Friday, August 3rd, 2012
After the financial implosion of the past half decade, along with relative stagnation of the U.S. economy ex housing bubble since the early ’00s, many are looking at Germany as a compelling mix of private enterprise, government, and worker i.e. a more balanced form of “capitalism”. Unlike U.S. corporations, large German companies have labor represented on their corporate boards. Unions in the private sector still are viable entities as they have a vested interest in long term success of companies. After the integration of East and West Germany a lot of very difficult labor reforms took place, and German wages have adjusted downward to compete globally. Obviously the country has a benefit from the “lower than it would if Germany was independent” currency, but Germany seems to be doing a lot of things right economically. One area is in unemployment where the German rate has been below America’s for quite some time. This was highlighted in 2010 when I asked if we could dare to learn anything [Oct 1, 2010: German Unemployment Down to 7.2% after Peaking at 8.7%; Can we Learn Anything?]
BusinessWeek takes a closer look at one intriguing part of the German model: German style vocational apprenticeships. Would they ever be accepted in the U.S.? Most likely not – at least in the current environment – where corporations would push back against the added cost (and regulation), and the view on businesses are more as independent global entities rather than part of American society. That said, I have read of a few individual companies starting small pilot programs of this type but nothing large scale.
Either way, it’s an interesting question to ask if they would benefit the society as a whole versus the current system of students taking on enormous debt for “going nowhere” degrees, concurrent with corporations complaining of a lack of applicable skills in the workforce. In a perfect “free market” students should be figuring out on their own what those skill sets are that are needed in the U.S. corporate world and putting themselves into those type of educational programs to benefit – but there seems to be a disconnect somewhere in the chain. Since the Germany model has education designed by industry rather than “the ivory tower set” there is a lot to be said for this form of training, and a substantial benefit to companies. But certainly someone has to pay the cost of it. It also puts to question the larger system in the U.S. – should large business care about the domestic economy at all or is it simply profit at all cost with little worry about the impact of a local economy? With a global labor pool these questions are much more important than they would have been 50 years ago where business was much more tied to the country they were located in.
- In a world of high youth unemployment, where the supply of skilled labor often fails to match employer demand, Germany believes help can be found in its Dual Vocational Training System (TVET)—a time-tested economic model now incorporated into the Federal Republic’s law. This program, many supporters believe, is the reason why Germany has the lowest jobless rate among young people of any industrialized nation in the world—around 7 percent or 8 percent. With so many Americans struggling to find employment after graduating high school and college it might be worth asking: Can the German approach be brought to the U.S.?
- The German concept is simple: After students complete their mandatory years of schooling, usually around age 18, they apply to a private company for a two or three year training contract. If accepted, the government supplements the trainee’s on-the-job learning with more broad-based education in his or her field of choice at a publicly funded vocational school.
- Usually, trainees spend three to four days at work and one to two in the classroom. At the end, the theory goes, they come out with both practical and technical skills to compete in a global market, along with a good overall perspective on the nature of their profession.
- They also receive a state certificate for passing company exams, designed and administred by industry groups—a credential that allows transfer to similarly oriented businesses should the training company not retain them beyond the initial contract.
- The advantages are clear. TVET ensures there’s a job ready for every young person enrolled in vocational school, because no one is admitted unless an employer has already offered a training contract. No job offer, no admission. In this way, there is less risk of heartbreak when years of hard work in university go unrewarded by an unforgiving market. Students also know what they’re getting before the first day of class. This contrasts with the U.S., where many young individuals take on exorbitant amounts of debt to attend college and grad school, only to find no placement on the other end
- But the apprenticeship model faces significant obstacles in the U.S. “Thus far, the U.S. corporate sector does not see technical and vocational training as one of its key responsibilities,” says Andreas Koenig, Head of Section, Vocational Training & Labour Markets at the Economic Development & Employment Department in Germany. “It is therefore not yet ready to invest in technical and vocational education and training that goes beyond a few weeks of induction or learning on the job.”
- Indeed, a need to change the culture of the industrialized world is a point Koenig and his colleagues made repeatedly during a presentation of the TVET model at the German Mission to the U.N. in New York last week. To create an effective system, many advanced nations must lose the stigma attached to vocational and technical school as a fallback for those who have failed in higher education. Rather, the training system should be embraced because it works, as the German youth unemployment rate shows.
- Also standing in the way of the dual system’s acceptance is the antiregulatory fervor shared by many American corporations. As Yorck Sievers from the German Chambers of Industry and Commerce points out, efforts of private industry must be harmonized to fund and make the system effective. Companies would have to accept state oversight of training, which generates overhead expenses.
- But to proponents, the immediate cost pays for itself in the form of a more skilled economy. “German VET builds competence and real ability in blue and in white collar jobs,” writes Sievers, who says the trainees benefit from their acquired technical abilities in a globalized market economy. “They find jobs easier these days, get paid better, and work under much better conditions.”
Tags: Applicable Skills, Apprenticeships, Businessweek, Enormous Debt, German Companies, German Model, German Unemployment, Global Entities, Housing Bubble, Implosion, Individual Companies, Pilot Programs, Private Enterprise, Quite Some Time, Relative Stagnation, S Corporations, Term Success, Vested Interest, Viable Entities, West Germany
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Friday, April 13th, 2012
by Neel Kashkari, Head of Equities, PIMCO
- Stock prices today are anchored on strong profits, hence investors’ intense focus on the sustainability of those profits. If they fall, stock prices are likely to follow.
- No doubt individual companies and individual sectors will face margin pressure. But for the equity market as a whole, our central scenario is for corporate margins to remain strong in the near future.
- As always, we are buying individual companies we like based on our analysis of their own fundamentals in the context of the economic environment they are operating in, and we are keeping one eye focused on managing downside risks.
We’ve all heard the story of Sir Isaac Newton sitting in his garden pondering the universe when an apple fell from above and supposedly smacked him in the head. It is said to have been a Eureka! moment when Newton first asked the fundamental question: Why? Why did the apple fall? For centuries people had seen objects fall, but Newton was the first to question what the rest of humanity had just accepted for thousands of years. Today Newton’s question seems obvious – but the most powerful ideas are usually obvious after someone points them out. Newton’s ability to see through the common beliefs of those around him and spot something important is a trait shared by scientific visionaries over the centuries – and one that the most successful investors have occasionally exhibited.
Newton’s questioning of nature led to his development of fundamental laws of physics that have transformed our understanding of the universe. Indeed, in many ways Newton’s ideas have become our own common beliefs similar to those that Newton so brilliantly looked past in his own time. Newton’s Laws, as they are called, are taught in introductory physics classes worldwide:
- A body at rest tends to stay at rest. A body in motion tends to stay in motion.
- Force is equal to the product of mass times acceleration.
- For every action there is an equal and opposite reaction.
These simple rules permeate our beliefs about how the world works and we often don’t realize it. When people say “what goes up must come down,” they are implicitly referring to Newton’s Second Law: In the presence of earth’s gravity, a mass will always accelerate in the direction of that force. Hence, an apple thrown in the air (or grown on a tree) will eventually fall to the ground.
These Newtonian beliefs also affect how many people think about investing. “Mean reversion” is the investment world’s version of “what goes up must come down.” It’s usually a pretty good rule. Mean reversion suggested that the extraordinary price to earnings multiples of technology stocks in the late 1990s couldn’t last; they would eventually revert to historical average valuations. Similarly, mean reversion suggested that house price increases in the U.S. in the mid-2000s weren’t sustainable. They didn’t last either.
But is mean reversion always right? In 2000 mean reversion would have suggested the bull market for bonds would be over. Interest rates couldn’t stay low, let alone fall further, could they? But here we are in 2012 and we’re not predicting a bear market any time soon.
In tension with mean reversion is Newton’s First Law: A body at rest tends to stay at rest. In investment parlance there needs to be a catalyst to force the system to revert to the mean. Left alone, it may continue in its elevated state for a long time.
The timing of that reversion matters: Just because someone can identify a bubble doesn’t mean they can make money from their insight. People who shorted tech stocks too early may have lost a lot of money while the bubble kept expanding.
Today many equity investors are asking whether corporate profit margins can stay strong. Coming out of the financial crisis, many large corporations, especially multinationals, have enjoyed record profits. This is counterintuitive given the low growth much of the developed world has experienced during this time. Corporations responded to the financial crisis by paying down debt and cutting costs, positioning them for strong profit growth as their end markets slowly recovered. Figure 1 is a chart of corporate profit margins, earnings multiples and the overall level of the S&P 500.
Global equity markets have climbed 6.5% year to date (source: MSCI World Index through 11 April 2012). With record profits, earnings multiples still seem reasonable at 14.5 times. Stock prices today are anchored on strong profits, hence investors’ intense focus on the sustainability of those profits. If they fall, stock prices are likely to follow. To assess the vulnerability of profit margins, let’s review several possible catalysts for profit mean reversion and consider how likely they are to occur:
1. Increase in Cost of Labor
Labor costs are about 70% of the total cost of production for corporations, according to Federal Reserve research. There is no question that if competition for a finite labor pool increased, this could put immediate pressure on corporate margins. However, in the U.S. unemployment remains high, stuck at 8.2% as of March 2012, with 14.5% of Americans either out of work or looking for more work (source: Bureau of Labor Statistics). Obviously individual industries and companies may experience wage inflation due to scarcity of workers with specialized skills, but until unemployment falls closer to more normal levels, corporate margins do not appear vulnerable from a spike in unit labor costs. Last week’s disappointing jobs report highlights labor’s slow recovery.
2. Economic Slowdown or Recession
Clearly if the U.S. or world economy were to meaningfully slow or fall into another recession, corporate profits and stock prices would suffer. Our base case continues to be a muddle-through scenario of low growth while avoiding recession in the U.S. and globally (though we do forecast a recession in Europe due to their fiscal crisis and policy response). Certainly a disorderly unraveling of the eurozone, an oil price shock or a hard landing in the emerging markets could tip the global economy into recession, but that is not our central scenario.
3. Dollar Strengthening
Strong appreciation of the dollar would make U.S. exporters less competitive, which would certainly affect their margins. But companies producing goods and services abroad for sale in America would benefit. Our base case scenario is for a long-term secular decline of the dollar, which assumes continued strengthening of emerging market economies and a Europe that muddles through its fiscal crisis. If either proved incorrect, they could trigger a global recession, which would have a larger impact on corporate margins than dollar strengthening alone.
4. Cost of Capital Increase
If costs for corporations to borrow or to raise equity capital increased substantially, corporate margins would be vulnerable. Corporations today on average have low net leverage with record cash of some $2.23 trillion, according to Federal Reserve data. Climbing rates could pressure corporate margins. They could also push companies to grow more slowly or even contract their activities. Again, this is not our central forecast. We believe the Federal Reserve will stick to its forecast of maintaining exceptionally low rates until at least late 2014, and we believe the European Central Bank will be forced to continue aggressive monetary stimulus to combat its fiscal crisis. It is worth noting that corporations could in fact increase their net leverage from today’s conservative levels, which could actually boost corporate margins.
5. Increased Corporate Taxes
If the federal government increased effective taxes on corporations their net margins would obviously fall. But this appears highly unlikely in today’s political environment. Both Democrats and Republicans are advocating various policies to boost job growth, including pro-growth corporate tax reform. The most common tax reform proposals are revenue neutral, lowering marginal corporate tax rates in exchange for eliminating loopholes and deductions. Policy theory suggests a simpler, fairer tax code should encourage investment and enhance economic competitiveness. While political winds can change direction, as long as unemployment remains high, politicians will be cautious about increasing barriers for corporate investment.
None of these catalysts for profit mean reversion appears likely in the near future, though each is impossible to rule out. Given the importance of corporate margins on today’s stock prices, it is worth taking this review further and also considering a macroeconomic perspective on margins.
Some investors have used the Kalecki profits equation to break corporate profits into its fundamental macroeconomic elements, specifically:
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
From this equation, investors can see that corporate profits have expanded to such a large share of GDP due to large government deficits. Therefore, if the government implemented a deficit reduction plan, corporate profits could suffer.
Let’s explore this scenario in more detail. We know that Washington D.C. is currently dysfunctional and that large deficit spending is ultimately unsustainable. However, if Republicans and Democrats can agree on anything, it is to keep spending. This is the reason Washington hasn’t produced a new Federal budget in three years – they have simply agreed to extend the status quo. Hence the dysfunction of Washington suggests no meaningful deficit reduction agreement in the near future. Don’t forget that President Obama and both Congressional Republicans and Democrats were united in their dismissal of the serious Simpson-Bowles deficit reduction plan.
Let’s say the tone in Washington does somehow change and consensus is reached to bring the Federal budget into balance. Policy analysts of both parties know that long-term deficits are being driven by demographic changes and the long-term expansion of entitlement programs for our aging society. As with Simpson-Bowles, any major deficit reduction agreement would almost certainly phase in slowly, over many years. Even though current law prescribes a fiscal cliff at the end of this year due to last year’s temporary budget and debt ceiling extensions, Washington will almost certainly agree to delay this deadline. It is hard to imagine an abrupt fiscal adjustment happening in the near future.
If there were a long-term grand bargain, it is true federal government deficits as a percentage of GDP would likely fall, but such a scenario would almost certainly be a net positive for confidence in our economic and political systems and provide a strong tailwind to economic activity. Even if corporate margins fell as federal budgets gradually came into balance, it is easy to imagine corporate profits continuing to grow. It is ultimately the dollars of profit, rather than margins, that drive the value of companies. It is hard to see corporate profits, or stock prices, falling because of long-term fiscal discipline.
These considerations all suggest corporate profits are not on the verge of collapsing. In fact, we are optimistic corporations, on a case-by-case basis, can even continue to improve them through the adoption of new technologies. As always, we are buying individual companies we like based on our analysis of their own fundamentals in the context of the economic environment they are operating in, rather than buying sectors or the market as a whole. No doubt individual companies and individual sectors will face margin pressure. But for the equity market as a whole, our central scenario is for corporate margins to remain strong in the near future. Profits are strongly correlated to nominal GDP. The Federal Reserve’s commitment to lowering unemployment through aggressive monetary stimulus should support both nominal GDP and corporate profit growth.
As we’ve written in the past, we are keeping one eye focused on managing downside risks in our equity portfolios. Serious risks from Europe remain, and at some point the Federal Reserve will have to end its aggressive easing policy. We are still living in a bimodal world, but we are finding good companies today at attractive values that are selling into higher growth markets. We prefer those with strong balance sheets that are paying healthy dividends.
Given the investment analogies of Newton’s First and Second Laws, you may be wondering if there’s an investment analogy for Newton’s Third Law: For every action there is an equal and opposite reaction? Yes: There is no free lunch. That’ll be the subject of a future Equity Focus. In the meantime, be wary of predictions of falling apples (I’m talking about the fruit).
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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. 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.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. 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 material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
Tags: Accelera, Apple Fall, Body In Motion, Downside Risks, Economic Environment, Fundamental Laws, Fundamental Question, Individual Companies, Intense Focus, Introductory Physics Classes, Isaac Newton, Laws Of Physics, Margin Pressure, Margins, Mass Times, No Doubt, Own Time, Sir Isaac Newton, Stock Prices, Visionaries
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Tuesday, April 10th, 2012
by Dr. Scott Brown, Ph. D, Chief Economist, Raymond James
April 9 – April 13, 2012
The stock market has risen nicely this year, partly on improving economic data, but are such gains justified by the earnings outlook? The level of the S&P 500 Index does not appear to be out of line with earnings expectations, but there may be some pressure on profits over the longer term. As the election approaches, we may hear more about class warfare.
In the late 1990s, share prices rose more than was justified by the earnings outlook. In hindsight, the market was clearly in a bubble. In the last decade, the market rose roughly in line with earnings. However, the Great Recession sent earnings sharply lower, and the stock market followed. Since the recession has ended, earnings have more than recovered. Bottom-up earnings estimates for more than a year out, compiled from analysts’ forecasts of individual companies, still look a bit giddy, but that’s typical. Top-down estimates, provided by economists and strategists, are more moderate – and consistent with some slowing in corporate earnings relative to the last few years. That’s to be expected. Much of the rebound in earnings has reflected the bounce-back from the recession. Firms have a tendency to cut too many jobs and overly curtail capital expenditures near the end of the downturn and there’s some catch-up as conditions begin to improve.
Part of the strength in corporate profits in the recovery has been due to the restraint in labor costs. Given the large amount of slack in the labor market, wage pressures are relatively subdued. Moreover, since the labor market slack is expected to remain elevated for some time, corporate profits are likely to stay relatively strong. As a percentage of national income, corporate profits are very high and labor compensation is relatively low. The share of national income going to profits and the share going to labor cycles back and forth over time and at some point the pendulum seems likely to swing back in the other direction, but probably not anytime soon.
It’s hard to have an intelligent discussion about the distribution of income. One side sites “corporate greed,” the other sites “class envy.” For the most part, economists have generally shied away from income distribution issues. This is mostly a question of politics. It’s difficult to say what an “appropriate” distribution of income should be and what steps should be taken to achieve it.
However, there’s no doubting that the distribution of income has widened significantly over the last thirty years. Real wages have stagnated. A lot of that is due to the decline of union membership. In the early 1970s, 25% of private-sector jobs were union jobs. Now unions account for less than less than 7% (note that 37% of public-sector jobs are union, but many of these are teachers and the dynamics are a lot different). In the late 1960s and early 1970s, we typically had more than 300 work stoppages per year, involving millions of workers. We had 19 last year, involving 113,000 workers.
It’s unclear what role the distribution of income will take in this year’s election, but investors should pay attention.
Tags: Capital Expenditures, Chief Economist, Class Warfare, Corporate Earnings, Corporate Profits, Downturn, Dr Scott, Earnings Estimates, Economic Data, Hindsight, Individual Companies, Labor Compensation, Last Decade, Raymond James, Recession, Share Prices, Slack, Stock Market, Strategists, Wage Pressures
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Monday, November 14th, 2011
by Neel Kashkari, Chief Equity Strategist, PIMCO
- We believe investment managers can analyze numerous data sources and apply lessons learned from past economic cycles to make reasonable assessments about the global economic outlook.
- We also believe managers can make reasonable judgments about asset classes over the long term and, through rigorous bottom-up research, develop an edge regarding the outlook for individual companies.
- However, the market as a whole is much better at aggregating all the information that could affect any of the thousands of companies in the stock market than any investor could possibly be. Hence predictions of where the stock market will close on a given date are likely to be wrong.
People love bold predictions. More precisely: People love people who make bold predictions that are eventually proven correct. We tend to put such soothsayers on pedestals and anoint them heroes. And why shouldn’t we? They were able to see important outcomes that the rest of us missed.
Consider two notable examples:
- In 1969 quarterback Joe Namath boldly guaranteed his underdog New York Jets would beat the Baltimore Colts to win the Super Bowl. An audacious prediction, when Namath successfully led his team to beat the Colts he ensured his place in sports history.
- In 1961 President Kennedy called for the nation to land a man on the moon and return him safely to Earth by the end of the decade. At the time an American hadn’t even orbited the Earth, let alone made it to the moon. Considering today it takes almost a decade just to design a new rocket, Kennedy’s call to action from virtually a blank sheet of paper was truly a “moon shot.”
But our memories tend to be skewed: we remember the heroes but often forget the bold predictions that fell flat. For example:
- What was the name of the pastor who predicted the world would end on May 21, 2011? I can’t remember either. I’m sure I would remember had the world actually ended. (Well, maybe not, but you get my point.)
- In December 2007 sell-side equity strategist Abby Joseph Cohen predicted the S&P 500 would climb from 1,463 to reach 1,675 by the end of 2008. Given the brewing financial crisis, this was a bold call. In fact, the crisis dramatically worsened and the S&P 500 ended 2008 at 903. As the U.S. crisis recedes into memory, people have moved on.
Turning on business television, one can hear bold predictions almost daily: Where will interest rates be in the future or what actions will policymakers take to solve the European debt crisis? Every January many strategists predict the level of the stock market at year-end. It’s an annual tradition.
But with so many bold predictions routinely made on every side of virtually every economic issue, it can be hard to determine which predictions to take seriously. How does one make sense of the noise?
I believe two questions are essential to assessing predictions:
First, is the prediction “knowable?” Joe Namath was certainly able to influence the outcome of the Super Bowl. His prediction should have carried more weight than that of the average football commentator. We should pay more attention to those with special insights into knowable topics.
Second, does the person making the prediction have any downside if wrong? While President Kennedy is rightly lauded for setting the country on a path that transformed America’s standing in the world, presidents frequently make such bold calls, and the majority of them expire unfulfilled and unnoticed. For example, in 1983 President Reagan called for development of a missile shield to defend America against a nuclear attack from the Soviet Union; “Star Wars” never came to pass. In 2003 President Bush called for hydrogen cars to be commercially viable by 2020; seven years later President Obama cancelled their funding. There is little downside to Presidents setting ambitious goals – and they might improve their place in history if one of them works out.
In a society where we hoist the heroes but forget the mistakes, incentives are strongly skewed toward making as many bold predictions as possible, because at least a few are bound to hit. We should pay more attention to those who actually have something to lose if they are wrong.
So let’s analyze both questions in the context of predicting markets:
We at PIMCO believe certain investment topics are knowable and some are not knowable. To borrow a phrase from former Defense Secretary Donald Rumsfeld, there are Known Knowns and Known Unknowns. I will leave Unknown Unknowns for a future piece.
- Global economic outlook. We believe investment managers can analyze numerous data sources on global economic activity and apply lessons learned from past economic cycles to make reasonable assessments for what the future is likely to hold. This is complicated by changing global dynamics and sometimes unpredictable politics. But a robust economic framework can yield real benefits for investors.
- Relative value among asset classes. Looking at the current prices of securities, such as P/E multiples, dividend yields and expected earnings growth for stocks, and spreads and yields for bonds, in the context of the current economic environment, managers can make reasonable judgments about the overall expected return from asset classes over the long term. From this perspective, managers can determine which asset classes they believe will provide the best risk-adjusted returns over time. Stress testing these assumptions against a range of economic environments is important.
- Outlook for an individual security, be it a stock or bond. Through rigorous bottom-up research, analyzing financial statements, meeting with management, speaking with suppliers, customers and competitors, we believe managers can develop an edge regarding the outlook for individual companies. We will often research a stock only to uncover no special view; we let a lot of pitches go by before we find a stock we like in which we believe we have found an edge.
- However, innovation, business expansions and turnarounds take time. While investment managers may have confidence in a company’s growth plans, whether that expansion takes one quarter or one year to bear fruit can be hard to know. Hence, taking advantage of fundamental research often requires lengthy holding periods. We generally expect to hold stocks for three to five years.
- The level of the stock market on a particular date in the future. Stocks receive cash flows last in the capital structure, so any new information that can affect instruments senior to equities can also affect equities: Political events. Economic events. Interest rate moves. Industry dynamics. Management changes. Product innovation, etc.
- Equity prices are continuously updating to reflect the constant stream of new information that could affect the stock. As described above, we believe we can get to know individual companies well through deep fundamental analysis. But the market as a whole is much better at aggregating all the information that could affect any of the thousands of companies in the stock market than any investor could possibly be.
- Think of an individual trying to compete against a supercomputer that is composed of an almost infinite number of microprocessors working in parallel crunching vast amounts of data as it pours in. The computer isn’t perfect and may not have wisdom, but it has a huge advantage over the analyst. In the short-term, equity markets contain the bulk of available information that should affect stocks.
- As a result, predicting where the Dow will close on a given date is like trying to predict where ocean waves will splash against the Newport Beach pier at a given moment in time. While oceanographers can tell us the general time and average level of high and low tide, they know the natural dynamism of the sea limits their precision to forecasting trends and averages rather than point estimates. We believe the same is true for forecasting the stock market as a whole.
To understand the second question, the downside of being wrong, it is important to consider who is making the prediction. One common group of predictors work for broker-dealers, generating investment ideas hoping investment managers will find their ideas interesting and reward them by trading with their firms. They are incentivized to offer as many ideas as possible. Some are bound to be thought-provoking, and there is little downside if their predictions are wrong: They aren’t actually investing based on their views.
In contrast, investment managers are seeking to generate attractive returns for their clients. Managers make decisions based on their outlook for securities and if they are wrong, there is downside: Clients may not perform as well as they hoped. While PIMCO has sought to generate strong performance for our clients over our 40-year history, we aren’t perfect, and we work hard to get as many of our calls right as possible.
Most of the commentators predicting the level of the Dow at year-end are sell-side analysts rather than investment managers. This makes sense: There is little downside for being wrong most of the time. The interesting question for the investment managers who do partake in such fortune-telling is do they actually utilize their own predictions? Most equity investment managers are managing portfolios that are required to be fully invested in equities at all times. If they believe the Dow will close at 13,000 on December 31, can they actually take advantage of that view since they don’t have idle cash to put to work? And if they can’t use their own predictions, why are they making them in the first place?
If we’re right – and neither PIMCO, nor anyone else, can accurately predict the level of the stock market at a certain date in one week, one month or one year – why do so many sell-side analysts (and a few investment managers) make such predictions? And why do we pay any attention?
I will answer my question with a question: Why do millions of people watch professional wrestling, “The Real Housewives” or “Jersey Shore?” It makes for entertaining television.
My hope from this piece is not that you stop watching business television. I certainly watch regularly and I also participate, sharing PIMCO’s views. I think it is a unique medium in which to follow markets and quickly hear a variety of perspectives on important topics.
My hope is that it becomes a little easier to distinguish thoughtful commentators discussing knowable economic topics from entertainers throwing darts.
In conclusion, I will leave you with my very own bold prediction. I am utterly unqualified to make it. I have no information edge nor can I possibly influence the outcome. In addition, there is absolutely no downside to my being wrong. Are you ready for it? “The Cleveland Browns will win the Super Bowl.” You heard it here first. (Note: I didn’t specify in which year.)
Copyright © PIMCO
Tags: Asset Classes, Baltimore Colts, Blank Sheet Of Paper, Bold Predictions, Data Sources, Economic Cycles, Global Economic Outlook, Individual Companies, Investment Managers, Joe Namath, Known Unknowns, Man On The Moon, Moon Shot, New Rocket, New York Jets, Pedestals, President Kennedy, Soothsayers, Sports History, Stock Market, Strategist
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Thursday, July 15th, 2010
This article is a guest contribution by John R. Taylor, Jr., Chief Investment Officer, F/X Concepts.
This week, the US equity market is starting its quarterly earnings ritual and the odds favor a strong performance for the closely followed investor favorites. Although the game is rigged as almost 50% of the corporate managements have adjusted their guidance in the past month trying to lower analysts’ projections down to levels that the companies know they can beat. Despite the opera buffa quality of the process, the S&P 500 companies will still produce a dramatic increase in earnings over the second quarter of 2009. The same can be said of the major European corporations. The increase in corporate earnings and the projection of further increases seems to be universal, and many argue that the positive outlook for thousands of individual companies must sum to an impressive economic recovery.
Despite these positive micro stories, they do not add up to a happy macro outcome. There are several reasons why this is the case, but the result is that the vast majority of the analysts that examine individual companies are bullish and almost all of the macro analysts are bearish, many like us, and dramatically so.
There is a very large segment of the US, Canadian, and European economies that is not part of theglobal equity system and this major fraction of the economies is not doing at all well. Even if theoptimists will retort that moaning about the depressed readings in the National Federation of Independent Businesses (NFIB) reports, the collapse in bank credit, and the sharp decline in the ECRI leading indicators are nothing but anecdotal examples, they should carry at least as much weight as the positive earnings numbers. These smaller businesses represent the lion’s share of the internal and retail economies, while the giants represent almost all of the export and global part of the economies.
The slowdown in the non-S&P sector of the economy is actually reflected in the sluggish increase in the major companies’ top-line revenue, but the tight cost controls that have allowed their reported earnings to keep climbing has exaggerated the decline hitting the independent businesses. The shrinking cost of goods at every Fortune 100 company represents the top line sales of many smaller companies and the take-home pay of thousands of employees. Because nominal GDP is growing more slowly than the outstanding national debt is compounding, it is becoming a more oppressive weight on the “non-S&P” economy, tightening the financial position of small businesses and the consumer.
The macro pessimists actually have academic research firmly on their side. Just two points must suffice here. Keynes famously noted that there was a savings paradox. As I would paraphrase it, if one family saves, it is good for the family, but if all families save, the economy will be ruined. This is happening everywhere. The S&P 500 companies are all saving, by cutting costs – and building giant worthless cash mountains (like they did in the 1930’s) – but this is shrinking nominal GDP as their saved costs are others’ lost earnings. The global economies are all trying to grow by increasing exports, which is the same as saving. If there are no countries stimulating consumption, the world economy will shrink. If all countries try to balance their fiscal books, they are clearly saving. The Eurozone, the UK, and the American states are dramatic examples of this. And if consumers build up their savings, we know what happens to retail sales and the GDP. On top of this the money multiplier comes into play. With the global banking system suffering under an extremely high load of worthless assets – whether recognized or not – and being forced to improve their capital allocation for risk by the Basel II and Basel III rules, banks must cut back the amount of credit that they make available to the economy. The multiplier will force global economies to shrink in the years ahead. Cash is now king, worthless or not, so buy dollars.
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Monday, May 10th, 2010
This article is a guest contribution by Mark Mobius, Vice Chairman, Franklin Templeton Investments.
The value of the Chinese currency, the renminbi, has been a hot topic in recent weeks. China ties the value of the renminbi to the value of the U.S. dollar. Recently, however, the U.S. and some global institutions have increased pressure on China to change this valuation, which, they argue, has kept Chinese exports relative to the U.S. comparatively cheap. But the U.S. Treasury Department, which was due to issue a report on China’s currency on April 15, 2010, delayed this report by several months in order to allow a series of high-level meetings to take place.
As bottom-up equity investors, we focus on individual companies when evaluating investment opportunities. However, it is also important for us to understand how a company looks within its sector and country or region, and as such, our outlook on currencies forms part of our broader assessment on a company’s operating environment.
We look at all currencies on the basis of purchasing power parity (i.e. comparisons of different inflation rates) and, of course, any controls and influences imposed by the central bank of each country. We then try to asses whether a currency is over or undervalued, how devaluation or revaluation may impact a specific currency, and then gauge the potential impact of such currency characteristics on the business of each company. For example, for an export-oriented company, a devaluation of its operating currency could be positive because it may be able to export more aggressively and more profitably, while the opposite could be true for an import-oriented company.
Our purchasing power parity studies indicate that China’s currency, the renminbi, is actually close to fair value against the U.S. dollar at this stage. Judging from past experience, we believe that China is unlikely to act quickly on currency adjustments because they are afraid of the consequences of such volatility.
The Chinese Central Bank Governor, Zhou Xiaochuan, hinted in March that the renminbi might be allowed to rise once the global economy recovered. However, the Commerce Ministry and others protective of Chinese exporters expressed opposition to a rise in the renminbi, as exporters saw shipments fall early in 2009 for the first time since China began opening trade in the late 1970s.
As we see it, Chinese exporters have plenty of orders and Chinese companies are even stockpiling commodities such as crude oil, various metals, and grains, as a hedge against what appears to be rising inflation. Wages are moving up – in the export provinces of coastal China, for example, wages were raised by about 20% recently in an attempt to attract more workers from the interior.
If the renminbi appreciates, that could mean losses in China’s vast foreign reserves, which would fall in renminbi terms. Meanwhile, the Chinese are addressing the depreciation of the U.S. dollar with a diversification of their foreign reserves into other currencies and a move to higher interest rate securities compared to low-interest U.S. Treasuries.
The purchasing and storing of commodities is another way for China to conserve its value of foreign exchange reserves in an environment of a depreciating U.S. dollar. While statistics on commodity inventory levels in China may not be reliable or fully disclosed, our current information indicates that China’s commodity inventory levels are high. The Chinese favor commodities knowing that they will eventually be used, and also because they are concerned, given high and increasing demand, that commodity prices could rise further. A possible course of action could be to revalue the renminbi upwards so commodities would be cheaper in renminbi terms and wage demands could more easily be met. But with nationalist emotions rising, that course is probably closed.
Even though it is not clear if, when, and how China will make an upward revision in the value of its currency, one trend is clear: moves involving the renminbi by Chinese authorities will be closely watched around the world as China steps up to play a bigger role in world trade.
Source: Department of Human Resources and Social Security of Guangdong Province, Ministry of Human Resources and Social Security of the People’s Republic of China, as of April 30, 2010.
Source: Keeping an Eye on Currencies, Mark Mobius, Franklin Templeton Investments, May 10, 2010.
Tags: China, China Currency, Chinese Currency, Chinese Exports, Commodities, Devaluation, Equity Investors, Franklin Templeton Investments, Global Institutions, Hot Topic, Individual Companies, Inflation Rates, Level Meetings, Mark Mobius, Operating Environment, Oriented Company, Purchasing Power Parity, Renminbi, Revaluation, Treasury Department, U S Treasury, U S Treasury Department
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