need to be appropriately allocated among various asset classes, which may mean moving into areas that are not exactly comfortable and where clarity is lacking.
US looks good—relatively speaking
We believe that domestic equities are among the most attractive assets currently. We’ve seen a pullback that has come close to correction territory (down 10% from the top), which has helped to alleviate some of the overly optimistic sentiment indicators that we highlighted in early April. The American Association of Individual Investors (AAII) recently noted that its bullish reading is now at the lowest level in 20 months. The pullback has also helped to bolster the valuation picture as earnings remain healthy. In fact, on a forward-earnings basis, the multiple on the S&P 500, at 12, is four points lower than the long-term average of 16.
Economically, domestic data has been a bit soft, but several areas—notably autos and housing—have improved; and US growth is decidedly stronger that in many other areas of the world. The mild winter likely had an impact on data, and we are likely seeing a little give-back recently; but we think the risk of another recession in the near-term is low. Although unemployment claims are no longer descending at the same pace as earlier this year, the labor market continues to heal. The May labor report was disappointing but we don’t want to panic over one or two weak numbers from a lagging indicator. However, the mere 69,000 jobs gained in May along with a tick up in the unemployment rate to 8.2% is certainly concerning and the next several weeks of data will be key to watch.
Claims have shown strength after soft patch
Source: FactSet, U.S. Dept. of Labor. As of May 31, 2012.
As noted, we’ve seen increasing signs that the housing market is slowly starting to heal. While its impact on the economy has dramatically fallen over the past several years, an even modestly improving market should help to bolster confidence and stimulate activity in various areas of the economy. The National Association of Home Builders confidence reading rose to 29 recently, still quite low, but the highest reading since May 2007. Additionally, we saw housing starts rise 2.6% month-over-month (m/m), new home sales gain 3.3% m/m, and existing home sales advance by 3.4%. Perhaps even more encouragingly, the median price of those existing homes rose 10.1% year-over-year. Finally, housing affordability remains at an all-time high thanks to still-low prices and record-low mortgage rates.
Tags: Brazil, BRICs, Charles Schwab, Chief Investment Strategist, Contagion, Debt Crisis, Diversified Portfolio, Domestic Economy, Economic Data, energy, European Equities, Eurozone, Exogenous Events, Federal Reserve, Fixed Income, Ills, India, International Markets, Liz Ann, Money Market, Pricing Models, Sector Analysis, Senior Vice President, Sustainable Solution
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Friday, May 25th, 2012
by Matt Tucker, iShares
The high yield bond market is back in the news again. On the back of increased concerns over the events in Europe there’s been an increase in high yield market volatility over the past few weeks. Investors have seen this in the price movements of HYG (the iShares iBoxx High Yield Bond ETF). Of particular focus has been a series of redemptions out of HYG and other high yield ETFs. These trades have been at times misunderstood by market participants, so I’m going to try to provide some clarity.
First off, it’s important to remember that HYG, just like all other iShares ETFs, has a process by which shares can be created and redeemed in large quantities on a daily basis (see a great video explaining this concept here). So if investors are leaving the high yield bond market and selling shares of HYG, this may result in shares of HYG being redeemed and the shares outstanding declining. This is a classic example of the ETF creation/redemption process in play.
But what’s interesting about the recent activity is that in addition to investors exiting the high yield market, some of the redemption activity we have seen in high yield ETFs is from investors who actually want to own high yield bonds. Confusing? I’ll explain.
Let’s say that you are a large investor and you want to build a high yield bond portfolio. You know that transaction costs in the high yield market can be very high and that, due to the nature of the over-the-counter bond market, it could take days or even weeks to build a diversified portfolio. With the growth of high yield ETFs, you now have a faster, cheaper way of building a bond portfolio – by buying shares of the ETF on the exchange, and then redeeming those shares in exchange for bonds from the ETF.
This is what happened with some of the redemptions we recently saw in the market. Large investors wanted to own a diversified portfolio of high yield bonds, so they bought up shares of a high yield ETF on the exchange, and then redeemed the shares of the ETF for the underlying bonds. This is exactly what HYG and our other high yield iShares ETFs are designed to do – provide a liquid alternative to the over-the-counter bond market.
The key to such a trade is that HYG and our other fixed income iShares ETFs primarily use an “in kind” creation and redemption process, which ensures that the costs of creating and redeeming shares are kept outside the fund. The transaction costs for creations and redemptions are borne by the transacting investor, and don’t impact other shareholders.
Investors should note that not all fixed income ETFs use the same creation and redemption mechanism employed by HYG. I would recommend that investors do their due diligence on any ETF that they are looking to invest in to ensure they understand the details.
Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.
Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. There can be no assuarance that an active trading market for shares of ETF will develop or be maintained.
Buying and selling shares of iShares Funds will result in brokerage commissions.
Tags: Bond Market, Bond Portfolio, Buying Shares, Clarity, Daily Basis, Diversified Portfolio, ETF, ETFs, High Yield Bond, High Yield Bond Etf, High Yield Bonds, Ishares, Market Participants, Market Volatility, Matt Tucker, Nbsp, Quantities, Redemption, Redemptions, Selling Shares, Trades, Transaction Costs
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Tuesday, February 21st, 2012
Ben Graham’s Curse on Gold
by John Mauldin
February 20, 2012
This week we have a shorter Outside the Box, from my friend David Galland at Casey Research, with an interesting insight into why gold can be considered as a poor investment by some rather influential investors (like Warren Buffett) while others may see it as the core of a diversified portfolio. As usual when I use someone’s material for an OTB, I include a link at the end, if you want to look deeper. The rather large team at Casey Research specializes in gold, natural resources, and energy-related investments, for those with such an investing bent.
As a quick note, the feedback on this weekend’s letter on taxes has been substantial, and a great deal of it is quite good and worth thinking about. Many bring up real problems with the position I took in my letter, and I may surprise you by agreeing with some of them. My intention right now (barring something happening between now and Friday night) is to take some of the better statements and questions, and answer them. I am not married to any specific plan. I just want to solve the problem and am open to anything that is politically feasible and makes sense, as long as we solve the basic problem of the deficit. I think it will make for a very interesting letter. I do read your feedback, by the way. So if you wanted to respond and wondered if I might actually read it, the answer is yes I do, and this week will answer as many as I can.
And to answer a question I get a lot, I buy a little physical gold every month. I don’t even look at the price. The check is written the same day each month, for the same amount. I take delivery. I hope the price of gold goes down so I can get more gold per dollar. I also hope it ends up being worthless, as that will mean everything else has worked out just fine. But my gold is there just in case my crazy gold bug friends are right and we can’t actually trust the government to find a reasonable solution to our dilemma. And maybe because deep down I really don’t trust the (insert your favorite expletive). Just a little insurance, you understand.
So, until we connect this weekend, have a great week!
Your I am not a gold bug analyst,
John Mauldin, Editor
Outside the Box
Ben Graham’s Curse on Gold
By David Galland, Casey Research
It seems that the mainstream investment community only takes a break from ignoring gold to berate it: one of gold’s most outspoken critics, uber-investor Warren Buffett, did so recently in his latest shareholder letter. The indictments were familiar; gold is an inanimate object “incapable of producing anything,” so any investor holding it instead of stocks is acting out of irrational fear.
How can it be that Buffett, perhaps the most successful (and definitely the most well-known) investor of our time, believes that gold has no place in an intelligently allocated investment portfolio?
Perhaps it has something to do with his mentor, Benjamin Graham.
Graham, author of Security Analysis (1934) and The Intelligent Investor (1949), is correctly respected as one of history’s most knowledgeable investors. Over a career spanning 1915 to 1956, he refined his investment theories, in time becoming known as the father of value investing. Much of modern portfolio theory is based upon Graham’s work.
According to Graham, while no one can tell the future, there are periods when the valuations of stocks and bonds would deviate from fair value by becoming excessively over- or undervalued. To enhance returns and reduce risk, investors should alter their portfolio allocations accordingly. A quick look at a long-term chart supports Graham’s theory clearly shows periods when one asset class offered a better value than the other:
But what of the periods when both stocks and bonds stagnated or fell together? For much of the 1970s and again from 2001 through today, any portfolio allocated solely between stocks and bonds would have at best treaded water and at worst drowned in a sea of stagflation. To earn any real return, an investor would have needed to seek alternatives.
It’s clear from this next chart that gold was exactly that alternative, a powerful counter-trend investment for periods when both stocks and bonds were overvalued. Yet gold is conspicuously absent from Graham’s allocation model.
But this missing asset class is entirely understandable: for most of Graham’s adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed. Banned for private ownership by FDR in 1933, it wasn’t re-legalized until late 1974. Graham passed away in 1976; he thus never lived through a period in which gold was unmistakably a better investment than either stocks or bonds.
All of which makes us wonder: if Graham had lived to witness the two great bull markets in precious metals during the last 40 years, would he have updated his allocation models to include gold?
We can never know.
We can know, however, that given Graham’s outsized influence on investment theory, there is little question that his lack of experience with gold, and therefore its absence from his observations, has had a profound effect on how most investment professionals view the yellow metal. This, in our opinion, goes a long way toward explaining the persistently low esteem in which gold is held by the mainstream investment community. And, as a consequence, its widespread failure to even be considered as an asset class.
A couple of takeaways: first, perhaps now you can stop wondering why your broker, the talking heads in the financial media, and Warren Buffett continue to misunderstand gold as a portfolio holding. More importantly, however, is that in order to have sustained, long-term investment success, one must accept that an intelligent portfolio allocation needs to include not two but three broad categories of investment – stocks, bonds and gold, with the amounts allocated to each guided by relative valuation.
[JFM here: I would suggest additional broad categories of investments depending on your personal situation. Alternative investments like commodity trading funds. Low leveraged income oriented real estate consistent with your ability to handle the ups and down of the rental/leasing market and shorter term carry costs. I for one am not psychology capable of dealing with renters, of whom I am one. I want service and you to pay for major maintenance, and the ability to move at the end of my lease. My choice, not dependent upon your cash needs. But I know of plenty of people who can do that and have amassed considerable portfolios over time. Perhaps your own small business that has the potential to grow. Investments outside of your country of residence. Etc.]
Investors who understand this tenet have an almost unfair advantage over other investors as it allows them to get positioned in gold ahead of the crowd and enjoy the bulk of the ride, while others sit on their hands.
So when you hear commentators ridiculing gold as a barbarous relic, lamenting that they cannot eat it or smugly asserting that it produces nothing, rest contently in knowing that they’re operating with a severe handicap in their own portfolio. Meanwhile, we’ll prosper, armed with the understanding that gold fulfills a very important and specific purpose in a portfolio, namely as real money that protects net worth during periods marked by excessive government debt and currency debasement such as we are currently experiencing.
Given the powerful influence of Ben Graham and his disciples, his curse on gold will not go quietly into the night. But it should.
David Galland is managing director of Casey Research, which provides independent investment analysis on a subscription basis to a global network of over 180,000 self-directed investors and money managers. Recognizing the emerging bull market in gold early on, in the late 1990s, Casey Research formed a metals and mining division that has grown into a leading provider of actionable gold and resource intelligence. For investors looking to become familiar with the asset category, Casey Research offers a monthly newsletter, BIG GOLD (try it risk-free for 90 days), focusing on undervalued opportunities in mid- to large-cap producers, as well as best practices in buying, holding and selling precious metals. Learn now why it’s more important than ever to invest in gold and gold-related equities.
Tags: Casey, Curse, Dil, Diversified Portfolio, Friday Night, Friend David, Galland, Gold Bug, Gold Dollar, Insight, Intention, Investments, John Mauldin, Natural Resources, Otb, physical gold, Poor Investment, Price Of Gold, Reasonable Solution, Warren Buffett
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Wednesday, December 14th, 2011
A lot of stocks have been taken out to the woodshed this week, as anyone with a diversified portfolio likely knows. But many of the Dow 30 stocks are holding up well. As shown in our Dow member trading range screen below, seven stocks in the Dow are still overbought (more than one standard deviations above their 50-DMAs). The list of overbought stocks is made up of Boeing (BA), Home Depot (HD), Kraft (KFT), McDonald’s (MCD), Merck (MRK), Pfizer (PFE), and Verizon (VZ). Only three stocks in the Dow are currently oversold — Alcoa (AA), Bank of America (BAC), and Du Pont (DD). The other 20 stocks in the index are currently in neutral territory within their “normal” trading ranges.
Tags: Alcoa, Bank Of America, Diversified Portfolio, Dmas, Dow 30 Stocks, Dow Stocks, Du Pont, Home Depot, Investment Group, Kraft Kft, Mcd, Merck, Merck Mrk, Neutral Territory, Pfe, Pfizer, Standard Deviations, Stocks In The Dow, Trading Ranges, Woodshed
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Monday, September 12th, 2011
Jack Bogle: Why Mark Cuban Is Wrong on Investing, Wall Street Journal Video
Buying and holding stocks and bonds for the long term and maintaining a diversified portfolio are still the smartest strategies for the average investor, says Vanguard founder Jack Bogle in answer to Mark Cuban and other critics of these traditional approaches. In the Big Interview with Journal columnist Jason Zweig, Bogle takes aim at the culture of market speculation. Betting on long odds, he says, “doesn’t pay off very often.”
h/t: Dan Richards, ClientInsights.ca
Tags: Aim, Bonds, Buying Bonds, Buying Stocks, Diversified Portfolio, Investing, Investor, Jack Bogle, Jason Zweig, Journal Columnist, Long Odds, Mark Cuban, Market Speculation, Stocks And Bonds, Stocks Bonds, Traditional Approaches, Vanguard, Wall Street, Wall Street Journal
Posted in Bonds, Brazil, Markets | Comments Off
Thursday, July 21st, 2011
prepared by Capital International Asset Management
1994 is remembered as one of the most challenging bond markets on record. Interest rates rose 300 bps in the first six months of the year, and bond investors took a big hit.
Would a diversified yield source have helped investors in that extreme market environment?
DEX Universe Bond Index: -4.31%
Blended bond portfolio: -2.21%
(Blend* = 70% DEX Universe; 20% global bonds; 5% high-yield bonds; 5% emerging markets debt)
Of course, today’s bond market is different, especially since about half of emerging markets bonds are now investment grade. But it’s clear that a diversified portfolio would have held up better in 1994 than an all-Canadian bond portfolio.
Our Canadian Core Plus portfolio offers a diversified yield source — across sectors, countries and currencies — with high-quality Canadian bonds at the core. This flexibility may serve investors well in a rising rate environment, and it’s one of the few ways to add value in fixed income today.
Last week, we hosted a webinar featuring Jim Mulally, a 35-year veteran of fixed-income markets. For Jim’s commentary on interest rates, inflation and European sovereign debt, as well as how he’s structuring our Canadian Core Plus portfolio for the current environment, see the links below.
- Audio replay: 888/203-1112; code 7354460 (Available through August 1)
*Global bonds = Barclays Capital Global Aggregate Bond Index; High yield = Barclays Capital U.S. Corporate High Yield Index; Emerging markets debt = J.P. Morgan Emerging Markets Bond Index. Indices are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
Tags: Barclays Capital, Bond Index, Bond Investors, Bond Market, Bond Markets, Bond Portfolio, Canadian, Canadian Bond, Canadian Bonds, Diversified Portfolio, Emerging Markets, Fixed Income Markets, Global Bonds, High Yield Bonds, Index Indices, International Asset Management, Investment Grade, Litmus Test, Market Environment, Rate Environment, Sovereign Debt
Posted in Canadian Market, Markets | Comments Off
Friday, July 15th, 2011
On Your Mind: Debt Ceiling and the US Dollar
by the Schwab Center for Financial Research
There’s been a lot of media attention on the US debt ceiling and the outlook for the US dollar. Here, we’ll answer some of the questions we’ve been receiving from clients.
The US debt ceiling
- What are the chances of the United States defaulting on its debt?
- Will the United States automatically default if the debt ceiling isn’t raised by August 2?
- When can we expect a resolution to this issue?
- What will happen if the United States does default?
- What does this mean for investors?
Outlook for the US dollar
- Is there a risk of the dollar collapsing in the short term?
- Is the world going to abandon the dollar as a reserve currency?
The US debt ceiling
We believe that there will, in fact, be a resolution to the debt-limit debate, and that default on US Treasury debt remains unlikely. The United States has a resilient economy and a strong ability to pay, despite the current political debate. That said, the situation illustrates the importance, we believe, of a global, broadly diversified portfolio.
What are the chances of the United States defaulting on its debt?
We believe a default is extremely unlikely. We expect that the political debate will continue, but believe that the negative consequences, both political and economic, will become more apparent the longer the delay. According to the Treasury, those consequences could include delay of Social Security payments, Medicare, military salaries and other expenses, and ultimately default. As the deadline approaches and the potential pain becomes more apparent to the average citizen, or is reflected in a rise in yields, we believe that politicians will act and raise the debt ceiling.
Will the United States automatically default if the debt ceiling isn’t raised by August 2?
If the debt ceiling isn’t raised by August 2, the Treasury has stated that its cash-flow management strategies will run out and it will either need to issue new debt above the limit (which it can’t legally do) or stop payment on a variety of obligations, including debt payments. A default could be staved off for a short time if the federal government prioritized payments to bondholders over paying its other bills, but as of yet no there’s no legal prioritization for payments. Given the enormous amount of interest and principal due on the federal government’s outstanding debt, this temporary solution wouldn’t be sustainable for long. However, we believe that the debt ceiling will be raised, allowing the government to avoid suspending payment to its bondholders or to anybody else.
When can we expect a resolution to this issue?
A deal would probably need to be made no later than July 22 in order to meet the August 2 deadline for completed legislation. Once the broad outlines of a deal are agreed upon, it normally takes two to three weeks to hammer out the specifics and produce draft legislation. That schedule would likely be compressed here, given the urgency of the situation. Once draft legislation is complete, both the House and Senate must vote to approve it—and this may be the trickiest step of all. President Obama and House and Senate leaders will have to forge bipartisan coalitions in both chambers to get the bill across the finish line. We believe that this will be difficult, but it is very likely to happen.
What will happen if the United States does default?
It’s impossible to say with any degree of certainty because this has never happened before. The three major bond rating agencies have said that they would lower the US’s current AAA rating even if interest and principal payments were interrupted for only a few days. Should this occur, we still expect that global demand for Treasuries and confidence in ultimate payment won’t disappear. Treasury yields would likely rise in the event of a default, and we expect more volatility in Treasury yields until an agreement is reached.
What does this mean for investors?
For the moment, we see less upside and more risk in new Treasury purchases for price-sensitive bond investors. However, we believe that buy-and-hold investors should remain confident that US capacity to pay will ultimately remain strong. We don’t believe that a dramatic change in investment strategy is warranted for most investors.
Fundamental demand for US Treasuries has remained strong, as evidenced by yields that remain near historical lows. This, we believe, is due to a number of factors, including:
- Confidence that the debt limit will be raised
- Weaker economic data leading to continued demand for Treasuries
- Some positive sentiment (toward Treasuries) that a serious budget/deficit debate will lead to a strong US fiscal position
- Some negative sentiment (toward the economy) that large and/or rapid cuts in government spending might slow economic growth in the short term.
It’s true that we’ve seen a recent increase in yields, which we believe has to do with the debt-ceiling debate as well as many other variables: the ongoing challenges in Europe and, specifically, Greece; changing market consensus about the pace of US economic recovery; and the recent end to the Federal Reserve’s bond-buying program (QE2).
Outlook for the US Dollar
Recent events have caused some investors to wonder about the dollar’s short-term prospects and its status as a world reserve currency. While there are genuine reasons for the dollar’s weakness—including large deficits, a loose federal monetary policy, and a less-than-robust economic recovery—we believe that a sudden collapse of the dollar or a precipitous change in its reserve currency status is unlikely. Additionally, we believe that a global, broadly diversified portfolio can help investors protect US-denominated portfolios from a dollar decline.
Is there a risk of the dollar collapsing in the short term?
A sudden sharp decline of the dollar would not be in anyone’s interest. This includes Japan and China, which are the largest external holders of US Treasuries. It would destroy the value of their massive foreign currency reserves that are heavily overweight in dollars. Sudden sharp moves in exchange rates are generally seen as a threat to the stability of economies and global financial markets. Were the dollar to suffer a sharp decline, it would most likely lead to concerted currency market interventions similar to the recent G7 intervention to stabilize the yen.
Because the whole world is so dependent on the dollar, no one wants violent moves in the currency. Therefore, a possible shift away from the dollar is likely to take place over several years or even decades and not in the near term. This will give you time to assess your portfolio and the changes you might want to make.
Is the world going to abandon the dollar as a reserve currency?
It’s unlikely that the dollar will lose its status as the world’s number one reserve currency anytime soon. Talk of creating new supra-national currencies or even a global fiat currency has gotten louder due to recent events and negative sentiment toward the US Fed’s monetary policy. But even if there is a will to work toward creating new currencies, the countries involved are nowhere near realizing those plans.
No other existing currency can offer the necessary stability and liquidity to replace the dollar as the world’s reserve currency in the foreseeable future. This suggests that the dollar will keep its status for now.
In the mid- to long-term, however, we believe it’s possible that the dollar will eventually share its reserve status with other currencies such as the euro, the yen and maybe even the Chinese yuan. The creation of new currencies is also possible. However, keeping the euro area’s difficulties in mind, the success of such endeavors first has to be proven, and takes time.
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 (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.
Diversification does not eliminate the risk of investment losses.
Tags: Cash Flow Management, Citizen, Deadline Approaches, Debt Ceiling, Debt Limit, Diversified Portfolio, Limit Debate, Management Strategies, Media Attention, Medicare, Military Salaries, Negative Consequences, Political Debate, Politicians, Reserve Currency, Schwab, Social Security, Social Security Payments, Treasury, United States
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Monday, February 7th, 2011
by John P. Hussman, Ph.D., Hussman Funds
The famous quote attributed to John Maynard Keynes – “the market can remain irrational longer than you can remain solvent” – is a favorite of speculators here. Actually, I very much agree with this observation, provided that it is correctly understood. Solvency is always a function of debt, and it’s extremely important for investors to recognize that when you take investment positions by borrowing on margin, you’d better use stop-losses, because the debt obligation stays intact even if the investment values decline.
On the other hand, we certainly don’t believe that this aphorism amounts to a recommendation that it is required (or even advisable) for investors to accept speculative risks just because prices are advancing, particularly at the point where overvalued, overbought, overbullish conditions are joined by rising interest rates, as they are at present.
In my view, the more appropriate quote for the present environment is from Benjamin Graham: “Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”
Ironically, while the “irrational longer than you can remain solvent” quote is embraced by speculators as a license to take risk, they may not recognize that whatever lesson might be learned from Keynes has nothing to do with his views about “irrational” market advances. Rather, Keynes’ learned his lesson as a result of steep losses that resulted from holding a poorly diversified portfolio – apparently on margin – during a market plunge, years after the Depression trough of 1932. As biographer Robert Skidelski observes, “In the year of the ‘terrific decline’ which had started in the spring of 1937, he lost nearly two-thirds of his money.”
Let’s briefly walk through the 1930′s, to examine the context in which Keynes was operating. As I’ve noted in prior commentaries, the U.S. stock market at its 1929 peak was priced to achieve slightly negative total returns over the following decade (based on estimates using our standard methodology). Once the market had lost half of its value, the prospective 10-year total return reached 10% annually. From there, however, the market would lose another two-thirds of its value to its ultimate trough in 1932. All told, the market lost more than 80% from the 1929 peak to the 1932 low (which is what you get when a 50% loss is compounded with a 67% loss).
By 1937, the favorable valuations that existed at the 1932 trough were long gone. Stocks were overbought and overvalued, and interest rates were rising. The Dow moved above 194 at the beginning of March 1937, when in a conversation with Felix Somary (“the Raven of Zurich”), Keynes said “We will not have any more crashes in our time.” Over the following year, the market lost about half its value, with the Dow reaching its trough near the 100 level. Based on our standard methodology for estimating prospective 10-year total returns on the S&P 500, a reasonable projection at the March 1937 market peak was only about 6% annually. The Shiller P/E was over 23 (meanwhile, long-term Treasury yields were at 2.84% and trending higher). By March 1938, the plunge in the market was enough to increase the projected 10-year total return of the S&P 500 to over 14% annually.
Judging from Keynes’ confident assertion in 1937 that major market losses could be ruled out in the future, we might infer that the sentiment of investors at the time was probably overbullish, as well as being overvalued, overbought and coupled with rising yields. Needless to say, from our perspective, Keynes walked right into the 1937-1938 plunge.
That said, by early 1938, the market troughed, and with prospective long-term market returns now significantly higher, the market would gain nearly 50% in the next 8 months before stumbling again, experiencing a series of 20-30% gains and losses – though with little durable progress – for nearly a decade. One could have performed quite well over the full period by recognizing that while prospective returns may be very attractive at market troughs, they are no longer attractive – and sometimes abysmal – once a substantial advance has occurred.
Fast forward to the present, and the lessons that we should keep in mind here. First, it matters critically to long-term investors whether stocks are priced to achieve strong or weak long-term prospective returns. Moreover, regardless of what segment of historical data one examines, there is enormous risk in market conditions that feature overvalued, overbought, overbullish conditions coupled with rising interest rates. It is crucial to understand that the valuations we observe today are nothing like the valuations of early 2009. At the trough, our estimates of 10-year prospective returns exceeded 10% annually (though our concern at the time was that we could not rule out the sort of sustained follow-through we’ve seen in other crises). At present, we estimate that the 10-year prospective total return for the S&P 500 is just 3.2% annually. The Shiller P/E is currently about 24.
Risk premiums are no longer wide – they are dangerously compressed. Bullishness is excessive. Interest rates are rising. While the conditions we observed in early 2009 had mixed implications depending on whether one considered U.S. post-war data or data from other periods of credit crisis, the implications of the present set of conditions is unequivocal regardless of which data set one chooses.
If we can clear out any component of this syndrome – most likely the overbought or overbullish components – without a substantial deterioration in market internals, there will be enough ambiguity in market conditions that we can expect to accept at least a moderate exposure to market fluctuations. The ensemble methods that we’ve implemented in recent months have expanded the range of Market Climates we identify, so shareholders can expect to see more variation in the market exposure we accept than we’ve had in recent years. But without clearing some component of the present, hostile syndrome, we are simply in a set of conditions that has rarely worked out well in any subset of the data we consider – even during “uptrends” from a technical standpoint, even during “seasonally favorable” conditions, and even in periods when the Federal Reserve was easing monetary policy conditions.
Undoubtedly, the “unpleasant skew” that we’ve observed in recent months has been a challenge, as has the equally skewed performance of individual stocks toward cyclicals, commodity stocks, speculative small-caps, and highly-indebted, inconsistent businesses that we typically avoid as “low quality.” Given how extended some of these speculative trends have become, and the hostile nature of the present set of market conditions, I certainly expect this to be resolved, but there’s no assurance that we’ll observe that resolution over the short-term.
From its all-time high in 2008, the Strategic Growth Fund is down about 16%, with about 12% of that decline occurring since mid-2010 in response to the simultaneous speculation in ‘risk assets’ and punishment of ‘stable assets’ that was triggered by QE2 (which I continue to view as the Emperor’s Clothes). That’s certainly a tough loss for us, which is saying something in a market that has lost more than 50% on two separate occasions in the past decade alone. Having broadened the set of Market Climates we define, and having introduced robust methods to allow us to combine the implications of multiple data sets in a satisfactory way, I’m comfortable that our long-term strategy is well suited to a far wider range of market environments than even we anticipated in 2008.
It’s imperative to learn the right lessons from market. While simple aphorisms such as “don’t fight the tape” and “don’t fight the Fed” are appealing, their performance can be tested historically and their shortcomings can easily be evaluated. The lessons of recent years emphatically do not include the notion that trends should be blindly followed, or that an “easy” Fed can be trusted to defend the market against losses in a speculative environment. In our view, good lessons can be demonstrated to be valid in historical data, and good research improves the expected long-term performance of a strategy without substantially increasing the depth of its periodic losses. This remains our focus, and is the basis of the confidence we have in our investment discipline.
On the subject of the long-run (which we generally define as at least one complete market cycle measured from peak-to-peak or trough-to-trough), another favorite quote of speculators here is Keynes’ remark that “The long-run is a misleading guide to current affairs. In the long run we are all dead.” Once again, this quote is taken far out of context. Keynes was speaking about monetary reform, arguing that government intervention was necessary to control inflation, and that economists could not simply comfort themselves that the price distortions and misallocations resulting from inflation would be eliminated over time. With respect to investing, Keynes’ views about the long-run could not be clearer: “I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself… An investor should be aiming primarily at long-period results.”
Tags: Benjamin Graham, Decline, Diversified Portfolio, Famous Quote, Handicap, Hussman Funds, Investment Positions, Investment Values, John Keynes, John Maynard Keynes, Market Knowledge, Market Plunge, Rising Interest Rates, Solvency, Speculator, Speculators, Steep Losses, Trough, Two Thirds, Typical Experience
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