Is Dodd-Frank the Death of Preferreds?

Wednesday, August 8th, 2012

by Mariela Jobson, iShares

Investors typically don’t like uncertainty, and regulatory uncertainty is no exception. So it’s not surprising that our sales team has been fielding a lot of questions from clients about the iShares S&P US Preferred Stock Index Fund (PFF). Clients are wondering what impact regulations put in place after the 2008 financial crisis might have on PFF specifically and preferred securities in general.

As the portfolio manager for our preferred stock ETFs, I spend a lot of time with our sales team and clients, helping them to understand the complexities of these products. Here, I’ve recapped the two main conversations I’ve been having with investors about the effects of these regulations on preferreds:

Q: Will regulatory changes deplete the supply of preferred stocks?

A: First, it’s important to understand what the regulatory changes are, and how they assumedly will affect preferreds. The preferred market is going through a significant transition driven by the Dodd-Frank (D-F) legislation. Under D-F, the Tier 1 capital treatment of hybrid and trust preferreds from bank holding companies will be phased out at 25% per year from 2013 until 2016. The fear is that the law will change the preferred market and could shrink the market size over the next few years. As of 8/4/12 approximately 22% of PFF’s holdings were trust preferreds that would be affected.

So what does this change really mean for preferred stocks? First, it helps to remember that the change does not actually forbid the issuance of trust preferred securities. Even after D-F goes into effect, banks may still choose to issue trust preferred shares, and they can simply opt to exclude them as part of their Tier 1 capital calculation. One reason they may choose to do this is because the interest is tax deductible.

In addition, this change is only aimed at hybrid and trust preferred securities — not the entire asset class. Companies are still issuing and should continue to issue perpetual preferred securities (see chart below). Preferreds are typically a more cost-efficient cost of capital than common equity, and as such they have been an attractive source of financing for companies.

Q: With the onset of the Dodd-Frank Act, will large volumes of preferreds be called?

A: In response to the new rules, banks can either call their preferred securities and replace them with another form of capital if needed, or they can let them continue to mature. The current low rate environment is increasing the possibility of securities of being called similar to any other security that has a call option, and in some cases, banks have the option of calling the securities even prior to normal five-year call protection.

But at this point, we believe it is highly unlikely that banks would call all of their trust preferred securities. Many of them have publicly stated their intention not to – for example, JP Morgan only plans to call half of their trust preferred issues. Instead, we believe banks will call their preferreds over time. While it is always difficult to predict what decisions management will make, we believe the chart below – which illustrates expected call dates for preferreds within PFF if prices remained at current levels and issuers were solely motivated to call based on trading prices – shows a more likely scenario.

The bottom line is that despite these regulatory changes, investors can still consider using preferred stock as part of a diversified income-oriented portfolio. While Dodd-Frank may change the treatment of trust preferred securities, we do not believe it will curtail the supply of preferreds, and as new preferreds are offered, they should continue to make their way in to PFF.

Sources: BlackRock, Bloomberg as of 6/30/12

Mariela Jobson, Vice President and portfolio manager in BlackRock’s iShares Index Equity Portfolio Management Group.

Ms. Jobson’s service with the firm dates back to 2006, including her years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. At BGI, she was a portfolio manager for the index equity team, focusing on iShares and taxable accounts. She was responsible for managing U.S. and global portfolios, including preferred equity. Prior to joining BGI, Ms. Jobson worked as an equity research analyst in the asset management group at ING Investments in New York and at Wedbush Morgan Securities in Los Angeles.

 
Diversification may not protect against market risk. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.

Tags: asset class, Bank Holding Companies, Complexities, Dodd, Financial Crisis, Ishares, Issuance, Jobson, Mariela, Pff, Portfolio Manager, Preferred Market, Preferred Shares, Preferred Stocks, Regulatory Changes, Regulatory Uncertainty, Stock Index Fund, Tier 1 Capital, Trust Preferred Securities, Trust Preferreds
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Stocks Are At Their Most Hated In 27 Years, Maybe It’s Time To Buy Some

Friday, August 3rd, 2012

by Mark Gongloff, Huffington Post

People hate stocks more than at any time in the past quarter century. That could mean it’s a decent time to buy them. Wall Street’s optimism about the stock market is the lowest it has been since at least 1985, according to a research note on Wednesday by Bank of America’s stock strategist Savita Subramanian. The bank measures market agita by tallying how much stock strategists are recommending their clients buy stocks.

In the Bank of America chart at the bottom of this post, you can plainly see that sentiment has absolutely plunged this year. Stock-market strategists are almost always bullish on the stock market, in part because if nobody is buying stocks, then there’s not much point in having stock-market strategists, is there? They’d have to go home and sit on their couches. But today, these same strategists are so spooked by the European debt crisis and the fiscal cliff and whatever else — Obama, or something — that they are recommending clients sell stocks, more than they did even during the financial crisis or the dot-com bubble bursting or after the 9/11 terrorist attacks.

Typically, you’re going to get some pretty good bargains in stocks when you’ve got so little competition for them, Subramanian writes. She would be one of the dwindling breed of bullish strategists: “Given the contrarian nature of this indicator, we are encouraged by Wall Street’s lack of optimism.” Speaking of contrarian indicators, on Tuesday Pimco founder Bill Gross, manager of the world’s biggest bond mutual fund, declared, “The cult of equity is dying.” He warned that carnival barkers promising you annual returns of 6 percent to 7 percent every year in stocks were lying to you, that you should get those people out of your lives immediately. This is the same Bill Gross that predicted interest rates would soar last year (spoiler: they didn’t) and then put his money where his mouth was, taking a big hit to his fund’s performance and his reputation in the process.

Read Complete Article …

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Tags: 9 11 Terrorist Attacks, Agita, Bank Of America, Barkers, Buying Stocks, Couches, Debt Crisis, Decent Time, Financial Crisis, Founder Bill, Good Bargains, Huffington Post, Market Strategists, Obama, Optimism, PIMCO, Quarter Century, Savita Subramanian, Stock Market, Strategist
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The Vanishing Treasury Yield

Thursday, August 2nd, 2012

by Neuberger Berman Research

July 2012 – Investment Strategy Group

Despite hitting record lows earlier in the year, the yields on U.S. Treasury bonds continue to tumble. The 10-year rate ended last month at 1.62%, materially below the long-time monthly record low of 1.95% set in January 1941. Yields for 10-year Treasury Inflation-Protected Securities (TIPS) have been persistently negative since the fourth quarter of 2011 and continue to trend lower, implying that investors are paying increasingly higher prices for the relative safety these investments are supposed to provide. In this edition of Strategic Spotlight, we consider why yields continue to decline and the implications for investors.

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A Mystery, But Is It?
Yields on long-term Treasuries have been declining since the 1980s, when they peaked along with inflation. Since the financial crisis of 2008, the continued reduction in Treasury yields has at times perplexed even the most astute investors. One prominent bond guru famously avoided them in 2010 to the detriment of his portfolio, and pundits who prematurely declared the imminent “death” of bonds couldn’t have been more wrong. In recent years, yields have moved even lower even though inflation has held fairly steady.

Over the longer term, nominal yields for long-term Treasuries generally follow inflation levels and growth expectations. When inflation rises, nominal yields typically rise to compensate for the erosion in purchasing power and, similarly, if growth expectations rise, the increase in attractive investment opportunities in the economy tends to result in rising real (after inflation) interest rates (see Figure 1). Oddly enough, inflation expectations (as implied by the difference between the nominal 10-year Treasury yield and TIPS yield) have held steady at around 2% and the decline in nominal rates has been driven mostly by declining real yields—all in the face of a positive, albeit slow, growth environment.

REAL YIELDS AND GDP TEND TO MOVE TOGETHER

Source: Factset.

So, what explains this somewhat unusual phenomenon? Since the onset of the financial crisis, bond purchases by the Federal Reserve have increased as it has implemented unconventional monetary policies, specifically quantitative easing and maturity extension programs (known to most as Operation Twist). Through these measures, which have tended to lower long-term interest rates, the Fed has sought to stimulate the economy and reduce unemployment at a time of low inflation. Another pressure on rates has come from foreign demand for Treasuries, which has generally been very strong, especially during periods of heightened market anxiety. In recent months, slowing purchases by emerging market central banks have been offset by flight-to-quality demand from European investors, who have also driven the nominal rates on certain German, Dutch and Danish bonds to negative levels. Meanwhile, U.S. investors have shown a lack of appetite for risk as flows to bond mutual funds have outpaced those into equities.

How Low Can Rates Go?

In theory, there is no bottom for bond yields. Declining inflation and continued risk aversion have historically caused nominal rates to fall. Real yields have been significantly negative in certain time periods, although admittedly when inflation was higher than today. Figure 2 shows that there have been two key periods since the 1920s in which real rates where very negative—during the Great Depression and World War II era, and in the 1970s when inflation spiked along with oil prices. Should global economies falter in the coming months, it’s possible that interest rates could move In theory, there is no bottom for bond yields. Real yields have even been significantly negative in certain time periods. lower (even turning negative on the short end), especially if the Fed engages in another round of asset purchases.

REAL RATES HAVE ‘GONE NEGATIVE’ IN THE PAST

Source: Factset.

Better Opportunities Elsewhere

It should be noted, however, that there are major risks in holding Treasuries with little to no yield. An end to the continued bull run in Treasuries would imply a reversal of some factors supporting it now, such as low inflation, deteriorating growth expectations and worsening prospects for the eurozone debt crisis. With global central banks launching unprecedented levels of monetary easing, potentially higher levels of inflation could hamstring the Fed’s ability to continue asset purchases – causing both inflation expectations and real yields to go higher. In addition, investors may realize that Treasuries might not be as “risk-free” as they assumed, particularly as the debate over the U.S. federal budget deficit intensifies later this year.

While interest rates could still move lower in the short term, we believe that the return profile for the asset class is skewed to the downside, especially given our base-case assumption of low but positive growth. We advise caution in holding excess levels of Treasuries and believe that other assets, such as high yield fixed income and high-quality U.S. equities, could be more attractive in this environment. Similar to buying tech stocks in the late 1990s with no sales and earnings, buying today’s Treasuries with minimal yields could prove hazardous for investors.

*Source: Factset

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Berman’s Investment Strategy Group (ISG), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of five investment professionals who consult regularly with portfolio managers and investment officers across the firm. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events may differ significantly from those presented. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

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The Longest Yard (Crescenzi)

Tuesday, July 31st, 2012

by Tony Crescenzi, PIMCO

• As the global slowdown progresses, we can expect central banks to deploy more policy tools – without limits – to stem the pace of deleveraging.
• In Europe, quantitative easing using ESM bonds could prove to be another bridge that buys politicians more time, but does not solve the root problem.
• We expect real economic growth in China to be muted. While some stabilization is possible later this year, it is hard to foresee a sustained recovery.

Saddled with debt and mindful of recalcitrant investors, nations in the developed world have lost their ability to solve their economic woes by adding more debt, leading them more than ever to rely upon central bank action. It is fantasy, however, to think that central banks can keep the game going for long. No central bank ever created anything tangible – you won’t find any stories about a Fed chairman discovering electricity or creating the light bulb. What central banks are best at creating is fiat currencies, and these are only as valuable as what they are backed by, whether it be gold, silver or the productive capability of a nation. Create or print too many of these and they will have no value to anyone, save for nerdy numismatists.

All that a central banker can do to add value to society is help foster financial conditions that facilitate the efficient use of capital, but even here central bankers can get it wrong and produce exactly the opposite result. The housing bubbles that preceded the onset of the recent financial crisis are proof; they were in fact at the heart of the crisis.

Central bankers today are striving valiantly to help smooth the deleveraging process by promoting conditions aimed at reflating the value of financial and real assets that would otherwise almost certainly fall in price. This isn’t easy to do because the world is striving just as valiantly to reduce its debt, taking actions that result in persistent downward pressure on asset values.

Central bank liquidity can’t turn the lights on in Italy

The orderly liquidation of debt requires economic growth. By boosting asset prices, central bankers have sought to promote economic growth and buy time for the fiscal authorities of the developed world to formulate and implement growth-oriented policies. Global investors have been patient, but the repeated failure of policymakers has their patience running thin.

No amount of central bank liquidity by the Federal Reserve, the European Central Bank (ECB) or any other central bank can possibly fix what ails the developed economies. The ECB, for example, can’t fix the fact that Italy ranks 109th out of 183 countries in providing electricity. Nor can it fix the fact that Spain ranks 133rd in the ease of opening a business. How about Greece?

Can the ECB reduce the size of government, improve tax collection or reduce the number of occupations Greece considers so hazardous that hairdressers, pastry chefs and clarinet players can retire in their early 50s? In the U.S., can the Fed reduce the outsized growth rate of the entitlement system? Central bankers can do nothing about these competitiveness issues, but the restoration of growth and competitiveness is essential to improving the ability to repay debt.

To use football vernacular – and here I mean American-style football – central bankers have taken the ball about as far down the gridiron as they can. To be sure, they can still do more; the Fed could implement another round of asset purchases, cap Treasury rates, cut the interest rate it pays banks on excess reserves, extend further its conditional promise to keep rates low, or perhaps consider some form of credit easing. If the Fed did any of these it would mark another courageous effort by The Decider, Fed Chairman Ben Bernanke, but it will never get the ball into the end zone.

To cross the goal line, to restore growth and competitiveness, the fiscal authority – not the monetary authority – must move the ball. This isn’t easy because the citizens of the world are voicing their objection to the changes necessary to do so. Try all you might, central banker, but at the 99th yard you will find the longest yard!

Unlimited global monetary policy – Ben Emons

In recent media debates, some commentators have pointed out that quantitative easing (QE) programs may have seen their effectiveness diminish. However, monetary policymakers in both developed and emerging markets continue to pursue easing measures. Different kinds of policies emerged, such as the Bank of England’s direct lending scheme, known as “credit easing.” The European Central Bank and the Danish central bank went another direction, cutting their deposit rates to zero or even negative. The lower zero bound is often viewed as a constraint, a limit in using conventional tools. The ECB and Danish central bank decisions to cut deposit rates showed how conventional policy is not necessarily limited. In fact, all central banks could cut deposit rates or rates on excess reserves in order to “force” out large cash balances held at the central bank to stimulate lending.

There could be “practical limits,” where QE or deposit rate cuts cause nominal and real interest rates to turn negative, affecting future income streams on savings accounts, pension funds and money market portfolios. The central banks’ growing market share in longer-term Treasury bonds and their low yields has added to the challenge. These practical limits are not necessarily seen as a barrier, evident by the recent string of actions by emerging and developed market central banks. Milton Friedman argued in his 1968 paper, “The Role of Monetary Policy,” how monetary policy should be based on limits. His view was that policy should not “peg” interest rates for a prolonged period of time or it may lead to structural inflation. Friedman pointed out that rapid monetary base growth was generally associated with high nominal rates, a sign in his view of easy policy, e.g., Brazil in the 1960s. Low interest rates were related to slow money growth, like the U.S. during the 1930s, which Friedman viewed as tighter monetary policy. Friedman saw the setting of rates connected to the amount of money growth the central bank would conduct to influence price expectations. When interest rates are pegged in an environment of seemingly stable inflation expectations, Friedman noted a risk of disconnect where the monetary base could become uncontrollable and lead to higher inflation.

In today’s environment of low interest rates, monetary base growth and stable inflation expectations, such disconnect is not seen as a risk, as debt deleveraging has been overwhelming. Since most major central banks see deflation as a bigger risk at this point, practical limits or those limits that Friedman spoke of do not seem to be tempering the willingness of global central banks to go further. In fact, as the global slowdown materializes further, we can expect more policy tools will be deployed to stem the pace of deleveraging, and without any limits.

The ECB can only provide a bridge – Andrew Bosomworth

The ECB can only provide a bridge for the European monetary union’s problems, not a solution. Its decision to cut all policy rates by 25 basis points (bps) earlier this month signaled the bank’s ongoing willingness to provide that bridge by creating time for political and fiscal agents to implement durable solutions. Judging by the gyrations in yields on southern European bonds since the ECB’s meeting, however, markets were evidently disappointed the ECB did not announce further unconventional measures to shore up Europe’s dysfunctional bond markets. Even after ECB president Mario Draghi’s “whatever it takes” statement on 26 July, we still have not seen yields on outer peripherals drop to sustainable levels.

Market expectations for unconventional measures derive from at least two sources. First, since the ECB crossed the Rubicon in 2010 by buying Greek government bonds, markets now believe the bank will do whatever it possibly can to prevent the Economic and Monetary Union (EMU) from breaking up; the costs of not doing so would be too great. Indeed, the ECB currently holds €211 billion in securities from previous forays into the bond market. Second, some market participants, policymakers and influential figures, like Italy’s prime minister and the head of the IMF, are lobbying the ECB to buy even more in order to drive southern European bond yields lower.

Such proposals are shortsighted and address the symptoms rather than cause of the EMU’s problem. Buying bonds without fixing the design faults in the EMU’s governance structure is a near-term fix whose beneficial effects, like painkillers, will soon wear off. Were the ECB to follow lobbyists’ calls and resume the Securities Market Program (under which it bought government debt in 2010 and 2011), it will not solve the governance structure problem. However, buying bonds to ward off deflation once conventional monetary policy has reached the zero lower bound is likely warranted.

The ECB usually refers to Article 123 of the Treaty on the Functioning of the European Union, which prohibits it from financing governments’ budget deficits. The ECB’s reasoning is not entirely clear, given the same European law (part of the Lisbon Treaty) governs both the ECB and Bank of England (BoE) yet the latter buys government bonds as part of its quantitative easing. We think the explanation lies in differences between the ECB and BoE’s perceived risk of deflation, the degree of trust between the monetary and fiscal authorities and the fragmentation of the EMU government bond market relative to the singularity of the United Kingdom’s government bond market owing to its centralized fiscal policy.

As credit to the EMU’s private sector declines – the natural consequence of deleveraging after a credit boom – the risk of deflation in Europe is likely to rise. We think deflationary forces will intensify, making a further reduction in the main refinancing rate to 0.5% likely and perhaps necessitating quantitative easing. Which government bonds might the ECB buy in those circumstances?

The ECB’s capital key (which reflects each member country’s proportional contribution to total capital) suggests about one-quarter and the largest allocation of purchases would be in German Bunds. But capital flight to Bunds has already driven their yields abnormally low, suggesting quantitative easing would achieve little. And the ECB would send mixed signals if it concentrated purchases in Italian and Spanish government bonds. Would the ECB do this to offset eurozone-wide deflation risks or to compensate for member states’ reluctance to centralize fiscal policy?

Purchasing the bonds of the European Stability Mechanism (ESM) could circumvent this dilemma. Unlike the ECB, the ESM is designed to provide member states with financial assistance subject to conditionality. While it lacks the same degree of democratic legitimacy as Europe’s parliaments, at least the ESM is a child born of the democracy. However, like its predecessor, the European Financial Stability Facility (EFSF), the ESM’s main weakness is that it is unfunded. We think the ESM will find it equally difficult to raise sufficient funds from the capital market at low enough yields to perform the job it is designed for. And even if it finds buyers, the ESM will likely crowd out demand for other government bonds from Italy, Belgium, France and Austria, thereby raising their borrowing costs. Quantitative easing using ESM bonds could thus prove to be yet another bridge that buys politicians more time but does not solve the root problem. When it comes to Europe there is only one thing we can say with certainty: This crisis is not yet over.

People’s Bank of China moves to counter weakening growth – Isaac Meng

Policymakers in China face different limitations today than those in the U.S. and Europe, but they too have had to respond to the strain in the global economy, especially as slowing global demand exerts downward pressure on China’s export-investment-driven growth model. In a surprise move, the People’s Bank of China (PBOC) cut its benchmark rate by 25 bps twice within a month. The PBOC also deregulated deposit rates, allowing a 10% float above the benchmark, which largely offsets the cut’s effect on deposit and lending rates.

Though one to two months earlier than the market expected, the latest rate cut is not surprising in light of weakening growth and a slowing inflation outlook. Second quarter growth at 7.6% is barely above target, and inflation risk is easing fast with CPI likely stay below 2.5% over the next two to three quarters versus the PBOC’s target of 4%. Even though rates were cut by 50 bps, China’s real rates are still rising because CPI is heading down toward 2%. If the PBOC targets positive real deposit rates as a floor in the medium term, then there is still room to cut another 25 bps to 50 bps. The 8% to 9% average lending rates remain too high for borrowers struggling to deleverage amid a deepening industrial slowdown.

With the Chinese yuan’s outlook and foreign flows turning to a more balanced stance, the PBOC needs to further unwind past foreign exchange sterilizations, most likely by cutting the Reserve Requirement Ratio by 50 bps per quarter to maintain money market rates in the range of 2.5%–3.0%.

Despite room for monetary easing, the PBOC still seems behind the curve in easing financial conditions. Chinese banks remain tight in credit and slow to cut their lending rates. Domestic Chinese borrowers have excess capacity to deleverage, and the yuan’s nominal effective exchange rate is rising amid a rigid foreign exchange rate regime. Thus, we expect real economic growth in China to be muted and slow, and while some stabilization is possible in late 2012, it is hard to see a sustained recovery.

Past performance is not a guarantee or a reliable indicator of future results. This material contains the opinions of the authors 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 publication may be reproduced in any form, or referred to in any other publication, without express written permission.

Copyright © 2012, PIMCO.

Tags: Asset Values, Central Banks, Downward Pressure, Economic Growth In China, Economic Woes, Efficient Use, Fed Chairman, Fiat Currencies, Financial Crisis, Global Slowdown, Gold Silver, Light Bulb, Longest Yard, Numismatists, PIMCO, Policy Tools, Productive Capability, Real Assets, Root Problem, Tony Crescenzi
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And Now Back To Reality And The Impossible Earnings Season Stepfunction

Sunday, July 15th, 2012

Last week the S&P erased 6 days of consecutive losses in 30 minutes of trading on the back of news that JPMorgan lost at least 25% of its average annual Net Income in one epic trade, and stands to make far fewer profits in the future, even as the regulators are about to fire a whole lot of traders for mismarking hundreds of billions in CDS. This was somehow considered “good news.” This being the “new normal” market, where nothing makes sense, and where EUR repatriation as a result of wholesale asset sales by European banks drives stocks higher, we were not too surprised. Sadly, even in the new normal, things eventually have to get back to normal. And that normal will come as corporate earnings are disclosed over not so much over the next 3 weeks, when 77% of the companies in the S&P report Q2 results, but in the 3rd quarter. Why the third quarter? Simple: as Goldman’s David Kostin explains, “consensus now expects year/year EPS growth to accelerate from 0% in 2Q, to 3% in 3Q to 17% in 4Q.” Sorry, but this is not going to happen, and as more and more companies preannounce on the back of the global slowdown which many has seeing US GDP down to 1.3% in Q2, and sliding further in Q3 absent some massive QE program out of the Fed, it is virtually guaranteed that the unchanged Earnings precedent that Q2 will set (and there is a very high probability that Q2 2012 will mark the first YoY drop in earnings since the unwind Great Financial Crisis) will continue into Q3 and likely Q4. Because, sadly there simply is no catalyst that will drive revenues higher, even as margin contraction was already set in.

All of this also means that the only possible driver of S&P growth in Q3 (of which we are already 2 weeks deep into) and Q4 will be multiple expansion. This, however too, will be a disappointment. Again from Kostin:

We believe P/E multiple expansion is unlikely in 2H. Headwinds include the fast-approaching Presidential election, associated policy uncertainty, and the looming “fiscal cliff” that everyone outside the beltway decries but no one in Washington, DC seems willing to seriously address.

Not to mention the debt ceiling which is still on track from making US landfall sometime in the next 3 months.

So while short covering rallies are fast and furious, corporations -that traditional deus ex to justify US “decoupling” – now have only one fate before them: disappointment.

Which leaves the Fed. Sadly, not even the extension of Twist can do anything about the biggest concern that banks are currently facing, namely the accelerated decline in reserves, as a result of the prepayment of Maiden Lane obligations and the gradual drop in FX swaps (at least until the next time Europe needs a Fed-based bail out that is). As can be seen in the chart below, Adjusted Reserves have tumbled to level not seen since December, and then May of 2011, both times when the market was about to turn over if not for global coordinated central bank intervention.

Full note from Goldman:

Our 2012 investment thesis for the US equity market has three pillars: a stagnating economy, static P/E multiple, and minimal earnings growth.

First, weak macro data and three proprietary Goldman Sachs indictors support our view of a lackluster economy. The Goldman Sachs Current Activity Indicator (CAI) shows the US economy growing at an annualized pace of just 1.3%. The three-month moving average of our Earnings Revision Leading Indicator (ERLI) diffusion index, a measure of 29 separate micro-driven industry data points, remains below trend at 41, consistent with a softening of our Global Leading Indicator (GLI). On the macro front, the June ISM report slipped to 49.7, the first sub-50 print in three years.

Second, we believe P/E multiple expansion is unlikely in 2H. Headwinds include the fast-approaching Presidential election, associated policy uncertainty, and the looming “fiscal cliff” that everyone outside the beltway decries but no one in Washington, DC seems willing to seriously address.

The third leg of our three part framework will come into clarity during the next several weeks as firms report 2Q results and offer guidance on business activity for the second-half of 2012. 80% of S&P 500 market cap will report between July 16th and August 3rd. Firms to watch next week include: BAC, C, GE, IBM, JNJ, KO, MSFT, PM, SLB, and VZ.

We expect a modest quarterly earnings miss. A shortfall in sales rather than margins will be the primary culprit. Firms will struggle to meet revenue forecasts given weak global demand and a strong US Dollar. Consensus margin expectations are already flat or negative in most sectors.

Bottom-up consensus currently forecasts flat year/year EPS growth, driven by a 4% increase in sales and a 40 bp fall in margins to 8.9%.

Five sectors are expected to post negative earnings growth in 2Q 2012 compared with 2Q 2011: Energy, Materials, Utilities, Consumer Discretionary and Consumer Staples. Analysts forecast Materials and Energy will both post year/year EPS declines of 12% reflecting the sharp fall in commodity prices during 2Q, with Brent plunging by 16% and copper dropping by 10%. In contrast, Industrials and Information Technology will report EPS growth of 7% and 11%, respectively. Apple (AAPL) will again be a standout performer with year/year sales and EPS growth of 32% and stable margins of 25.6%. Including AAPL, the Tech sector is forecast to deliver sales and EPS growth of 9% and 11%, respectively. Without AAPL, the sector will post revenue and EPS growth of 6% and 7%, respectively.

2Q results will affect the market’s outlook for earnings in 2012 and 2013. Consensus now expects year/year EPS growth to accelerate from 0% in 2Q, to 3% in 3Q to 17% in 4Q. Consensus forecasts full-year EPS growth will double from 7% in 2012 to 14% in 2013. In contrast, we do not forecast a steep 4Q 2012 inflection and anticipate EPS growth climbing from 3% in 2012 to 7% in 2013.

Our full-year 2012 and 2013 S&P 500 EPS forecasts remain $100 and $106. Current bottom-up consensus equals $103 and $117. Consensus 2012 estimate has dropped from $107 in January and from $114 in August 2011.

Earnings season focus points: (1) domestic demand; (2) international weakness; (3) margins; and (4) losses from JP Morgan’s CIO unit.

Our ERLI Diffusion Index suggests US micro data improved in June but the three-month moving average remains below trend at 41. In May, our diffusion index of micro driven, industry-level data points fell to 29, the lowest reading since April 2009 (a reading of 50 implies “trend” growth). However, data rebounded in June producing a slightly above trend reading of 53, with 23 of 29 industry variables increasing at a trend or better pace. Examples include hotel occupancy, rail car loadings, and NY/NJ port activity. If this trend persists, it implies that the micro data points which inform equity analysts’ earnings projections may not be as poor on a near-term basis as an otherwise gloomy macro picture suggests. In contrast, our macro driven Global Leading Indicator of industrial production has been contracting at an accelerating rate for the last three months, which our research has shown augurs poorly for S&P 500 returns.

Margins will once again be source of scrutiny. Margins have stabilized at 8.9% for more than a year after having surged by 300 bp from a cyclical low of 5.9% in 2009. Differing margin forecasts explain 80% of the gap between our top-down EPS estimate and bottom-up consensus for 2012. Consensus expects margins to remain flat during the first three quarters of 2012 before rising sharply starting in 4Q and expanding to 10% by year end 2013. In contrast, we forecast margins will hover around 8.9% for the next two years.

JP Morgan CIO trading losses. This morning JPM reported 2Q EPS of $1.21, 59% above consensus expectations of $0.76. Of course, analysts had cut estimates by 38% since May after the bank disclosed large trading losses in its chief investment office. The JPM CIO losses of $4.4bn reduce 2Q 2012 EPS for the S&P 500 by $0.49. For the Financials sector, year/year EPS growth in 2Q is anticipated to be 8% including JPM and 12% without.

Tags: 2q, 3q, 3rd Quarter, Asset Sales, Consecutive Losses, Contraction, Corporate Earnings, Earnings Season, European Banks, Financial Crisis, Global Slowdown, Goldman, Kostin, Net Income, Nothing Makes Sense, Q3, Q4, Qe, Repatriation, S David
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Does Central-Bank Gold-Buying Signal The Top Is Near?

Saturday, July 14th, 2012

Submitted by Jeff Clark of Casey Research

Does Central-Bank Gold-Buying Signal The Top Is Near?

Doug Casey told me in January, “The only thing that scares me is that central banks are buying a lot of gold; they’re historically contrary indicators.” When it comes to buying gold, central banks have such a poor timing record that they’re frequently joked about as a contrary indicator.

Recently, they have been buying, quite literally, tonnes of it. Consider the following:

• Net central-bank purchases in 2011 exceeded 455 tonnes. This was only the second increase since 1988 (the first in 2010) and the largest since 1964.
• Turkey has added over 123 tonnes since last October, buying 29.7 tonnes in April alone.
• Mexico has purchased over 100 tonnes since February 2011.
• The Philippines added 32 tonnes in March, its second-largest monthly purchase ever. Largely under the radar is the fact that it’s buying some of its local production.
• Russia continues buying, adding 15.5 tonnes in May. Its total reserves now stand at 911.3 tonnes, the highest level since 1993.
• Thailand has raised its holdings by more than 80% since mid-2010.
• South Korea has bought 40 tonnes since May 2009, an increase of 180%.
• The World Gold Council (WGC) reported that central-bank purchases totaled 80.8 tonnes in Q1 2012, about 7% of global demand.
• Over the past 12 months, net purchases have averaged almost 20% of total annual supply.

Here’s the picture of what has transpired since the financial crisis hit in late 2008.

(Click on image to enlarge)

Central banks have added a net of 1,290 tonnes since the fourth quarter of 2008. This total excludes China and other nations that don’t regularly report their activity, as well as countries that have been surreptitiously buying their own production.

That’s a lot of gold buying. One has to wonder whether so much buying may in fact signal a top for gold. After all, a number of prominent analysts have claimed for some time that gold is in a bubble and that it’s all downhill from here.

Not so fast. Like many mainstream reports, looking at the short-term picture usually leads to erroneous conclusions. Let’s put central-bank purchases into historical perspective.

(Click on image to enlarge)

In spite of the recent activity, world central-bank holdings are far below what they were in 1980. Clearly, a few years of net buying does not a bubble make.

The difference is greater than you might realize. Consider that since 1980…

• The global population has grown 55%
• Worldwide gold supply has grown 120%
• Foreign-exchange holdings have increased 650% since 1995, and now total $10.4 trillion.

It seems rather obvious that a lot more “catch-up” buying is needed before we start talking about a top for gold on this basis.

Meanwhile, we think the trend of central-bank gold buying will continue. It’s not hard to see why: central bankers around the world know what it must ultimately mean to run the printing presses the way the US has since 2008, even if price inflation is not immediately obvious. It’s no surprise that they want to hedge their bets, moving more reserves into something with actual value… something that can’t be debased with a few keystrokes. The US dollar has been the world’s reserve currency since WWII, and that’s beginning to change – the movement into gold is just one facet of that change.

The entire world may indeed be beginning to understand that it’s operating on a fiat currency system backed by nothing. At the same time, the sovereign debt crisis in the Eurozone is intensifying, and some countries have succeeded in inflating their currencies faster than the Fed has inflated the USD. It doesn’t take Nostradamus to read this writing on the wall… and while the world’s central bankers can lie to the public, they themselves know how bad things are.

In fact, the WGC is so confident that central banks will continue to buy gold that it’s changed its reporting structure: it’s added “official sector purchases” as a new element of gold demand, while eliminating “official sector sales” as a negative supply factor.

Of course, gold will someday top, and Doug Casey believes a bubble in gold and related equities is highly likely at some point, courtesy of the trillions more currency units governments will create in a desperate (and ultimately unsuccessful) attempt to stave off the Greater Depression.

But we’re nowhere near that point. There’s a long way to go before we start legitimately using the “B word” (bubble) or “S word” (sell).

In the meantime, I suggest using the “B word” (buy) or “A word” (accumulate) to make your decisions about gold.

Tags: 911, Bank Gold, Bank Purchases, Buying A Lot, Buying Gold, Central Banks, Doug Casey, Financial Crisis, Fourth Quarter, Global Demand, Image Banks, Nbsp, Philippines, Q1, Radar, Russia, South Korea, Wgc, World Gold Council
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Barclay’s: The Keystone Cops of LIBOR Manipulation

Wednesday, July 11th, 2012

Was Barclay’s Incompetent When Dealing with FSA?

Here is the FSA’s report from June 27^th.

I will admit when I first looked at it, it seemed pretty damning. The dialogue was awful and the charts looked bad. But as I look through the details I have to say, Barclay’s seems incompetent in its own defense. I owe some of this report to Simone Foxman who looked at one of the trades in some detail, but here is a closer look at some of the accusations in the report and what impact it had.

My assessment so far is that Barclay’s was incompetent at moving LIBOR and was incompetent at defending itself against the FSA. I expect that the financial crisis period will be a lot more interesting as there is some real divergence and the potential influence on LIBOR is big and real.

Lost Reputation with Little Accomplished is what analysis of FSA examples demonstrates

1. Barclays’ Derivative Traders would request high or low submissions regularly in emails, for example on 7 February 2006, Trader C (a US dollar Derivatives Trader) requested a “High 1m and high 3m if poss please. Have v. large 3m coming up for the next 10 days or so”. Trader C also expressed his preference that Barclays would be “kicked out” of the average calculation. Trader C’s aim was therefore that Barclays’ submissions would be high enough to be excluded from the final average calculation, which could have affected the final benchmark rate.

So this looks bad. On Feb 6^th, 2006 a trader asks for a high 3 mth Libor setting over the next 10 days. Here are the submissions by each bank. Barclay’s is in a nice Barclay’s blue.

So you can see that they went from being at the “tight” end on February 6^th, to the high end. Since the memo wasn’t clear on 10 business days or calendar days, or exact start, so I have gone out to the 21^st which would be 10 business days starting on the 8^th.

It is clear that at some times Barclay’s was not actually the highest and was even at the low end a couple of times. Assuming they were trying to get LIBOR higher, what was their impact?

Let’s assume Barclay’s was going to be the lowest setting otherwise. That is the worst case, that they “lied” and had they not “lied” they would have tied for lowest. That is the most possible damage they could have caused LIBOR.

On 9 of the 12 days I looked at, that would have caused NO change in the LIBOR for the day. On one day it would have created a 0.0006% shift in LIBOR as it would only have been 4.7400% rather than 4.7406%. Even with the law of large numbers, that is small, and had Barclay’s just submitted at the average than tightest, no impact.

The second last day had an even smaller move, a maximum potential LIBOR manipulation of 0.0003%. On the final day, which I’m not even sure was in the 10 day window, they could have manipulated it by as much as 0.0013%. One basis point is 0.01% so it is an 1/8^th of a bp. I’m not condoning their behavior, but I am surprised they capitulated on such small moves – and had they just submitted the average rather than what they submitted, only the last day would have been impacted, and that by 1/16^th of a bp.

59. On Friday, 10 March 2006, two US dollar Derivatives Traders made email requests for a low three month US dollar LIBOR submission for the coming Monday:

i. Trader C stated “We have an unbelievably large set on Monday (the IMM). We need a really low 3m fix, it could potentially cost a fortune. Would really appreciate any help“;

ii. Trader B explained “I really need a very very low 3m fixing on Monday – preferably we get kicked out. We have about 80 yards [billion] fixing for the desk and each 0.1 [one basis point] lower in the fix is a huge help for us. So 4.90 or lower would be fantastic“. Trader B also indicated his preference that Barclays would be kicked out of the average calculation; and

iii. On Monday, 13 March 2006, the following email exchange took place:

Okay, this looks promising, and is actually the one Business Insider took a look at.

The person did as they were asked. They put in 4.90 as the rate and it is pretty clear 4.91 was the “right” rate. But LIBOR was set at 4.91 so the “manipulation” accomplished nothing. LIBOR was not affected by the action – just Barclay’s reputation. On the 14^th they remained low, and had they actually submitted at the high end, they could have influenced LIBOR by as much as 0.0006%.

1. In response to a request from Trader C for a high one month and low three month US dollar LIBOR submission on 16 March 2006, a Submitter responded: “For you…anything. I am going to go 78 and 92.5. It is difficult to go lower than that in threes, looking at where cash is trading. In fact, if you did not want a low one I would have gone 93 at least“.

So here again, the fix came in and we see Barclay’s at 4.925. Yes, 4.93 was the “right” level, but the submission didn’t affect the outcome. Had Barclay’s submitted at 4.95 (which incidentally seems high and makes you wonder what BofA was trying to accomplish) the LIBOR setting would still have been 4.93% so once again only the reputation was affected and NOT LIBOR.

1. Trader C requested low one month and three month US dollar LIBOR submissions at 10:52 am on 7 April 2006 (shortly before the submissions were due to be made); “If it’s not too late low 1m and 3m would be nice, but please feel free to say “no”… Coffees will be coming your way either way, just to say thank you for your help in the past few weeks“. A Submitter responded “Done…for you big boy“.

How could anything that ends with “big boy” end well.

This one appears to have done marginally better, though it is hard to tell. The day before and after the “request” Barclay’s was already at the low end of the range. Maybe they were axed (or had their own agenda) or just thought LIBOR was there. In any case, had they submitted 5.04% (the high end of the range) they would have accomplished making LIBOR 0.0006% on that day. That would be a “stunning” success by their standards of manipulation but the fact that they seemed to be low anyways leaves some doubt as to whether they were low for other reasons, and that is a maximum they could have shifted LIBOR.

1. On 6 August 2007, a Submitter even offered to submit a US dollar rate higher than that requested:

So the 5.37 was “unnecessary” it was just overkill, but 5.36 doesn’t seem unreasonable. Had Barclay’s submitted 5.35 or less, LIBOR would have shifted by 0.0013% as the full basis point would have counted. That is potentially meaningful, but again, 5.36 certainly doesn’t seem out of line (unless a consortium was set up to do 5.36). I’m almost more curious why UBS was in at 5.325, which seems like more of an outlier than 5.36. Given the trader’s willingness to put in 5.37 I suspect that 5.36 is where he (or she) thought the rate should be – consistent with many other dealers.

1. For example, on 15 February 2006, Trader C made a request in relation to Barclays’ three month US dollar LIBOR submission: “Please go for [unchanged], or lower if poss“. A Submitter sent a positive response to this request. The following graph illustrates the changes in Barclays’ submissions as compared to the final three month benchmark rate:

In this one, the FSA pulls up some fancy charts how on the 13^th Barclay’s was at high end, on 15 the low end, and back to high end.

But the keystone cops of LIBOR manipulation are back at it. Yes, they were the highest quote on Feb 13^th and the lowest by Feb 15^th, but they didn’t impact LIBOR. Had they submitted 4.76 on the 15^th rather than 4.74, LIBOR would still have come out at 4.75. What a waste. On any of the days in question, had Barclay’s matched the highest rate the LIBOR setting wouldn’t have been affected.

I’m not sure whether shareholders should be angrier about the manipulation or about how bad they were at manipulating it. I think the focus needs to shift to the “crisis” period where

Tags: 1m, 3m, Accusations, Barclay, Barclays, Benchmark Rate, Business Days, Calendar Days, Closer Look, Crisis Period, Divergence, Dollar Derivatives, Financial Crisis, Foxman, Fsa, June 27, Keystone Cops, Libor, Mth, Tight End
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China: A Mixed Bag Turns Very Ugly

Monday, June 11th, 2012

by Wolf Richter, www.testosteronepit.com

2010 was a magical year in China. Among the world records: 18 million new vehicles sold. Due to unprecedented stimulus, sales had skyrocketed 33% that year and 54% in 2009—mind-boggling growth rates which catapulted China to the number one new-vehicle market in the world, far ahead of the US which had never sold that many units in a single year, not even during the halcyon days before the financial crisis. In terms of passenger vehicles (excluding buses and trucks), 14.5 million units were sold in China that year, compared to 12 million in the US.

Exuberone, a hormone that governs industry thinking from time to time, had taken over. In January 2011 at the Automotive News World Congress in Detroit, Dazong Wang, president of Beijing Automotive, threw a number into a room: 40 million. That’s how many new vehicles would be sold in China by 2020, he said, roughly 30 million passenger vehicles and 10 million commercial vehicles.

People sucked in air. The number was beyond easy comprehension. But soon, it became a guidepost. Investment in manufacturing plants surged as foreign and Chinese automakers scrambled to get their share of that 40 million—and foreign automakers had to pay a steep price in terms of technology transfer, an inescapable feature of investing in China’s auto sector. For how automakers dealt with that last year, read…. China Puts the Screws to BMW.

Alas, in 2011, sales inched up only 2.5% to 18.5 million vehicles—though foreign brands still did well. 2012 may turn out to be even tougher. And now, the problem is production.

Automakers have ramped up at a torrid pace. In May, wholesale deliveries to distributors jumped 23% from prior year to 1.28 million units, higher than analysts had expected. Toyota and Honda, recovering from last year’s supply problems following the earthquake and tsunami, nearly doubled their sales to distributors. Ford pushed 23% more units into the pipeline, GM 21%. BMW announced on Monday that it had achieved record global sales in May, despite very tough conditions in some teetering Eurozone countries. Reason: China, where sales jumped 32%. And those are the sales that make their way into automakers’ financial statements.

Stunning as they may be, they’re wholesales to distributors, not to consumers. At dealerships, however, the scenario is turning from less rosy to gruesome—final sales in May were not robust enough to digest the flood of production. Inventories on lots across the country ballooned from 45 days’ supply at the end of April to 60 days’ supply by the end of May—a dizzying 33% increase in just 30 days.

And the ballyhooed 23% increase in wholesale deliveries that got analysts drooling all over themselves? Unsold. Added to inventory. Channel stuffing. Testimony of rampant overproduction. And it has turned into an inventory glut. Yet, not a week goes by without a major automaker announcing starry-eyed plans of investing in new plants or expanding existing ones. As these plants come on line, their production washes over the market, adding to a market that is already saturated.

The auto industry—not just manufacturing vehicles and components but also building plants and the infrastructure to supply them—has been a driver of economic growth. And it’s still playing that part, just like building ghost cities is contributing to growth. But for how much longer? [Bubbles can last far longer than reasonable observers might expect. For one of those, a bit off the beaten path, read.... Now They Have another Speculative Bubble in China: Art.]

Perhaps the People’s Bank of China saw a thing or two beyond publicly known data when it announced a 25-basis point rate cut last week, the first since 2008, because so far, economic data has been a mixed bag of decent numbers. Exports were strong, up 15.3% in May over prior year. Retail sales rose 13.8%, lower than expected, but still. And industrial production grew 9.6%, a healthy clip—but ominously, it included hundreds of thousands of new vehicles that have been overproduced and are now piling up on lots around the country.

And so there are divergent scenarios: automakers under the influence of euphorone are building plants, adding capacity, pumping out units, and stuffing channels with all their might—while dealers, who are forced to take their quotas, are unable to sell about a third of the new production. For them, it will turn into a nightmare as they drown in inventory, the costs of carrying it, and the losses inherent in selling vehicles that have been sitting on the lot too long.

Their only hope is that the government or automakers will introduce incentives to lure people into dealerships. Some are already underway, such as a subsidy for vehicles with engines of less than 1.6 liters. But vehicle sales to consumers would have to skyrocket to meet the phenomenal and still growing production. Unlikely. Next step will be production cuts and layoffs. When that proves insufficient, expansion plans will be trimmed. Another sharp hissing sound from the China bubble.

Populist and nationalist movements sweeping the world are another threat to China, globalization’s biggest winner, and are a visceral rejection of China as the world’s biggest exporter. For a fiasco in the making, read…. Death Of Globalization Will Shatter China.

Copyright © www.testosteronepit.com

Tags: 30 Million, Auto Sales, Auto Sector, Automotive News, Chinese Automakers, Commercial Vehicles, Dazong Wang, Financial Crisis, Guidepost, Halcyon Days, Investing In China, manufacturing plants, Million Vehicles, New Vehicles, Palas, Passenger Vehicles, Ppeople, Span Id, Steep Price, Stimulus, Technology Transfer, Torrid Pace, Wholesale Deliveries, World Congress
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Dividend vs. Treasury Yields

Friday, June 8th, 2012

by Econompic Data

The dividend yield of the S&P 500 is above that of the ten year Treasury for the first time since the financial crisis. Before that we have to go all the way back to the 1950′s to find a time when this was the case.

The kicker… stock dividends have only made up about 45% of total S&P composite stock returns over the past 100 years, while Treasury bond coupon payments have made up north of 96% of Treasury bonds returns over that same period (see below). What this means for an investor is unless you think dividends will be cut and/or capital appreciation will be negative (i.e. corporate America will shrink in terms of nominal value), stocks are poised to outperform.

My take… stocks appear to be very cheap relative to bonds for investors with a long-term investment horizon, while near term investors need to be careful as we seem to be in a world that is likely to have binary outcomes (i.e. either a boom or an absolute collapse).

The remaining 55% of S&P stock returns have been in the form of capital appreciation, which has become increasingly important since the 1950′s (see above), as corporations reinvested earnings back into their businesses / bought back shares (vs paying out dividends), while investors evaluated the relative merits of equities relative to bonds (see the much tighter relationship to bonds, which ratcheted up P/E multiples).

Source: Irrational Exuberance

Tags: Capital Appreciation, Composite Stock, Corporate America, Coupon Payments, Dividend Yield, Financial Crisis, Investment Horizon, Irrational Exuberance, Kicker, Long Term Investment, Nominal Value, Relative Merits, Stock Dividends, Stock Returns, Term Investors, Treasury Bond, Treasury Bonds, Treasury Yields, Value Stocks, What This Means
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Benchmarking Tail Risk Management (PIMCO)

Friday, May 11th, 2012

by Vineer Bhansali, PIMCO

- While tail risk hedging is a new and critically important area of modern portfolio management practice, the relative newness of the area means standard frameworks for benchmarking such portfolios have not developed.
- In fact, we’ve found that once the framework for proper tail hedge construction is defined based on key guidelines (including exposures, attachment, cost, and basis risk), the task of creating a proper index becomes relatively straightforward.
- To compensate for insufficient real-time performance measurement, we believe that tail hedges need to be evaluated on the basis of scenario analysis.

​This article was originally published in the May/June 2012 edition of the Journal of Indexes, www.indexuniverse.com.
No topic has gathered more interest since the financial crisis of 2008 than the topic broadly called “tail risk management.” The term and its practice have been open to much interpretation; this phenomenon of initial confusion is not particularly different from the growing pains experienced by many other market sectors. Mutual funds, hedge funds, even ETFs at the very beginning of their life cycle operated without much uniformity or proper reference indexes. As the market for tail-hedging solutions evolves, it will become critical that the end-user at least have a framework within which to evaluate the potential and realized costs and benefits of particular practices. We believe that to add value over time, tail risk management has to be active rather than purely passive; thus, a proper benchmarking framework is not simply a luxury but a necessity. The purpose of this article is to start to lay out exactly such a framework, which we have evolved over almost a decade of implementation.

Defining a hedge mandate

As discussed in much detail elsewhere¹,  a small set of inputs or guidelines is the natural starting point for defining a tail hedge mandate. In our view, the minimal set consists of the following:

1. Exposures
2. Attachment
3. Cost
4. Basis risk

The first step is quantifying exposures. Our analysis of the long-term history of many different types of assets shows that a small set of risk factors drives the returns of these assets. The two major secular exposures are the equity beta and the interest rate or duration exposure. In addition, over cyclical periods, factors like liquidity, currency exposure, momentum and monetary policy also play important and significant roles. In our practice, we first try to quantify the exposures of each underlying portfolio to these key factors, both for normal and stressed periods. Interestingly, both our research and the work of others show that even very diversified portfolios exhibit similar exposures to the key risk factors, with equity beta as the dominant risk exposure.

The second step is to define what we have called the “attachment” level (taking a term from the reinsurance industry). The closer the attachment level is to the current value of the portfolio, the higher one should expect the cost of the tail risk program. Generally, we believe that broadly diversified portfolios should have an attachment level anywhere from 10% to 15% below the current portfolio value.

This brings us to the important question of cost. We generally do not believe that tail hedging can be done efficiently in a perfectly costless manner over short-term horizons. Yes, there are structures (especially exotics) that purport to reduce the cost, or in many cases even eliminate the cost, but usually they consist of embedded sales of options that one would frequently rather not sell. Instead of this hidden discount, we believe that an explicit cost target is essential both to thinking of tail risk management as an asset allocation decision and as a commitment that one can continue to support in periods where fat tail events do not occur. Because of the natural difficulty in forecasting the time and form of the next tail event, we believe that tail hedging is an “always on” part of any risky investment portfolio. Our empirical and theoretical research validates the belief that over longer periods (three to five years), tail hedging is generally self-financing when one accounts for both the ability to tilt portfolios more aggressively and following a systematic approach to rebalancing in the presence of such hedges.

Finally, one has some freedom to replace what might be expensive direct hedges with relatively cheaper indirect hedges, taking advantage of the tendency for correlations to increase, especially when extreme events happen. This cheapening comes with a trade-off, that the indirect hedges will not perform as well as the direct hedges conditional on the extreme event happening. To quantify this basis risk, we specify a level of confidence within which the likely outcomes of the actual portfolio are likely to fall relative to the direct hedge through simulations. The performance of a particular hedge program should be quantified in terms of the trade-off between basis risk and cost savings relative to a low- or no-basis-risk benchmark.

Creating a proper index

Once the framework for proper tail hedge construction is defined, the task of creating a proper index becomes relatively straightforward. If the benchmark is equity beta, we can use the most liquid traded market sectors that carry the key risk factor exposures to start with a shortlist of potential benchmark constituents. For instance, it would make sense to use S&P 500 Index options close to the maturity of the hedge mandate as a reference instrument, since by definition this index has an equity beta of 1 to itself (one can choose another equity index for this reference, e.g., the MSCI World, if that is the index of reference for the underlying portfolio). If the reference portfolio is a blend of equity beta and fixed income – for instance, something like the MSCI World Index combined with the Barclays Aggregate Bond Index – then the tail hedge will be a blend of the best equity beta and duration hedges for this combination. The best reference market instruments will therefore be options on the equity and bond indexes. But since options on bond indexes are not very liquid, it makes sense to select options on tradable markets such as Treasury futures for index construction. Also, note that tail options on a portfolio are not the same as the sum of options on the individual constituents, so adjustments for the correlations of the underlying constituents need to be made.

Once the proper sectors are identified, the next step is to set a “strike” for the portfolio of reference market options. As an example, if the attachment level for an overall 60% equity, 40% bond portfolio is set at 85% (i.e., 15% out of the money for the whole portfolio), then assuming that the bond part remains static, the reference equity option strike is 15%/0.60 = 25%. So the natural strike of the reference equity option is 25% out of the money. One can proceed in a similar manner for the other underlying risks as a crude starting point.

The advantage of constructing the basket of reference securities in such a way is that they can be monitored in real time. Options-based tail hedges have various “Greeks,” such as time-decay, gamma, vega, theta, etc., which are very dynamic and have to be actively monitored and traded. The value added by an investment manager is proportional to how the actual portfolio of hedges behaves over time relative to the theoretical benchmark. It also solves the problem of behavioral aversion to cost. Once the actual hedge cost and time decay is put relative to the cost of a theoretical hedge, it is much easier to commit to the cost as a long-term asset allocation decision and to compare this cost versus the implied cost of de-risking or buying government bonds. The important point is that all types of tail hedging cost something, and this includes de-risking and moving to cash. The process of going through the relative value comparison of different types of hedges allows the investor to anchor the tail-hedging analysis to something realistic.

We should emphasize that the use of market-traded options is a simplification that works only if the underlying hedge objective is rather plain vanilla. If the objective is more complex, e.g., “hedge so that at no point in time the portfolio suffers a loss more than x percent,” the reference index security would have to be more of an exotic option such as a knock-in option. While these options are traded heavily in the over-the-counter markets, their prices are not as easily available as vanilla index options. More complex replicating option portfolios can be constructed to index these payoffs. Complexity vs. transparency is an important trade-off when it comes to tail hedging. We generally err toward simple portfolios and hence simple benchmarks to measure them against.

Measuring performance

For traditional indexes, the task of performance measurement is relatively straightforward. One can look at the returns of the actual portfolio versus the index and discern whether the decisions of the manager are adding or subtracting value. For tail risk hedging, the problem is only simple if all the hedges are relatively plain vanilla and the underlying instruments are liquid and replicate the portfolio without any basis risk. The moment the hedges become complicated, performance measurement takes a new twist. The reason simply is that the current price of the hedge does not reflect the potential it has for a large tail payoff, and since tail events are rare events, observation of a few nontail periods is not sufficient to identify the prospects of the tail hedge. Naively, a tail hedge could look like it is performing better than a reference index of securities by losing time value slower than the reference hedges, but this is most likely to offer less potential of payoff if there is a jump event in the market (if the option hedges have less time decay, they probably, though not necessarily, have less gamma as well). To compensate for this shortcoming of real-time performance measurement, we believe that tail hedges need to be evaluated on the basis of scenario analysis. By identifying scenarios of concern and shocking the underlying market factors at different horizons, one can evaluate the potential of these hedges to pay off in the situations that matter. Robust technology and sensible stress-testing systems are thus of paramount importance for this exercise.

Conclusions

While tail risk hedging is a new and critically important area of modern portfolio management practice, the relative newness of the area means standard frameworks for benchmarking such portfolios have not developed. In this article, we sketched the rudiments of benchmark construction that we have used. While much work remains to be done, we believe that standardization and benchmarking in this area will result in the same value added to investors as it has done in the areas of traditional equity and bond portfolio management. Most importantly, it will give end-users a means via which they can quantify the “distance” of a bespoke tail hedge portfolio versus an easily measurable index to evaluate the cost versus benefit trade-offs.

1. See, for example, V. Bhansali, “Tail Risk Management,” Journal of Portfolio Management, Winter 2008.

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​Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. 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.

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 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: Basis Risk, Financial Crisis, Funds Hedge, Growing Pains, Hedge Funds, Hedges, Initial Confusion, Management Practice, Market Sectors, Modern Portfolio, Performance Measurement, PIMCO, Portfolio Management, Proper Benchmarking, Proper Index, Proper Reference, Relative Newness, Risk Management, Scenario Analysis, Time Performance
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