Are Investors Worried About the Right Risk?

Monday, July 30th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

Individual and institutional investors alike have been shifting their capital from stocks to cash and bonds at a rapid rate in recent years, despite extraordinarily low interest rates. But if investors stop to weigh the importance of two different types of risk, they’ll see they still need stocks.

It’s tempting to give up on stocks after more than a decade of high volatility and low returns from stocks—and lower volatility with higher returns from bonds. But we think that 10 years from now, investors who do so will wish they had stayed in stocks—or added to them.

That’s not to say we think investors don’t need bonds. Despite extremely low current yields, we think bonds should still play their usual roles in the portfolios of most long-term investors: providing income, preserving capital and providing protection in times of stock-market distress (because bond prices tend to rise at such times). Bonds will be especially important if the market outcomes are at the extreme low end of our forecast range of potential outcomes.

But most investors are likely to need stocks to feel confident that they will have enough to live on, despite the high volatility of recent years. Remember that volatility isn’t the only type of risk. There’s also shortfall risk: not having enough money to meet your spending requirements. Investors must weigh both types of risk when making strategic asset-allocation decisions.

If you’re just thinking about market volatility, bond-oriented portfolios may look very appealing, especially today. We estimate there is less than a 2% chance that a portfolio with a 20% allocation to stocks and an 80% allocation to bonds will suffer a 20% peak-to-trough loss at some point over the next 10 years, compared with the 15% chance of such a loss for a portfolio with 60% in stocks (Display, left), as the left side of the display below shows. But if you’re just thinking about shortfall risk, a portfolio with 60% in stocks looks more attractive (Display, right).

We estimate that a 65-year-old retired couple planning to withdraw only 3% of their portfolio, grown with inflation, has a 12% chance of running out of money if they invest in the portfolio with 60% in stocks. That may not sound great, but it is materially better than the 24% odds of running out of money if they invest in a portfolio with 20% in stocks.

Today, uncertain macroeconomic conditions make large stock-market drops more likely than usual, and very low bond yields provide a thinner cushion. As a result, market risk can’t easily be avoided. And trying to avoid market risk is not a good strategy if it increases shortfall risk too much. A 20% loss is certainly painful, but it doesn’t hurt as much as running out of all of your money. Many investors who are currently focused on market volatility should be paying at least as much attention to shortfall risk.

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

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

The Bernstein Wealth Forecasting System,^SM driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Copyright © AllianceBernstein

Tags: Asset Allocation Decisions, Bond Prices, Bonds, Chief Investment Strategist, Current Yields, Enough Money, Institutional Investors, Low Interest Rates, Market Outcomes, Market Volatility, Portfolios, Rapid Rate, Seth, Shortfall, Stock Market, Stocks, Strategic Asset Allocation, Term Investors, Trough
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We Are All Alone

Thursday, July 19th, 2012

by John Nyaradi, Wall Street Sector Selector

Investors are on their own and cannot count on the Federal Reserve to save their portfolios.

Global markets seem to be pricing in a new round of quantitative easing from the Federal Reserve.  Dr. Bernanke and his colleagues will likely comply sometime between now and December.  However, even with more quantitative easing, investors can’t count on the Federal Reserve to rescue the stock market and their portfolios.  We are on our own, and here’s why:

1. Europe’s Debt Crisis

Europe is the crisis that just won’t quit, with Spain, Italy, Greece, ad nauseam , all running out of money. There is simply no solution to this problem as there is simply not enough money in Europe to save Italy and Spain. When the piper finally demands to be paid, no central bank on earth will have the firepower to stop the global financial avalanche that this crisis could trigger.

2. Earnings

Second-quarter earnings season is shaping up as a weak affair with downgrades coming from most every sector. As we all know, stock prices eventually are based on earnings, and no amount of monetary policy, low interest rates or quantitative easing can add profits to corporate bottom lines. Monetary policy can set the stage for, but cannot create, demand.

3. Global Recession

This item is part and parcel of Items #1 and #2. Recession is quickly spreading across Europe. China’s economy, while still growing briskly by developed world standards, is rapidly slowing. The United States limps along with a 1.9% growth rate and recent GDP estimates have been sharply revised downwards. Like antibiotics for a sick person, Dr. Bernanke and his Fed can help but the disease must run its course and the patient must have the physical strength to survive on his own.

4. Diminishing Returns of Quantitative Easing

Each round of quantitative easing has smaller impact and brings greater risks for the global economy. Last week’s interest rate cuts by the European Central Bank, the People’s Bank of China and more quantitative easing from the Bank of England were largely ignored by global markets which, in the “good old days,” would have rallied hard on this sort of same-day global intervention.  Like antibiotics fighting a virus, quantitative easing is losing its effect as the virus grows immune and mutates to offset continued attacks.

5. The Dreaded Fiscal Cliff

Dr. Bernanke has made it quite clear in recent testimony to Congress that the “fiscal cliff” coming up in December is too big for him to manage and that it needs to be resolved to avoid a significant economic shock. The hit to GDP from the fiscal cliff would likely trigger another recession in the United States (See Item #3)

ETF strategies for difficult days

So what are we supposed to do as we try to protect capital, prepare for retirement and secure our financial futures? Several options come to mind:

A. Cash: Cash is king, particularly in deflationary, depression-like environments. The U.S. dollar, represented by PowerShares DB Bullish Dollar ETF (NYSEARCA:UUP) is up some 5% since early May as capital seeks the perceived safety of the U.S. dollar. Cash doesn’t have to be U.S. dollars, either, as Swiss francs have been on a roll, along with the Japanese yen (NYSEARCA:FXY)

B. U.S. Treasury Bonds: Like the dollar, the U.S. is still seen as the safest harbor in an uncertain world and U.S. Treasuries are near record low yields and high prices as money flocks to the perceived safety of Uncle Sam. The biggest moves will probably come in the long end of the curve and iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is up some 14% since early April. iShares Barclays 7-10 Year ETF (NYSEARCA:IEF) has gained more than 5% in the same time frame. One day, the “short” bond trade will be the position of a lifetime, but that day does not look like today.

So now it’s summertime, but the living is not likely to be easy, at least for awhile. (apologies to George and Ira Gershwin, “Porgy and Bess”)   We can’t count on Dr. Bernanke and his Federal Reserve to save us from what lies ahead but we can use the power and versatility of exchange traded funds to navigate through these challenging times.  We are all alone.

Get Wall Street Sector Selector’s Free Stock Market Warning Indicator!

Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time. Wall Street Sector Selector holds a position in (TLT)

Copyright © Wall Street Sector Selector

Tags: Ad Nauseam, Bernanke, Bottom Lines, Debt Crisis, Diminishing Returns, Downgrades, Earnings Season, Enough Money, Firepower, Gdp Estimates, Global Economy, Global Markets, Global Recession, Interest Rate Cuts, Italy Greece, Low Interest Rates, Physical Strength, Second Quarter Earnings, Sick Person, Stock Prices
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Three Years and Counting (Kashkari)

Thursday, June 14th, 2012

• In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.
• As heightened volatility persists, many equity investors remain on the sidelines. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.
• We believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term. Equity investors should continue to focus on
  higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

We recently concluded our Secular Forum, an annual event in which PIMCO investment professionals from around the world discuss and debate our three- to five-year outlook for the global economy and financial markets. The Secular Forum process demands that we focus on the long term and imposes a discipline on us that we believe makes us better stewards of our clients’ capital.

Mohamed A. El-Erian published a summary of our conclusions from the Forum, titled Policy Confusions and Inflection Points. And my portfolio manager colleagues are participating in a series of interviews discussing these conclusions.

My goal here is to discuss what our revised Secular Outlook means for equity investors. But first I think it is important to take a moment to review conclusions from prior Secular Forums and objectively consider what has actually happened in the intervening periods. What have we gotten right? What has surprised us?

In the spring of 2009, with the U.S. economy and financial markets still reeling from the financial crisis, PIMCO conducted its annual Secular Forum right on schedule. It was during this time that PIMCO first applied the term New Normal to its updated outlook for the global economy. It is important to note that I wasn’t at PIMCO at the time – I was still at the Treasury helping to fight the financial crisis. I only joined PIMCO six months after I left government.

As government officials consumed with trying to stabilize the global financial system, my colleagues and I were much more concerned about surviving the next few days or weeks than thinking about the next three to five years. It is noteworthy that an investment management firm had the poise to stop to think about the longer-term outlook during that stressful time.

The New Normal called for long-term deleveraging that would lead to lower growth than society had been accustomed to. It called for more modest investment returns across asset classes, as the leveraging of the economy reversed course. It called for increased regulation and reduced globalization. Most importantly, it said there would be no V-shaped recovery that is typically seen after a recession. It would be a long, hard adjustment period with sustained high unemployment. It also called for a transition of stress from private balance sheets to sovereign balance sheets.

These trends, unfortunately for societies, have played out as my PIMCO colleagues forecasted. I also observe that implicit in their forecast was the assumption that policymakers would be successful in stabilizing the financial system and preventing a collapse. In hindsight, they seem to have been more confident than we in government were at the time. I am glad they were right.

While this may seem self-congratulatory for me to pat my PIMCO colleagues on the back, as I noted above, I wasn’t at PIMCO at the time. I am just observing, with the benefit of hindsight, what has actually happened.

While PIMCO’s New Normal call has proven remarkably accurate, its implications for equities were less clear. PIMCO did not forecast that central banks would employ unprecedented aggressive monetary policy via quantitative easing with the specific goal of pushing up the prices of risk assets in an attempt to stimulate economic activity. The QEs have been effective in pushing up equities (see Chart 1 below) and staving off deflation, though the effect on real GDP is less clear. In addition, the New Normal did not forecast record corporate profits that many companies have enjoyed, especially large multinationals. In the past three years, equities have rallied more than the underlying economic fundamentals would have predicted on the back of extraordinary monetary policy activism and strong corporate earnings.

In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.

Chart 2 shows the VIX, or volatility index of the S&P 500 Index, over the past 10 years. You can see three fairly clear periods: “old normal,” financial crisis and New Normal. As the crisis has spread from corporate to sovereign balance sheets and from the U.S. to Europe, sentiment has repeatedly swung from fear to greed and back to fear, triggering wild swings in equity markets.

Many investors, both individuals and institutions, were truly shocked by the losses they experienced during the financial crisis: The S&P 500 fell 38% in 2008. After years of gains, many people couldn’t believe their nest eggs were being destroyed. This experience has left many investors both scared and scarred – and as heightened volatility persists, many equity investors remain on the sidelines.

Our updated Secular Outlook calls for a continuation of the deleveraging we’ve experienced for the past few years. Slow real economic growth in America of 1% to 2%, a likely recession in the eurozone stemming from the ongoing debt crisis, and – and this is really important – slowing growth in the emerging markets of 5%, down from 6% previously. Remember, emerging markets have powered the global economy for the past few years; the U.S. will have to carry more of that load now. But with more moderate overall global economic growth in the next three to five years, markets will be more vulnerable to shocks.

The volatility that equity markets have experienced in the last few years is also likely to continue for the foreseeable future. The crisis in Europe will take years to resolve in part because policymakers there are trying to simultaneously achieve multiple, often-divergent objectives: 1) preserve basic eurozone stability, 2) keep pressure on fiscal authorities to make hard choices and 3) keep inflation in check. These multiple objectives prevent them from taking final, decisive action to quell the crisis. Our base case outlook is continued spurts of crisis and volatility coming out of Europe. These policy and macro factors will likely continue to overwhelm company-specific factors in the short term.

Many investors aren’t sure what to do – where to turn for “safe” investment returns in light of this volatility. As I regularly meet with clients and financial advisors, I repeatedly hear a few questions about how to navigate these choppy equity markets that are worth discussing here:

Given the volatility of the New Normal, why should I invest in equities at all? Why shouldn’t I just sit in cash and wait it out?
Unfortunately the final end-state for the global economy following this debt-induced crisis is unclear. If the global economy faces deflation, sitting in cash or fixed income instruments will probably be the best option. Purchasing power will increase as prices fall. While a deflationary scenario is not impossible, it is the least likely outcome given central banks’ actions to date. More likely is a moderate inflation scenario. Sitting in cash in such a scenario will see purchasing power degrade due to inflation. Equities should perform well in a moderate inflation scenario. This is our highest likelihood outcome.

A high inflation scenario can’t be ruled out either. It is possible that central banks could lose control of inflation expectations. In such a scenario cash and bonds will likely perform the worst, with equities next. Real assets and commodities would likely perform best, because prices for those assets should rise with inflation.

Because of the uncertainty regarding the end-state of the global economy and the fact that the only scenario in our view where cash performs well is the least likely, deflationary scenario, sitting on the sidelines is unfortunately not a good option for those who have future liabilities they need to meet. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.

Given our outlook that moderate inflation is the outcome with the highest long-term probability, we believe equities should be a meaningful part of a diversified investment portfolio. Equity investors should continue to focus on higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

My clients just can’t take the equity market pullbacks. What should I do as a financial advisor?
Many clients are in this situation. From May 2002 to May 2007, during the old normal, the S&P 500 experienced a 5% correction from a recent high five times, or on average of once per year, and a 10% correction four times. In the three New Normal years from May 2009 to May 2012, the S&P 500 experienced seven 5% corrections, more than twice as often, and a 10% correction three times. This increased downside volatility not only has direct financial implications for clients, but also has indirect effects that are important too: The emotional swings are scaring clients into sitting on the sidelines. As discussed above, this could prove very costly if central banks are successful in engineering moderate inflation, let alone high inflation.

We believe clients and advisors should focus on strategies that can be used to manage downside volatility. There are a number of ways to pursue this: 1) Buying higher-quality companies and those with strong balance sheets, because they tend to be more resilient against shocks, according to our research. 2) Buying companies at deep discounts to their intrinsic value. 3) Buying companies offering more immediate return on investment through dividends. 4) Actively hedging the portfolio, with tail risk hedging (which refers to taking a defensive position against extreme market shocks), or other means. 5) Investing in multi-asset solutions that provide diversification and include equities, fixed income securities and commodities in one vehicle.

Is passive or active management better in this environment?
We believe there is a place in client portfolios for both passive and active management. Each has advantages. Passive management tends to be cheaper than active management. But with each pull back in the equity markets, a passive strategy should fall in lock-step with the market. Passive index replication, by definition, has no downside protection against market moves. If clients are alarmed about market corrections, passive management won’t help them. A related point that I have written about previously (Teaching to the Test – September 2011) is that many managers associate index investing with taking less risk. Index investing is taking no benchmark risk, but clients are still taking risk – as the S&P 500’s 38% loss in 2008 so painfully reminds us.

We believe active management should aim to provide clients with a better experience. That means enabling clients to participate in much of the growth, appreciation and income potential provided by a vibrant equity market, while also actively managing against major pullbacks associated with macroeconomic shocks that we’ve been experiencing over the last few years. Achieving this – capturing most of the upside while limiting the downside – isn’t easy. It requires both deep company-specific analysis and a strong top-down, macroeconomic framework. And we believe it requires investing globally to take advantage of the best possible risk-adjusted return opportunities wherever they are. Limiting the downside likely requires giving up some upside in a rally – and in this environment especially – we think that’s probably a good tradeoff. It would be great to be able to limit the downside without sacrificing any upside. Unfortunately that’s not realistic – but we believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term.

Although markets are again focused on risks from Europe right now, sentiment will likely swing back to “risk on” again, and people will wonder what all the fuss was about. And then at some point it will swing back to “risk off.” Equity investing in this environment isn’t easy or for the faint of heart. With long-term risks of global inflation, sitting on the sideline isn’t an option for many people. We think the right approach is to focus on the right companies and to be willing to give up a little upside, while working hard to protect the downside. Call it the New Normal of equity investing: Three years and counting.

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. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

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. Investors should consult their financial advisor prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.

Copyright © PIMCO

Tags: Asset Classes, Attractive Returns, Balance Sheets, Confusions, Downside, Equity Investors, Erian, Financial Markets, Global Economy, Growth Markets, Inflection Points, Investment Approach, Investment Professionals, Low Interest Rates, Market Volatility, Portfolio Manager, Quality Companies, Sidelines, Stewards, Term Equity
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High-Yield Bonds—Extra Income, But Added Risk

Friday, June 8th, 2012

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Key points:

• In a world of low interest rates, high-yield (or sub-investment-grade) bonds can be a source of added income in an individual investor’s portfolio. The yield on the Barclays U.S. Corporate High-Yield Bond Index is currently 8.2%—more than double the yield on the Barclays U.S. Intermediate Corporate (investment grade) Bond Index and more than 7.0 % greater than US Treasury bond yields of comparable maturity.¹
• Over the past few years, improving economic growth and easing strains on financial markets have resulted in strong returns in the high-yield market.
• With interest rates on Treasury bonds near 40-year lows, higher coupon-interest payments have been especially valuable during the past few years. When reinvested, the compounding of interest income can help reduce volatility in a portfolio.
• However, extra yield comes with added risk: Companies that issue high-yield bonds are, by definition, less credit-worthy than investment-grade companies and are therefore more likely to default. In addition, the market for high-yield bonds is less liquid than for other types of bonds, and high-yield bonds tend to be more correlated with the stock market than with Treasury bond prices, potentially changing the overall diversification of your portfolio.
• We advise limiting the amount of aggressive income investments in a fixed income portfolio to 20% to help reduce potential volatility and losses.

With the Federal Reserve holding US Treasury yields near 40-year lows, investors seeking income often expand their search for higher yields into riskier sectors of the bond market. One such sector is high-yield bonds, which are rated below investment-grade because companies issuing them are less credit-worthy. The issuers may have more balance-sheet debt and weaker earnings power, and/or they may do business in more-volatile sectors of the economy, making their earnings less predictable.

Lower Credit Quality Corresponds with Higher Default Rates

Source: Schwab Center for Financial Research, with data from Standard & Poor’s 2011 Global Corporate Default Study. The study analyzed the rating and default history of 14,654 US and non-US companies first rated by Standard & Poor’s between December 31, 1981 and December 31, 2010. The 15-year cumulative average default rate is calculated by weight-averaging the marginal default rates in all static pools. Past performance is no indication of future results.

Because of these risks, less-credit-worthy companies must offer higher yields than those offered on investment-grade bonds. As of May 31, the yield on the Barclays U.S. Corporate High Yield Bond Index—where the average maturity is four years—is 8.2%, compared to 2.8% for the Barclays U.S. Intermediate Corporate (investment grade) Bond Index, with an average maturity of 5.3 years.

Over the past 25 years, the average ratio of the high-yield index yield to investment-grade was 1.74 compared to the current ratio of 2.92. This higher-than-average ratio implies that the market is pricing in a higher degree of risk in high-yield bonds than the historical average despite the fact that default rates for high-yield issuers are currently below the long-term average.

Default rates among high-yield-bond issuers have declined since the peak of the financial crisis, and the ratio of upgrades to downgrades within the sector has improved. The most-recent figures from Moody’s indicate that average default rates are running at 2.2%, below the long-term average of 5.6% and significantly below the recent peak levels of 17.1% in 2009.

As the chart below illustrates, the high-yield market can be volatile. During times of financial distress such as the financial crisis in 2008-2009, or in the aftermath of the technology-stock bubble bursting in 2000-2001, yields spiked sharply higher—with prices declining steeply. When financial markets are under stress, liquidity can be scarce—both for companies seeking loans and in the high-yield market itself, as buyers retreat.

Recent improving financial conditions, as shown by the decline in the St. Louis Financial Stress Index, have been supportive of the high-yield bond market. (The St. Louis Fed’s index is comprised of indicators such as interest-rate yield spreads and volatility indexes that measure ups and downs in the financial sector of the economy.)

St. Louis Financial Stress Index Versus Barclays High Yield Index

Source: Barclays Database and St. Louis Federal Reserve Bank, monthly data as of April 2012.

To some extent, the high-yield bond market has been experiencing a positive cycle. As interest rates have fallen and economic conditions have improved, companies have been able to refinance debt at lower levels, which has improved the measures of their financial performance. As those measures improve, investors seek out the bonds, pushing yields lower, which in turn allows for more refinancing.

Income is important

A potential benefit of high-yield bonds in the current environment is the relatively high level of coupon income. It’s obviously helpful for investors looking to use that income to meet expenses, but it can also be beneficial when reinvested, because it can help dampen volatility in an overall portfolio when interest rates rise. In a rising-rate environment, higher-coupon bonds tend to decline less than bonds with lower coupons because the current income can be reinvested at higher interest rates, all else being equal.

Tags: Barclays, Bond Market, Corporate Investment, ETF, ETFs, Extra Income, Fixed Income Portfolio, High Yield Bond, High Yield Bond Index, High Yield Bonds, Income Investments, Individual Investor, Interest Income, Interest Payments, Investment Grade Bonds, Low Interest Rates, Risk Companies, Sectors Of The Economy, Treasury Bond Prices, Treasury Bond Yields, Treasury Bonds, Treasury Yields
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Run of the Mill (Hussman)

Monday, June 4th, 2012

by John Hussman, Hussman Funds

Since late-February, our estimates of the market’s prospective return/risk tradeoff (over a set of horizons from 2 weeks to 18 months) have persistently held in the worst 0.5% of all historical observations. It’s always important to emphasize that we try to align ourselves with the average return/risk profile that has historically accompanied the particular set of investment conditions we observe at each point in time, but that the outcome in any specific instance may not reflect the average return, and may even fall outside of what we view as the likely range of outcomes. That said, the awful behavior of the market in recent weeks is very run-of-the-mill in terms of how similarly unfavorable conditions have usually been resolved historically, and there is no evidence that this awful prospective course has changed much. The chart I included three weeks ago in Dancing at the Edge of a Cliff presents similar periods for historical perspective.

It’s probably needless to say that last week’s decline improved valuations modestly – we presently estimate prospective 10-year total returns (nominal) for the S&P 500 about 5.5% annually, based on our standard methodology. Most bear markets have historically ended only after prospective returns moved above 10% (including bear markets in periods of very low interest rates, and also including 2009). Moreover, regardless of whether interest rates have been high or low, extended secular bear markets have ended – and secular bull market advances have begun – only when prospective 10-year returns have reached about 20% annually (see Too Little To Lock In for a chart on this). So it won’t come as a surprise that we don’t view a 5.5% annual prospective total return as having much investment merit. You don’t “lock in” prospective stock market returns – you ride them out, and holding on for the expectation of a 5.5% prospective annual return is likely to involve a very bumpy 10-year ride.

Investors with most of their assets already invested and unhedged should hope that prospective market returns move no higher than about 8% through the completion of the present cycle, since even touching a prospective return of 10% in the interim would require an S&P 500 in the mid-800′s. Though I think it’s plausible that we’ll establish prospective returns consistent with the start of a secular bull market at some point in the next few years, actually quoting the associated level for the S&P 500 would only strain credibility here. Investors have forgotten so much after just 3 years time that it seems fruitless to talk about secular lows that only occur every 30-35 years (even if the last secular low was all the way back in 1982).

At this point, the S&P 500 has achieved a cumulative total return of less than 10% since April 2010. Meanwhile, of course, there remains a great deal of faith in the “Bernanke put,” because even though it’s fairly obvious that QE has done nothing durable for the economy or the financial markets over the last couple of years, a hit of QE might at least be good for a few months of “risk on” delirium. If the American public can’t get thoughtful economic leadership, at least Wall Street’s speculative junkies can hope for a little taste of Q from Sugar Daddy.

One of the problems with QE here, however, is that it would essentially represent fiscal policy for the benefit of speculators, at taxpayer expense. To see this, note that the 10-year Treasury yield is now down to less than 1.5%. One wonders how Bernanke would be able to argue, with a straight face, that this is not low enough. Nevertheless, a 10-year bond has a duration of 8 years – meaning that each 100 basis point fluctuation in interest rates is associated with a change of about 8% in the price of the bond. So if you buy the bond and hold it for a full year, an interest rate change of of 1.5/8 = .1875, or less than 20 basis points, is enough to wipe out the annual interest and leave you with a negative total return.

So at this point, if the Fed buys Treasury bonds, it will predictably lose money – after interest – unless interest rates rise less than 20 basis points a year during the period that the Fed holds those bonds. Over the past year, the standard deviation of week-to-week changes in the 10-year Treasury yield has been about 13 basis points, so 20 bips over the course of a full year is nothing. Whether or not a speculator is willing to take a bet on lower yields, it’s highly unlikely that the Fed could buy Treasury bonds here at a yield of 1.5% and ever expect to unload its portfolio later at even lower yields, because yields would shoot higher merely on the anticipation of Fed liquidation.

As a result, Treasury debt purchased by the Fed here would almost certainly result in capital losses, at taxpayer expense, and those capital losses would be an implicit subsidy to speculators who sold those bonds to the Fed at elevated prices. Of course, “sterilized QE” – where the Fed would buy bonds, and then pay banks 0.25% interest to keep the balances on reserve – would involve an even larger subsidy, and would then require only a 15 basis point move to put the Fed into loss mode.

“QE3 – subsidizing banks and bond speculators at taxpayer expense” – there’s a pithy slogan. That doesn’t mean the Fed will refrain from more of its recklessness (which will be nearly impossible to reverse when it becomes necessary to do so), but does anyone actually believe by now that QE would improve the economy, durably elevate risky assets beyond a few months, or materially relieve global debt strains?

Despite the uncertainties, our game plan remains fairly straightforward. As I noted two weeks ago in Liquidation Syndrome, “there may be latitude to take a more constructive stance between the point that any new monetary intervention produces an improvement in our measures of market internals, and the point where we re-establish an overvalued, overbought, overbullish syndrome. Without a material improvement in valuations or market action here, we remain defensive. Undoubtedly, the best outcome would be a strong improvement in valuations, followed by signs of improvement in our measures of market action, which is the typical sequence of events that complete a market cycle and can launch a very favorable investment environment.

Tags: Bear Markets, Decline, Expectation, Historical Perspective, Horizons, Hussman Funds, Investment Conditions, John Hussman, Low Interest Rates, Methodology, Nbsp, Periods, Point In Time, Prospective Course, Risk Profile, Secular Bull Market, Stock Market, Tradeoff, Unfavorable Conditions, Valuations
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U.S. Equity Market Drops on Eurozone and Employment Concerns

Monday, June 4th, 2012

U.S. Equity Market Radar (June 4, 2012)

The S&P 500 Index fell 3.02 percent this week as the global economy appears very fragile. Global economic data disappointed and weak employment data here in the U.S. drove the market sharply lower on Friday. Traditional defensive areas such as utilities, telecommunication services and consumer staples were the best performers, while energy, financials and industrials all fell by more than 4 percent.

Strengths

• The utilities sector was essentially flat, in a very rough week for the market with Pepco Holdings, Duke Energy and Public Service Enterprises among the best performers.
• The telecom services sector was not far behind, posting modest weekly losses. AT&T was able to scrape out a modest gain this week, helping the group outperform.
• The best individual stock performer this week was Newmont Mining which rose 3.4 percent as speculation grew that the Federal Reserve would implement additional monetary easing measures in response to the weakening economy.

Weaknesses

• The energy sector was hit hard this week as oil prices fell by more than 8 percent. Cabot Oil & Gas, WPX Energy and Range Resources all fell by more than 11 percent.

• Financials were also hit hard this week on a combination of concerns, such as European banking problems affecting U.S. institutions and extremely low interest rates negatively affecting the life insurers. MetLife and Lincoln National Corp. were the worst performers in the sector with both stocks falling by about 9 percent.
• First Solar was the worst performer in the S&P 500 this week falling 17.2 percent, continuing a dismal run as the stock has fallen 65 percent this year.

Opportunity

• For the third week in a row gold stocks and airlines were among the best performers. Gold stocks were driven by the potential for more quantitative easing from the Fed while airlines are being positively impacted by lower oil prices.
• While much of the news this week was negative the silver lining is that this weakness will likely elicit a response from global policy makers. Government policy actions are often a precursor to change in the financial markets and should be monitored closely.

Threat

• Stresses continue to build in Europe and missteps by policy makers could negatively impact the markets.

Tags: Cabot Oil, Consumer Staples, Dismal Run, Duke Energy, Employment Concerns, Employment Data, European Banking, Eurozone, Global Economy, gold stocks, Life Insurers, Lincoln National, Lincoln National Corp, Low Interest Rates, Market Radar, Newmont Mining, Pepco Holdings, Range Resources, Telecom Services, Telecommunication Services
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Jeff Rubin: The End of Growth

Thursday, May 31st, 2012

 

 
Jeff Rubin, author of The End of Growth (his second best-selling instalment), discusses the effect and ramifications of expensive-to-produce oil, in the context of the developed world’s over-indebtness, with Pierre Daillie. He says our growth expectations, including those of Canada need to be adjusted downward, as low interest rates will not be sufficient to re-ignite growth, and the catch-22 of (high) oil prices will snooker (global economic) growth in the foreseeable future.

Rubin, former Chief Economist, CIBC World Markets, shares his current investment outlook as well.

At the heart of Rubin’s thesis is his well-informed premise that we’ve burned all the ‘cheap’ oil, and unless we learn to use less oil, growing global consumption of the black stuff can only come at growth’s expense.

Bottom line: We are destined to relinquish economic growth in return for the increasing global appetite for energy.

The End of Growth, by Jeff Rubin, is an eye-opener, an interesting and controversial perspective on the future of trending issues affecting global economic progress.

Discussion:
The End of Growth – Do You agree or disagree?

Tags: Appetite, Bottom Line, Canadian Market, Catch 22, Cheap Oil, Chief Economist, Economic Progress, Eye Opener, Foreseeable Future, Global Consumption, Global Economic Growth, Growth Expectations, Indebtness, Instalment, Investment Outlook, Jeff Rubin, Low Interest Rates, Nbsp, Oil Prices, Perspective, Premise, Ramifications, Snooker, Thesis, World Markets
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Gold Market Radar (May 21, 2012)

Saturday, May 19th, 2012

Gold Market Radar (May 21, 2012)

For the week, spot gold closed at $1,592.40 up $13.59 per ounce, or 0.86 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 1.87 percent. The U.S. Trade-Weighted Dollar Index gained 1.28 percent for the week.

Strengths

• Gold ETF holdings in India have reached close to the $2 billion mark for the first time as of April 30. According to data released by the Association of Mutual Funds in India, assets under managements for gold ETFs have more than doubled from a year ago.
• Billionaire investor George Soros raised his stake in the SPDR gold trust, the biggest exchange-traded product backed by bullion, according to a filing this week. Against a backdrop of record low interest rates and expectations for further central bank gold buying, which is running at its fastest pace in five decades, there apparently are still buyers adding to gold at current levels. Using a 60-day rate of change, gold prices have fallen 2.2 standard deviations now. Over the last 10 years, gold fell to 2.4 standard deviations in October 2006 and to an extreme of 3.4 in October 2008. One year after those falls, the gold price was up 29 percent and 46 percent, respectively.
• The U.S. House Natural Resources Committee Wednesday passed the National Strategic and Critical Minerals Act, aimed at streamlining the permitting process for U.S. mining. The U.S. Department of Energy identified the 7-10 year period to obtain mining permits in the U.S. as compared to the average 1-2 years in Australia as one of the principle barriers to new U.S. mining ventures. Behre Dolbear, an international consulting firm, has identified the U.S. as having one of the longest permitting processes in the world for mining projects. The bill now goes to a floor vote by the full House, but the bill is not without detractors. Rep. Ed Market, D-Massachusetts, unsuccessfully tried to amend the bill to require a royalty payment for 12.5 percent of the value of the minerals produced as a result of a federal permit for mineral exploration or mining on federal lands.

Weaknesses

• Commodities guru Jim Rogers said he is not buying gold as he expects gold prices to fall further and believes they could tumble 40-50 percent off their top if India were to stop its gold imports or if Europeans were to sell their gold. Rogers notes those probabilities are pretty low but there has been some effort in India to curtail the purchase of gold, such as the introduction of new or higher tax rates on gold purchases. This proposed tax, which was announced in March, was later abandoned after widespread protest.
• Two mining CEOs called it quits this week. John Greenslade left Baja Mining after a drawn-out proxy fight with the company’s largest shareholder. International Tower Hill Mines announced that the Board of Directors has decided to undertake a review of the Livengood Project in order to optimize available development alternatives and that it accepted the resignation of James Komadina as President and Chief Executive of the company.
• In an interview on Mineweb.net, Gold Fields CEO Nick Holland said that the gold industry needs a price above $1,500 per ounce otherwise curtailment of projects, rationalization and possibly more consolidation was in the cards. Nick pointed out that the all-in cost of the industry to produce an ounce of gold is probably around $1,400 per ounce and that doesn’t leave a lot of margin at $1,500. CIBC recently pegged $1,700 per ounce as the replacement cost for an ounce of gold and highlighted that tax increases have been one of the fastest growing components of the cost creep.

Opportunities

• Low gold prices have been a weight on gold equities. Gold mining analyst Tanya Jakusconek of Scotia Bank highlighted that its group of North American senior gold miners is currently trading at 0.90 times the NAV compared to the lows of 0.79 achieved in 2008.

• Before gold rallied in the last two days of the week, all the price gains made this year were erased as the dollar had gone a record 13 days of consecutive gains. What may have snapped gold back was the realization that the run on the banks in Greece by its citizens withdrawing their money could be a wildcard that forces the European Central Bank to act sooner than expected and/or lead to a policy mistake on how to address the country’s solvency crises. Goldman expects gold prices to rise 25 percent to $1,940 an ounce in 12 months and Morgan Stanley forecast prices to rebound to an average of $1,825 this year and $2,175 in 2013.
• As for gold equities they are down but not out. However, investors are adamant about one thing…SHOW ME THE MONEY! In his seminal research report “Stop ‘Growth At Any Price’ (GAAP) Building,” George Topping of Stifel Nicolaus noted that rampant mining inflation has benefited those involved in mine-building to the detriment of shareholders. George pointed out that if mining companies deferred lower internal rate of return (IRR) deposits this would allow management to better focus on cost control, send a message to consultants/contractors that fees have gone too far, and free up labor for the remaining projects. Projects should pass stress test levels of using a $1,200/oz long-term gold price and deliver a minimum 10 percent IRR. The current dynamic in the sector of escalating cash cost and capital expenditure creep has made the high grade/high margin deposits more accretive and with less downside exposure on the gold price. These are the types of companies our gold funds focus on for delivering the best value creation over time. Gold company shareholders are likely to be supportive if the capex savings are paid out as dividends which could be raised to levels that approach 5 percent. George points out that a change of strategy by the gold mining companies is required to reverse the flow of funds out of the gold sector.

Threats

• HSBC Global Research lamented that at some point, the focus will come back to America versus Euroland and the U.S. dollar will come back under pressure. HSBC documents the pending fiscal cliffhanger the U.S. faces with nine tax expirations or spending cuts that investors should worry about seeing in the near future: 1. Expiration of 2001/2003 Bush-era income tax cuts, 2. Budget Control Act Sequester, 3. Alternative Minimum Tax (AMT) increase, 4. Interaction of AMT and income tax changes, 5. Payroll Tax Cut expiration, 6. Expiration of extended unemployment benefits, 7. Reduction in payments for Medicare physician services, 8. New Medicare Tax, and 9. Tax extenders.
• HSBC compiled a worst-case scenario for these potential policy changes and a reality-check scenario that tries to estimate what may actually happen. In the worst-case scenario, the tax increases and spending cuts could amount to $665 billion or about 4.1 percent of GDP in 2013; in a reality-check scenario HSBC forecast 2013 GDP to come in at 1.8 percent.
• David Rosenberg, of Gluskin Sheff Research, also reminded us this week the current luster surrounding the U.S. economy may be in for some headwinds as the fall approaches. With arguably the most important presidential election since 1980, in terms of setting the economic and fiscal path for the next decade, the U.S. government is on track to again hit the debt ceiling by October, just weeks ahead of the election, with Republicans planning a new standoff on debt limits to be front and center. Dave notes that “at that point in the fall, a lot of folks may have wished they were buying the dip in gold during the winter and spring.”

Tags: 2 Standard Deviations, Bank Gold, Critical Minerals, Floor Vote, George Soros, Gold Etf, Gold Etfs, Gold Market, Gold Miners, Gold Price, Gold Prices, gold stocks, International Consulting Firm, Low Interest Rates, Market Radar, Mining Permits, Natural Resources Committee, Nyse Arca, Royalty Payment, Spot Gold
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The Fed’s Next Move

Sunday, April 22nd, 2012

April 20, 2012

The Fed’s Next Move?

“If everything seems under control, you’re not going fast enough”—Mario Andretti.  If you’re an investor, you might hope that policy makers in the developed world would heed the wisdom of Mario Andretti. After a burst of confidence in the first quarter, when things appeared to be running smoothly, the markets have re-focused on the challenge of trying to reduce government debt in the absence of economic growth. Here in the U.S., the next opportunity bond investors will get to observe shifts in policy will be the Federal Reserve’s next meeting on April 24-25th. The Fed may feel reasonably confident that they’re “in control,” but it seems less likely to us that they’ll feel we’re going “fast enough.”

• We don’t expect any change in policy at the Fed’s April 24-25th meeting. But the market will be scrutinizing the Fed’s economic projections for hints about further quantitative easing, the end of Operation Twist and the length of the Fed’s commitment to low interest rates. At the January FOMC meeting, the committee made the historic decision to publish forecasts on rates and economic measures from the 17 committee members, along with the “central tendency” (i.e. where the bulk of the projections reside.) It’s the range that we’ll be watching most closely for signs of shifting expectations.
• Projections for GDP growth are likely to indicate a moderate, but not exceptional, growth rate. The range is likely to remain in the 2.5% to 3.0% range, in our view. Based on the January projections, the range of forecasts for GDP wasn’t very wide, though there was a wider range of views on inflation and unemployment. Positive growth is encouraging, of course, but the pace of growth remains sub-par compared to a more robust recovery.
• The unemployment rate has already fallen to the low end of the Fed’s range, based on the January projections. Therefore, it seems reasonable to anticipate that range will be lowered from the 8.2% to 8.5% projections published in January. FOMC members appear to disagree on the reasons for the recent path of unemployment. Fed Chairman Ben Bernanke and the more “dovish” Fed members (meaning, they favor lower rates and more accommodative monetary policy) suggest that the drop in unemployment is largely due to discouraged workers dropping out of the labor force. In contrast, some more “hawkish” members (those who tend to lean toward a tighter monetary bias) believe that unemployment is high due to a structural mismatch of skills with job openings. It’s no surprise to report that the Bernanke “dovish” camp is still driving policy.
• On inflation, the views also diverge between the hawks and doves. The January Fed report showed a wide dispersion of projections for the deflator for personal consumption expenditures (PCE, one of the Fed’s preferred inflation measures) between 1.3% and 2.8% for 2012. The central tendency narrowed to 1.4% to 1.8%, but clearly this is where there is some disagreement on the outlook. The more dovish Bernanke camp, expecting lower inflation, will hold sway here (in our view) as well, until data showing higher prices driven by increased lending and/or wage growth clearly changes.
• We don’t expect that the Fed will hint at or announce further quantitative easing. GDP appears to be growing at 2% to 2.5% rate or higher, unemployment is falling and core inflation is holding near the 2% level. Lending growth is improving, pointing to a more stable banking sector and adequate liquidity in the financial system. Returns from each round of easing appear to be diminishing. However, we also expect that Bernanke will leave the possibility of QE3 (i.e. a third round of bond buying from the Fed designed to help keep interest rates low) on the table. He has consistently said that the Fed is prepared to do more if economic conditions warrant it.
• What would warrant more action by the Fed? We’re encouraged by stronger signs from the U.S. economy, as well as efforts to stabilize the European credit crisis. But two risks we worry about are the upcoming fiscal tightening that may happen in 2012—the so-called “fiscal cliff”—as well as a worsening of the European debt crisis.

1. On fiscal stimulus. Bush-era tax cuts are set to expire, automatic spending cuts are set to trigger and stimulus programs are winding down. Cuts to stimulus alone even with an extension of tax cuts will likely be a drag on the U.S. economy in the short-term. The effect of this is estimated to be in the vicinity of 3% of GDP by many economists.
2. On Europe. If European sovereign debt problems threaten to spread over to the U.S. banking sector and affect U.S. growth, the Fed may be pushed to respond with some form of monetary stimulus.

• Bottom line. While we don’t expect an official policy change at the upcoming FOMC meeting, the release of a new set of economic expectations, if they vary greatly from the last projections in January, could be a market moving event. For bond investors, there’s nothing to indicate to us that the tilt won’t remain toward accommodative rate policy until 2013 and beyond until there’s rate of change in growth speeds up.

Central Tendency of Fed Forecasts—January 2012

Source: Federal Reserve, January 25, 2012.  Numbers in the table are year-over-year percentage change for real GDP, PCE inflation, and core inflation.

Moody’s Downgrade of GE

While it may not have been a major news event to most market watchers, Moody’s downgraded the debt ratings for General Electric Company (GE) to Aa3 along with the rating on its wholly-owned financial subsidiary, GE Capital Corporation (GECC), to A1. GE was once one of the seemingly ‘untouchable’ Aaa/AAA-rated industrial corporations, so the changes aren’t insignificant. In Moody’s view, GE still has “many AAA-like credit characteristics.” But their view also reflects the “heightened risk profile inherent to finance companies like GECC,” they say, a significant part of GE’s operations. The broader takeaway to us is not so much a comment on GE specifically. We are not making a company-specific comment or investment recommendation. It’s more about the inherent sensitivity of lending and financial companies to smoothly functioning financial markets as well as access to money when they need it.

• The credit crisis continues to reveal the risks in market funded financial institutions, a risk that rating agencies and markets strive to understand. Moody’s indicated that the GE downgrade was a reflection of risk stemming from its financial arm, GECC. While the downgrade isn’t good news for investors, it’s not a major surprise. On March 19, Moody’s revised its global rating methodology for financial institutions and warned that others may be downgraded as well, some, potentially, by several rating notches. Their views, they say, reflect ongoing market and structural developments as well as insights gained from the recent global credit crisis and 2007-2009 recession.
• “During the credit crisis, [credit] markets were unreliable for even the strongest issuers.” While oversight has improved, the sensitivity of banks and financial firms to market conditions is still a fundamental part of the business model of finance firms. Financial institutions, including GECC, involve risks associated with a “high reliance on confidence sensitive funding,” even though, in Moody’s view, GECC is “one of the strongest finance companies in the world.” Even with its fundamental strengths, and connection to General Electric, GECC still “relies on the capital markets” to fund its portfolios.
• For investors, be careful about credit quality and too much exposure to a single sector or security. Most banks and financial institutions have taken steps to build capital and strengthen reserves. Regulatory scrutiny, including Dodd-Frank and the Volker rule, are seeking to put rules in place to manage and limit risk. Other banks continue to deal with legacy issues from the financial crisis. Still, this is an area to be wary of lower-rated issuers and investing based on higher yields only.
• We divide corporates broadly into financial institutions, industrials and utilities. We’re not committed to the notion that investors should strictly benchmark their exposure to individual bond sectors, such as corporate bonds, to an index or snapshot of the market. But it’s helpful to understand the composition of markets as a whole as a reminder to spread out investments in a way that provides diversification and limits exposure to any single sector alone.  The table below shows this market balance, over time, using the widely-followed Barclays US Corporate Bond index.

Composition of the U.S. investment-grade corporate market by sector

Source: Barclays U.S. Corporate Bond Index, daily data as of April 17, 2012.

Financials including banks currently account for roughly 35% of the U.S. investment-grade corporate market, a level that’s fallen from nearly 50% prior to the 2008 credit crisis. Industrials, including conglomerates like GE and a wide range of other non-financial issuers excluding utilities, now accounts for 54%.

• Yields should be higher, in our view, compared to similarly-rated industrials and utilities. This is market pricing in compensation for ratings volatility, the potential for future changes in regulatory policy and methodology from the rating agencies as well as fundamentally leveraged, market-reliant business models. The chart below shows these yield spread over time. Currently, it looks to us that investors are generally being compensated, relative to the risks, if they can stomach some price volatility and diversify adequately against risk in any single issuer. Whether you are receiving adequate compensation for your needs should be an individual decision, depending on your risk tolerance and the role in the rest of your portfolio.

Yield Spread of the U.S. investment-grade corporate market by sector

Source: Barclays U.S. Corporate Bond Index, daily data as of April 17, 2012.  Option-adjusted spread (OAS) is the basis point spread relative to Treasuries, net of the cost of any embedded options.

The Growing Divide in Muni Bonds

The direst predictions about muni defaults haven’t materialized. The revenue picture for state and, to a lesser degree, local governments, is stabilizing in our view. Still, municipal governments are caught in the bind of rising social service needs and employment costs and the “age of austerity”—the fundamental need, as well as the political tide, of limited revenue and taxing ability. We think that we’re well into a process of divergence in credit quality in state and local government muni bonds—that is, the division between the vast, silent majority that are managing challenges and the vocal minority who are not. It’s our view that defaults in state and local government bonds will remain isolated events. But issuers have become less homogenous, less interchangeable with each other without investigation or credit analysis.

• We think the top priority for municipal governments will be managing multiple stakeholders and obligations. This is generally the case for the wide range of 50,000+ state and local municipal bodies, whether they’re active bond issuers or not. That’s the reality of a tight revenue climate and a tough balance of employment and healthcare costs, service obligations, and other obligations like employee pensions that have been promised and funded. This is a much tougher task when resources are limited. It’s not a surprise to see debate and headlines focused on these issues. This will be a challenge for the next decade or more, in our view. We’ll likely see more idiosyncratic cases of these pressures leading to distress. For the most part, we expect that that the impact to bondholders will remain isolated, but not zero.
• Stockton, California and others are case studies. What happens, exactly, when a municipality reaches the end of its rope and needs help? We’re finding out, with the widely-publicized examples of Vallejo, CA, Jefferson County, Alabama and now Stockton, CA. As we said, there will be exceptions. And other issuers will watch the cases to see if they’re “successful.” Note: Vallejo, CA is one example that has been widely cited as an example of the enormous expense, and limited benefit, of a municipal bankruptcy filing. The city was able to negotiate very few concessions with stakeholders including unions. And individual bondholders—not the primary source of most of Vallejo’s problems—were largely unaffected.
• Pay close attention to the bonds you buy, and own. There’s more and more information available every day to help with this, thanks to ongoing reforms from municipal security governing bodies such as the Municipal Securities Rulemaking Board (MSRB). The MSRB’s website, EMMA, has links to current municipal bond disclosures. But the consistency and quality of the disclosures is being watched closely by the MSRB and other rule-making authorities. Even with current disclosure, investors must also have some sense of how to use the information they receive. This is still a challenge, given the complexity and idiosyncrasies of municipal credit analysis.
• Few municipalities will broadcast in plain English pending credit stress. Unlike corporations, municipalities aren’t profit-seeking organizations. And they don’t have quarterly reporting requirements, their budget processes can be opaque and they don’t have publicly traded equity as a measure of current and future success. (The flip-side to this, we’d note, is that you’d have to work hard to find a way for a municipal government to shut-down and disappear. This is not the case with corporations where liquidations happen regularly.) As a result, you won’t hear much in plain English about credit risk unless you’re well-trained in reading between the lines and finding the fine line between ordinary business and signs of real stress.
• Outsourcing credit analysis using funds and professional managers is still a good option, for many. Professional managers, whether for funds or managed accounts, can help look for problems, but also provide the variety of individual muni issuers to diversify against idiosyncratic, issuer-specific risk. We don’t expect that we’ll see a widespread shift in defaults, as we’ve said previously. But credit analysis and active monitoring may be increasingly important in the “next phase” for the historically stable, but strained, universe of state and local government bonds.

Diversification and Bond Benchmarks

What’s a good benchmark to build a bond portfolio around, and is it adequate as a starting point in the current market for most investors? The Barclays U.S. Aggregate Bond Index is a commonly-used taxable bond index. Over time, it has become heavily skewed toward government bonds, with very low yields and limited exposure to other sectors. Does this provide enough diversification for most investors focused on a broader range of investments as well as income now?

• The Barclays U.S. Aggregate Bond Index is now dominated by Treasuries and government-backed securities. Since the financial crisis, a concern we have is that the index has a greater proportion in government bonds, including agency-backed securities, many of them mortgage bonds from Ginnie Mae as well as Fannie Mae and Freddie Mac. Both Fannie and Freddie mortgage bonds, a multi-trillion dollar part of the U.S. taxable bond market, are currently supported by the U.S. government. Only about 20% of the index represents corporate bonds. Note: This index does not include tax-exempt muni bonds. Many investors could consider using highly-rated munis, in our view, as the foundation for a core bond portfolio in taxable accounts.
• The index is now more concentrated in one issuer—the Federal government—and has been delivering a lower yield than many clients may want for an income-oriented portfolio. It will be no surprise to most fixed income investors, but the yields on government bonds remain low, with the yield for the Aggregate Bond Index 2.1% as of April 16, 2012. The average maturity of bonds in the index has also become slightly longer, currently at 7 years. This may be longer, with lower yield, than many investors will be comfortable with, even in their core holdings.  Keep in mind that the Aggregate Bond index does not incur management fees, costs and expenses and cannot be invested in directly.
• One strategy is to diversify into other sectors of the bond market, subject to need and risk tolerance. We continue to favor credit (i.e. investment-grade corporate bonds) in the current climate, for up to 30% or so of a core bond portfolio, as well as certain types of municipal bonds in taxable accounts. In the current climate, a core portfolio may benefit from “tilts” in credit away from an 80% exposure to Treasuries and government-related mortgage bonds. The key point to us, as always, is diversification and not pushing the boundaries here too far. A “core and explore” strategy, starting with bonds with low credit risk, supported by exposure to intermediate-term corporate and muni bonds using ladders, still makes sense to us for most income-oriented investors in the current climate.
• We also continue to believe that investors can also “expand the core” using mutual funds or exchange-traded funds to build a diversified bond portfolio. For examples of portfolios using funds, clients can log-on to Schwab.com and go to Products, then Portfolio Solutions, and then look for the Schwab PortfoliosTM link. They’ll find an online tool they can use to view a pre-set list of mutual funds allocated according to the risk profile they select.  Consider using the list as a starting point, boosting diversification using other funds—such as credit-specific exchange-traded funds (ETFs) or multi-sector and world bond funds—to expand your portfolio.

For additional help or a look at the mix of maturities and credit in your portfolio, talk with your financial consultant or a Schwab Fixed Income Specialist at 800-626-4600.

Please visit www.schwab.com/onbonds for more fixed income perspective from the Schwab Center for Financial Research. If you have questions or concerns about the issues raised in this publication, please speak to your Schwab representative.

Important Disclosures

Tags: April 24, Bond Investors, Bond Markets, Bond Portfolio, Central Tendency, Committee Members, Diversified Bond, Economic Growth, Economic Measures, Economic Projections, Federal Reserve, Fixed Income, Fomc Meeting, GDP Growth, Government Debt, Low Interest Rates, Mario Andretti, municipal bond market, Schwab, Strategist
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Is Capitalism Dead or Simply Dying?

Thursday, April 19th, 2012

Noted financial author Richard Duncan says Capitalism is Dead, Credit New King.

The world needs to clue in to changes to its economic system, including the death of capitalism, according to noted financial author Richard Duncan, who warns that attempts to turn back the clock on our credit-driven economies could be cataclysmic

Recognizing that the world operates on a different set of rules from the laissez-faire capitalism of the 19th century is among the key arguments in Duncan’s 2012 book, “The New Depression: The Breakdown of the Paper Money Economy.”

Stuck with ‘Creditism’

Duncan sees the global economy as having undergone a fundamental transformation during the past 43 years. Since changes in 1968 that freed the Federal Reserve from holding physical gold in reserve against dollars in circulation, total global credit has expanded 50 times, or from about $1 trillion to $50 trillion in 2007.

Over that period, credit creation and consumption, or what Duncan calls “creditism,” took hold as the growth dynamic behind the global economy, displacing capitalism, which he says relied upon sound money, hard work and capital accumulation.

Attempts to break the global economy’s reliance on credit creation as a driver and reboot back to earlier ways won’t work, said Duncan, who sees “sound money” policy recommendations as a recipe for disaster.

Duncan believes that true capitalism died in 1914, when nations across Europe abandoned gold-backed currencies, running up huge deficits in preparation for what would come to be known as the Great War.

“I’m recommending making use of this new economic system. Borrow money at the government level at very low interest rates and then invest that money and change our world for the better.” Duncan said.

Building a national solar-energy grid that could tap the arid landscapes of Nevada are among Duncan’s recommendations.

Duncan said he first outlined his thinking on government-led investment in a 2008 book. On speaking tours, he encountered the “greatest push-back” from free-market, libertarian thinkers who are skeptical of government involvement in the economy.

He says many libertarians “are with me along through the argument” on causes of the global crisis, but that they tend to be “very surprised” by his conclusion that part of the solution requires governments to spend more — not less.

Monetary Madness

Duncan is yet another author who predicted a financial crisis but whose solutions can only be described as monetary madness.

“Glutted with excess industrial capacity and a banking system laden with massive loans that will never be paid back, China faces difficult decisions much as Japan did” says Duncan.

Indeed!

Then like an economic madman, Duncan wants the US government to undertake massive infrastructure projects just like the ones that bankrupted Japan and China’s State-Owned-Enterprises (SOEs).

Obama’s Excursions Into Clean Energy

Look at Obama’s backing of Green Energy companies Ener1, Solyndra Inc., and Beacon Power, all three now bankrupt as noted in Another Obama-Backed Green Energy Company Goes Bankrupt.

Solar Energy Madness in Europe

In an effort to spur solar energy in France, Germany, Spain and other European countries, bureaucratic dunces decided to pay as much as 10 times market rates for those supplying energy to the power grid.

In response, farmers in France have started building “barns” that serve no other purpose than a place to put solar panels. Supermarkets put solar panels on their roofs and unused sections of parking lots.

It has been a boom to solar panel makers (China), but it is costing the French power company Electricite de France SA more than a billion euros ($1.3 billion) a year to meet government mandated pledges to accept solar energy from those supplying the grid.

At the end of 2010, EDF received 3,000 applications a day to connect panels to the grid. In 2008, the number of applications was 7,100 for the entire year.

The results should have been easy to predict in advance, but you can never explain anything to economic illiterates interfering in the free markets hoping to make things better. They never do.

For more details, please consider EDF’s Solar ‘Time Bomb’ Will Tick On After France Pops Bubble

Is Capitalism Dead?

If capitalism is dead, it is because socialists, fascists, bureaucratic fools, and central-planner advocates like Duncan destroyed it via foolish proposals to improve on it.

The idea that governments can invest wisely in technology, at reasonable costs, and the free market cannot is downright absurd as the US, Japan, China, and Europe have proven in spades. In short, Duncan has lost his mind.

Mike “Mish” Shedlock

http://globaleconomicanalysis.blogspot.com

Tags: Arid Landscapes, Capital Accumulation, Credit Creation, Driven Economies, Economic System, Energy Grid, Financial Author, Fundamental Transformation, Global Credit, Global Economy, Government Level, Laissez Faire Capitalism, Low Interest Rates, Money Economy, Money Policy, Paper Money, physical gold, Policy Recommendations, Richard Duncan, Sound Money
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