May Rout Leads to June Rally (Edwards)

Sunday, June 10th, 2012

On April 6th, just after US stocks touched a high for the year and climbed to within 10% of the all-time high set back in October 2007, we wrote:

“The market will do one of three things over the rest of the year:

Trade flat for the next 9 months – not likely.
Surge into a “buying panic” as investors finally jump back into stocks, which would leave the market up 20% or more by year end.
Plummet as some exogenous event (like last year’s Japanese tsunami or the Greek credit crisis) cause investors to retreat to cash once again.”

We got three “exogenous events” in May:

• Greek credit crisis resumed, with Greece likely to exit the Eurozone this summer.
• JP Morgan Chase lost $3 billion on Credit Default Swap trading.
• The FaceBook “FacePlant”.

And on June 1st, the Labor department reported a minimal gain in jobs, which has economists worried anew about the United States returning to recession.

So from the high on April 2, to the low on June 1st, US stocks sank 9.9%. Unfortunately, human nature focuses more on losses than on gains. Stocks remain 81% above the March 9, 2009 low, and 18% above the October 3rd low. But as we saw today (best one day return of the year,) universal bearishness tend to lead to outsize upside returns.

Many, many questions from our clients:

What is going on with Europe?

As we have said many times, the Europeans spent 30 years building to the current situation, and it will take at least a decade to straighten things out. The situation in Greece is the “canary in the coal mine.” Greece is an artificial country cobbled together by the US and Great Britain at the end of World War II to prevent the Soviets from getting warm water naval ports on the Mediterranean. As of 2010, Greece had about the same GDP as Maryland, now probably 20% less. The country has three important industries: agriculture, tourism and shipping. These industries did not generate enough cash flow to purchase what Greeks wanted to buy, namely, German cars and dishwashers. Germans were anxious to keep exports booming, so helpful French and Italian banks stepped in to lend money so that Greeks could buy German exports (and build super-highways and other modern infrastructure.) The bankers felt confident in making loans despite the Greek national tendency to not pay taxes because a.) the loans were denoted in Euros, not some trashy third world currency like the Drachma and b.) scores of hedge funds were willing to write Credit Default Swaps on Greek debt (more on CDS below.) The bankers did not consider that their purchase of CDS did not eliminate their risk in buying Greek debt. It only transferred that risk from a junky country to junky hedge funds, which, as history has shown, tend to close shop when a payment is owed.

Over the last two years, bankers, governments, hedge funds and the Greek people have played “hot potato” as to who ultimately takes the loss on tens of billions in Greek debt. Thus, time and again a “deal” is declared, which is replaced by another deal a few months later, and another and another. The latest deal will most likely be rejected by a new Greek Parliament elected June 17th, 2012 and Greece will exit (or be forced out of the Euro.) 50% of young Greeks will emigrate over the next 3 years as unemployment remains in the +20% range.

The real threat is that Spain (the 12 largest economy in the world, ahead of Texas but behind California) goes next.

Is Greece the next Lehman Brothers?

No – two distinctions:

Lehman was central to the world banking system, Greece is peripheral to the Eurozone. When Lehman failed so did AIG. Merrill Lynch, Morgan Stanley, Goldman Sachs, Barclays Bank and Deutche Bank were right behind. Only a miraculous intervention by the US Treasury and Federal Reserve to payoff AIG’s liabilities in CDS (there’s that word again!) saved the day. As of now,

Greek debt has already been written down by 75%.

Lehman was there Friday afternoon and gone Sunday afternoon, leaving its counterparties no time to react. Is there any investment manager in the world who hasn’t expected to Greece to fail for a year now?

What is a Credit Default Swap?

Once upon a time, managers of bond portfolios believed it was their job to adequately evaluate the credit quality of their bond investments and diversify accordingly. Then, in the mid 1990′s, JP

Morgan bankers created a nifty bond put option. In the event that an issue failed, the writer of the put option would pay the buyer of the put option the difference between the issue price (par) of the bond and any residual value of the bond.

Tags: 9 Months, Agriculture Tourism, Coal Mine, Credit Crisis, Credit Default Swap, Dishwashers, Eurozone, Exogenous Event, Exogenous Events, Faceplant, German Cars, Greeks, Human Nature, Jp Morgan, Jp Morgan Chase, Labor Department, Plummet, Rout, Soviets, Warm Water, World War Ii
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It’s All Relative (Sonders)

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

Key Points

• 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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Diminished expectations, double dips, and external shocks: The decade after the fall

Tuesday, September 21st, 2010

Is the global economic recovery about to grind to a halt? This column provides evidence on economic performance in the decade after a macroeconomic crisis. It finds that growth is much slower and as well as several episodes of “double dips”. It adds that many of these economies experience plain “bad luck” that strikes at a time when the economy remains highly vulnerable.

“The process of contraction, like the process of expansion, is cumulative and self-reinforcing. Once started, no matter how, there is a tendency for it to go on, even if the force by which it was provoked has in the meantime ceased to operate.”–Gottfried Haberler, Prosperity and Depression, 1937

In our recent paper (Reinhart and Reinhart 2010), we examine the behaviour of real GDP (levels and growth rates), unemployment, inflation, bank credit, and real estate prices in a twenty-one-year window surrounding selected adverse global and country-specific shocks or events. This note summarises some of our main findings.

Chief among these is that economic growth is notably slower in the decade following a macroeconomic disruption. We extend our results to provide evidence of several post-crisis “double dips” in the years following a crisis. Indeed, a faltering of economic recovery is not uncommon after a severe financial shock – although this can often be ascribed to exogenous events.

We study the 1929 stock market crash, the 1973 oil shock, the 2007 US subprime collapse, as well as fifteen severe post-World War II financial crises. We have chosen not to look at the immediate antecedents and aftermath of these events and instead focus on longer horizons that compare decades rather than years.

Methodology preamble

Our statistical analysis, which is described in more detail in the paper, is based on nonparametric comparisons of the data that are applied to the episodes listed in Table 1. Simply put, we examine if key macroeconomic indicators seem to come from the same distribution before and after a dislocating event. The exact time periods of the before-and-after windows vary across our exercises, but we usually try to employ the longest possible spans of comparison.

Growth, GDP levels, and unemployment

Real per capita GDP growth rates are significantly lower during the decade following severe financial crises and the synchronous world-wide shocks. The median post-financial crisis GDP growth decline in advanced economies, as shown in Figure 1, is about 1%.

Tags: Antecedents, Bad Luck, Contraction, Dips, Disruption, Economic Performance, Economic Recovery, Exogenous Events, External Shocks, Financial Crises, Financial Shock, Macroeconomic Crisis, Note Summarises, oil, Oil Shock, Preamble, Real Gdp, Reinhart, Statistical Analysis, Stock Market Crash, World War Ii
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Doug Kass: Market Has Blinders On

Monday, November 16th, 2009

Doug Kass, of Seabreeze Partners, who called the generational low in the market in March 2009, says the market is complacent about bad news now.

I do believe with some certainty that the market’s vulnerability to disappointment and/or exogenous events has been elevated and that many apparent warning signs — for instance, a 17.5% underemployment rate, weak consumer and small business (National Federation of Independent Business) sentiment, the unrelenting increase in the price of gold, a steadily declining U.S. dollar, the specter of cost-push inflation from higher commodity prices and so forth — are too comfortably being ignored or are being rationalized away in a tide of rising world stock prices.

These days bad news is what is keeping interest rates at zero, and the stimulus flowing, so as long as bad news is good news, market ignorance is bliss.

Read the whole article here.

Tags: Bad News, Business Sentiment, Commodities, Commodity Prices, Disappointment, Doug Kass, Exogenous Events, Federation Of Independent Business, Gold, Ignorance Is Bliss, inflation, interest rates, National Federation Of Independent Business, Price Of Gold, Seabreeze Partners, Specter, Stimulus, Stock Prices, Tide, Vulnerability, Warning Signs, World Stock
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