The Economy and Bond Market Radar (July 16, 2012)

Saturday, July 14th, 2012

The Economy and Bond Market Radar (July 16, 2012)

Treasury yields headed lower again this week but not dramatically so. The minutes from the June Federal Open Market Committee meeting were released this week and indicate that Fed members remain divided on an additional round of quantitative easing (QE). In the past few years bonds have tended to rally into the QE announcement and sell off when announced as expectations are for the easing to boost the economy and financial assets. There was little in the way of real market moving economic data released this week in the U.S. but China released second quarter GDP results showing a deceleration to 7.6 percent on a year-over-year basis. This was the slowest growth since the financial crisis but is far from the “hard landing” that many were expecting. Treasury yields moved higher on Friday and the stock market rallied, in what was likely a “relief” rally for stocks.

Strengths

• We did get some inflation data this week with import prices and the producer price index; both continue to show a benign inflation environment.
• Brazil and South Korea cut interest rates this week, following the coordinated actions last week from the ECB, Bank of England and the Bank of China.
• Consumer credit hit a five-month high in May as the consumer appears to be more comfortable and banks are lending.

Weaknesses

• Chinese imports slowed dramatically in June to 6.3 percent, well below estimates. This raises concerns about the depth of the slowdown in China.
• Japanese core machinery orders plummeted 14.8 percent in May, dramatically below estimates.
• Quarterly earnings reports will pick up sharply next week but we had many companies warn this week that the economy is weakening. This was particularly true in technology and industrials.

Opportunity

• The Fed reaffirmed its commitment to an ultra low interest rate policy through 2014 and additional monetary easing is possible in the near future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.

Tags: Bank Of China, Bank Of England, Bond Market, Chinese Imports, Deceleration, Ecb Bank, Economic Data, Federal Open Market Committee, Financial Assets, Import Prices, Inflation Data, Interest Rate Policy, Japanese Core, Machinery Orders, Market Radar, Open Market Committee, Producer Price Index, Quarter Gdp, Quarterly Earnings Reports, Treasury Yields
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Swimming with Black Swans: The Volatile Decade Ahead

Tuesday, July 10th, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

Investors, prepare for a rocky decade ahead.

I have already warned on this blog that heightened market volatility is likely to continue for the remainder of the year. The truth is that markets have become more volatile in recent years, and they’re likely to remain that way throughout this decade.

Looking at weekly data, between 1982 and 2007, a period often referred to as the “Great Moderation”, the annualized volatility of the S&P 500 was approximately 15%. Since 2008, however, the annualized volatility has risen to nearly 25%.

While no single explanation fully captures why volatility has risen, in my view the rise in equity market volatility can primarily be attributed to a rise in economic volatility. Work done by my colleague Daniel Morillo demonstrates that the volatility of financial assets is closely correlated with the volatility of the underlying economy. In less stable economic environments in which recessions are more frequent and economic measures more volatile, financial assets tend to be more volatile as well.

And since the most recent recession began in 2008, the economies of most developed countries have simply been less stable then they used to be, as reflected in the seemingly out-of-the-ordinary “Black Swan”-type economic events that have occurred in recent years. In fact, over the last few years, developed market economic volatility has increased by almost any measure. In the United States, inflation is more volatile, industrial production is more volatile and overall consumption is less stable. In Europe the situation is even worse. For example, since 2008, European-wide industrial production is approximately 80% more volatile than it was between 1990 and 2007.

What’s behind this newfound economic volatility? I would attribute most of it to the lingering impact of the financial bubble and accompanying deleveraging. Most developed countries are attempting to reduce their debt levels, European countries through fiscal austerity and the United States through the household and financial sectors. This deleveraging is creating significant economic headwinds, leading to less stable economies and more volatile markets.

Unfortunately, the deleveraging in the developed world is still in its early stages. Credit growth has been on an upward trajectory for roughly four decades, but deleveraging has been occurring for barely four years. European sovereigns and US households still have much more deleveraging to do. Worse, the biggest offenders – the United States and Japanese governments – have not even begun to reduce their debt burdens.

To the extent that the deleveraging cycle is likely to last throughout this decade, investors should get accustomed to more economic instability (think more Black Swans) and more market volatility.

They may also want to consider taking a defensive portfolio positioning through dividend-paying stock funds such as the iShares High Dividend Equity Fund (NYSEARCA: HDV) and minimum volatility funds such as the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA: ACWV).

Source: Bloomberg

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

The author is long HDV

There is no guarantee that dividend funds will pay dividends.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. The Minimum Volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Copyright © iShares

Tags: Black Swan, Black Swans, Chief Investment Strategist, Colleague, Cou, Economic Environments, Economic Events, Economic Measures, Economic Volatility, Financial Assets, Financial Bubble, Ishares, Market Volatility, Moderation, Morillo, Most Developed Countries, Recession, Recessions, Russ, Swans
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Where’s the Collateral? (Smith)

Tuesday, May 1st, 2012

Submitted by Charles Hugh Smith from Of Two Minds

Where’s the Collateral?

A sound system of credit is built on collateral. A doomed system of debt sits precariously on phantom collateral.

The global “recovery” is based not on reducing debt but on increasing it. Nice, but where’s the collateral? The basic idea of debt is that credit is extended based on collateral, i.e. something of enduring, tradable value, or an income stream that isn’t reduced to zero by non-discretionary spending and taxes.

A funny thing happened to collateral like housing equity and financial assets in the past four years–it shrank by trillions of dollars. According to the latest Z1 “Balance Sheet of Households and Non-Profits” from the Federal Reserve, real estate fell by $4.9 trillion since the bubble top in 2007 and owners’ equity lost $4.2 trillion.

Despite the stock market doubling since 2009 and a healthy run-up in the value of bonds, financial assets shrank by $2 trillion as well.

These are non-trivial sums when we consider that collateral is generally leveraged. If a home buyer puts down 20% cash, then that cash collateral is leveraged 4-to-1 in an 80% mortgage. If the buyer puts down 3% (as in an FHA loan), then the leverage is over 30-to-1.

Collateral matters when it comes to assessing the value of the debt. If a bank lists the mortgages in its “assets” column at full value even though the underlying collateral (the houses) has lost much of their value, then the bank is grossly over-estimating the value and security of the mortgage. The bank’s “assets” are based on phantom collateral.

Take away $1 in collateral and you impair $4, $10, $20 or even $30 of debt.

Recall that the vast majority of real estate equity and financial wealth is owned by the top 20%, with the majority of that concentrated in the top 5%. That means the bottom 80% own little collateral to leverage into debt.

How about leveraging income into more debt? Since the top 10% receive almost 50% of the income, and most of the bottom 90%’s income goes to non-discretionary spending and taxes, then only the top 10% have discretionary income that can be leveraged into more debt.

Interestingly, The Wedge between Productivity and Wages by economist Mark Thoma reports that the enormous advances in productivity over the past few decades did not translate into higher wages for the bottom 90%.

I have often addressed income disparity and the evaporation of collateral, for example, Two Americas: The Gap Between the Top 5% and the Bottom 95% Widens (August 18, 2010) and The Housing Bubble Broke the Middle Class (April 27, 2011).

Regardless of the various causal factors, the fact remains that 90% of American households have limited collateral or discretionary income to leverage into more debt. That leaves around 10 million households (the top 10%) with the means to take on more debt–if they want to. Can 10% of the households prop up the entire economy with more debt and consumption? What if the wealthy decline the opportunity to leverage more debt?

We can also ask “where’s the collateral?” of the banking sector. As frequent contributor Harun I. observed about the European banking sector’s phantom collateral:

European banks do not have enough money for deposit redemptions (people withdrawing their cash from the banks) and the only way to get it is to have the European Central Bank (ECB) print money out of thin air thereby devaluing every euro, thereby destroying purchasing power (you get your money but it buys less).

 

And what collateral are the banks providing for these loans? The sovereign debt of countries that are insolvent. Why not sell the bonds to raise the capital that is rightfully owed to depositors so that they could receive their money at par? Why then bond prices would tumble and governments would be forced to borrow at much higher interest rates. But borrow from whom? Insolvent banks that must have money printed to give depositors their money back at a fraction of its worth from when they deposited it. Not due to market forces which indicate their labor is worth less but because everybody just wants what’s rightfully theirs.

 

So to summarize this, the ECB prints money to buy the bonds of insolvent banks which are backed by the bonds of insolvent nations. The result of which is insolvent nations or in reality the people thereof are not only poorer, they are now responsible for paying back money that was their property to begin with… at interest.

Put these two factors together and you get a global economy dependent on debt borrowed against phantom collateral and an American economy in which only the top 10% have credible collateral and income to leverage into more debt. In a sane system, when the collateral vanishes, so too does the debt (writedowns, write-offs, bankruptcy, take your pick). In an insane system, then phantom collateral supports ever greater mountains of debt.

How long do you reckon the insane system we have now will last? The collateral is phantom, but the interest payments are very, very real.

Tags: Balance Sheet, Bubble Top, Cash Collateral, Collateral Recovery, Discretionary Spending, Estate Equity, Federal Reserve, Fha Loan, Financial Assets, Funny Thing, Global Recovery, Home Buyer, Hugh Smith, Income Stream, Leverage, Reducing Debt, Stock Market, Trillion, Trillions, Z1
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Economic Insights: When Will Corporate Cash Flow? (Ezrati)

Tuesday, April 3rd, 2012

by Milton Ezrati, Lord Abbett

One of the great constants in this otherwise inconstant environment is the strength of corporate finances. Financial excesses and the need to de-leverage concern governments and households, not the corporate sector, which actually came out of the 2008–09 financial crisis and recession with its finances in good order, and has only strengthened them since. The question now is how and when companies will deploy these impressive financial resources—whether on capital spending, hiring, or, especially, on the mergers and acquisitions (M&A) that typically proceed from strong corporate finances.

Huge cash holdings constitute the most impressive aspect of this financial strength. At the close of 2011 (the most recent period for which complete data are available), cash on non-financial corporate balance sheets had risen to more than $1.9 trillion—a jump of almost 60% from the dark days of 2008 and more than 50% from the last cyclical peak in 2007. Cash and cash equivalents have risen, so that today they constitute almost 13% of all corporate financial assets, up from 9.4% in 2008 and 9.1% in the cyclical peak year 2007. They amount to some 14% of all corporate liabilities, up from 9.2% in 2008 and 9.7% in 2007, and almost 12% of corporate net worth, up from 8.9% in 2008 and 8.0% in 2007.

Aside from the powerful cash flows that permitted such accumulations, it is the high and persistent levels of uncertainty that have kept the funds in cash instead of flowing into other corporate uses. Speaking volumes to this motivation is the fact that the bulk of this cash sits neither in time nor savings deposits nor money market shares nor in commercial paper, but rather in checkable deposits. These have grown remarkably—more than 1,500%, in fact—since 2008. The high level of uncertainty behind this behavior is hardly surprising either, on at least four counts.

First and primary as a behavioral motivator is the legacy of the 2008–09 financial crisis. Still fresh in managers’ collective memories, these events have kept companies sensitive to how suddenly economic and financial conditions can change and, consequently, how valuable ready, liquid assets can be. But more, because bank credit standards tightened during the crisis and by and large have remained tight since, companies have lost the conviction that they can borrow should the need arise. It does not help in this regard that many banks during the crisis withheld formerly well-established corporate lines of credit, an act that has left in its wake conviction among corporations that they ought to rely more on self-financing. The sovereign debt problems in Europe, threatening a rerun of 2008–09, have only redoubled this conviction.

Second, Obamacare has contributed, too. Whether a good idea or a bad one, good legislation or not, the huge changes built into this complex law impose tremendous uncertainty on corporate decision making, particularly about hiring. The natural response in the circumstance is to hold back on major corporate decisions and the enlarged cash holdings are an obvious financial reflection of that posture.

Third, the Dodd-Frank financial reform has had its own separate influence. Although this huge piece of legislation covers only financial corporations, it does nonetheless create uncertainty among all companies about future financing, both availability and cost. In this regard, whether Dodd-Frank is good law or bad, it has surely had an effect similar to the liquidity problems of 2008–09, even though it was ostensibly designed to correct them, adding to management convictions that they can no longer rely on credit lines from financial institutions and need, therefore, to do more than previously to cover their short-term cash needs for themselves.

And fourth, if these matters did not weigh heavily enough, corporations must also cope with the uncertainties surrounding the federal budget debate. Without knowing the nature and size of future federal spending or taxes or even the federal government’s prospective borrowing needs, it is difficult for managers to gain any sense of the future and, consequently, how to deploy their resources.

But for all this, there are tentative signs that corporations are beginning to use some small portion of this cash accumulation. Though compared with past cyclical standards hiring has remained subpar (hardly a surprise in such an uncertain environment), it has nevertheless picked up some in recent months. Corporations have also increased capital spending, raising such outlays by almost 8% over the course of 2011—hardly a boom, but certainly faster than sales have risen and a use for some of these surplus funds. At the same time, corporations have shown a modest willingness to extend themselves by accepting a rise in their trade and tax payables. Together, these have risen more than 13% during the past year, faster than sales and even than cash balances.

Still, it will take time before a return of confidence can move matters beyond these recent, tentative expressions. Cash and the lack of confidence it reflects remain high. There is, however, a tremendous potential for dramatic expansion in corporate spending, hiring, and M&A activity from even a modest improvement in confidence. Especially because equity market valuations these days make it cheaper to buy than to build, the M&A potential, with its always immediate market impact, looks particularly powerful.

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.

Copyright © Lord Abbett

Tags: Cash And Cash Equivalents, Corporate Balance Sheets, Corporate Finances, Corporate Liabilities, Corporate Sector, Dark Days, Economic Insights, Excesses, Financial Assets, financial strength, Impressive Aspect, Lord Abbett, Market Shares, Mergers And Acquisitions, Milton Ezrati, Money Market, Motivator, Net Worth, Peak Year, Speaking Volumes
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Paul Kasriel’s Parting Thoughts – Mary Matlin’s Economics

Friday, March 30th, 2012

Kasriel’s Parting Thoughts – Mary Matlin’s Economics

As many of you know, I will be retiring from The Northern Trust Company on April 30. In the few remaining days of my tenure, I will be sharing with you some of my parting thoughts with regard to economics as time permits and the spirit moves me. By the way, after April 30, my Northern Trust email address will disappear into the ether, but I hope I will not follow it there. If you feel the need to contact me after April 30, and I cannot imagine why you would, I have established a personal email address, which has gone live: econtrarian@gmail.com.

Now, on to Mary Matalin. I saw her on one of the cable news shows on Wednesday defending Republican presidential candidate Mitt Romney’s planned car “elevator” in his new La Jolla home in terms of job creation. Ms. Matalin argued that by installing this elevator, Romney would be creating new jobs for the economy. How might Bastiat, the 19th century French political economist, have reacted to Ms. Matalin’s argument? My suspicion is that he would have made a distinction between what Ms. Matalin “sees” and what is “unseen.” Ms. Matalin sees the additional workers manufacturing and installing the elevator. What she apparently does not see are the workers who otherwise would have been hired for some other unrelated project had Mr. Romney forgone the installation of the elevator and rather invested, or saved, these “elevator” funds. Ms. Matalin, a Republican partisan, appears to have bought into the Keynesian fallacy often trumpeted by Democratic (or is it Democrat?) partisans that an increase in saving implies less total spending in the economy and diminished job creation. If Mr. Romney chooses to forgo the installation of a car elevator in favor of, say, purchasing some additional financial assets, in effect, he is transferring some of his purchasing power to another entity – a business, another household or a governmental body – that has a greater urgency to spend currently than does Mr. Romney. So, although Mr. Romney would be hiring fewer workers to manufacture and install a car elevator, the recipient of Mr. Romney’s investment funds would be hiring additional workers to produce whatever they were purchasing. (This concept of transfer credit comes from the Austrian school of economics, whose pupils greatly admire Bastiat.)The only way Mr. Romney’s decision to forgo the installation of a car elevator would not lead to a creation of jobs is if Mr. Romney chose to increase his saving by holding more bank deposits and/or currency, in which case would result in a decline in the velocity of money.

So, boys and girls, like Bastiat, keep your eyes open. Try to see everything when analyzing economic issues. Ms. Matalin was not incorrect to argue that Mr. Romney’s decision to install a car elevator in his new abode would create new jobs. But what she apparently failed to see is that new jobs would have also been created if Mr. Romney had chosen to forgo the purchase of the car elevator and instead invested those funds. Increased saving in general does not result in decreased aggregate spending. Rather, it merely changes the composition of who is engaging in the new spending.

Copyright © Northern Trust

Tags: Cable News, Chief Economist, Elevator, Fallacy, Financial Assets, Job Creation, La Jolla, Mary Matalin, Mary Matlin, Mitt Romney, New Jobs, Northern Trust Company, Parting Thoughts, Partisan, Partisans, Paul Kasriel, Political Economist, Purchasing Power, Republican Presidential Candidate, Republican Presidential Candidate Mitt Romney
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Bill Gross: Investment Outlook (April 2012)

Tuesday, March 27th, 2012

The Great Escape:
Delivering in a Delevering World

by William H. Gross, PIMCO

April 2012

• When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
• In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
• We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.

About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.

The term delevering implies a period of prior leverage, and leverage there has been. Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth. Stocks for the Long Run was the almost universally accepted mantra, but it was really a period – for most of the last half century – of “Financial Assets for the Long Run” – and your house was included by the way in that category of financial assets even though it was just a pile of sticks and stones. If it always went up in price and you could borrow against it, it was a financial asset. Securitization ruled supreme, if not subprime.

As nominal and real interest rates came down, down, down and credit spreads were compressed through policy support and securitization, then asset prices magically ascended. PE ratios rose, bond prices for 30-year Treasuries doubled, real estate thrived, and anything that could be levered did well because the global economy and its financial markets were being levered and levered consistently.

And then suddenly in 2008, it stopped and reversed. Leverage appeared to reach its limits with subprimes, and then with banks and investment banks, and then with countries themselves. The game as we all have known it appears to be over, or at least substantially changed – moving for the moment from private to public balance sheets, but even there facing investor and political limits. Actually global financial markets are only selectively delevering. What delevering there is, is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece. The delevering is also relatively hidden in the recapitalization of banks and their lookalikes. Increasing capital, in addition to haircutting and defaults are a form of deleveraging that is long term healthy, if short term growth restrictive. On the whole, however, because of massive QEs and LTROS in the trillions of dollars, our credit based, leverage dependent financial system is actually leverage expanding, although only mildly and systemically less threatening than before, at least from the standpoint of a growth rate. The total amount of debt however is daunting and continued credit expansion will produce accelerating global inflation and slower growth in PIMCO’s most likely outcome.

How do we deliver in this New Normal world that levers much more slowly in total, and can delever sharply in selective sectors and countries? Look at it this way rather simplistically. During the Great Leveraging of the past 30 years, it was financial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more levered those flows, then the better they did. That is because, as I’ve just historically outlined, future cash flows are discounted by an interest rate and a risk spread, and as yields came down and spreads compressed, the greater return came from the longest and most levered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the ability of global economies to consistently replicate them. Financial assets relative to real assets outperform in such a world as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns.

To put it even more simply, financial assets with long interest rate and spread durations were winners: long maturity bonds, stocks, real estate with rental streams and cap rates that could be compressed. Commodities were on the relative losing end although inflation took them up as well. That’s not to say that an oil company with reserves in the ground didn’t do well, but the oil for immediate delivery that couldn’t benefit from an expansion of P/Es and a compression of risk spreads – well, not so well. And so commodities lagged financial asset returns. Our numbers show 1, 5 and 20-year histories of financial assets outperforming commodities by 15% for the most recent 12 months and 2% annually for the past 20 years.

This outperformance by financial as opposed to real assets is a result of the long journey and ultimate destination of credit expansion that I’ve just outlined, resulting in negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie staring Steve McQueen called The Great Escape where American prisoners of war were confined to a POW camp inside Germany in 1943. The living conditions were OK, much like today’s financial markets, but certainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and American officers to try to escape and get back to the old normal. They ingeniously dug escape tunnels and eventually escaped. It was a real life story in addition to its Hollywood flavor. Similarly though it is your duty to try to escape today’s repression. Your living conditions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover liabilities. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this financial repressive world.

What happens when we flip the scenario or perhaps reach the point at which interest rates cannot be dramatically lowered further or risk spreads significantly compressed? The momentum we would suggest begins to shift: not necessarily suddenly or swiftly as fatter tail bimodal distributions might warn, but gradually – yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 2% and in most cases moves higher, delivering double-digit or even 7-8% total returns from bonds, stocks and real estate becomes problematic and certainly much more difficult. Real growth as opposed to financial wizardry becomes predominant, yet that growth is stressed by excessive fiscal deficits and high debt/GDP levels. Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.

That is not to say that inflation cannot continue to elevate financial assets which can adjust to inflation over time – stocks being the prime example. They can, and there will be relative winners in this context, but the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited. Total return as a supercharged bond strategy is fading. Stocks with a 6.6% real Jeremy Siegel constant are fading. Levered hedge strategies based on spread and yield compression are fading. As we delever, it will be hard to deliver what you have been used to.

Still there is a place for all standard asset classes even though betas will be lower. Should you desert bonds simply because they may return 4% as opposed to 10%? I hope not. PIMCO’s potential alpha generation and the stability of bonds remain critical components of an investment portfolio.

In summary, what has the potential to deliver the most return with the least amount of risk and highest information ratios? Logically, (1) Real as opposed to financial assets – commodities, land, buildings, machines, and knowledge inherent in an educated labor force. (2) Financial assets with shorter spread and interest rate durations because they are more defensive. (3) Financial assets for entities with relatively strong balance sheets that are exposed to higher real growth, for which developing vs. developed nations should dominate. (4) Financial or real assets that benefit from favorable policy thrusts from both monetary and fiscal authorities. (5) Financial or real assets which are not burdened by excessive debt and subject to future haircuts.

In plain speak –

For bond markets: favor higher quality, shorter duration and inflation protected assets.

For stocks: favor developing vs. developed. Favor shorter durations here too, which means consistent dividend paying as opposed to growth stocks.

For commodities: favor inflation sensitive, supply constrained products.

And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.

With regard to all of these broad asset categories, an investor in financial markets should not go too far on this defensive, as opposed to offensively oriented scenario. Unless you want to earn an inflation adjusted return of minus 2-3% as offered by Treasury bills, then you must take risk in some form. You must try to maximize risk adjusted carry – what we call “safe spread.”

“Safe carry” is an essential element of capitalism – that is investors earning something more than a Treasury bill. If and when we cannot, then the system implodes – especially one with excessive leverage. Paul Volcker successfully redirected the U.S. economy from 1979-1981 during which investors earned less return than a Treasury bill, but that could only go on for several years and occurred in a much less levered financial system. Volcker had it easier than Bernanke/King/Draghi have it today. Is a systemic implosion still possible in 2012 as opposed to 2008? It is, but we will likely face much more monetary and credit inflation before the balloon pops. Until then, you should budget for “safe carry” to help pay your bills. The bunker portfolio lies further ahead.

Two additional considerations. In a highly levered world, gradual reversals are not necessarily the high probable outcome that a normal bell-shaped curve would suggest. Policy mistakes – too much money creation, too much fiscal belt-tightening, geopolitical conflicts and war, geopolitical disagreements and disintegration of monetary and fiscal unions – all of these and more lead to potential bimodal distributions – fat left and right tail outcomes that can inflate or deflate asset markets and real economic growth. If you are a rational investor you should consider hedging our most probable inflationary/low growth outcome – what we call a “C-“ scenario – by buying hedges for fatter tailed possibilities. It will cost you something – and hedging in a low return world is harder to buy than when the cotton is high and the living is easy. But you should do it in amounts that hedge against principal downsides and allow for principal upsides in bimodal outcomes, the latter perhaps being epitomized by equity markets 10-15% returns in the first 80 days of 2012.

And secondly, be mindful of investment management expenses. Whoops, I’m not supposed to say that, but I will. Be sure you’re getting value for your expense dollars. We of course – perhaps like many other firms would say, “We’re Number One.” Not always, not for me in the summer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are certainly a #1 seed – with aspirations as always to be your #1 Champion.

William H. Gross
Managing Director

“Safe Spread” also known as “Safe Carry” is defined as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios. All investments contain risk and may lose value.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. 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. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. 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. 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. An investor should consult their financial advisor prior to making an investment decision.

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. 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 article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2012, PIMCO.

Tags: Bill Gross, Bond Market, Bretton Woods, Central Banking, Commodities, Commodity, Commodity Products, Debasement, Dividend Paying Stocks, Financial Assets, Financial Leverage, Future Returns, Global Economy, Gold Standard, Great Escape, Gross Investment, Inflation Protected Bonds, Investment Outlook, PIMCO, Three Decades, Treasury Bills, William H Gross
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Golden Boy: Paul Brodsky on Warren Buffett

Tuesday, February 28th, 2012

Warren Buffett deserves the public’s respect. His great success and apparent modesty, kindness and reason in a field replete with promoters and chest thumpers have allowed him to stand out in our society. He is to most an honest broker among charlatans, uniquely capable of separating truth from fiction, the way it is and will always be versus cockeyed theories touted by ignorant newbies. He has been the most successful and most charitable financier of the last hundred years, and his proclamations become, ipso facto, the common perception of truth.

Buffett may be a sage, a wizard, and an oracle when it comes to nominal relative value pricing of financial assets, but it is well worth noting that Buffett’s proclamations are not necessarily worthy of being considered “fact” in matters unrelated to finance, just as the legendary Joe Paterno’s judgment seems to have been sorely lacking when it came to sorting out matters unrelated to a winning football program.

That has not seemed to stop Mr. Buffett from expressing wide ranging views from tax policy to the value of gold. In fact, over the last two weeks — in a Forbes interview, in Berkshire Hathaway’s annual report and this morning on CNBC — Buffett chose to comment on gold even though he does not have a publicly disclosed position in it. We must assume his aggressive gold comments have been meant to force the price of gold lower. (We do not know why he is so interested in doing so though we do have a reasonable theory, for another time). We strongly disagree with Mr. Buffett’s views and we thought it would be best to explore his comments and provide our counter-arguments.

Productive Assets vs. True Savings

The crux of Buffett’s argument is that he prefers productive assets (procreative, he calls them) and that gold is not one. This implies correctly that gold is a form of savings. Regrettably, the rest of his argument relies on confusing the two, which leads him to two-dimensional logic that clearly fails in practical terms.

We would share Buffett’s preference for productive assets in a Utopian world where money was scarce and credit was funded exclusively with organic savings. In such a world simply depositing our savings in a bank would pass-on our capital to productive businesses that would in turn earn the productive return, all while we (the saver) would retain the risk. That would be a great deal for the bank and the producer but a lousy deal for the saver.

Such a warning to savers (gold holders) is a ridiculous position to take, however, in the context of our modern global monetary system characterized by over-levered currency and unreserved bank credit. Though Buffett is correct that saving in the form of incessantly inflating fiat currency is a fool’s game today, he is dangerously wrong in not seeing that exchanging fiat currency for financial assets and businesses with egregiously inflated enterprise values, (via the egregiously inflated and inflating currencies in which they are denominated), is not equally foolish.

Warren Buffett’s argument against gold falls woefully short of the mark because he does not acknowledge that there is always a role for robust savings wherein the saver neither suffers the dilutionary pain of fiat currency devaluation nor the deflationary pain of acquiring over-levered assets. The medium that allows the true saver to escape both trap doors is gold. It is simply a form of savings that cannot be diluted and the nominal prices of all things leveraged (including financial assets) will revolve around it and other scarce, unlevered items.

Within this context, we re-print and rebut Mr. Buffett’s specific observations related to gold from Berkshire’s annual report, below:

Buffet:

“…the second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.”

QB:

Gold is not an asset and is not meant to be procreative. Above all else it is a currency, like US dollars, and its daily spot pricing reflects its exchange rates with currencies currently being issued by global central banks on behalf of their host governments and used as media of exchange. Gold is not currently a medium of exchange (although to some people it remains a store of purchasing power vis-à-vis other currencies currently in use as exchange media). Thus, in today’s fiat monetary system gold is simply potential money and its spot price indicates the degree to which global wealth holders are willing to handicap the possibility that the future purchasing power of central bank-issued currency will be diluted against it.

Gold is no more or less “lifeless” than Dollars, Euros or Yen. One needs to lend each in order to have a return on them. (We argue one would be foolish to lend gold and receive interest denominated in other currencies when gold is relatively scarce — and getting scarcer — to them.) As for being “not of much use”, yes gold is pretty useless…until it isn’t.

Mr. Buffet is wrong when he implies gold is a bubble (like Tulips). In fact, in spite of all the noise there is very little sponsorship of gold today relative to financial assets. As indicators, the value of the world’s largest gold ETF is one-fifth the market capitalization of Apple, and total precious metal exposure represents just 0.15% of global pension assets.

Mr. Buffet is again wrong in arguing gold needs more avid buyers to keep the bubble inflating. It does not, and in fact we think it is unlikely there will be many buyers relative to financial asset holders as time goes on. Rather, we believe the price of gold will increase in fiat terms with or without widespread secondary market endorsement precisely because central banks must increase their monetary bases to de-lever their banking systems, which in turn de-values the currencies in which leverage is denominated.

Paper claims on gold, such as futures, swaps and dubiously-backed ETFs, will fluctuate with the changing sentiment of financial asset investors until, one day, for some reason that cannot be predicted, claim holders begin to demand physical bullion. All it will take to trigger “a run” will be more demand for physical bullion than the amount available on-hand for delivery. When this happens there will not be a “reasonable” price at which an exchange can be made. Spot pricing will cease to exist and all paper claims on gold will settle in brokerage accounts at the price of the last spot trade. We think very few committed financial asset investors will own gold in any size at the precise moment they will need it most.

Those that do hold physical gold (or shares in gold miners) would be able to then set the exchange rate to fiat currencies (gold price) at which they would part with their bullion. Any externalities, such as government intervention or price controls that would serve to try to set the exchange rate at a lower-than-market rate, would likely be met with indifference among bullion holders and miner shareholders. So yes, Mr. Buffet may be correct that an ounce of gold will always be only an ounce of gold, but he does not seem to be considering its exchange rate.

Buffet:

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

As “bandwagon” investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

QB:

The great bubble from 1981 to 2006 was in unreserved global credit distribution, which explains the funding behind Mr. Buffett’s market psychology discussion. The current bubble is in global base money printing, which has risen over 200% just since 2008 and must increase five times more from current levels to cover unreserved bank assets. Financial assets are the direct beneficiary of credit expansion and real assets are the direct beneficiary of base money expansion. Gold is simply responding to the bubble policy makers are administering. We believe gold is the most under-valued and most optimal risk-adjusted hedge against the current bubble.

Buffett:

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).

Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”

QB:

As we’ve written in the past, our preferred piles (we call them “buckets”) are these: Bucket A is the stock of money and Bucket B is the value of all things not money. At any given point of measurement the value of Bucket A must equal the value of Bucket B. Thus, the debate reduces to “what is money?” If one presumes that fiat currencies and unreserved bank credit have no marginal cost of production (electronic ones and zeros), then their terminal value in exchange must be zero. This leaves gold in the money bucket to assume the value of all things not money. Mr. Buffet again misidentified gold as an asset, not as money.

Summary

We think it is imprudent to advise legitimate savers to invest in levered financial assets. The extraordinary relative wealth one may have amassed over the last forty years in the financial markets was most likely legitimized by nominal scale that cannot be sustained in real terms. Such beneficiaries of leverage and inflation typically built very little sustainable capital and innovated nothing. The largest beneficiaries of leverage and inflation had a near infinite funding advantage, either near zero-rate short-term fiat currency funding or very low term funding. Insurers like Berkshire could effectively divert wages from their country’s factors of production (by charging insurance premiums) and reinvest those wages by providing financing to businesses that would maintain their pricing power (through strong branding or demand inelasticity). That great funding advantage is now gone and Mr. Buffett does not seem too happy about it.

The narrow gap separating wage growth and asset price growth had to widen following the demise of Bretton Woods. Mr. Buffett may have known about this opportunity earlier and better than almost anyone else because his father, (Howard Buffett, US Congressman from Nebraska), was outspoken in aggressively supporting gold and a fixed exchange currency system. It would be counterproductive and beyond our area of study to try to understand what psychological impulse might compel Mr. Buffett to pursue and achieve lifelong financial success in a manner directly contrary to his father’s views on the value of gold and paper currencies. So we can only guess whether his astounding success in consistently positioning a leveraged inflation portfolio has been the result of a sound pre-meditated strategy passed down from his father or has merely been very ironic.

Mr. Buffett’s motivations are not important. He is rich and we think he will always be rich in relative terms because most wealth holders will remain committed to financial assets. Nevertheless, we suspect Mr. Buffet is aware that his wealth is about to be greatly devalued in real terms, just as he correctly foresaw the fate of dot-com billionaires who held their outlets for unreserved credit too long (in the form of corporate shares). Further, we think Mr. Buffett must be aware that the procreative assets he touts are currently priced at multiples of their future nominal cash flows and discounted for almost 0% interest rates, ensuring their future purchasing power will be destroyed in an inflationary environment no matter how much revenue growth they produce.

We believe true savers across the world not beholden to Western financial assets understand or will soon understand the difference between relative nominal returns and absolute real returns. They do (or will) not care about the views of very successful leveraged money changers. Yes, an inert rock today will be an inert rock tomorrow. But it will be an even scarcer inert rock tomorrow relative to the fiat currency in which it is priced (same for fine art). Levered productive assets will lose their value against both unlevered scarce inert rocks and unlevered inelastic commodities. The only things they will outperform in a period of great monetary inflation are bonds and cash (both also levered).

Mr. Buffett is no doubt brilliant but we respectfully disagree with his sense of real value. We find inspiration in the good sense and graciousness of Sir John Templeton who became fabulously wealthy investing in capital building enterprises and always seemed to maintain an objective and flexible investment perspective.

Kind regards,

Lee Quaintance & Paul Brodsky
pbrodsky@qbamco.com

(h/t: Barry Ritholtz, The Big Picture)

Tags: Berkshire Hathaway, Brodsky, Buffett Warren, Charlatans, Cnbc, Financial Assets, Football Program, Honest Broker, Joe Paterno, Legendary Joe, Mr Buffett, Price Of Gold, Proclamations, productive assets, Relative Value, Thumpers, True Savings, Truth From Fiction, Value Of Gold, Warren Buffett
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Europe’s Cash-For-Trash LTRO-’Scam’ And The Indentured Servitude Of The Citizenry

Friday, February 24th, 2012

In a must-watch follow-up to his original Punk Economics Lesson, David McWilliams describes how the new bankocracy in Europe will lead to a massive injection of liquidity; blowing bubbles in financial assets while the citizenry is bled dry (ring any recent bells?). The banks again get all the money they need while the average citizen shoulders the burden. Specifically in the case of the Greeks, they are left with the uncertainty of a return to the Drachma or the certainty of decades of indentured servitude. Enter the ECB with their cash-for-trash deal. This is a scam, he proclaims correctly, insolvent banks lending to insolvent governments and we are calling it success? The banks can turn a tidy profit, but the straight-talking Irishmen asks the question every Greek citizen should be asking: “where does the profit come from?” The answer: the average tax-paying European citizen, and it is this that provides the comfort for the Germans to allow the Greeks to default without bringing down every bank in Europe in a contagious cascade of margin calls, un-hypothecation and deleveraging. Critically, the question is not if or when Greece will default but will they be allowed to default enough? The lesson for all is that to stay in the Euro, all European nations have to become more like Germany – which is very different from the community of equal nations that the Europeans signed up for 20 years ago at Maastricht. Don’t be fooled that the European debt story is over, it is not. In fact, he finishes – rather ominously, the interesting bit hasn’t even started yet.

While austerity is argued not to work, we think it can if countries manage to cut expenses while keeping a balance. We once again remind readers that alas, the balance is out of skew due to 30 years of runaway full-Keynesianism, which leads indeed to the problems that McWilliams so well espouses.

Tags: Austerity, Blowing Bubbles, Citizenry, David Mcwilliams, Drachma, ECB, European Citizen, Europeans, Financial Assets, Germans, Greek Citizen, Greeks, Hypothecation, Indentured Servitude, Insolvent Banks, Irishmen, Keynesianism, liquidity, Massive Injection, Tidy Profit
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Shilling Sees Evidence of Deflation in 5 of 7 Key Areas; Bernanke Begs Congress for Fiscal Stimulus, Admits Fed is Out of Bullets

Friday, September 30th, 2011

by Michael ‘Mish’ Shedlock, Global Economic Trends Analysis

Shilling Sees Evidence of Deflation in Financial Assets, Tangible Assets, Median Income, Commodities, Currencies

Shilling says “Forces of deleveraging and deflation are greater than the Fed can handle.”

I certainly agree and have been saying the same thing (correctly I might add) for several years. All the Fed has ever managed to do is slow the deflationary outcome and that is in spite of $trillions in both monetary stimulus from the Fed and fiscal stimulus from Congress.

Once again, if you mistakenly think inflation and deflation are about consumer prices instead of vastly more important credit, you will come to a different conclusion.

For further discussion as to what deflation is all about, please see

• Yes Virginia, U.S. Back in Deflation; Inflation Scare Ends; Hyperinflationists Wrong Twice Over
• Bizarro World Inflation; About that 2011 Hyperinflation Call …

Fed Out of Bullets

In spite of what the Fed says and wants everyone to believe the Fed is Out of Bullets

Let’s Twist Again (and Not Much More) as I expected

There were a lot of expectations regarding numerous options the Fed might take today. I did not expect the Fed would risk trying them.

See Six Things the Fed May Announce Tomorrow (But Likely Won’t); Would Any of Them Matter? Gaming the Reaction for details.

The Fed said “Let’s Twist Again” and not much more other than throwing a bone at mortgages. Neither will work and the Fed is out of bullets.

Bernanke Begs Congress for Fiscal Stimulus

In a question session following Bernanke’s speech Lessons from Emerging Market Economies on the Sources of Sustained Growth (in which Bernanke proves he does not really understand what is really happening in China), Bernanke begged Congress for help and admitted the Fed is out of bullets.

Yahoo Finance reports Bernanke: Long-term unemployment a national crisis

Federal Reserve Chairman Ben Bernanke said Wednesday that long-term unemployment is a “national crisis” and suggested that Congress should take further action to combat it. He also said lawmakers should provide more help to the battered housing industry.

Bernanke said the government needs to provide support to help the long-term unemployed retrain for jobs and find work. And he suggested that Congress should take more responsibility.

In the question-and-answer period, Bernanke cautioned U.S. lawmakers against cutting deficits too quickly to reduce budget deficits. He has said that could put the fragile economy at risk.

In practical terms, Bernanke was begging Congress for help, and in the Q&A session, Bernanke went even farther.

Please consider Everyone Missed It, But Ben Bernanke Peed On The Fed Again Last Night by Joe Weisenthal.

We’ve talked about this before, the fact that Ben Bernanke is growing increasingly vocal about his skepticism that monetary policy can do much to save this economy.

This is a HUGE change from someone who once said that the Great Depression was entirely the Fed’s fault, and that the Fed would never let that happen again!

In his daily note, Art Cashin caught a key bit from a Ben Bernanke Q&A last night after he gave a speech, further emphasizing that Bernanke has radically changed his views.

“Monetary policy can do a lot, but monetary policy is not a panacea,” Bernanke said.

That is a close an admission that the “Fed is out of Bullets” that you are ever going to see.

Mike “Mish” Shedlock

http://globaleconomicanalysis.blogspot.com

Tags: Bullets, Commodities, Deflation, Emerging Market Economies, Financial Assets, Fiscal Stimulus, Global Economic Trends, Hyperinflation, inflation, Key Areas, Long Term Unemployment, Median Income, Michael Mish, Mish Shedlock, National Cris, Question Session, Shilling, Spite, Tangible Assets, Trillions
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“Can You Hear Me Now?” (Saut)

Wednesday, September 7th, 2011

“Can You Hear Me Now?”
September 6, 2011

by Jeffrey Saut, Chief Investment Strategist, Raymond James

“As I have emphasized on previous occasions, without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage.”

So said Chairman Ben Bernanke a fortnight ago. He went on to state:

“The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.”

On the surface I think the esteemed Chairman is sending a message to our elected leaders that the Federal Reserve has done all it can do to resuscitate the economy. The implication, it is now up to those leaders to put forth market-based programs to solve our nation’s woes. Surprisingly, President Obama stated he actually wanted “market-based” solutions for the housing debacle before he left on holiday. In past missives I have written about one such program in Puerto Rico. Said program has sent sales of new homes surging by some 80%, while sales of existing homes have risen 24%, over the past 10 months. The story was in The Wall Street Journal on 8/13/11. We should find out if the President will adopt such practical, market-based solutions this Thursday when he addresses a joint session of Congress. Still, I have to admit suing the nation’s banks, and supporting the NLRB’s decision to send jobs to Mexico rather than South Carolina, are NOT practical market-based solutions. Accordingly, this Thursday’s address becomes increasingly important for the economy, as well equity prices.

However, if the stock market’s action is any indication, it is going to be more of the same political finger-pointing and blame game shenanigans inside the D.C. Beltway since the D-J Industrial Average (INDU/11240.26) has lost ground in five out of the past six weeks. The result has left the Doleful Dow down 11.8% from its 7/22/11 intraday high into last Friday’s close. The quid pro quo is that the senior index is up ~6% from its “selling climax lows” of 8/9/11. The resulting four-week range-bound chart formation continues to look eerily similar to the bottoming sequences of October 1978/1979 so often referenced in these reports (see chart on page 3). Studying those bottoming patterns shows at least three retests of the selling climax “lows,” and in both cases, those “lows” were actually marginally broken in the retests. Therefore, unless the “lows” of 8/9/11 are decisively violated, I am sticking with the October 1978/1979 bottoming themes. That said, while I am hopeful the 8/8/11 Dow Theory “sell signal” will prove false, like the one of May 6, 2010 (flash crash), I have learned the hard way to be respectful of ANY Dow Theory signal! Hence, if I am to err, it is going to be by being too conservative, which is why most of the investment recommendations noted in these comments recently have been fundamentally sound, statistically undervalued, dividend-paying situations that our fundamental analysts think have already made their “lows,” even if the Dow takes more time to complete its bottoming process.

So how do investors determine what’s undervalued? Well, one can begin by eliminating overvalued asset classes like sovereign debt, the Swiss Franc, the Japanese Yen, Hong Kong real estate, in the near-term precious metals, etc. and diversify among the asset classes that reside on the left side of the bell-shaped curve (read: undervalued). For years I have opined that water is the most undervalued asset I know, but water has become increasingly difficult in which to invest because “smart money” has been acquiring water-centric companies for more than 30 years. Another way to determine an undervalued asset is to observe what smart people are buying and try to understand why. Recently, however, individual investing titans have not been buying much despite the fact that as of last week Lowry’s Buying Power Index rose above its Selling Pressure Index. Yet another way of seeking undervalued investments is to watch what smart companies are buying; recently smart companies are buying intellectual property (IP) … aka, knowledge. As the brainy folks at the GaveKal organization, whose mutual funds are worth your consideration, write:

“The reason ‘knowledge’ is such an undervalued quantity is that our accounting systems are completely obsolete in establishing where the value lies in a company. Indeed, as companies exit capital intensive manufacturing processes and concentrate more on design and distribution functions, they invest less money on capital expenditure and more on research and development. And, as companies go through this transformation, relying on GAAP-based accounting for information falls way short of painting an accurate picture. … So basically, we live in a world where R&D spending gets a terrible deal: an investment in a tangible asset (e.g., a machine tool) is counted as a productive asset for years while, in accounting terms, the in-house development of a distribution network (e.g., Dell) loses the entirety of its value within a year. How does this make sense? Obviously it does not, which is why the market may start to move towards new valuation metrics. Remember the old ‘price per eye-balls’ or ‘price per clicks’ of the old late 1990s TMT boom? Who is to say that these will not be replaced by a ‘price per patent’ on which Google, or IBM, may no longer appear so expensive?”

We love the sagacious GaveKal folks for such “out of the box” thoughts, which is what drives superior investment results. Using the R&D prism (research and development) as a guide, I screened Raymond James’ research universe for stocks of companies that spend more than 15% of their revenues on R&D and are rated Strong Buy. The list includes: Amyris (AMRS/$18.89); Ciena (CIEN/$13.78); LSI (LSI/$6.59); NVIDIA (NVDA/$12.92); SuccessFactors (SFSF/$20.83); Analog Devices (ADI/$32.01); Medidata Solutions (MDSO/$15.75); Semtech (SMTC/$21.07); and Adtran (ADTN/$28.89). While most of these names possess no dividend yield, if you “buy into” the knowledge theme, these companies’ metrics are worth consideration.

Tags: Based Solutions, Chief Investment Strategist, Debacle, Federal Reserve, Financial Assets, Financial Markets, Fortnight, Implication, jeffrey saut, Joint Session Of Congress, Missives, Nlrb, Obama, Raymond James, Sending A Message, Shenanigans, Stock Market, Wall Street Journal, Woes
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