What History Suggests About the Future of Stocks

Thursday, August 2nd, 2012

by Seth Masters, Chief Investment Officer, AllianceBernstein

Some experts today argue that the world has entered a “New Normal” condition in which stocks have permanently lost their return edge. We’ve heard this before. It was wrong then, and we think it’s wrong now, too.

In 1979, BusinessWeek published a cover story famously called “The Death of Equities.” Then, like now, stock market returns had lagged 10-year Treasury returns for a decade, although for somewhat different reasons.

Stock returns had been dragged down by the bursting of a bubble (the Nifty Fifty) and bleak economic conditions. OPEC had unleashed its second oil-price shock in five years. The so-called misery index—the sum of the unemployment and inflation rates—was 20% in the US, double its level today (because inflation is now very low). And corporate profits were very weak (today, they are very strong).

BusinessWeek was capturing widespread sentiment about the economic and market outlook. Nonetheless, stocks handily beat bonds over the 10 years starting in 1979.

As the ubiquitous legal disclosure says, past performance does not guarantee future returns. Indeed, performance often reverses sharply.

Between 1901 and the onset of the recent credit crisis, there have been 11 10-year rolling periods in which bonds beat stocks, all of them coinciding with the Great Depression or the stagflation of the 1970s. And after each and every one of them, stocks beat bonds for 10 years—on average, by 5.8%, as the Display below shows.

Because we are human, we all tend to expect the future to resemble the recent past—to become “anchored” in our recent experience. It takes guts to buck the trend. But at a September 1983 client conference, we cited good fundamental reasons in making “The Case for the 2,000 Dow.” The Dow Jones Industrial Average was then slightly below 1,300. It reached 2,000 in January 1987, about three-and-a-half years later.

Today, our median annual return projections for global and US stocks are about 8% over the next 10 years, far ahead of our projected 2% median return for 10-year Treasuries. At that rate, the Dow could hit 20,000 in five to 10 years. In the same time frame, the S&P 500, a more representative index, could hit 2,000. (It’s now around 1,300.)

Our projected stock returns may sound optimistic. They’re not. They are well below the long-term average for US and global equities, and are based on conservative assumptions about economic and market conditions.

Still, many pundits argue that stocks today are overpriced. My next blog post will assess stock valuations.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Businessweek, Chief Investment Officer, Corporate Profits, Credit Crisis, Different Reasons, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Fundamental Reasons, Future Returns, Great Depression, Inflation Rates, Legal Disclosure, Market Outlook, Misery Index, Oil Price Shock, stagflation, Stock Market Returns, Stock Returns, Stocks Bonds
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Is a U.S. Recession Looming?

Wednesday, July 11th, 2012

by Scott Colyer, Advisors Asset Management

In the third quarter of 2011 the Economic Cycle Research Institute (ECRI) called for a 100% chance of a U.S. recession. They have a stellar track record of calling U.S. economic cycles. We noted this in our communication to clients at the end of 2011 and again in the first quarter of 2012. We gave the call credence because of who was making the call. What we also noted is that the ECRI estimated the severity of any slowdown to be shallow and fairly short-lived. Most recessions in the U.S. are over even before they are positively identified. Other very reliable indicators did not flash a U.S. recession and did not support the ECRI assertion which included a very positively sloped U.S. yield curve (still 100-110 basis points between the 30’s and 10’s).

The ECRI is very well thought of as Morgan Stanley reversed their bullish call on the U.S. equity markets back in August of 2011 based on the same data. Months and months have gone by since these calls were made. It now appears that we have a slowing economy based on the trajectory change in job creation and other monitors. Europe woes are the blame of the day. Is this the 2011 recession coming in 2012? I am not sure but I doubt it makes much difference to us.

Normally, a slowing U.S. economy would prompt Central Banks to ease monetary policy. However, right now, not only the U.S. Federal Reserve (Fed) has the monetary policy pedal already to the metal. Likewise, the global economies are easing at record pace. The point here is the Fed, if faced with a recession, will certainly move to implement QE3. We believe this would be supportive of higher U.S. equity prices and lower bond yields. The bottom-line here is that whether we are seeing a recession or just a soft patch in the economy, our investment thesis remains the same. With monetary policy GLOBALLY being the easiest in history, we would expect future returns in the equity markets to be greater than high grade debt. Additional QE measures should goose hard asset prices and tend to weaken the dollar. Income assets will be what investors will seek as traditional assets have little yield. This situation will be supportive of the prices of income producing assets.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.

Copyright © Advisors Asset Management

Tags: Basis Points, Bond Yields, Central Banks, Colyer, Credence, Economic Cycle Research Institute, Economic Cycles, Ecri, Future Returns, Global Economies, Investment Thesis, Job Creation, Monetary Policy, Morgan Stanley, Recession, Recessions, Record Pace, Slowdown, Trajectory Change, Yield Curve
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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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Is Elevated Stock Market Risk Premium a Secular or Cyclical Change? (Paulsen)

Thursday, June 2nd, 2011

Is Elevated Stock Market Risk Premium a Secular or Cyclical Change?

by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)

May 31, 2011

During the 2008 crisis, the risk premium associated with U.S. stocks (i.e., the difference between the stock market’s earnings yield and the 10-year Treasury yield) exploded and has since remained significantly higher compared to its range during the last 40 years. Many believe backto- back crises during the last decade have led to a permanent reassessment of risk or an enhancement in the return required by investors from the stock market relative to safer assets. Indeed, until the last 40 years, the risk premium associated with the stock market was persistently higher than it has been in recent decades. Therefore, today’s elevated risk premium may represent a return to a range which was normal throughout most of U.S. history. In our view, however, the recent rise in the stock market risk premium represents a cyclical phenomena rather than a secular shift. It appears importantly tied to the destruction of U.S. confidence during the “Great Recession” and will likely persist only for as long as confidence remains near recession-like levels.

Whether the newly elevated range of the equity risk premium proves enduring or temporary is important for investors. If it has been permanently boosted, the stock market may already be nearing a full valuation. If the elevated risk premium proves temporary, however, the stock market probably offers compelling prospects since future returns can be enhanced simply by a slow but steady revitalization in economic confidence.

A History of the U.S. Stock Market Risk Premium

Chart 1 illustrates the history of the equity risk premium since 1870. Prior to the late 1960s, the earnings yield was usually at a healthy premium to bond yields. Indeed, between 1871 and 1965, the average stock market risk premium was 4.1 percent.

In the late 1960s, however, the risk premium dropped below its range of the previous 100 years and established a new trading range whereby bond yields typically exceeded the earnings yield. Between 1965 and 2007, the average risk premium was -1.5 percent. Only since the 2008 crisis, has the equity risk premium again undergone a watershed shift in its trading range, returning to the much higher range commonplace prior to the late 1960s.

Why has the equity risk premium undergone such radical changes in its trading range? The explanations are probably numerous. First, U.S. recessions occurred much more frequently prior to the 1960s then they have since. Second, prior to WWII, the Consumer Price Index changed little (bursts of inflation were typically offset by longer periods of mild deflation), but beginning in the late 1960s, consumer prices embarked on an unprecedented uninterrupted advance lasting several decades. Third, bond yields rose to all-time U.S. record highs in the 1970s and remained elevated above historic norms for most of the next three decades. Finally, the post-war era ushered in an economic policy approach which has since been much more supportive of economic expansions and much more aggressive in fighting recessions.

Tags: 10 Year Treasury, 1960s, Bond Yields, Chief Investment Strategist, Crises, Cyclical Change, Earnings Yield, Economic Confidence, Equity Risk Premium, Future Returns, Last Decade, Market Risk Premium, Reassessment, Recession, Revitalization, Stock Earnings, Stock Market Risk, U S Stock Market, Wells Capital Management, Wells Fargo
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Secrets of Elite Funds – Brief Intro

Monday, May 9th, 2011

Secrets of Elite Funds – Brief Intro

by Leo Kolivakis, Pension Pulse

What a beautiful day it was in Montreal. Absolutely perfect weather to celebrate Mother’s Day. I wish all the moms out there a Happy Mother’s Day, especially my mother who I love a lot. The only problem is that I was out all day enjoying this weather and I’m tired as I hit the gym early today.

Before I delve into this topic, please go back to read my comment on the value of losing money. If you’ve never felt the exhilaration of making money and more importantly, the pain of losing money in the markets, then you are not ready to manage money, especially not your own money. Most people shouldn’t be managing their money which is why I wrote a comment on the big secret stating that most investors are better off investing in some small cap value ETF and rebalancing their stock/bond portfolio at least once a year or as needed.

But I’m reminded of the wise words of Paul Samuelson who once remarked that if everyone adopts Burton Malkiel’s “random walk” approach and invests in ETFs, even small cap value ETFs, then the collective actions of many will influence future returns. I mention this because legendary fund manager Jeremy Grantham, chairman of fund shop GMO and one of the few people who successfully called the 2008 crash in advance, is warning investors that small cap stocks are overvalued:

His firm’s latest calculations predict that investors in U.S. small-cap stocks will actually lose about a fifth of their money in real terms over the next seven or so years. That’s an annualized loss of about 2.8% after inflation.

As always when it comes to predictions, there are no guarantees. But GMO’s forecasts have a good track record.

The article cites many reasons as to why small cap stocks are overvalued, including QE2 and the fact that investors believe small caps outperform over the long-run (with greater volatility), but let me tell you the real reason why small caps are rising so much. Go back to read my comment on whether hedge funds have grown too big. With so much money being shoveled to hedge funds, it’s not surprising to see small cap stocks rally so strongly.

Why is that? For one, a large percentage of hedge fund investments go to Long/Short Equity funds. The strategy of these funds is very similar. They go long small cap stocks which are not covered properly by analysts and go short large cap stocks which are more liquid and covered to death by analysts. I wouldn’t be surprised if many hedge funds are just swapping into a small cap index for their long position.

I believe in tracking the activity of elite funds closely. In particular, I track quarterly holdings of a number of elite hedge funds and long-only funds, many of which I mentioned in the past when I wrote about why small is beautiful. Why do I track quarterly holdings of elite funds? Simply because the best funds attract the best talent (they can pay them top dollar) and they typically exhibit performance persistence over a long period. You’re not going to get a thousand elite funds. Only the cream of the crop can truly boast of long-term success.

The question I often get is do I just mimic what these top funds are doing? I don’t mimic anyone and will choose my entry and exit very carefully. The quarterly holdings of top funds helps me focus, especially if I notice a cluster of activity in a certain stock or sector. Institutional investors investing in top funds should be asking them their top 10 long and short positions every month and the reasons behind these positions.

I screen stocks daily, looking at largest percentage moves (up and down), moves on unusual volume, and then I add them to a list of stocks that I filter by industry. This allows me to see if the stocks are moving in unison (beta) or if it’s company specific news moving one stock up or down.

There are always news stories covering some elite hedge fund. For example, Marketwatch reports that Greenlight Capital is betting on a possible initial public offering by auto-parts maker Delphi Automotive. Minyanville reports that Einhorn’s quarterly letter to investors in his funds discussed establishment of new positions in Internet-giant Yahoo (YHOO) and electronics retailer Best Buy (BBY). This is the type of information I look for to do my own analysis, paying close attention to whether other elite funds are also initiating or accumulating more shares of certain companies.

It sounds easy but it’s far from easy. Quite often stocks that are being bought by top funds are also heavily shorted or heavily manipulated by other funds. You might see great earning reports, one after the other, and yet the stock keeps falling, leaving you bewildered. Trading stocks, especially day or swing trading stocks, is not an easy game. I’ve done it before, and will do it again if I have to, but it’s very tough to consistently make money. You need to have discipline, cut your losses, and know that things can get very volatile (tight stop losses can work against you).

I’m running out of gas so I will come back to this topic next weekend, providing you with more analysis of what top funds are actually buying and selling. If you love picking stocks, this is going to be a treat for you.

Tags: Beautiful Day, Bond Portfolio, Burton Malkiel, Cap Value, Collective Actions, ETF, Exhilaration, Future Returns, Gmo, Jeremy Grantham, Paul Samuelson, Perfect Weather, Qe2, Random Walk, Real Reason, Small Cap Stocks, Small Caps, Stock Bond, Volatility, Wise Words
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Monetary Policy in 3-D (Hussman)

Monday, April 25th, 2011

Monetary Policy in 3-D

by John P. Hussman, Ph.D., Hussman Funds

One of the most important factors likely to influence the financial markets over the coming year is the extreme stance of U.S. monetary policy and the instability that could result from either normalizing that stance, or failing to normalize it. It is not evident that quantitative easing, even at its present extremes, has altered real GDP by more than a fraction of 1% (keep in mind that commonly reported GDP growth rates are quarterly changes multiplied by 4 to annualize them). Moreover, it’s well established – on the basis of both U.S. and international data – that the “wealth effect” from stock market changes is on the order of 0.03-0.05% in GDP for every 1% change in stock market value, and the impact tends to be transitory at that.

Still, by replacing an enormous quantity of interest-bearing assets with non-interest bearing money, quantitative easing has created profound distortions in asset prices, where Treasury bills now yield less than 5 basis points annually, while “risk assets” such as stocks and commodities have been driven to prices high enough that their likely future returns now compete perfectly (on a time-horizon and risk-adjusted basis) with the zero expected returns on cash.

Taken together, despite the limited and transitory real effects of QE on output and employment, the Federal Reserve has created an unprecedented monetary position that creates an extremely unstable equilibrium for the financial markets. There are several ways that this might be resolved. Based on the very robust relationship between short-term interest rates and the monetary base, it is clear that a normalization of short-term interest rates, even to 0.25-0.50%, would require the Federal Reserve to fully reverse the $600 billion of asset purchases it conducted under QE2. Alternatively, with the monetary base now exceeding 16 cents for every dollar of nominal GDP, any external upward pressure on interest rates (that is, not produced by a Fed-initiated reduction in the monetary base) would quickly provoke inflationary pressures.

Last week, my friend John Mauldin reprinted our April 11 market comment Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet . John told me that he had received several nearly identical questions, along the lines of “Wait, now I’m confused – I thought that the Fed reduces inflation pressures by raising interest rates. Why would higher interest rates trigger inflation?”

So, this is where that phrase “external upward pressure” comes in. We have to distinguish between what economists would call an “endogenous” increase in interest rates – one that the Fed itself provokes by reducing the monetary base – and an “exogenous” increase in interest rates – one that is produced by changes in the behavior of investors and the economy, independent of actions by the Fed.

See, when the Fed decides to raise interest rates, it does so by reducing (or slowing the growth) of the monetary base, which can reasonably be viewed as an “anti-inflationary” policy. However, if interest rates rise independent of any change in the monetary base, then cash – which doesn’t bear interest – becomes a “hot potato” that is suddenly less desirable. In that case, you get one of two outcomes: people holding cash may bid up Treasury bills, lowering short-term interest rates to the point where people are again indifferent between cash and non-cash alternatives, or failing that, the attempt to get rid of cash holdings in other ways provokes inflation and a depreciation in the foreign exchange value of the dollar (which was the outcome in the 1970′s).

As I’ve argued elsewhere, one of the primary sources of exogenous inflationary pressure is growth in unproductive forms of government spending (spending that creates demand but does not expand capacity or incentive to produce), but I’ll leave that feature of the argument for another time.

Monetary Policy in 3-D

The extreme stance of monetary policy is such a critical factor in the financial markets here that it is worth spending a bit more time on the relationship between interest rates, inflation, and the monetary base.

Tags: Adjusted Basis, Asset Prices, Asset Purchases, Enormous Quantity, Extreme Stance, Future Returns, Gdp Growth Rates, Gold, Hussman Funds, Monetary Base, Nominal Gdp, Qe2, Quarterly Changes, Real Gdp, Stock Market Changes, Stock Market Value, Stocks And Commodities, Time Horizon, Treasury Bills, Unstable Equilibrium, Wealth Effect
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“Money is made in the buying”

Tuesday, December 8th, 2009

Referring to the lofty valuations of the US benchmark indices, the quote du jour today comes from Richard Russell, 85-year-old author of the Dow Theory Letters. He said: “Long-term profits depend largely on your original buy price. Today, as I write, stock valuations are extremely high. For instance, the price-earnings (PE) ratio for the Dow is now 18.02. The dividend yield for the Dow is a thin 2.67%. For the S&P 500 the PE is 86.20; the dividend yield is a mini 1.96%. In the face of these valuations, the odds of building impressive profits over the next decade are very poor (unless, of course, there’s a crash and a new bull market).

“The great fortunes in stocks are made by buying stocks at true bear market lows. At today’s bloated values, profits in stock over the coming decade will probably not be any better than the percentage increase (if any) in the GDP over the same time period.”

What can one expect as far as future returns are concerned?

A good way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows that the “normalized” PE ratio of the S&P 500 Index is currently 20.4. This compares with a long-term average of 16.4 and implies an overvaluation of 24%. The graph below show data since 1950, but the actual calculations date back to 1871.

As a next step, the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) as shown below.

The cheapest quintile had an average PE of 8.5 with an average ten-year forward real return of 11,0% per annum, whereas the most expensive quintile had an average PE of 22.6 with an average ten-year forward real return of only 3.1% per annum.

Based on the above, with the S&P 500 Index’s current ten-year normalized PE of 20.4, investors should be aware of the fact that the Index is by historical standards in expensive territory. As far as the stock market in general is concerned, this argues for unexciting long-term returns for quite a number of years to come, providing support for Richard Russell’s statement above.

Tags: Bear Market, Benchmark, Business Cycle, Buying Stocks, Dividend Yield, Dow Theory Letters, Fortunes, Future Returns, Intervals, Lows, Pe Ratio, Percentage Increase, Price Earnings Ratio, Quintile, Richard Russell, Robert Shiller, Same Time Period, Stock Valuations, Term Profits, Valuation Levels
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Stocks for the Long Run? Not so fast Jeremy

Friday, October 9th, 2009

John Keefe, columnist for CBS MoneyWatch, FT.com, and ex-Wall Streeter, refutes Jeremy Siegel’s “Stocks For the Long Run,” FT.com Op-Ed, stating that there is no long run, only many short runs.

Here is an excerpt:

The author and promoter of Stocks For The Long Run, Professor Jeremy Siegel of The Wharton School, is back. A few days ago in an op-ed submission Siegel revved up his old hypothesis – that investing in stocks always beats investing in bonds, sort of. In my view, his advice for individual investors was simplistic and dangerous when it was fresh in 1994, and seeing that Dr. Siegel’s patter has not been informed by the two stock market crashes since then, the message has become only more so. (This is a long post, but worth it; please bear with me.)

I. The beating stocks took in 2008 and 2009 did plenty to disprove, or at least soften up, Siegel’s hypothesis. At the stock market low in March, “stocks for the long run” (hereinafter SFTLR) was in tatters, because at that point, the returns to U.S Treasury bonds had beaten equities for the prior 40 years. (If 40 years doesn’t constitute the long term, I don’t know what does.)

Therefore this week I was disappointed to see that the Financial Times, a publication that I adore and sometimes have the privilege of writing for, had given Dr. Siegel time on its podium. Here’s a sample of his defense of SFTLR:

[F]or the 13 10-year periods of negative returns stocks have suffered since 1871, the next 10 years gave investors real returns that averaged more than 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all 10-year periods, and is twice the return offered by long-term government bonds.

Strong future returns also followed poor returns if one extends the analysis to the worst-performing of all 127 10-year stretches since 1871. Without exception, for each 10-year return that fell in the bottom quartile, the following 10-year period yielded positive real returns and the median return exceeded the long-run average…

He went on to suggest that the comparison with bonds for the last 40 years wasn’t fair, because their returns had been above average. Huh? He didn’t omit the above-average years for stocks.

You can read the whole article here.

Tags: Bottom Quartile, Cbs Moneywatch, Financial Times, Future Returns, Government Bonds, Hypothesis, Individual Investors, Investing In Bonds, Investing In Stocks, Jeremy Siegel, John Keefe, Patter, Professor Jeremy, Promoter, Stock Market Crashes, Tatters, U S Treasury, U S Treasury Bonds, Wall Streeter, Wharton School
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Jeremy Seigel: Stocks for the Long Run (Still Alive)

Friday, October 9th, 2009

Jeremy Siegel, Wharton School Professor, has recently published an op-ed in FT.com, arguing in favour of his  “Stocks for the Long Run” thesis, which has been challenged in recent times as a result of the ‘lost decade’ in equity markets.

Here is an excerpt:

A look at history shows that the recent experience is not uncommon and excellent returns are available to those who survive rough patches. Since 1871, the three worst 10-year returns for stocks have ended in the years 1920, 1974 and 1978.

These were followed, respectively, by real, after-inflation stock returns of more than 8 per cent, 13 per cent, and 9 per cent over the next 10 years.

In fact for the 13 10-year periods of negative returns stocks have suffered since 1871, the next 10 years gave investors real returns that averaged more than 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all 10-year periods, and is twice the return offered by long-term government bonds.

Strong future returns also followed poor returns if one extends the analysis to the worst-performing of all 127 10-year stretches since 1871. Without exception, for each 10-year return that fell in the bottom quartile, the following 10-year period yielded positive real returns and the median return exceeded the long-run average.

Stocks also swamp the returns on fixed-income assets over the long run. Even with the recent bear market factored in, stocks have always done better than Treasury bonds over every 30-year period since 1871. And over 20-year periods, stocks bested Treasuries in all but about 5 per cent of the cases.

Read the whole article here.

Tags: Bear Market, Bottom Quartile, Excerpt, Favour, Fixed Income, Future Returns, Government Bonds, inflation, Jeremy Seigel, Jeremy Siegel, Periods, Rough Patches, School Professor, Stock Returns, Stocks, Stretches, Treasuries, Treasury Bonds, Wharton School
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Stocks vs. Bonds: What’s Next?

Friday, October 9th, 2009

A very interesting chart from Leuthold Group points out that this would be the third time since the 1920s that we have emerged from a period in which bonds have outperformed stocks.

In the periods following this re-emergence from bond superiority, stocks enjoyed massive outperformance. The first of the three periods outlined in the chart, was the 1930s bust, the second was 1949 thru 1955.

Jeremy Siegel, too, offers the following argument in favour of “stocks for the long run,” from his recent op-ed in FT.com (worth reading):

A look at history shows that the recent experience is not uncommon and excellent returns are available to those who survive rough patches. Since 1871, the three worst 10-year returns for stocks have ended in the years 1920, 1974 and 1978.

These were followed, respectively, by real, after-inflation stock returns of more than 8 per cent, 13 per cent, and 9 per cent over the next 10 years.

In fact for the 13 10-year periods of negative returns stocks have suffered since 1871, the next 10 years gave investors real returns that averaged more than 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all 10-year periods, and is twice the return offered by long-term government bonds.

Strong future returns also followed poor returns if one extends the analysis to the worst-performing of all 127 10-year stretches since 1871. Without exception, for each 10-year return that fell in the bottom quartile, the following 10-year period yielded positive real returns and the median return exceeded the long-run average.

Both Leuthold and Siegel make a notable case for the future of stocks, though Leuthold focuses on 5 year periods and Siegel on 10 year periods.

Earlier this year, we featured Robert Arnott’s thesis on Bonds for the Very Long Run (Bonds: Reversion Cuts Both Ways); Arnott focuses on the past 40 years:

For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns.

Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways; indeed, those 5 percent excess returns, earned in the auspicious circumstances of rising price-to-earnings ratios and rising bond yields, are a fast-fading memory, to which too many investors cling, in the face of starkly contradictory evidence. Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero.

Bill Gross, PIMCO’s Bond King, Chief Card Counter and Handicapper, has been exchanging high-grade corporate bonds for longer-dated government bonds, out of concern for deflation.

Is it possible they are all right? Bonds are forecasting deflation and stocks are forecasting reflation. The track record of the bond market, however, as a forecasting tool has proven to be more accurate historically. Pragmatic Capitalist says:

Bond investors (who tend to have a longer time horizon) are forecasting a long battle with deflation.  Equity investors (who tend not to think much farther than one quarter into the future), on the other hand, are putting their money on the line in the hopes that the reflation trade is alive and well.

Unfortunately for equity investors, they have a poor record of forecasting the future when compared to bond investors.   There have been 4 famous cases of such bond and stock divergences in the last 20 years.  The most famous is the summer of 1987.  We all know what occurred then.  The other three cases were fall ‘94, summer ‘98 and winter 2000.   All three preceded declines in the market.  Of all 4 instances, three of them preceded 15% declines in the S&P 500.

The strongest case for equities today seems to rest on the sheer amount of cash sitting on the sidelines; $10-trillion in the US and $1-trillion in Canada. Its a weak argument – investors do not invest simply because they have the cash, and these days investors aren’t exactly inspired.

James Bianco, of Bianco Research, however, (via WSJ), is skeptical of this simplistic theme:

“If you look at the mutual-fund flows there is a record amount going into bond funds. Forty-two billion dollars went into bond funds in August, which is an all-time monthly record. In fact, the all-time monthly record, I believe, for stock funds was $55 billion back in February of 2000. So it’s pretty close to the stock-fund record. But when you break it down, what you’ll find is that short-term muni funds, and short-term corporate funds, those are the funds that are getting huge, huge inflows.

The short-term corporate funds are up 12% this year. And as we talk right now, the S&P 500 is up around 16% this year and the Dow is up about 11% this year. That’s including dividends. So my conclusion was, “Yes, there’s a lot of money that’s built up in the cash on the sidelines. Yes, it is going to come out of that zero interest rate funds. And its going into short-term bond funds, which by the way are performing pretty much in line with the stock market. So don’t hold your breath. You’re going to be waiting a long time before you see that money ever matriculate into the stock market.””

And,

“Now a couple things about that. The first one is I hate when they say, “There’s $3.5 trillion on the sidelines and that’s a whole lot of money.” It implies that all of that money should be put in investments like the stock market. That’s not true. The vast, vast majority is in transactional balances.

It’s money that is going to be needed in a very short period of time, like, within a year. It’s going to be spent on something. They’re almost like checking accounts, if you want to think of it that way. It’s like somebody saying, “You’ve got $10,000 dollars in your checking account, why don’t you $10,000 worth of stocks?” And the answer is, “Well because I’ve got to pay my credit card bill and my rent.”

The strongest case for the bond market is coming out of PIMCO’s thesis, which calls for a ‘New Normal,” a future of De-Leveraging, De-Globalization, and Re-Regulation. The three elements combine as a recipe that ultimately results in stable and stronger dollar outcome as debt repayment repatriates cash from abroad as well as domestically into the credit and bond markets. A strong dollar on this basis results in falling prices, thus the case for deflation.

Bottom line: This may be time to use the equity market’s strength to rebalance out of equities in favour of government bond and money market allocations.

Tags: 1920s, 1930s, Bill Gross, Bottom Quartile, Bust, Canadian Market, Emergence, Favour, Future Returns, Government Bonds, inflation, Jeremy Siegel, Periods, Robert Arnott, Rough Patches, Skeptics, Stock Returns, Stocks, Stocks Bonds, Stretches, Superiority, Thesis, Third Time
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