Posts Tagged ‘Downside Risk’
Monday, July 30th, 2012
by Andrew Pyne, PIMCO
- Equity valuations appear reasonable, but volatility is likely to remain elevated amid slowing global economic growth and macroeconomic risks.
- As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value.
- Investors should consider increasing exposure to emerging markets, deploying downside-risk and volatility-mitigation, emphasizing dividends and focusing on active share.
PIMCO’s secular outlook calls for slowing global economic growth, a world that is still multi-speed, and unresolved macroeconomic risks that are likely to result in continued heightened volatility. While our view on the economy is a cautious one, overall equity valuations appear reasonable, and corporate fundamentals, as measured by earnings, margins and balance sheets, are relatively attractive. The outlook for equities, then, can be expressed as a tug of war between these macro headwinds and micro fundamentals.
What does this mean for equities, which are still the dominant risk in investor portfolios? Overall, we believe that continued policy confusion and economic fundamentals that are trending in a negative direction will create headwinds. As the developed world continues to delever, we expect global equities to experience a modest-return environment.
Challenges and solutions
The clear implication is that this creates a challenge for investors. Most investors historically have relied on equities to help achieve their target portfolio returns. In this environment, though, beta is unlikely to deliver the returns required. We believe that investors should consider the following:
- Increase exposure to faster-growing economies. Many portfolios should be more global with higher allocations to emerging markets.
- Incorporate downside-risk and volatility-mitigation to address the higher probabilities of negative macro events.
- Emphasize dividends, which will likely be a more important component of equity total returns.
- Take greater active risk and focus on active share. In a modest-return world, if beta doesn’t get the job done, then alpha may be a significant percentage of an investor’s equity returns.
The key risk to the global economy is Europe, which given significant structural challenges and policy uncertainty is facing prolonged subdued growth and the risk of recession. Why then do we suggest equity portfolios be more global? The answer lies partly in the way equities have traditionally been categorized. Companies are often classified by their country of domicile, but we think they are better defined by their end-markets. Despite significant risks at home, many European multinationals have meaningful exposure to emerging markets. If we find businesses with stable cash flows, high dividend yields, strong end-market growth – and with valuations that discount home-market risks – these can be attractive investment opportunities.
In addition, we believe most investors, particularly those with a home-market bias, would benefit from increased direct exposure to emerging markets. While emerging markets are certainly not immune to the struggles of the developed world, emerging markets and developed markets face very different economic scenarios. We expect emerging markets to continue to gain share of global GDP, but most investors are still underweight the asset class. We expect emerging markets to account for more than 50% of global GDP in purchasing power parity terms over the next three to five years. They already are about a third of global equity market caps. Yet emerging market equities represent only about 7% of the average investor’s portfolio.
Managing macro risks
Our second suggestion is to prioritize downside- and volatility-mitigation in equity portfolios. Correlations among stocks have increased meaningfully over the past few years; they’ve tended to spike around negative macro events and decrease as uncertainty subsides (see Figure 1). This suggests that the “risk-on/risk-off” sentiment that drives stock prices is often governed by macro news flows, not company fundamentals.
There are two takeaways for investors. The first is that macro does impact stock prices, and so while equity investing has traditionally been thought of as a bottom-up endeavor, we believe managers need to consider both bottom-up and top-down views as part of their research process.
The second takeaway is that because there are unresolved macro risks, investors must recognize that, given the way returns compound over time, protecting on the downside could be a critical contributor to long-term returns. Part of the solution may be increasing allocations to active mandates from passive. Although investors could lose more with an active approach, by definition traditional indexes will capture 100% of down-market performance.
We believe protecting on the downside requires a very active approach. Strategies including low-volatility and dividend-focused investing, tail-risk hedging, and flexibility to short stocks or raise cash, may result in improved risk mitigation compared with a passive strategy.
Dividend income, a significant portion of historical equity returns, is likely to be even more important in an environment of slower growth. Of course, if we were expecting broad multiple expansion and strong global growth – as we saw in the ‘80s and ‘90s – then the message simply would be “buy equities and enjoy the ride.” As Figure 2 shows, however, dividends often have been a substantial portion of total equity performance during periods of modest returns. While many investors’ assumptions and expectations for equities were formed by the 20-year bull market of the ‘80s and ‘90s, the ‘40s, ‘60s and ‘70s may be more instructive for the period ahead.
We also believe the opportunity for dividend-paying stocks is more of a global story than a U.S. one. Given demand from U.S. investors for income, traditional dividend-paying sectors in the U.S. – telecom, utilities, Real Estate Investment Trusts (REITs), and Master Limited Partnerships (MLPs) – are generally quite expensive, whereas select non-U.S. equities, including emerging markets, remain attractive sources of yield.
Two points outlined above – the notion that macroeconomic news flow influences stock prices and the expectation for modest returns – each reinforce the importance of alpha in helping investors achieve their goals. As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value. The key is to be highly selective, identifying the long-term winners even as the markets are indiscriminate in the short term.
For many investors, the importance of alpha should prompt a reconsideration of the mix of passive and active equity allocations. At the very least, we believe investors should ensure that their active managers are truly active, with high active share a prerequisite for inclusion in their portfolio (please see Equity Investing: From Style Box to Global Unconstrained, May 2012).
Revisiting equity portfolios
In an environment of fatter tails, there is always the possibility of a right-tail event. Enactment of comprehensive and bipartisan policies to address structural problems in developed markets, for example, would be welcome news and would likely lead to broad multiple expansion and higher returns in the equity markets. However, absent such developments, economic fundamentals suggest more modest returns.
Many investor portfolios may not be positioned for a lower-return world, particularly those that were structured during a higher-return equity environment. We believe investors would be well served to take a fresh look at their equity allocations. If beta will not suffice, then investors should work to ensure their portfolios have the characteristics needed to succeed.
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The S&P 90 (prior to 1957) was a value-weighted index based on 90 stocks. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Tags: Active Share, Balance Sheets, Downside Risk, Economic Fundamentals, Emerging Markets, Global Economic Growth, Global Equities, Headwinds, Impo, Mitigation, Negative Direction, PIMCO, Policy Confusion, Portfolio Returns, Pyne, Target, Tug Of War, Valuations, Value Investors, Volatility
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Wednesday, May 16th, 2012
Equity Investing: From Style Box to Global Unconstrained
by Andrew Pyne, PIMCO
- PIMCO sees greater potential benefit to global portfolios in strategies that are unconstrained by a benchmark, and with managers who think about absolute return at least as much as they think about relative return.
- We believe the style box approach resulted in too great a focus on returns relative to a very narrow index and led investors to have too short of an investment time horizon in which to evaluate their managers, and that the cycles of style performance and the narrow benchmarks in the style box world encourages manager turnover and undermines long-term portfolio return potential.
- Even though many managers have become less active, many continue to charge active fees, and as a result, we believe, the style-box framework basically became an expensive index strategy.
- At PIMCO, our active equity strategies are positioned for this evolving equity landscape. All of our strategies are global, unconstrained by the benchmark (seeking at least 80% active share), and consider downside risk mitigation as a critical part of the client experience.
Most investors are probably familiar with the “style box” approach to equity investing, but they may not know that the unintended consequences of this construct may result in underperformance.
In our view, style boxes have constrained managers and limited their opportunity set. Instead, PIMCO sees greater potential benefit to global portfolios in strategies that are unconstrained by a benchmark, and with managers who think about absolute return at least as much as they think about relative return. We believe that stepping outside the style box allows an active investment manager the opportunity to lower volatility and improve downside risk mitigation.
Inside the style box
Let’s quickly review how the style box was often constructed, simplifying to three basic steps.
First, the world was divided by region, style and market cap. Second, an emphasis was placed on the investor’s home market (in this example the U.S.), with international equity added for diversification. And third, managers were hired to fill a very specific and narrow role within the portfolio (see Figure 1).
For example, to fill the large cap value box, often several managers were hired – for manager diversification – and each manager typically was instructed to stay within that market segment. They were told not to drift down the market cap spectrum, as mid cap and small cap managers were playing those roles within the portfolio, and they were told not to drift over to growth, as that was the territory of other managers. And importantly, these managers were measured against a market cap and style specific benchmark, in this example the Russell 1000 Value index.
The attractiveness of the style box was twofold. In theory, it allowed investors to precisely control their equity exposures and to hire “specialist” managers who were expected to deliver strong performance in their specific area of focus. However, we believe this style box approach has failed investors.
Unintended consequences of the style box approach
We believe this approach resulted in too great a focus on returns relative to a very narrow index and led investors to have too short of an investment time horizon in which to evaluate their managers. By measuring managers against just a slice of the market, the cycles of style performance often dictated manager success.
Consider investor behavior in the technology bubble of 1999 to 2000. As tech stocks dominated the market, aggressive or momentum-oriented managers tended to outperform their more valuation-sensitive growth-at-a- reasonable-price (GARP) competitors. These GARP managers on average had good absolute returns that in many cases exceeded that of the broad market, but industry flows show that investors tended to hire the more aggressive growth managers to fill their growth boxes. As the bubble burst, though, the valuation discipline that kept many GARP managers largely out of tech stocks helped lessen, for many, dramatic losses. GARP managers appeared “smarter,” having navigated the tech bubble better, and as a result they eventually replaced the momentum players as the growth managers in many investment portfolios.
This dynamic of the timing of manager selection has repeated itself over time, as observed in a 10-year study of manager performance pre- and post-hiring and firing (Figure 2).
These charts suggest an element of performance chasing in the hiring and firing of equity managers. PIMCO believes that the cycles of style performance and the narrow benchmarks in the style box world encourages manager turnover and undermines long-term portfolio return potential.
Another drawback of the style box construct is that it may have been the catalyst for managers to “play the game” and become benchmark oriented. It seems many active managers recognized that assets and revenues were at risk if they deviated too far from the benchmark, and so they became closet indexers.
Research shows that managers have become less active over time (see Figure 3). According to Antti Petajisto of the NYU Stern School of Business, December 2010, thirty years ago, nearly all U.S. equity fund assets were with managers defined as “active” or “highly active,” based on their active share, or the percentage by which their holdings differ from the benchmark. The chart above shows the rise of index funds, which makes sense – we know there has been an increase in passive investing – but surprisingly, assets in closet indexers have grown at an even higher rate, such that closet indexers today represent approximately one-third of all U.S. equity fund assets! At the other end of the spectrum, assets in highly active managers, who tend to invest based on research conviction and do not have a benchmark orientation, have declined from 60% of overall fund assets to less than 20% today. In other words, it is easier to find managers that are benchmark constrained than managers that are highly active.
Even though many managers have become less active, many continue to charge active fees, and as a result, we believe, the style box framework basically became an expensive index strategy.
The dangers of benchmark hugging
The problem with a benchmark orientation is that it can cause managers to be reactive to the market. Consider that indexes frequently become distorted – think of the weighting of Japan in international equity indexes in the late 1980s, the weighting of technology in the U.S. equity and growth benchmarks in the late 1990s, and of financials in value benchmarks prior to the financial crisis in 2008.
The closet indexer defines risk primarily in benchmark terms, or tracking error, and therefore tends to follow the benchmark weights, i.e., buying more Japan equity as it becomes a larger part of the index, buying more technology and financials as they become larger parts of the index. While these managers are focused on minimizing benchmark risk, they may be creating significant absolute risk, and when these bubbles burst their investors learned the painful lesson that low tracking error does not necessarily mean low risk.
The performance problems associated with benchmark orientation and measuring managers relative to a narrow index can create a significant challenge for investors. A recent McKinsey & Company study (August 2011) cites a growing awareness that the structure and mindset that is entrenched in the investment management industry needs to change, that benchmarks create the wrong incentives, that manager focus should not be just on beating the index, and that fighting the relative investment mindset is a constant battle.
The case for global unconstrained
Why global? Remember that traditionally equity portfolios tended to be built with a home-market focus, with international equity added as a diversifier. However, correlations between stocks globally have increased over the last decade and have stayed at this elevated level (see Figure 4).
In addition, the lines between what it means to be a U.S company and a non-U.S. company are blurring, with over 30% of S&P 500 company revenues coming from outside the U.S., according to Goldman Sachs (2010). As the world has become more interconnected, and as diversification benefits fade, we believe the equity classifications of “domestic” and “international” have become outmoded. The implication is that as the world is evolving, managers who are not constrained to a specific region and have a global opportunity set may be better positioned to find the most attractive investment ideas regardless of company domicile.
Why unconstrained? Below we show a measure of performance of global managers vs. those that are regionally constrained and the performance of all cap managers vs. those that are market cap constrained (see Figure 5). The performance shown is the information ratio, or excess return over a benchmark, or alpha, divided by the standard deviation of that alpha. Information ratio is one of the risk-adjusted returns employed by consultants and institutions.
Tags: Absolute Return, Active Share, Benchmark, Benchmarks, Box Approach, Client Experience, Downside Risk, Equity Strategies, Index Strategy, Investment Manager, Investment Time, PIMCO, Portfolio Return, Relative Return, Risk Mitigation, Style Boxes, Term Portfolio, Time Horizon, Unintended Consequences, Volatility
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Thursday, May 10th, 2012
Going Global Can Pay Dividends
by Brad Kinkelaar, PIMCO
- In today’s low yield environment, many investors now include dividend-oriented equities in their portfolios in an effort to reach their income goals.
- U.S. investors with home market bias risk severely limiting their income potential because in the U.S., dividend payout ratios are on the decline, taxes are potentially on the rise, and valuations in sectors that typically offer attractive dividends are near historical highs.
- In our view, global equities can provide more attractive dividend income opportunities and offer potential for additional benefits, including diversification
You don’t have to look very far these days to find yield-oriented investors starving for attractive income options. With 10-year Treasuries yielding about 2%, the usual playbook of generating income from a simple portfolio of government bonds has proven inadequate. This has serious implications for investors: As the large number of people born between 1946 and 1964 – the baby boomers in the U.S. – begins to retire, many retirement portfolios, once the recipients of net inflows, are under the strain of increasing distribution requirements.
In search of solutions, many investors now include dividend-oriented equities in their asset allocations. In an effort to reach their income goals, the temptation is great for these many investors to simply survey the local U.S. market and buy the highest yielding stocks. But we believe that in many cases, investors are over-reaching for yield in the wrong places and for the wrong reasons, which could have negative consequences for those sensitive to downside risk. In our view, global equities can provide more attractive dividend income opportunities and offer potential for additional benefits, including diversification.
The dangers of a home bias today
With the current yield environment as backdrop, dividend equity strategies have enjoyed significant popularity. Over the past year alone, these strategies have received over $41 billion of net inflows, despite outflows of an equal magnitude from all equity funds. As a result, some have called dividend investing a “crowded trade” or “overvalued,” and recent articles in the press have warned that dividend funds carry “considerable risk” and are an “unsafe bet.” One even warned the unknowing “dividend stampede” that it faces a dilemma in owning dividend equities. The one thing all of these warnings have in common is that they address a U.S.-focused dividend approach, and for this reason, we think they may be right.
We believe the root of the problem for portfolios today, from individual retirement accounts to institutional pensions, is home market bias. Think of it as putting all your eggs in one basket: With this home-market bias, U.S. investors risk severely limiting their income potential because yield opportunities in the U.S. are slim pickings, in our view. Beyond telecom and utilities, no U.S. sectors yield much more than 3% today. Dividend managers constrained to the U.S. might reach beyond these sectors to include real estate investment trusts (REITs) or master limited partnerships (MLPs), but the universe is still relatively narrow.
Constructing a dividend equity portfolio with a home market bias thus shifts the focus from being diversified across sectors to reaching for yield and overweighting securities in a narrowly defined group. This increases concentration risk in the portfolio and the potential for loss if one sector falls in value. Despite this risk, over the past year, the majority of inflows have gone to U.S.-focused dividend mutual funds and exchange-traded funds (ETFs), prompting much of today’s concern.
Beyond the dearth of yield among U.S. equities generally, we think there are other fundamental problems with a U.S.-only dividend strategy, including:
- Dividend payout ratios in the U.S. have been in secular decline, as shown in Figure 1. Reasons for the decline are the subject of some debate, but that doesn’t change the reality. Conventional wisdom in the U.S. is that companies exhibiting earnings growth and those issuing dividends are mutually exclusive. Since the dot-com driven market of the 1990s, U.S. investors have been led to believe that you must ask for either dividends or growth – that you can’t expect both – so shareholders don’t routinely demand a healthy dividend payout from all their companies. Additionally, the U.S. now has the highest corporate tax rate in the world, and multinational U.S. companies that may have the ability to issue dividends may not have the willingness to repatriate international profits under the current tax regime.
- Since 2003, U.S. individual investors have enjoyed a lower tax rate on the qualifying dividends they receive, but this may change as the tax rate on dividends is scheduled to significantly increase at the end of 2012, barring new legislation. Because of this, U.S. companies with a high domestic individual investor base may face further pressure from shareholders to lower their dividends and attempt to redistribute profits in other ways, such as stock buybacks.
- Finally, and most importantly in our view, the U.S. equity sectors most commonly targeted by investors for income (telecoms, utilities, REITs and MLPs) are trading at historically high valuations, as shown in Figure 2. This supports our view that many investors are in the wrong places and for the wrong reasons. Current yields may be attractive, but we believe the high valuations of these sectors are at the heart of the concern about a crowded dividend trade today and why warnings to investors in U.S.-focused dividend strategies and ETFs are justified. These funds may just be carrying around a group of overvalued stocks, and buying overvalued assets has the potential to create significant downside risk. For all the importance of current yield and growing dividends to investors, we believe attaining capital appreciation by employing a valuation discipline should be an equally important goal.
Ongoing benefits of going global
A U.S.-centric portfolio constraint may be artificial and unnecessarily exclude the vast majority of available dividend stocks. A viable alternative is going global and unconstrained. We see a variety of reasons to embrace this approach to dividend investing, but we’d like to highlight three:
- While the U.S. offers a limited menu of companies with attractive dividend yields, loosening this constraint provides for diversification, not only by geography but also by country and sector. Going global enlarges the menu to a yield buffet, as Figure 3 illustrates. There are a number of reasons for this. For example, some countries have regulations that mandate a dividend payment, such as Brazil with a 25% minimum payout. More significant, we see a cultural difference in that global investors, unlike their U.S. counterparts, simply do not view earnings growth and dividends as mutually exclusive – global investors typically demand both, and investor demand can have great influence on company management decisions. We believe this dynamic also imposes a certain capital allocation discipline upon company chiefs, which in turn has the potential to produce better economic results for shareholders.
- Dividend policies that favor payouts are examples of companies aligning their interests with shareholders, and this goes a long way toward solving the classic “agency problem,” or conflicts of interest, that corporations often face. Among international companies, we more frequently see a dynamic that encourages this alignment of interests. Often, a local shareholder – an individual, a family or a government agency – has a controlling interest in a company and wants the same thing a dividend-focused investor does: that a portion of net income be paid out in dividends (a healthy payout ratio), and that these dividends grow with earnings. In some ways, dividend investors can think of this as being well-connected.
- Surveying the global landscape indicates to us that some of the best values in high-yielding companies are found outside the U.S. In past years, dividend stocks in the U.S. traded at a meaningful discount to the market. Today’s parity or premium to the market supports claims of a dividend bubble, but only in the U.S. Dividend stocks in Europe, the Middle East, Asia and Latin America offer better discounts relative to their respective home equity markets, as well as the U.S. equity markets in general, as Figure 4 shows.
The low yield environment has prompted many income-hungry investors to add dividend-oriented equities to their portfolio allocations. With so many investors piling in, have dividends become a “crowded trade” and an “unsafe bet?” Do they present investors with a clear and present danger and a dilemma? This may sound like hyperbole, but in the U.S., dividend payout ratios are in a long-term decline, taxes on dividends are potentially on the rise, and valuations in sectors that typically offer attractive dividends are near historical highs. For the investor whose dividend investments are focused in the U.S., these are certainly reasons to pause. However, the evidence suggests that for the global dividend investor – unconstrained by geography, market capitalization and benchmark – attractive opportunities still abound.
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
The Morgan Stanley Capital International World Free Index is an unmanaged market-weighted index that consists of over 1,200 securities traded in 21 of the world’s most developed countries. Securities are listed on exchanges in the US, Europe, Canada, Australia, New Zealand, and the Far East. The index excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. It is not possible to invest directly in an unmanaged index.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
Tags: 10 Year Treasury, Asset Allocations, Attractive Income, Baby Boomers, Brazil, Distribution Requirements, Dividend Income, Dividend Payout, Downside Risk, Equity Strategies, Global Equities, Government Bonds, Highest Yielding Stocks, Home Bias, Income Goals, Income Options, Market Bias, Negative Consequences, Payout Ratios, PIMCO, Retirement Portfolios
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Thursday, April 26th, 2012
by Randy Frederick, Managing Director of Trading and Derivatives, Schwab Center for Financial Research
- Collars combine a covered call and a protective put.
- Collars help you cost effectively protect a position that you’re not ready to sell—but they limit your upside potential.
- A put spread collar is a sophisticated strategy for experienced option traders that can allow for more upside profit potential if you’re willing to take a little more risk on the downside.
A collar is a risk-management strategy that combines a covered call and a protective put. An investor who establishes a collar is usually concerned with protecting a position in a cost effective way. While a collar can provide short-term protection against a downturn in the stock, it also limits upside return.
But what if you only need some downside protection—for example, if you think a potential downturn will be limited and not catastrophic in scope. Or, what if you want more upside potential, but without spending any additional money?
If either of these scenarios applies to you, consider a put spread collar.
What is a put spread collar?
As with a traditional collar, a put spread collar is usually set up so that both the long (protective) puts and the short (covered) calls are out of the money, but with the same expiration date. However, with the put spread collar, the long put position can be purchased much closer to the money than the short call position and the difference in price is offset by the sale of a farther out-of-the-money put position.
This structure allows for greater upside potential, with less downside risk when there is only a small decline in the price of the stock. However, if there is a big decline, downside losses could be significant. A put spread collar is essentially a covered call combined with a bearish put spread.
An example of a put spread collar
To illustrate this strategy, let’s assume that a couple of months ago, you purchased 1,000 shares of XYZ at a price of $26 and since then the stock price has risen to $28.30. You are optimistic about the long-term prospects of XYZ, so you don’t want to sell it, but in the short term you’re concerned about a possible small pullback. No matter what happens though, you believe there will not be a large decline.
You only have a 2.30 unrealized gain in this stock so you would like to limit your immediate downside risk as much as possible without spending a lot of money. However, because you’re bullish you’d like to leave a fair amount of room for the upside too.
The solution may be to establish a put spread collar as follows:
|Sell 10 Jun XYZ 35 calls @
Buy 10 Jun XYZ 27.50 puts @
Sell 10 Jun XYZ 25 puts @
Even (plus commissions)
This position ensures that you won’t lose more than 0.80 unless XYZ drops more than 3.30 points. However, you can make 6.70 points if XYZ rallies. Your only out-of-pocket expense would be the commission charges. Let’s take a look at this strategy (as of expiration date) on a profit and loss graph.
Profit and Loss for a Put Spread Collar
Source: Schwab Center for Financial Research.
As you can see in the chart above, based on the starting price of 28.30, your profit, loss and breakeven thresholds at expiration are:
- Below $25 there is downside risk to zero. The maximum loss is 25.80 or -$25,800 if XYZ drops all the way to zero.
- From $25 to $27.50, the loss is limited to .80 points or -$800.
- From $27.50 to $28.30, the loss will range somewhere between -$800 and $0.
- From $28.30 to $35, the gain will range from $0 to $6,700.
- At $35 or above, the gain is capped at a maximum of $6,700.
Like a traditional collar, with a put spread collar you can specify how long you need the protection. One nice feature is that the costs should not change materially based on the length of time holding this strategy, because time value affects all the options similarly and the option premiums essentially cancel each other out.
Depending upon the price of XYZ at expiration, some of the options could expire worthless, get assigned, or be exercised, so in order to reach the profit and loss scenarios described above, let’s compare the put spread collar to a similarly structured (zero cost) traditional collar.
The table below identifies exactly what takes place at each price point. For comparison purposes, let’s assume all positions are purchased when XYZ is at the current market price of $28.30.
How Do They Stack Up? A Traditional Collar vs. a Put Spread Collar
Source: Schwab Center for Financial Research.
In the table, you can see that the traditional collar and the put spread collar have essentially the same initial cash outlay (not including commissions) and gains and losses at prices between $25 and $29.
However, at prices below $25, losses will not exceed $800 on the traditional collar but will continue to get worse as the stock drops on the put spread collar. Because the put spread collar is short 25 puts, they will need to be closed out in the market, and the farther the stock drops the more expensive this will be. The maximum loss on the put spread collar is -$25,800. Essentially the downside protection on the put spread collar ends if XYZ drops below $25.
At prices above $29, gains will not exceed $700 on the traditional collar but will continue to grow on the put spread collar until a price of $35. At all prices above $35, the maximum gain on the put spread collar is $6,700. This additional $6,000 of potential upside opportunity is the trade-off for the extra risk taken below 25.
The bottom line is that a put spread collar is only appropriate when you are trying to protect against a modest decline in price—not a severe decline.
What to keep in mind
A put spread collar is a unique strategy, suited for specific situations so I’d like to conclude with a summary of its benefits and risks:
- Provides limited downside protection at very low or potentially zero cost.
- Allows for greater upside profit potential versus a traditional collar.
- If the stock stays within the range of the call option and the higher strike put, the cost is zero or very low and all options expire worthless.
- While this strategy does limit risk somewhat, if the stock declines below 25 your losses could be quite significant.
- Anytime you sell a call, you have established a maximum selling price for your stock. While this strategy does allow for greater upside potential, if the underlying stock moves substantially above the short call strike price, your profit potential will still be limited.
- If your short calls go in-the-money, you could be assigned at any time.
- All options eventually expire, and the benefit of this strategy ends at expiration.
- Because a put spread collar is a spread, you have to be approved for spread trading in order to utilize this strategy.
For additional information on this strategy or for assistance with other options strategies, please contact a Schwab Trading Specialist at 800-435-9050.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 800-435-4000 for a current copy.
With long options, investors may lose 100% of funds invested. Multiple-leg options strategies will involve multiple commissions. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Writing uncovered options involves potentially unlimited risk.
Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
Past performance is no indication (or “guarantee”) of future results. 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. Examples are not intended to be reflective of results you can expect to achieve.
Tags: Covered Calls, Decline, Derivatives, Downside Protection, Downside Risk, Downturn, Expiration Date, Investor, Losses, Managing Director, Nbsp, Option Traders, Puts, Risk Management Strategy, Scenarios, Schwab, Scope, Sophisticated Strategy, Spread Collar, Xyz
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Sunday, March 25th, 2012
Emerging Markets Radar (March 26, 2012)
- China has cut the required reserve ratio (RRR) for 379 branches of the Agriculture Bank of China to boost rural area loan volumes, signaling fine-tuning monetary easing. The market is currently expecting further RRR cuts for all the banks this year.
- China has raised gasoline and diesel prices by 7 percent and 7.76 percent, respectively. After the increase, the downstream refinery business is closer to breakeven.
- Singapore’s Consumer Price Index (CPI) rose 4.6 percent in February, unexpectedly slowing as communication costs fell in the city state. In Malaysia, consumer prices also slowed, rising 2.2 percent year-over-year in February, down from 2.7 percent in January and well below the market estimate of 2.5 percent. The key reason for the decline in inflation was a drop in food price inflation.
- The Philippines’ budget deficit narrowed to 15.9 billion pesos ($370 million) in January from 101.5 billion pesos the previous month. In Thailand, the Bank of Thailand left its benchmark rate at 3 percent, pausing after two recent reductions. The result was widely expected.
- Nouriel Roubini turned more positive on Colombia, revising his 2012 and 2013 growth forecasts to 5 and 4.5 percent, respectively, citing a dissipation of downside risk from the global economy and a cool-down in domestic economic activity.
- The Brazilian labor market is showing that conditions are getting better for consumers. Although the February unemployment rate inched up to 5.7 percent from 5.5 percent in January and 4.7 percent in December, after stripping out seasonality, the unemployment rate remained at the series’ record low of 5.6 percent for the fourth consecutive month. Employment grew 0.6 percent month-over-month (while the number of unemployed workers dropped by 0.5 percent), which coupled with the 0.7 percent increase in real wages, pushed the real wage bill up by 1.3 percent month-over-month or by 17 percent in annualized terms.
- The number of people employed in South Africa’s formal sector inched up 0.3 percent in the fourth quarter of 2011, with the manufacturing sector primarily adding the jobs. Employment rose by 23,000 people during the last quarter of 2011, to 8.381 million, and was up 1.6 percent on a year-over-year basis, Statistics South Africa said.
- HSBC March China Flash Purchasing Managers’ Index (PMI) was 48.1, down 1.5 from February’s 49.6, indicating industrial activities are further contracting, particularly in export-oriented manufacturers.
- Bloomberg news reports today that CBRC said China banks misclassified RMB1.8 trillion (20 percent) of local government loans as fully-cash-flow-covered due to the inclusion of government subsidies. CICC bank analysts will check whether CBRC people have said this or not, but bank analyst Mao Junhua does not believe the 1.8 trillion number is correct.
- Lending by China’s four biggest banks was less than RMB 50 billion from March 1 to 15, the Economic Information Daily reports.
- BCA research reported recently that India’s capital rationing is deterring growth, and predicts a financial crunch in 2012, which will hamstring much-needed capital spending. The firm suspects that India’s potential growth rate is declining because of slowing productivity gains, which in turn are due to lower savings and investment rates.
- The South African rand gained for the first time in four days on Friday, trimming its worst weekly loss in six weeks, before data forecast to show U.S. sales of new homes rose last month, dampening demand for the dollar as a haven.
- Following a severe contraction in the fourth quarter of 2011, Thailand is in the midst of a solid rebound that should bring back a growth trend by the end of the year with a 5.3 percent annual expansion, Nouriel Roubini said this week.
- Verbal intervention from governments to bring down the price of crude has increased, in addition to rumors of an agreement between the U.S. and the U.K. to tap into strategic reserves. In fact, France has officially said that it and other industrialized nations are considering a strategic reserves release. Furthermore, Saudi Arabia has called present prices “unjustified,” citing a global supply surplus of 1-2 million barrels per day, signaling that it is prepared to increase production by 25 percent to bring prices down if needed.
- Indonesia’s stock market has lagged its peers this year, primarily due to the overhang of rising inflation risk. This is the result of the removal of government subsidies in fuel and power prices, and wage increases this year. However, the drivers of the economy in Indonesia (i.e., rising foreign direct investment, infrastructure construction, and rising middle class consumption) are intact and, therefore, the stock market appears to be a long-term play.
- The Chinese economy is still in the process of a soft landing, which may cause uncertainties for the economy.
- Poland’s shale gas reserves are about one-tenth the size of previous estimates, a government report showed this week, denting hopes for an energy source that could play a key role in weaning Europe off Russian gas. The long-awaited study estimated Poland’s recoverable shale reserves at 346 to 768 billion cubic meters, far less than the previous estimate of 5.3 trillion from the U.S. Energy Information Association.
- South Africa’s foreign affairs ministry said it is reducing Iran oil imports, as its largest supplier of crude oil faces international sanctions. The industry awaits further detail, as a national oil industry group said it hadn’t been informed of the plan.
Tags: Agriculture, Agriculture Bank Of China, Bank Of China, Bank Of Thailand, Benchmark Rate, Brazil, Budget Deficit, Communication Costs, Consumer Price Index, Diesel Prices, Downside Risk, Food Price, Global Economy, Growth Forecasts, Index Cpi, Price Inflation, Reserve Ratio, Rrr, Rural Area, Russia, Seasonality, Unemployed Workers, Unemployment Rate
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Thursday, December 22nd, 2011
Life Finds a Way
- In this New Normal economic environment of slow economic growth, high volatility and enormous macro risks — some identifiable, but many unidentifiable — we don’t believe ignoring major downside risks is prudent for equity investors.
- We believe investors are best served by employing a combination of three strategies to actively manage downside risk in equity portfolios to hedge against the risks they can see, and equally importantly, the risks they can’t see.
- Risk management is often a tradeoff, decreasing some risks while increasing or concentrating others. Being humble enough to admit what we don’t or can’t know is important.
I bought a cabin in a forest high in the Sierra Nevada Mountains in 2005. Surrounded by pine trees and natural beauty, it is a peaceful getaway from busy life. The cabin is fairly remote at an elevation of 6,500 feet and almost 10 miles from the local town. My closest neighbors are deer, birds, chipmunks and an occasional bobcat, coyote or bear.
This is the first and only home I’ve ever owned. Even though it is not fancy, it was a major financial commitment for me – the biggest I’ve ever made. A former engineer, I read everything I could find about the challenges of owning a home in a remote location.
Although it is connected to the power grid, water comes the old-fashioned way: from a well that runs 500 feet underground into a six-foot tall, 2,500-gallon storage tank that feeds the house. My research highlighted the risks that come with being so distant: Septic systems can freeze. Well pumps can go bad. Unlike a typical house, if power gets knocked out, you also lose your water because the pump can’t run.
With all of my research I concluded that these risks were manageable. I even created a checklist of procedures I would follow every time I visited the cabin to manage them, such as shutting off the water when I leave, using Ridex in the septic system every month and checking the water storage tank each visit.
It’s been six years now, and extreme cold winters and power outages haven’t been a problem. With the help of a back-up generator, my vigilance paid off. I considered and prepared for all contingencies.
Or so I thought.
This past August I visited the cabin and dutifully followed my checklist: I inspected the water tank. It was full as it should be. Everything was working fine.
And then something caught my eye: “What is that in the tank?” I shined my flashlight and squinted closely. “Oh… my…”
Yup. It was a frog, hanging on the inside wall of the water tank just above the water line. Oh, and there was another one. Oh, and there was a third. They were just hanging there – the frog’s equivalent of lying by the pool at a resort in Palm Springs.
I was stunned. Not because I don’t like frogs. I do like frogs: I remember catching and playing with them when I was a kid. Frogs don’t mean harm to anyone, except for the insects they eat. These three frogs were just hanging out, minding their own business, taking an occasional swim, eating a fly from time to time.
But they were hanging out in my water tank! The tank that feeds my house – drinking water, showers, laundry. And who knows how many of their friends were in the tank with them.
The shocking part for me was that I couldn’t figure out how they got there. There is no body of water within miles of my cabin. I’ve seen plenty of animals and insects but have never once seen a frog in this mountain forest. Even if they did live in the forest, how did they find my water tank and how did they climb six feet to the top and sneak their way in the lid? Could tadpoles have been living 500 feet underground and been pumped in? I had flashbacks to the movie “Jurassic Park,” in which Jeff Goldblum’s character tried to explain how a population of all female dinosaurs managed to procreate: “Life finds a way.”
No homeownership book I read ever warned me about frogs living in my water tank. I even Googled it to see if this is a common problem; I couldn’t find another example. With all my vigilance trying to identify things that could go wrong, I simply never conceived of this possibility.
Following the financial crisis of 2008, many people were understandably angry that banks, investors, ratings agencies and regulators all missed the housing bubble. How did they not see it coming? Why didn’t they take action to protect against such a collapse? The rallying cry became, “We need better risk management!”
It is easy to identify risks in hindsight – even frogs living in your water tank; unfortunately it is much harder to identify them in advance, particularly when they had been “unthinkable.” I bought real estate in 2005, after all. I didn’t spot the housing bubble either.
The most sophisticated risk management models can’t protect against scenarios that we’ve never contemplated. Leading up to 2008, most people believed that home prices across America could not fall all at the same time. Bundling mortgages from different parts of the country should have provided diversification against regional real estate downturns. The models were very sophisticated – until the impossible became reality.
Today, with the benefit of hindsight, it is easy to find people who spotted the housing bubble. Michael Lewis’ book “The Big Short” documents some of them. The book would have been far more impressive had Lewis written it in 2005.
Since the crisis of 2008 Washington has been busy passing new laws and policymakers implementing new regulations to ensure the crisis is never again repeated. Like the TSA adding security procedures in response to each new terrorist threat (x-raying shoes, for example), these numerous regulations should be effective in protecting against a repeat of the exact same mistakes. Unfortunately, markets of the future will no doubt make different mistakes. As much as we may try, we can’t legislate wisdom.
Unthinkable events now seem to be happening with increasing frequency: The U.S. losing its AAA credit rating. The euro on the verge of disintegration. Political turmoil in the Middle East overthrowing decades-old regimes. A terrible earthquake, tsunami and nuclear disaster devastating Japan. The complete dysfunctionality of Washington D.C. (Ok, so this isn’t new – but it certainly seems to be worse than ever).
With muted economic growth in the developed world, our economies are highly vulnerable to shocks that could tip us into recession. Policymakers are well-intentioned but are human, make mistakes and often face very real political constraints. These macro risks are overwhelming individual company factors and causing wild swings in the stock market almost every day.
If, despite all our vigilance, none of us can see all the major risks, how should equity investors manage risk in this environment?
Historically, with fewer macro risks on the horizon, most equity investors didn’t do anything about them. Most “self-insured,” which is a fancy way of saying they took no actions to protect themselves against bad outcomes. If markets corrected, such as when the NASDAQ came crashing down in 2000, many rode the correction down. Some got scared and sold low. Others rode it out and hoped prices would eventually rebound. Imagine getting in a car accident and the other driver tells you he is “self-insured.” I don’t think you would find it comforting. Self-insurance didn’t work well for technology investors in 1999.
In this New Normal economic environment of slow economic growth, high volatility, and enormous macro risks — some identifiable, but many unidentifiable — we don’t believe ignoring major downside risks is prudent for equity investors. We believe investors are best served by employing a combination of three strategies to actively manage downside risk in equity portfolios – to hedge against the risks they can see – and equally importantly – the risks they can’t see:
- Buy stocks at cheap prices
Investors should buy companies they want to own for the long term – and evaluate them in a range of economic scenarios. By buying companies at prices deemed cheap relative to fair value based on rigorous fundamental analysis, you can build in a cushion against market shocks. This doesn’t mean the stocks won’t fall with the next market correction, but it means that unless the macro shock meaningfully changes the outlook for the companies you own, the volatility may just create a buying opportunity.
- Buy higher-quality companies
Higher quality companies tend to be more resilient against bad events. They tend to have more effective management teams, stronger market positions and business models that are more defensible. We believe buying higher quality companies at cheap prices provides even greater defense against the unknown.
- Hedge the portfolio against “tail risks”
We believe investors should look all over the world for cheap hedges against left-tail events – or really bad outcomes. This could be options on equity indices, or currencies or credit instruments. Consider allocating a small amount to spend every year to buy hedges. Most drivers put on their seatbelt every time they get in their car even though they aren’t expecting to get into an accident. It’s a low-cost way of guarding against serious injury. Most equity investors know they are investing in a relatively volatile asset class. So we don’t recommend trying to hedge all volatility. But hedging extreme drawdowns from major market corrections can be a cost-effective strategy. And because many asset classes tend to become highly correlated during times of crisis, investors should look at a wide range of instruments in an attempt to find the cheapest effective hedges.
After discovering the frogs in my water tank, I upgraded my well pump, eliminating the need for the tank, which I then emptied into the forest. Reducing complexity is a proven engineering risk management technique. Now I have fewer things that could go wrong – but no back-up store of water if something does go wrong.
Risk management is often a trade-off, decreasing some risks while increasing or concentrating others. Although not perfect, being vigilant to identify and manage the downside is important. But being humble enough to admit what we don’t or can’t know is also important. Hoping for the best while preparing for the worst is generally a good strategy.
The frogs probably never considered the possibility that their luxurious swimming pool might one day disappear. Poor little guys. I wish them well.
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Tags: Chipmunks, Downside Risk, Downside Risks, Equity Investors, Equity Portfolios, Financial Commitment, Gallon Storage Tank, Occasional Bobcat, Owning A Home, Peaceful Getaway, Pine Trees, Power Grid, Ridex, Septic System, Septic Systems, Sierra Nevada, Sierra Nevada Mountains, Slow Economic Growth, Water Storage Tank, Well Pumps
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Thursday, December 22nd, 2011
Some Questions For 2012 And Beyond
by Dr. Scott Brown, Chief Economist, Raymond James
December 19 – 23, 2011
The U.S. economy is expected to advance at a moderate rate in 2012, but Europe presents a key downside risk to the outlook. That aside, there are longer-term uncertainties about potential growth over the next several years. Next year will be an election year and income inequality could be an issue.
Like any good horror movie, the European crisis has carried an ongoing feeling of dread. The potential for a catastrophic collapse is palpable. For the U.S., a meltdown would hit exports, but the bigger fear is possible financial market disruptions. U.S. banks may have a limited exposure to European sovereign debt, but they do have significant exposure to the big European banks. We could see a seizing up in the global financial system, much like we saw in the fall of 2008. However, the Fed and other central banks have foamed the runway, adding liquidity ahead of possible crash or rough landing.
For the most part, the prescribed medicine in Europe has not helped the patients. Austerity is contractionary policy, best employed in booms, not busts. Growth is the central issue here. More importantly, the governments in Europe will be unable to provide a large enough backstop if Italy were to leave the euro zone. The markets sense that, and without a lender of last resort, the crisis may be self-fulfilling. The ECB has rejected a role as the ultimate backstop of European debt, but it will likely be drawn in eventually as push comes to shove.
What about the U.S.? How long until we get a full economic recovery? It’s important to remember that this is not your father’s recession. It is your grandfather’s depression. There is no precise definition of a depression (note also that a recession is largely a judgment call). Most economists would say that a depression is an extended period of elevated unemployment. That suggests roughly where we are now.
Over the last several decades, real GDP growth has averaged about 3% per year. We are about 12.6% below that trend now. However, there may be some reasons why the trend may be lower in the years ahead. In the 1970s and 1980s, the U.S. experienced an increase in female labor force participation. That trend has played itself out, and both male and female participation rates may be expected to trend lower as the baby-boom generation moves into retirement. As a consequence, unless productivity growth picks up substantially, GDP growth is likely to trend somewhat slower in the years ahead.
The shares of national income going to corporate profits and labor tend to move in opposite directions over the course of the business cycle. However, since the early 1980s, the underlying trend has been more to profits and less to labor. Part of this can be explained by the steady decline in union membership and by increased low-wage labor competition from abroad.
Economists tend to shy away from questions about income inequality. It’s not clear whether moderate shifts in the distribution of income have much influence on overall economic growth or what should be done about it. For the most part, these are political issues, not economic ones. However, political issues often have implications for investors. While many have been quick to dismiss the Occupy Wall Street protests (the drum circles and lack of clear goals haven’t helped the cause), this bears watching closely. We’ve had a number of populist movements in our history. More often than not, they run out of steam, but sometimes they turn into a more significant political force. However, it seems doubtful that we’ll have a viable third party candidate in 2012. The question then is whether the Democrats can shed the mantle of “Republican-Lite” and embrace the OWS movement. Or perhaps the Republicans can motivate the Tea Partiers to go to the polls in force.
Whatever the case, it’s going to be an interesting year.
Copyright © Raymond James
Tags: Austerity, Backstop, Catastrophic Collapse, Central Banks, Chief Economist, Downside Risk, Dr Scott, Euro Zone, European Banks, Feeling Of Dread, Global Financial System, Horror Movie, Income Inequality, Judgment Call, Lender Of Last Resort, Market Disruptions, Moderate Rate, Precise Definition, Raymond James, Sovereign Debt
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Wednesday, December 21st, 2011
By Tom Bradley
“Tom, I agree with your view on stocks, and boy, you’re so right about how negative people are, but … I can’t help but wonder if it’s different this time.”
It’s different this time. I’ve been trained to never utter these words. They’re the most dangerous four words in investing.
So when I hear my friends, clients, readers, competitors and, in some cases, idols, telling me they don’t like what they see, I’m torn. I know how bad the global economic/debt situation is. I know there will be dislocation, shocks, volatility, perpetually gloomy headlines and earnings misses. And I know we’re navigating all of this without a (government) net. But it’s not that simple because:
- Mr. Market knows all this. He figured it out in April and has been worried ever since.
- The corporations we’re investing in have never been in a better position to take advantage of economic and competitive dislocations. They’re the antithesis of weak, overstretched, running-out-of-options governments.
- Recessions are all about cleansing and adjustments. The gloomy outlook does not take into account the fact that consumers, companies, cities and countries are adjusting to the new reality. The U.S. is learning to live without a real estate market. The resource industries are adjusting to shortages by spending record amounts on developing additional supply. Huge investments are also being made on more efficient power grids, solar panels, networks, air conditioners, cars, buses, aircraft, billing systems, medical procedures and the list goes on. The pace of progress on many fronts is accelerating, which means when the turn comes, it will be faster than expected.
- When negative sentiment is so firmly planted on the fear side of the fear/greed meter, the downside risk is significantly reduced. Stocks could still go down, but it’s less likely and the magnitude of decline is likely less.
It feels like we’ve entered the ‘it’s different this time’ zone again. Certainly there’s a lot that will be different over the next 5, 10 and 25 years, but I’m not convinced stock market behavior is one of them. The market will continue to over-react to short-term news, trade well below (and above) the intrinsic value of underlying companies and it won’t wait for complete resolution or perfect information to turn around. If the market doesn’t do these things, it will indeed be different this time.
Tags: Air Conditioners, Antithesis, Billing Systems, Debt Situation, Different This Time, Dislocation, Dislocations, Downside Risk, Efficient Power, Gloomy Outlook, Medical Procedures, Negative Sentiment, New Reality, Overstretched, Power Grids, Recessions, Resource Industries, Solar Panels, Tom Bradley, Volatility
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Monday, December 19th, 2011
As Bob Janjuah, of Nomura, notes in his final dissertation of the year, our in-boxes are stuffed with all the good cheer of sell-side research outlooks. However, the bearded bear manages to cut through all the nuance to get to the six questions that need to be addressed in order to see your way successfully in 2012. With the US two-thirds of the way through the post-crisis workout phase while Europe remains only half-way through, and China a mere one-third through the necessary adjustments to less global imbalance, he is not a global uber-bear on every asset class as the net effect is modest global underlying demand and plenty of savings sloshing around looking for a home. The market will have to adjust further to an extended period of weakness in Europe, which will impact EM growth expectations and so the existential ursine strategist is skewing his macro expectations to the downside and with the market pricing a ‘softish’ global landing, there remains a considerable gap between downside risk potential and current expectations. Furthermore, Janjuah believes the upside is relatively self-limiting on the basis of commodity price pressures and the potential for property or asset bubble bursts – leaving upside limited and downside substantial.
Q1: Where are we in the post-crisis work-out?
The US economy is proceeding with its excess capital stock work-off when measured against either the labour force or GDP. It still looks to us like it will take another 12-18 months for the excess capital to be cleared. During this phase it remains a truism that aggregate net investment will remain modest, corporate cash holdings remain high, and that the private sector will still generate higher savings than investment. It is still unclear if the “clearing” level of the capital stock has actually fallen owing to changes in banking and financial regulation. Nevertheless, that backdrop remains supportive of quality non-financial credit, low real yields and weak aggregate equity performance. It’s worth noting that high private sector net saving should be offset by high government sector dissaving during this phase. The US policy mix, while generating a lot of angst, has allowed the US to hold things steady while this background adjustment occurs. Note: demand management policies are not able to generate a return to pre-crisis growth rates until the supply-side work-out is complete; hence the sequential aborted risk market take-offs.
The problem now is that parts of the euro area are in a very similar position but are being forced to adopt what we consider inappropriate policies from a macro point of view. Spain is a good example: who would doubt that the capital stock is some way above the long-run suitable level? As such, Spain and others are likely face only modest private sector demand for several years. A policy of fiscal tightening will only serve to increase the national saving/investment balance as the current account moves into surplus and international debt is paid down. We see this as a good thing but still think gradualism would be better than cold turkey. The added complexity is that the “clearing” level in the euro area is no longer well defined: a combination of rapid banking reform, Basle 2.5/3 and major uncertainty about supply-side and macro policy makes for an open-ended period of capex spending falls.
The final point on background work-out is about EM. China has built a lot of infrastructure since 2008 and we would argue is running some way ahead of the current warranted level. Capital deepening in EM is a good thing, but a period of modest capex looks more likely than a continuation of hyper capex growth. We don’t know as a market whether that will be sufficient to trigger non-linear balance sheet effects and a Chinese credit crunch, but certainly think Mr Market will have to romance the idea in the next 12 months.
Our conclusion is that we are two-thirds of the way through the adjustment in the US, half way through in the euro area (but without knowing the clearing level it’s impossible to be too precise) and one-third through in places like China. Net effect is modest global underlying demand and plenty of savings sloshing around looking for a home.
Q2: Where are we in the business cycle?
Clearly, while this period of work-out is going on, the global economy and its markets are particularly vulnerable to new shocks given current policy settings and the state of weaker paticipants’ balance sheets. For a while now we have been talking about an EM slowdown and hard defaults in the euro area. Both risks are now centre stage for investors.
Two themes emerge from a detailed reading of our economics team’s year-ahead forecasts. First, that the global economy is slowing, led as much by domestic demand in emerging economies as the outlook for the euro area. Fiscal drag, the echo of higher commodity prices and tighter EM policy combined with banking sector deleveraging, has led our economics team to move its forecasts toward weak H1 2012 growth before a reasonably robust recovery in H2 2012. Naturally, this would lead one to be overweight rates and underweight risk now.
But the second overarching theme that emerges is one of contingent risk. Almost every country forecast highlights the evolution of the euro-area economy as the key foreseen risk. And importantly, the gap between the muddle-through shallow recession scenario and full-blown hard landing and cost of capital shock is substantial in the simulation runs provided not just for the euro area but for all economies. Our house opinion is that the euro area does not matter a great deal to global fundamentals, until it matters a great deal. This is classic non-linear gap risk.
One area that is useful to think about is how deleveraging in the euro area will play out in terms of the aggregate data and the euro area’s surplus. It seems to us that a cross-border deleveraging against the backdrop of high multinational corporate cash balances and modest funding requirements should primarily play out through the banking sector seeing a substantial and persistent jump in its funding costs in the current account deficit economies. And it is through this channel that the economy should be influenced via the household and SME sectors seeing a sequential tightening of credit availability and increased funding costs. Naturally if I have 100 large corporates that make up my equity market and I hit their funding costs I would expect a rapid impact. But if I have 5 million SMEs and 30 million households not all of them are looking to refinance at the same time and so I would expect a staggered impact on their effective cost of capital (it’s a bit like duration considerations for governments). Confidence and market pricing of course will not respond slowly.
Another consideration that hasn’t been given much air time is the supply-side flexibility of the euro area in comparison with other major economies. We can get a handle on this issue by comparing how long it takes for changes in growth to have their maximum impact on unemployment and in turn unemployment on inflation. The results are shown in Figure 3, with the maximum lag shown in months. The basic message is that taken over the past 20 years a movement in growth has taken six months to have its maximum impact on unemployment in the euro area and in turn it takes around 16 months for changes in unemployment to have their maximum impact on inflation. It therefore takes over two years for a growth shock to have its maximum impact on inflation, working via the labour and product markets. To put this in context, the US gets there in nine months, while the UK has fairly rapid labour market reactions but relatively slow wage/inflation reactions to unemployment.
What does this mean practically? The policy framework the euro area has adopted excludes high growth or high inflation as a way out of its debt/excess capital stock burden. Instead, we are moving toward a competitive realignment via supply-side adjustment. This is where the “sacrifice ratio” comes in – simply the output loss required to generate a 1% fall in inflation. The sacrifice ratio in the euro area is still higher than in the US and UK, and is particularly high in the periphery (not Ireland, though). Thus, if Spain et al are to compete their way into growth they will face a larger increase in unemployment than others before economic growth returns. Leaving aside the policy and political implications of this, the growth implications are clear – it should be weaker than that of other countries faced with a similar problem. Once the euro area starts adjusting its supply-it exhibits a super-tanker-style turning circle. In this scenario the euro area would shift into a current account surplus – another source of excess savings to the world.
Tags: asset class, Backdrop, Capital Stock, Commodity Price, Dissertation, Downside Risk, good cheer, Growth Expectations, Labour Force, Necessary Adjustments, Nomura, Nuance, Outlooks, Price Pressures, Q1, Stock Work, Strategist, Truism, Ursine, Workout
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Friday, November 18th, 2011
The World Gold Council has just published the latest issue of “Gold Demand Trends” (Third quarter 2011). This is a rather bullish report, highlighting a surge in central bank purchases – more than doubling from the second quarter and increasing by 556% from a year ago!
The report said: “Activity among central banks continued to fulfil our expectations of further purchases in Q3. In fact, net buying accelerated notably during the quarter – totaling 148.4 metric tons – as the issues surrounding the creditworthiness of western governments’ debt seeped into the official sector. A number of banks continued their well-publicised programs of buying, while a slew of new entrants emerged wishing to bolster their gold holdings in order to diversify their reserves. We see this trend continuing into 2012.”
This reports is very positive for the gold price and should limit the downside risk of corrections.
Click here to download the full report.
[pdf http://worldgoldcouncil.newsweaver.co.uk/images/5861/10802/1883495/WOR6562%20GDT%20Q3%202011.pdf 500 670]
Source: World Gold Council, November 17, 2011.
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Tags: Bank Purchases, Bullish Report, Central Banks, Creditworthiness, Downside Risk, Gold Bullion, Gold Demand Trends, Gold Holdings, Gold Price, Images, Metric Tons, Postcards, Q3, Report Pdf, Second Quarter, Slew, Source World, Western Governments, World Gold Council, Worldgoldcouncil
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