Preservation of Capital vs. Margin of Safety (Chris Clark)

Wednesday, April 18th, 2012

April 15, 2012

by Chris Clark, Royce Funds

As we highlighted in last month’s Contrarian View, a surprisingly underappreciated risk that we think investors are now confronted with is the potential for losses in their future purchasing power, especially those invested in low-yielding fixed income securities.

The combination of a highly stimulative Fed, artificially low interest rates, and a rapidly expanding monetary base is geared toward insuring both the stability of the global banking system and the upward trajectory of the fragile economic recovery, while also meaningfully shifting the balance of risks.

For some time now, investors have been understandably focused on the risk of deflation and therefore have been investing with a singular focus on the preservation of capital. In a deflationary world, results are measured in nominal terms, not real ones. With so many monetary programs being implemented around the world in response to the legacy effects of the financial crisis, our view now is that the longer-term preponderance of risk is skewed to the inflationary side of the spectrum.

Yet with so much lingering economic and political uncertainty, we understand investors’ reluctance to suddenly embrace risk assets, especially given both the recent uneven performance of those assets and the remarkable record of gains that have been achieved by less risky vehicles such as U.S. Treasuries. We recognize that equities have demonstrated greater price volatility and are generally riskier investments than high-quality fixed income securities. However, it’s also worth noting the variance in their relative risk can shift quite a bit over time.

When stocks have traded significantly above their long-term valuation averages, such as during the Nifty Fifty period in 1973-74 and the Tech bubble of 2001-02, they certainly carried more risk than they have at times when equities have been deeply out of favor due to recessionary economic conditions or other bear markets. By the same token, other factors can influence relative prices, such as investors becoming more enamored with one asset class over another.

“When stocks have traded significantly above their long-term
valuation averages, they carried more risk than they
have at times when equities have been deeply out of favor due
to recessionary economic conditions or other bear markets.”

In any event, we are now in a period where stocks are deeply out of favor. One only has to glance at asset flows over the past several years to recognize that bonds have been the overwhelming asset class of choice and as a result have prices that carry very little margin of safety. In other words, what investors have lost by focusing on preservation of capital on a nominal basis is that those assets currently deemed safe have arguably very little or no margin of safety on a real basis.

In nearly four decades of investment management, Royce has always recognized the need for a margin of safety. Equities can be volatile, but they don’t have to be risky, at least over the long run. In fact, risk management and the avoidance of permanent capital loss are not concepts exclusive to the fixed income world. A focus on risk —both nominal and real—an absolute value approach, and a long-term investment orientation are all hallmarks of our investment discipline.

How do we attempt to build a margin of safety? In three very important ways: The first, and arguably most important step, is a detailed examination of a company’s balance sheet. We want to be sure that a company has sufficient financial flexibility to both survive challenging periods and to invest in strengthening its business when the opportunity arises.

Second, we focus on finding high-quality companies where we can become comfortable with the long-term sustainability of the company’s success. High internal rates of return and the ability to generate free cash flow are key metrics in this analysis.

Finally, we focus on what we pay. We have found that investment returns are primarily a function of entry price. Put simply, we like to buy what is out of favor with the crowd. Paying a discount to our estimate of intrinsic value is an important aspect of our investment approach, especially in an uncertain future.

The world is gradually healing, and with this slow-but-steady improvement has come a shift in the balance of risks. It is our belief that investors need to refocus their attention on investments that have the potential to provide both a margin of safety and the flexibility to navigate the uncertain pricing environment that lies ahead.

Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements.

Tags: Banking System, Bear Markets, Condit, Contrarian View, Deflation, Economic Recovery, Global Banking, Income Securities, Low Interest Rates, Margin Of Safety, Monetary Base, Political Uncertainty, Preponderance, Preservation Of Capital, Price Volatility, Relative Risk, Remarkable Record, Royce Funds, Singular Focus, Uneven Performance, Upward Trajectory
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Is the Fed Promoting Recovery or Desperation? (Hussman)

Monday, April 9th, 2012

On Friday, the Department of Labor reported that March non-farm payrolls increased by 120,000, falling well short of consensus expectations in excess of 200,000. For our part, we continue to expect a deterioration in observable economic variables, with weakness that emerges gradually and then accelerates toward mid-year. On the payroll front, our present expectation is that April job creation will deteriorate toward zero or negative levels.

Immediately after the payroll number was released, CNBC shot out a news story titled “Disappointing Jobs Report Revives Talk of Fed Easing.” Of course it does, because this remains a market dependent on sugar. And with little doubt the Fed will eventually deliver it – perhaps following a market plunge of 25% or more – but with little doubt nonetheless, because like the indulgent parent of a spoiled toddler, the FOMC can’t stand to see Wall Street throw a tantrum without reaching for a lollipop.

If the Fed indeed steps in with an additional round of QE, a few distinctions may be helpful. First, regardless of Fed actions, and even in the past few years, the market has invariably suffered significant losses following the emergence of the “overvalued, overbought, overbullish, rising-yields” syndrome that we presently observe. In contrast, the main window where it has not paid to “fight the Fed,” so to speak, has been the period coming off of oversold lows. That’s primarily the window where financials, cyclicals, materials, and garbage stocks with highly leveraged balance sheets have outperformed. Regardless of the fact that QE has had no durable economic benefits (more on that below), and does little but to repeatedly lay fresh wallpaper over the rotting edifice that is the global banking system, the main effect of QE has been to provide temporary support for the most speculative corners of the financial market after they have been pummeled.

Strategically, then, we concede that there is some latitude to ease back on defensiveness between the point where QE induces an early improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an “overvalued, overbought, overbullish, rising-yields” syndrome is established. But once that syndrome is established, it is unwise to ignore it, and a defensive stance becomes essential (as we saw separately in 2010 and 2011, not to mention at most major market tops over history). Meanwhile, it is unwise to believe that additional rounds of QE will do much to help the economy in any event, as its primary effect is merely to drive investors into speculative investments by starving them of safer yields.

There is a very well-defined theoretical and empirical relationship between the monetary base and targets like short-term interest rates and monetary velocity (see Sixteen Cents: Pushing the Unstable Limits of Monetary Policy), but investors should note that the response of the stock market and other financial assets to quantitative easing is far more based on superstition than on structure. We can observe, for example, that drowning the financial markets in zero-interest assets has tended to lower the yields (and therefore raise the prices) of higher-risk, longer-duration assets, but that response is dependent on a certain form of myopia. Specifically, investors either have to assume that they can safely speculate until some particular date arrives on the calendar and they can all take their profits simultaneously, or they have to ignore the tendency for low prospective long-term returns to go hand in hand with quite negative prospective intermediate-term returns. For that reason, any “QE indicator” we might develop (as several people have requested) would likely be spurious and not very robust going forward, even though one might be back-fitted to the data. A better approach, as noted above, is to take a signal from market action and trend-following measures, but emphatically to also impose several alternate exit criteria – including for example a deterioration of those measures, or the establishment of an overvalued, overbought, overbullish, rising-yields syndrome. I remain convinced that investors who simply have blind faith that QE is reliably bullish in and of itself, or can be trusted to limit losses, will have their heads handed to them.

How QE “works”

Keep in mind that the U.S. banking system has trillions of dollars sitting in idle deposits with the Fed already. Quantitative easing simply does not relieve any constraint that is binding on the economy. Rather, QE is a method by which the Fed hoards longer-duration, higher-yielding securities like U.S. Treasury bonds and replaces them with cash that bears zero interest. At every moment in time, somebody has to hold that paper. The only way for the holder to seek a higher return is to trade it for a more speculative asset, in which case whoever sells the speculative asset then has to hold the cash. The process stops when all speculative assets are finally priced so richly and precariously that the people holding the cash have no further incentive to chase the speculative assets, and are simply willing to hold idle, zero-interest cash balances.

Why does the Fed want this? Simple. Chairman Bernanke believes that by creating a bubble in speculative assets, people will “feel” wealthier and keep consuming – regardless of the fact that real incomes are stagnant and debt burdens are already intolerable, and despite the fact that there is extremely weak evidence for any such “wealth effect” in the historical record. Undoubtedly, it would be difficult for Bernanke to refrain from these reckless policies when everyone is crying “do something!” But the willingness to tolerate short-term criticism in the interest of long-term benefit is part of what separates leadership from cowardice.

Given the bubbling concerns among various FOMC members about inflation risk, the next round of QE is likely to be “sterilized.” Essentially, the Fed would buy Treasury bonds from banks, and would pay for them with newly created cash, but the Fed would then borrow those funds back from banks, holding them as idle deposits with the Federal Reserve. By definition, the additional “liquidity” created by a sterilized round of QE would not be available for new lending (as if there aren’t enough idle reserves in the banking system already). So again, the main goal is to increase the outstanding stock of zero- and low-interest assets in the economy, in order to lower the yields and increase the prices of more speculative investments.

Now, if you think carefully about this, you’ll recognize that the U.S. government is still running a deficit of more than 8% of GDP, so the Treasury will have to issue more than a trillion dollars of new debt in the coming year anyway. Given that banks already hold trillions of dollars in idle balances, the Treasury could have the identical effect of an additional round of QE simply by issuing a larger portion of the new debt as very short-term T-bills, which also yield next to nothing. So why bother doing this as “quantitative easing” when the Treasury could just change the maturity profile of the new debt all by itself?

Well, for one, the Treasury securities are issued on the open market. The Fed typically pre-announces which issues it will buy, allowing the banks that act as primary dealers to essentially front-run: buying the newly issued debt from the Treasury in expectation of getting a higher price from the Fed. So doing all of this as QE has the benefit of handing the banks a nice trading profit. Second, the Fed has an awful lot of Treasury debt on its balance sheet, which is leveraged about 50-to-1 against its own capital. By purchasing Treasury securities and creating zero-interest cash (or low-interest reserves), the Fed essentially earns a spread that can cover any shortfall it might experience if it is ever forced to unwind its position and sell any of those securities at a loss. It’s true that if the Fed earns any surplus interest, it has to go back to the Treasury, but the surplus rendered back to the Treasury is only what remains after a night on the town in the Fed’s balance sheet.

Finally, the reason for doing QE through the Fed (rather than simply changing the maturity profile of the new Treasury debt) is that Wall Street – at least – believes that the Emperor is actually wearing clothes. Despite the fact that the main effect of QE is to boost speculation and release brief bursts of pent-up demand, both which immediately soften when the policies are suspended, this recurring pattern is still unclear to many investors and analysts. As long as that delusion persists, we can expect the Fed to periodically exploit it.

Ignore that the side-effect of this delusion is the misallocation of capital toward speculative assets in the belief that the Fed has set a “put option” under the markets. Forget that savings are discouraged, bad lending decisions are rescued, incentives and economic signals are distorted, and the accumulation of productive capital is disabled. We have the most creative, entrepreneurial nation on the planet, but our policy makers are intent on preventing debt restructuring and misallocating scarce capital. As a result, they continue to compromise long-term growth in favor of temporary bouts of short-term speculation.

What about recent employment gains?

But wait. How can we say that quantitative easing has such weak effects on the economy when we’ve clearly enjoyed a significant amount of job creation since mid-2009? Isn’t that clear evidence that Fed policy is working?

Well, that depends on what one means by “working.”

Last week, we observed “Real income declined month-over-month in the latest report, which is very much at odds with the job creation figures unless that job creation reflects extraordinarily low-paying jobs. Real disposable income growth has now dropped to just 0.3% year-over-year, which is lower than the rate that is typically observed even in recessions.” It wasn’t quite clear what was going on until I read a comment by David Rosenberg, who noted that much of the recent growth in payrolls has been in “55 years and over” cohort. Suddenly, 2 and 2 became 4.

If you dig into the payroll data, the picture that emerges is breathtaking. Since the recession “ended” in June 2009, total non-farm payrolls in the U.S. have grown by 1.84 million jobs. However, if we look at workers 55 years of age and over, we find that employment in that group has increased by 2.96 million jobs. In contrast, employment among workers under age 55 has actually contracted by 1.12 million jobs. Even over the past year, the vast majority of job creation has been in the 55-and-over group, while employment has been sluggish for all other workers, and has already turned down.

For most of history prior to the late-1990′s, employment growth in the 55-and-over cohort was a fairly small and stable segment of total employment growth. Undoubtedly, part of the recent increase has simply been a change in the classification of existing workers as they’ve aged (1945 + 55 = 2000, so the we would have expected to see some gradual bulge in this bracket since 2000 due to aging baby boomers). But the shift is too large to be explained simply by reclassification. Something more troubling has been underway.

Beginning first with Alan Greenspan, and then with Ben Bernanke, the Fed has increasingly pursued policies of suppressing interest rates, even driving real interest rates to negative levels after inflation. Combine this with the bursting of two Fed-enabled (if not Fed-induced) bubbles – one in stocks and one in housing, and the over-55 cohort has suffered an assault on its financial security: a difficult trifecta that includes the loss of interest income, the loss of portfolio value, and the loss of home equity. All of these have combined to provoke a delay in retirement plans and a need for these individuals to re-enter the labor force.

In short, what we’ve observed in the employment figures is not recovery, but desperation. Having starved savers of interest income, and having repeatedly subjected investors to Fed-induced financial bubbles that create volatility without durable returns, the Fed has successfully provoked job growth of the obligatory, low-wage variety. Over the past year, the majority of this growth has been in the 55-and-over cohort, while growth has turned down among other workers. Meanwhile, overall labor force participation continues to fall as discouraged workers leave the labor force entirely, which is the primary reason the unemployment rate has declined. All of this reflects not health, but despair, and explains why real disposable income has grown by only 0.3% over the past year.

Economic Notes

It’s important to recognize that our concerns about the stock market here are independent of our economic concerns, in that the “Angry Army of Aunt Minnies” we’ve recently observed are associated with very negative average market outcomes regardless of economic conditions. Even in the past few years, the emergence of these conditions has invariably been followed by declines that have wiped out all of the intervening gains since the earliest signal was observed.

As noted above, even in the event of another round of quantitative easing, the particular window to ease back on a defensive position would be between the point where QE induces an improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an “overvalued, overbought, overbullish, rising-yields” syndrome is established. To ignore the syndromes we observe at present, in the hope that the hope of QE will be sufficient to limit market risk, is a strategy that would not have been successful even in recent years.

Still, though our present market concerns are independent of economic concerns, they are also reinforced by those economic concerns. We’ve reviewed various lines of evidence, from leading indicators to “unobserved components models,” and I continue to view the coming weeks as a likely minefield of economic disappointments. The issue here remains the distinction between leading, coincident and lagging measures of the economy. As I’ve noted before, a tendency toward positive economic surprises over this period would improve the underlying economic state that we infer from observable data, but here and now, the most leading components remain clearly negative. The concerns are also clearly compounded by the uniform deterioration in economic measures in Europe, China and India, among other regions. The charts below convey the general situation.

Over the weekend, the New York Times published a good article (Some Dreary Forecasts from Recovery Skeptics) that summarized the concerns of a number of economic observers, placing Lakshman Achuthan of the ECRI and me into the classification of “perma-bears.” Actually, with respect to the economy, I’m pleased to be in good company, and don’t greatly object to the “perma-bear” label in that I continue to believe major underlying economic problems have merely been kicked down the road and remain unresolved (primarily an overhang of unserviceable debt, which continues to need restructuring, and which will leave the global economy prone to recurring crises until that happens).

I also periodically get the “perma-bear” label with respect to my views on the financial markets. While I do believe that stocks have been generally overvalued since the late-1990′s (a view that is supported by the predictably dismal overall total returns on stocks since that time), I do think that some observers misclassify the 2009-early 2010 period as being a reflection of our standard investment strategy instead of what it was – a period when we suspended risk taking until we were confident that we had adequately stress-tested our methods against Depression-era data. That may seem like a distinction without a difference, but the difference is that for most periods since 2000, our present investment methods would do very little differently than we actually did in practice (though there are of course a few moderate differences due to various refinements and ongoing research). The 2009-early 2010 period is distinct in that it is not at all indicative of the hedge position that can be expected of our strategy in future market cycles, even under identical conditions and evidence. The fact that we removed about 70% of our hedges in 2002 (when our projection for 10-year S&P 500 total returns was not much more compelling than what it is today), should be some evidence of that.

Financial markets fluctuate, and prospective returns change. We will undoubtedly have ample opportunities to accept financial risk in expectation of reasonable returns, and if history is any guide, those opportunities will emerge well before our economic problems are behind us. What concerns me here is the refusal of investors to even recognize those problems; the army of hostile syndromes we observe in both financial and economic data; the blind faith that simply changing the mix of Treasury debt and bank reserves can produce growth and put a floor under speculative assets; the near-complete denial of ongoing debt strains; and heavily bullish sentiment that Investors Intelligence correctly notes is now in “territory associated with market tops.”

Market Climate

As of last week, the Market Climate for stocks remained characterized by a hostile “overvalued, overbought, overbullish, rising-yields” syndrome, and a variety of other hostile syndromes that I’ve reviewed in recent comments. Strategic Growth and Strategic International Fund remain tightly hedged here. Strategic Dividend Value has a hedge equal to about 50% of the value of its holdings – its most hedged stance. Strategic Total Return continues to have a duration of just under 3 years, and a small percent of assets in utility shares and foreign currencies. We raised our exposure in precious metals shares to just over 4% on last week’s price weakness, but there too, our stance remains decidedly conservative at present.

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Tags: Balance Sheets, Banking System, Cnbc, Consensus Expectations, Cyclicals, Department Of Labor, Desperation, Economic Benefits, Economic Variables, Edifice, Fomc, Global Banking, Hussman, Job Creation, Lollipop, Lows, Market Plunge, Non Farm Payrolls, Payroll Number, Qe, Tantrum
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“Lehman 2.0″ Imminent Warns John Taylor

Thursday, February 16th, 2012

By John R. Taylor, Jr. Chief Investment Officer FX Concepts

Lehman 2.0

Global investors either have extremely short memories or they are far too concrete, as my wife the psychologist would say. Saying that Greece is not a bank but a country means nothing. Almost all Europeans argue that a default by the Greek government would now be more straightforward and not as significant as the collapse and bankruptcy of Lehman Brothers in September 2008, especially since the Eurozone, under the influence of the surplus countries, has effectively ‘ring-fenced’ Greece from the other 16 members. Lehman was not a very large factor in the global banking scene with less than one quarter the capital of the biggest US banks and with assets below those of more than 100 banks around the world. Greece might represent less than 3% of the GDP of the Eurozone, but when lined up against Lehman, Greece stands larger in its relevant market. Anyone can read the newspapers, blogs, and Internet scribblings before the Lehman collapse and see that the impact of its collapse was not expected to be significant. Tim Geithner, then head of the New York Fed, worked to arrange the emergency liquidation of Lehman’s assets and there were expectations that the company could be sold to Bank of America or Barclays, but the Bank of England vetoed a sale to Barclays and the US government refused to lend any support to Bank of America in its effort to buy Lehman.

Rereading the documents and remembering the situation as I set out for a weekend cruise on the Chesapeake, the world was not worried. The market had already seen the rescues or restructuring of Washington Mutual, Countrywide, Fannie Mae, and Freddie Mac, so no one was worried. This looked like another Bear Stearns, a manageable problem but this time the Bush administration was not interested in getting involved – ‘let the market solve this, don’t throw good money after the bad.’ So, what is the difference now? The world is as blasé about a Greek default or departure from the euro as it can be – credit spreads are dropping, the other weak Eurozone sovereigns are financing themselves easily, and everyone thinks the LTRO has solved the problem for the next year or two. Why should we worry about Greece? Who cares if their unemployment is 20.9% and climbing very fast, or that it is now in its fifth year of declining GDP? Let’s teach them a lesson!

Hubris is at the heart of this. Everyone says this cannot happen – we won’t allow it. Says who? The EU says: if it is written in an agreement, it must be totally correct, unchangeable, and followed at all costs. New realities can’t intervene and no slippage is allowed. Why the Germans are so sure that they know the future is beyond me. They are fallible too, but they won’t admit it, and the Greeks can’t make them budge. Haven’t they looked around? Santorini has a different economic and social cost structure than Wiesbaden. Humanity (and common sense) seems totally lacking in the negotiations with the Greeks and a violent backlash would be totally understandable. Why the countries that have been fattening up their current account surpluses selling products to Greeks, whom they should have known were basically broke – just as they always have been – should be paid 100% on the euro is beyond me. Major losses should apply not only to sovereign borrowings but also to accounts receivable for cars, electronics, and other consumer goods. The market has not opened its eyes to the impact this Greek unraveling will have. The Eurozone will be mortally wounded and the world will suffer a significant recession – maybe as deep as 2008. European banks will lose much of their capital base and many should be bankrupt, but just as in the Lehman aftermath, the governments will try to save the banks and the banks’ bondholders, solvent or not. As the bank appetite for Eurozone sovereign paper will be decimated, austerity will probably follow shortly, followed by deflation and uncontrollable money creation. The European recession should be one for the record books.

Tags: Bank Of America, Bank Of England, Bear Stearns, Chief Investment Officer, Eurozone, Fannie Mae, Fannie Mae And Freddie Mac, Freddie Mac, Global Banking, Global Investors, Greek Government, John R Taylor, Lehman Brothers, New York Fed, Relevant Market, Scribblings, Short Memories, Taylor Jr, Washington Mutual, Weekend Cruise
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Gold & Silver Cartel’s Prolonged Price Suppression Set Foundation for Explosive Move Higher in 2012

Tuesday, January 17th, 2012

Recently, public interest in gold and silver and gold/silver mining stocks has been at multi-year lows. And that is a super bullish contrarian indicator. In fact, a glance at the Gold Miners Bullish Percent Index illustrates that sentiment to start the year was at a three-year low.

At the end of last year, there was a lot of chatter on the internet, due to the end-of-the year slam down effected on gold and silver futures by the global banking cartel, that silver prices were going go collapse to $20 an ounce and gold prices were going to collapse well below $1000 an ounce by the first quarter of 2012. We felt that these discussions and the consequent, induced panic selling out of gold/silver mining stocks and physical gold/silver at the end of 2011 was highly unwarranted and the result of people falling for the global banking cartel price suppression tricks. In fact, we sent Special Alerts to all of our clients at the end of 2011 informing them that the banking cartel often paints charts in gold and silver to fool people and that one cannot make accurate predictive behavior based upon the assessment of technical charts alone.

At SmartKnowledgeU, it has always been our mantra that technical analysts often make huge mistakes in their predictive calls due to their sole reliance on technical charting and therefore often have to flip-flop like a politician on their calls regarding gold and silver, one moment calling for a huge crash and to sell everything gold and silver, the next moment calling for a huge run-up and to buy back everything gold and silver. While nimbleness is a good trait to have given the volatility of gold and silver assets and staying on the sidelines is sometimes necessary, trying to get out of the market on every single weekly downturn in gold and silver will surely drive an investor insane. Thus, sometimes it is necessary to ride out difficult periods of volatility and maintain your eye on the long-term trend instead of short-term banking cartel tricks. We prefer to remain more long-term trends with our calls and to keep our eyes grounded on a more fundamental outlook that incorporates technical analysis with more than a decade of knowledge regarding global banking cartel price suppression schemes. We have stated since day one of launching our company in 2006 that gold/silver technical analysis performed without incorporating the contextual nuances of global banking cartel price suppression schemes will not be accurate, especially since the cartel’s gold and silver price suppression schemes exert the most influence right now over setting the futures and spot prices.

Last year, we informed our clients at the very start of the year in January of 2011 that 2011 would yield massive volatility in gold and silver assets, proclaiming the coming year as “The Year of Volatility”. Before the year started, we knew that 2011 would produce a fierce battle between the global banking cartel and the dynamics of the physical markets for gold and silver as the global monetary crisis deepened. And indeed it did. Though we can mark 2011 as a win for the global banking cartel as they collapsed open interest in gold and silver futures repeatedly throughout the year by raising initial and maintenance margins for gold and silver futures (once raising margins on silver futures a ridiculous five times in just 9 days when silver broached $50 an ounce) and by also using the MF Global bankruptcy to force involuntary client liquidation of gold/silver futures at the end of the year, I am confident that all the banking shenanigans of 2011 has set the stage for a spectacular year ahead for PMs in 2012. If you are interested in my thoughts about how the banking cartel used the despicable MF Global fiasco to collapse gold and silver prices, you can read about it here: Did Bankers Deliberately Crash MF Global to Crash Gold and Silver Prices?

In 2011, due to the extreme volatility in gold/silver mining stocks, there were periods we opted to cash out and sit on the sidelines preceding banking cartel smash downs of gold and silver prices, and other periods we opted to stay in the market and ride out the extreme volatility due to our belief that the downside volatility would be short-lived. Thus, admittedly we had to sacrifice short-term performance for our mission of a longer-term reward with the gold and silver mining stocks in 2011. As you can see in the chart below, the HUI Gold Bugs Index re-tested lows in the 490-500 range on five separate occasions last year and greatly underperformed the metals themselves. No wonder bullish sentiment regarding gold and silver stocks just recently hit a three-year low!

However, despite the severe underperformance of the mining stocks last year, from the launch of our Crisis Investment Opportunities portfolio in June 2007 to December 31, 2011, even in light of our slight setback of 2011, our cumulative performance of +135.18% during the past four-and-a-half year period has still respectively outperformed the S&P 500, UK FTSE 100, and Australian ASX200 indexes by whopping +153.12%, +152.37% and +169.20% margins. Furthermore, our Crisis Investment Opportunities portfolio has even outperformed our closest comparable index, the Philadelphia Gold/Silver Sector (XAU) index by a whopping +104.75%. Thus we see 2011, as nothing more than a temporary setback in gold/silver mining stocks, and we’ll explain why below.

More than 3 years ago, on October 16, 2008, I wrote an article titled, JS Kim Uncovers Four Parallel Markets for Gold: Asia Futures, NY Futures, Physical Bullion, Physical Coins. In this article, I discussed the complicity of regulatory agencies such as the CFTC in the global banking cartel price suppression scheme executed against gold and silver that was, at the time, creating very significant premiums in the futures and spot prices in Asia over the Western markets, and in physical gold/silver prices over paper gold/ silver prices. Since the time I wrote that article, I have followed up with many more articles that express my belief that the premiums of physical gold/silver will increase, and eventually in exponential fashion, over the prices of bogus global banking cartel-produced paper gold/silver derivative products. Eventually, I believe that the world will ignore these bogus paper gold/silver markets entirely when setting prices for physical gold/silver. Because the global banking cartel expended so many of their bullets in 2011 in keeping the price of gold and silver much lower than their respective free market prices, it is of my opinion that it will be much more difficult for them to contain the price of gold and silver moving forward in 2012.

Today, there are still many reasons to expect a stellar next couple of years from gold and silver performance, including the mining stocks. From a technical standpoint, gold and silver appear to be on the verge of making a very significant run higher. I’m not saying that this will happen tomorrow, but it does look very probable within a short-time period. From a manipulation factor standpoint, gold and silver also look poised for a run higher too. So the two factors I use to assess gold and silver’s direction both appear aligned with one another to move gold and silver higher very soon.

As far as the timeframe? Currently, due to excessive banker meddling in gold and silver futures markets, and the unknown factor of when greater divergence will occur between physical and paper PM prices as public awareness of the paper scam grows, the exact “when” part of the equation is the most difficult to assess, though I still believe that we will see some strong moves higher in gold and silver during the first quarter of 2012. Furthermore, I strongly believe that gold and silver will still both rise multiples higher than their current banker-suppressed price and that 2012 will see periods of explosive growth for gold and silver, more so for silver than gold, and that PM mining stocks, although accompanied by great volatility once again, will perform much better than they did in 2011. I believe that the largest difference between 2012 and 2011 will be, despite some continued large bouts of volatility in the PMs, a much stronger annual trend higher for gold and silver.

The start of 2011 was a phenomenal start for junior mining PM stocks but the latter half of the year was very negative. Still, one could have done very well in 2011 with junior mining stocks by taking profits off the table when they existed and letting one’s remaining capital ride risk-free in the junior mining sector. In addition to using discipline to protect profits when they exist in the junior mining sector, the greatest friend of a gold/silver investor is patience. Sometimes one knows that great moves higher are coming, but one’s timing may be off by a mere six to nine months. Patience will allow one to still reap the bulk of the rewards from these great moves higher as long as one isn’t shaken out of the markets by the banking cartel induced price volatility in gold/silver assets. To this end, I leave you with 10-year charts of gold and silver. Sometimes, it really is necessary to step back and take a deep breath to see the forest from the trees.

About the author: JS Kim is the Chief Investment Strategist and Founder of SmartKnowledgeU, a fiercely independent investment research & consulting firm with a focus on precious metals. For much more detailed commentary about gold and silver, consider the SmartKnowledgeU Crisis Investment Opportunities newsletter. To sign up for our free investment newsletter, please visit SmartKnowledgeU and sign up here.

Tags: Collapse, Contrarian Indicator, Downturn, Explosive Move, Global Banking, Gold And Silver, Gold Miners, Gold Prices, Lows, One Moment, Set Foundation, Silver And Gold, Silver Assets, Silver Cartel, Silver Futures, Silver Mining, Silver Prices, Sole Reliance, Technical Analysts, Technical Charts
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Markets Cheer Economic and Policy Progress – A Sharp Rally for Stocks (Doll)

Tuesday, December 6th, 2011

December 5, 2011

A Sharp Rally for Stocks

After two weeks of disappointing economic and policy news that drove stock prices sharply lower, stocks witnessed a strong reversal last week. The main catalyst for the rally was a global coordinated central bank policy action designed to help banking liquidity, but markets also benefited from some improved economic data. For the week, the Dow Jones Industrial Average jumped 7.0% to 12,019, the S&P 500 Index rose 7.4% to 1,244 and the Nasdaq Composite advanced 7.6% to 2,626.

Central Bank Action a Positive, but More Is Still Needed

Last week’s market action centered on the US Federal Reserve’s and other central banks’ announcement that they would provide coordinated action to boost the liquidity of the financial system by reducing dollar borrowing costs from foreign central banks by between 50 and 100 basis points. The central bank actions are clearly a positive in terms of investor sentiment and will be helpful from a practical basis regarding expanding liquidity. Importantly, the move does underscore the willingness of the Fed and other central banks to support the global banking system.

The moves by the central banks, however, do not address the root causes of the European debt crisis. On that point, Germany’s chancellor Angela Merkel and French president Nicolas Sarkozy have been pushing hard for increased European integration and more effective fiscal discipline. Should these efforts succeed, they would provide some reassurance to the policymakers at the European Central Bank (ECB) that the politicians are serious about establishing the fiscal measures the ECB believes are necessary, which could pave the way for additional ECB intervention in the market. Whether any of this comes about is, of course, still an open question since any proposed plan would need the backing of countries other than Germany and France, but it does appear that the parties are moving in the right direction.

Also on the global policy front, China announced last week that it would lower its bank reserve requirements. This likely represents the first in a round of reductions and should be stimulative for Chinese growth, helping reduce the probability of a hard landing.

US Economic Improvements Continue

In the United States, economic data continues to point to an acceleration in growth. November’s labor market report was a solid one, showing that jobs growth came in at 120,000 (with private payrolls increasing by 140,000). The data also showed some solid upward revisions to October and September jobs growth. At the same time, unemployment fell noticeably in November, although it remains uncomfortably high at 8.6%. In addition to the labor market data, consumer confidence measures moved higher for November, which is a reflection of improved economic activity on a number of fronts.

In addition to the solid economic data, there have also been some signs of progress on the political front. It is still much too early to say for sure, but signs are emerging that politicians may be able to come together to enact an extension of the payroll tax cut (and possibly unemployment benefits) that are set to expire on December 31. Should these extensions not occur, they would cause a fiscal headwind in the first part of 2012.

Outlook Still Mixed, but Slowly Improving

Although last week’s news was positive (and investors were certainly cheered by recent events) it is too early to declare any sort of victory and it is important to remember that the market gains that occurred last week did not match the losses of the previous two weeks. In any case, however, it does appear that conditions are continuing to improve. The coordinated rate action and continued easy availability of money should ease some of the world’s debt burdens. On the economic front, we are expecting gross domestic product growth in the United States to increase to at least 3% in the fourth quarter, which should provide further evidence that the macro backdrop is getting better. The main risk remains a potential Eurozone failure or breakup, but the odds of that occurring have been at least slightly reduced.

About Bob Doll

Bob Doll is Chief Equity Strategist for Fundamental Equities at BlackRock^® a premier provider of global investment management, risk management and advisory services. Mr. Doll is also Lead Portfolio Manager of BlackRock’s Large Cap Series Funds. Prior to joining the firm, Mr. Doll was President and Chief Investment Officer at Merrill Lynch Investment Managers.

Disclaimer:

The information on this web site is intended for U.S. residents only. The information provided does not constitute a solicitation of an offer to buy, or an offer to sell securities in any jurisdiction to any person to whom it is not lawful to make such an offer.

Sources: BlackRock, Bank Credit Analyst. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 5, 2011, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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Tags: Angela Merkel, Central Banks, Chancellor Angela Merkel, Debt Crisis, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, European Integration, Fiscal Discipline, Fiscal Measures, French President Nicolas, French President Nicolas Sarkozy, Global Banking, Investor Sentiment, Nasdaq Composite, Nicolas Sarkozy, Open Question, President Nicolas Sarkozy, S Market
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The Economy and Bond Market Radar (December 4, 2011)

Sunday, December 4th, 2011

The Economy and Bond Market Radar (December 4, 2011)

Long-term Treasury yields ended the week higher as coordinated global central bank action helped alleviate immediate fears of a liquidity crisis in European banks.

The chart below depicts the 10-year Italian Government Bond yield which hit new highs last week but rallied sharply on this week’s central bank intervention. This was a “risk off” week with relatively risky assets rallying.

Strengths

• Coordinated action by global central banks lessens the odds of another financial crisis.
• Economic data in the U.S. remained relatively strong as the economy created 120,000 jobs in November, consumer confidence jumped, manufacturing indicators improved and auto sales were generally better than expected.
• International data was mixed, but Japanese industrial production rose 2.4 percent in October, well ahead of expectations.

Weaknesses

• The negative aspect of the central bank action this week was on rumors a European bank was on the cusp of a liquidity crisis and the central bankers were forced to act to avert a crisis.
• S&P downgraded many large global banking institutions.
• China’s purchasing managers index (PMI) fell into negative territory for the first time since 2009.

Opportunities

• The European Central Bank (ECB) indicated a willingness to provide additional support if European leaders agree to a fiscal union.

Threats

• The situation in Europe remains extremely fluid and negative news is almost expected at this point, unfortunately it is politically driven and difficult to predict outcomes and ramifications.

Tags: Banking Institutions, Bond Yield, Central Bank Intervention, Central Banks, Consumer Confidence, European Banks, European Leaders, Global Banking, Government Bond, Italian Government, Liquidity Crisis, Market Radar, Negative Aspect, Negative News, Negative Territory, New Highs, Purchasing Managers Index, Risky Assets, S Central, Treasury Yields
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Nassim Taleb Fears Protests May Devolve into Class Warfare

Wednesday, October 19th, 2011

Nassim Taleb, author of “The Black Swan” and a New York University professor, discusses the “Occupy Wall Street” protest and his view of the global banking system. He also discusses the need to apply the principles of “Hammurabi’s Code” to the banking system.

Source: Bloomberg, October 18, 2011.

Tags: Banking System, Black Swan, Class Warfare, Fears, Global Banking, Hammurabi S Code, New York University, Protests, Street Protest, Swan, System Source, Wall Street, York University Professor
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Hedge Funds Target “Expensive” Canadian Banks

Friday, October 14th, 2011

According to the Globe and Mail, it appears to large hedge funds (looking for something to short) that our boring, tried and true, and relatively stronger Canadian banks have become “expensive” relative to their less well run global peers. It might be a good idea to keep an (objective) eye on Canadian bank shares’ short interest levels.

Here are some highlights:

• The country’s five biggest banks trade at some of the highest price-earnings multiples in the global banking industry. That’s partly because their shares have held up relatively well this year, while their peers worldwide got clobbered on concerns related to Europe’s debt crisis and a possible recession in the U.S.
• “The hedge fund community has shown an increased interest in shorting Canadian bank shares of late,” RBC Dominion Securities Inc., the brokerage unit of Royal Bank of Canada, said in a research note this week. “While we recognize downside risks in a recessionary scenario, we ultimately believe Canadian banks will hold up relatively better than other sectors in the event of a downturn.”
• “The key investment concern from U.S.-based investors is the Canadian consumer’s health, and the level of indebtedness in the mortgage market,” said Cheryl Pate, a New York-based analyst with Morgan Stanley, which has a “neutral” rating on Canada’s banking industry. “We are looking broadly for a slowdown, but I would say it’s a slowdown to a normalized level.”
• While the banks may look expensive against their global counterparts, other measures show their valuations haven’t deviated from historical trends. Canadian banks now trade at an average of 11.5 times earnings, versus an average of 11 for the past decade.
• Veritas Investment Research, an independent firm in Toronto, evaluated the bank stocks by looking at their current prices against their average inflation-adjusted earnings over the past 10 years. This price-earnings gauge, developed by the economist Robert Shiller, strips out the effects of the business cycle on profits.
• “History suggests that investors with a five-year or longer time horizon have generally made very good returns buying the Canadian banks at the kind of Shiller P/E ratios available today,” Ohad Lederer and Yuting Liu said in a report last month.
• “The Canadian banks are great companies with very durable business models, but we would be careful with the idea that the Canadian banks are immune to global events,” said Rob Wessel, managing partner at Hamilton Capital, a Toronto-based fund manager specializing in financial services stocks.

Global Bank Valuations

Source: Hedge funds take aim at Canadian banks, Nicolas Johnson, The Globe and Mail, October 14, 2011

Tags: Bank Of Canada, Bank stocks, Banking Industry, Biggest Banks, Canadian, Canadian Banks, Canadian Market, Debt Crisis, Downside Risks, Global Banking, Globe And Mail, Independent Firm, Interest Levels, Morgan Stanley, Mortgage Market, Objective Eye, Price Earnings, Rbc Dominion Securities, Rbc Dominion Securities Inc, Robert Shiller, Royal Bank Of Canada, Short Interest
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Russ K.’s Market Calls – Equities, Mega Caps, Germany & More

Thursday, August 18th, 2011

by Russ Koesterich, Chief Investment Strategist, iShares

Call #1: Maintain Overweight Equities, Mega Caps, Germany, the Netherlands & Brazil

Given last week’s extraordinary volatility, my call this week focuses on the overall market today and my take on it. Essentially, I still believe the odds favor slow but positive growth; equities look inexpensive; and volatility appears too high.

As I’ve been discussing for some time, this was always going to be a slow recovery. That said, while I would continue to expect subpar growth, leading indicators aren’t suggesting that we’re heading back into a recession.

For instance, in the year leading up to the 2008 recession, leading economic indicators fell or were flat in 11 out of 12 months. In contrast, during the past year, leading indicators have risen in 11 out of 12 months, including the most recent month.

In short, while an unexpected event (such as a European banking crisis) could easily knock the world back into a recession, growth looks set to continue on a slow-but-positive path in the absence of such an event.

With that in mind, how do stocks look? At their lows last week, global equity markets were trading at around 1.4x book value, close to their 2009 trough valuations. While there are no shortages of headwinds for markets, recent valuations look extreme to me unless one believes that the global economy is going back into another severe recession, another global banking crisis or both. As I don’t see either situation as likely, I advocate being a buyer of equities.

In particular, I continue to like large, quality mega caps, which can be accessed through potential iShares solutions such as IOO, OEF, HDV and DVY. Second, I see good value in much of northern Europe, including in Germany (potential iShares solution: EWG) and in the Netherlands (potential iShares solution: EWN).

Finally, as I highlighted last week, I am also advocating an overweight view for select emerging markets, particularly Brazil (potential iShares solution: EWZ).

Call #2: More on recent market volatility

Now, a bit more on the level of recent market volatility. In May, I noted that market volatility seemed to low. Since then volatility has risen by more than 100%.

Given this big spike, I noted last week that market volatility was too high. As a result, I would now advocate being a seller of volatility and lightening up on fixed-income exposure in order to fund an increased allocation to stocks.

Disclosure: Author is long DVY, EWG and EWZ

Source: Bloomberg

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility. Bonds and bond funds will decrease in value as interest rates rise.

Tags: Banking Crisis, Brazil, Chief Investment Strategist, European Banking, Ewg, Global Banking, Global Economy, Global Equity Markets, Hdv, Headwinds, Leading Economic Indicators, Leading Indicators, Lows, Northern Europe, Positive Path, Recession, S Market, Trough, Unexpected Event, Valuations, Volatility
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Sunlight on U.S. Banks (PIMCO)

Thursday, July 21st, 2011

Sunlight on U.S. Banks

by Mark R. Kiesel

• ​ Among global banks, we believe U.S. banks are in a stronger position to absorb deterioration in the macroeconomic environment in Europe. U.S. banks also look relatively attractive given their profitability, improving asset quality and capital position.
• Global banks vary dramatically in their asset quality and ability to meet capital requirements over time. As a result, we believe financial markets will continue to reward the strongest and safest banks and penalize the weakest and riskiest banks.
• While we remain cautious on the U.S. housing market, U.S. banks appear to have the resources to manage further housing market weakness.

Uncertainty leads to rising risk aversion and fear, but it can also lead to opportunity. Financial markets are focused on the European sovereign debt crisis, growing political and policy risks and a slowdown in global economic momentum. At the same time, a dark cloud of heightened regulation overhangs the global banking industry while the market awaits the release of the European bank stress test results in mid-July. Naturally, investors have lost some confidence in risk assets and in banks due to a lack of clarity surrounding peripheral Europe, global banking regulations and the world economy.

We believe the probability of a near-term default in Greece has increased due to many factors. Greece has high debt levels and lacks sufficient growth, and is also facing bank deposit outflows, credit tightening, deep austerity, rising social unrest and challenging political realities. Greece lacks fiscal union with the EU despite sharing a currency and monetary union with the rest of Europe; this makes policy coordination a challenge and deep austerity measures difficult to enforce. The country’s inability to devalue its currency or set independent monetary policy means Greece can’t regain competitiveness, grow fast enough to service its high debt burden or inflate it away. Fundamentally, Greece has a solvency problem and not a liquidity issue. Although a Greek default and restructuring is likely just a matter of time given these dynamics, the potential spillover into the overall global economy varies dramatically.

The opportunity in today’s market is to distinguish between the strong and the weak in an uncertain world where most investors tend to go from “risk on” to “risk off” with relatively limited differentiation. We prefer to take risk in areas we believe have high expected risk-adjusted returns and avoid risk in areas with low expected risk-adjusted returns. In addition to Greek and sovereign debt concerns, heightened macro and regulatory uncertainty is putting pressure on global banks, creating opportunities for investors willing to do their homework.

Several members of PIMCO’s global credit team specializing in banks and financials recently traveled with me to New York for on-site due diligence meetings with CEOs, CFOs, treasurers and senior executives at several U.S. banks and specialty financial firms. Our meetings reinforced our conviction that today’s dark clouds may give way to clearer skies, particularly if the economy regains momentum and Greek and European sovereign concerns ease during the second half of this year. This could not only improve most risk assets but also shine sunlight on select banks that appear positioned to benefit from a gradually improving outlook. Despite near-term uncertainty, we believe credit investments in many banks, and in particular U.S. banks, should outperform various investment alternatives in fixed income (e.g., mortgages, municipals, non-financial investment grade corporate bonds, high yield corporate bonds and emerging corporate bonds) over a longer-term secular horizon due to deleveraging and stronger global banking regulations.

Banks in the New Normal
Investors in global banks and financials face two simple realities over the next several years. First, economic growth in the developed world will likely be below trend due to continued deleveraging of stressed public and private sector balance sheets. Second, global banking regulators are likely to make banks and financial institutions safer by requiring more capital and liquidity buffers.

The combination of subpar economic growth and heightened regulation suggest most entities (e.g., the government, consumers and banks) in the developed world will continue deleveraging. Given this environment, which PIMCO has referred to as the New Normal, it is not surprising in the U.S. that bank lending (and demand for loans) has been and remains weak (chart 1). Nevertheless, the secular journey of deleveraging banks’ balance sheets in developed economies, while a headwind for economic growth, should lead to improving credit trends and fundamentals for bondholders.

In regard to regulation, global banks over the next several years will be adopting Basel III standards for capital, and a relatively small group of systemically important financial institutions (SIFIs) will face additional buffers on top of the minimum 7% Tier 1 common capital ratio under Basel III. SIFI buffers could be up to 2.5%, which translates into minimum capital requirements approaching 9.5% for the largest and most interconnected U.S. financial companies. Regulators are giving banks several years to implement these new cushions (and the official date for compliance under Basel III isn’t until 2019). Nevertheless, we believe banks will race to reach higher capital levels: Stronger banks will likely gain market confidence much faster than weaker banks as Basel III requirements, SIFI buffers and deadlines become clear over time.
Global banks can meet higher capital requirements through retained earnings, restricting and limiting dividends and stock buybacks, asset divestitures or equity infusions. Higher capital buffers under Basel III will likely be the main driver of lower return on equity (ROE) as banks are required to build more equity cushion:

Return on Equity = Return on Assets * Assets / Equity
(lower) (roughly stable) (lower under Basel III)

Although the outlook for lower return on equity is challenging for bank equity holders, lower leverage and higher capital requirements are supportive for bondholders. PIMCO has long supported this view (see the December 2008 U.S. Credit Perspectives: “Credit Now, Equities Later”), which is why it is not surprising banks’ equities have underperformed relative to banks’ credit spreads over the past several years (chart 2). Simply put, the New Normal and global banking re-regulation have supported bank and financial investments higher in the capital structure at the expense of investments at the bottom of the capital structure.

While higher capital requirements help make banks safer and – all else being equal – are favorable for creditors, we should remain cognizant of potential negative unintended consequences across the capital structure if regulatory regimes prove overly onerous. In turn, we challenge global regulators to strike a thoughtful balance between preserving the safety and soundness of the financial system while also fostering economic growth.

Tags: Asset Quality, Austerity, Banking Regulations, Brazil, Capital Position, Debt Burden, Debt Crisis, Debt Levels, Economic Momentum, Global Banking, Global Banks, Macroeconomic Environment, Market Weakness, Monetary Union, Policy Coordination, Political Realities, Risk Aversion, Social Unrest, Sovereign Debt, Stress Test, World Economy
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