Month of May: Sell and Go Away, or Hang in There? (Sonders)

Tuesday, May 15th, 2012

May 14, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• We believe the stock market’s correction is likely to be less severe this year relative to 2010 or 2011.
• Be aware of the possible perils of following a “sell in May” trading strategy.
• For now, macro concerns—including Europe and the looming “fiscal cliff”—are trumping better micro news.

The stock market is in correction mode and investors are on edge. There are likely several reasons for the weakness, including what we pointed out in our early-April report on elevated optimistic sentiment. Since sentiment tends to work a contrarian magic on the market, we were anticipating a period of consolidation after the stellar six-month, 30% run off the early October 2011 low—and we’re getting it.

Of course, we’re also yet again dealing with the eurozone debt crisis, but also choppier economic indicators in the United States recently, a volatile election season and concerns about the so-called “fiscal cliff” heading into the end of this year. But one of the questions I’ve gotten most often recently has been about the seasonal phenomenon called “sell in May and go away,” and whether the market’s in store for another summer swoon like we’ve had the past two years.

Macro trumping micro

I’ll start with “sell in May,” but before I do, I want to address an important general observation. As we’ve noted many times recently in reports and media appearances; and as detailed in a terrific recent report by Wall Street research firm Wolfe Trahan, macro is trumping micro. One of the reasons for this is the decline in guidance investors are receiving from company managements.

In the past, guidance was often an anchor of reason in volatile times. Events like European elections or spiking eurozone sovereign bond yields might not have been such big market-moving events when we could rest on US companies’ guidance as to the future. Add to that rapid-fire trading, shortened time horizons, greatly increased access to information, greatly increased speed of news’ dissemination, and much more globalized economic and financial systems, and you have a recipe for increased volatility around macro events.

Sell in May?

Much is made every year of the “sell in May” phenomenon. Its basis is rooted in the fact that the best performance for the market has generally come in the November through April period, while the worst has come between May and October.

There is some truth to the adage. According to data compiled by Ned Davis Research (NDR), through the beginning of May this year the average performance for the period from May 1 through October 31 each year since 1950 was 1.2%. The average performance for the period from November 1 through April 30 each year since 1950 was 7.0%.

As compelling as those numbers may seem, there are many things to consider, especially if it’s your inclination to develop a trading strategy around those seasonal patterns. First, the calendar months individually tend to fall into either the “hot” or “cold” columns for performance, as you can see in the table below. Three of the six months that fall into the “all out” period spanning from May through October are actually historically strong months, while three of the six months that fall into the “all in” period spanning from November through April are actually historically weak months.

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of 1928-April 30, 2012.

As you can see, all of the seasons seem to be adequately represented in both columns. And what we know for a fact is that time horizons have become much shorter over the recent years, and the reaction function gets triggered more often. It’s likely that many investors may find their patience tested when experiencing either a great month (or two) during the May-October “all out” period and/or a poor month (or two) during the November-April “all in” period. Of course, the seasonal trading strategy must consider transaction costs and tax implications.

Sector performance May-October

For investors who like to take a tactical approach to the seasonal tendencies, a sector bias strategy may be worth considering. Before I get to the details, let me remind our clients that we moved toward a more sector-neutral strategy back in early April when we became more cautious about the market in the short term. Presently the only outperform rating we have is on the information technology sector, while the only underperform rating we have is on the utilities sector.

As you can see in the table below, courtesy of The Leuthold Group, cyclical groups have tended to outperform during the market’s traditionally strong November-April period, while defensive sectors have been the relative winners during the customarily weaker May-October period. In fact, the size and persistence of these effects have been impressive (at least since 1989, the span of the analysis).

S&P 500 Sector Seasonality

Source: The Leuthold Group, October, 1989-April, 2012. Defensive sectors: consumer staples, health care and utilities. Cyclical sectors: consumer discretionary, industrials and materials.

Buy in May in election years?

There’s also the rub of this being an election year, during which sitting out the May through October period has historically not worked well. Using the Dow Jones Industrial Average because of its longer history, the market has been up 4.5% during election years in the May-October span versus 2.6% for all years (including election years). And for what it’s worth, according to NDR, the market has bucked seasonal weakness even more when the incumbent president has won, with a median gain of 7.6% versus 0.5% when the incumbent president has lost.

NDR provides a clue as to why this is the case: A correction has occurred during the second quarter of election years, on average (sound familiar?). But the correction has tended to be concentrated in the second quarter, setting the stage for a summer rally.

2012′s positive offsets to present weakness

I actually think the scenario noted above is more likely than not this year. Muscle memory has many investors fretting a repeat of 2011 and 2010, when economic weakness in the spring led to brutal corrections each year, to the tune of -19% and -16%, respectively. But there’s a long list of positive offsets this year relative to the past two years:

• Inflation is coming down, especially among commodity prices.
• Credit growth is quite strong, especially for consumers.
• Housing has improved markedly.
• The US manufacturing sector is humming.
• NFIB’s small business survey made recent upside breakout.
• Job growth is much better.
• Consumer confidence is improving.
• Private-sector leverage ratios are much improved (debt servicing costs are extremely low).
• Recovery in state/local government spending.
• The US economy somewhat decoupling from rest of world; at least Europe.
• US bank capital/health is much better than Europe’s.
• The European Central Bank’s Long-Term Refinancing Operations have reduced likelihood of global financial contagion.
• Germany appears more willing to accept higher inflation, opening the door to easier monetary policy for the eurozone.
• Valuations are quite cheap, especially on forward earnings.
• Investor sentiment has improved sharply with the correction to-date (meaning pessimism has kicked back in).

I don’t think the present correction is over, but do believe it could be kept to within the normal 5-10% range. Since the current bull market began in March 2009, the S&P 500 has had 15 corrections of more than 5% that were preceded by at least a 5% rally (consistent with this year’s pattern). The table below highlights their duration and ultimate percentage drop.

S&P 500 5% Corrections

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of May 11, 2012.

Wall of worry being rebuilt

Tempering my short-term concern has been the aforementioned improvement in sentiment conditions. That said, I think there’s likely a bit more pessimism needed to establish a short-term bottom for the market. As you can see, the well-watched NDR Crowd Sentiment Poll (CSP) has moved decisively lower, but not yet to the extreme pessimism zone:

Bye-Bye Optimism

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as May 8, 2012.

NDR noted in a recent report several key reasons to expect the correction to be within the normal 5-10% range:

• Initial reversals in CSP extremes are consistent with median declines of about 8% within six months.
• The first half of election years have shown median declines of just less than 10%.
• Once “pre-waterfall” highs have been exceeded, as occurred in February of this year, median market declines have ranged between -3% and -7% within six months.

Saving the worst for last

I think investors and the media may be underestimating the impact the coming “fiscal cliff” is having on market and business psychology. The fiscal cliff refers to the near-simultaneous January 2013 expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester (automatic spending cuts) established in last summer’s debt-limit agreement.

The range of estimates for its ultimate impact are, unfortunately, quite wide. The lowest estimate I’ve seen comes from NDR, using Congressional Budget Office assumptions, with the impact at a relatively “low” 2.4% of US gross domestic product (GDP). Most estimates tend to cluster around 3.5% of GDP.

It’s impossible to know what’s right because different assumptions are being used. But the consensus is closing in on a worst-case scenario of about 4% of GDP. ISI recently put the numbers into three distinct buckets, each with about $200 billion of impact:

1. Provisions likely to create a fiscal drag (approximately (≈) $221 billion or 1.4% of GDP):
   • Cuts to discretionary spending (≈$84 billion)
   • Tax increases on upper-income Americans included in the Affordable Care Act (≈$21 billion)
   • Payroll tax cut (≈$116 billion)
2. Bush tax cuts (≈$200 billion or 1.3% of GDP, although likely impact would be spread over several years)
3. Items unlikely to be allowed to take affect and thus aren’t likely to create a fiscal drag (≈$179 billion or 1.1% of GDP):
   • Huge increase in number of Americans paying the alternative minimum tax (≈$94 billion)
   • Sequester cuts (~$85 billion)

There are three additional items that don’t fall neatly into ISI’s three buckets, including tax extenders, extended unemployment insurance benefits and the “doc fix,” which would together total about $75 billion. These items are not expected to create a significant fiscal drag.

I actually think this is having a larger impact on psychology than many believe, especially on the confidence of corporate leaders and their ability to plan (and guide Wall Street’s analysts) for the future.

Muscle memory may fail us this year

In sum, there’s much to fret about, and volatility is likely to remain elevated until this correction has run its course. But a lot has changed in the past two years—much for the better—particularly for domestically oriented US companies. There’s at least a little bit of decoupling underway, certainly between the United States and Europe, and that’s likely to assist in keeping the correction from mirroring the ones in 2010 and 2011.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Anchor, Bond Yields, Charles Schwab, Chief Investment Strategist, Debt Crisis, Economic Indicators, Election Season, European Elections, Liz Ann, Media Appearances, Micro News, Perils, Seasonal Phenomenon, Senior Vice President, Sentiment, Stock Market, Swoon, Trading Strategy, Trahan, Volatile Times
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Panic Is Not a Strategy—Nor Is Greed (Sonders)

Monday, May 14th, 2012

Panic Is Not a Strategy—Nor Is Greed

Updated May 10, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Originally publishing in 2008, it’s time for a refresher about the perils of panic.
• Asset allocation, diversification and rebalancing are as close to a “free lunch” as you can get as an investor.
• In a world where time horizons have shrunk precipitously, think longer-term.

If markets are good at one thing, it’s reminding investors that they don’t go up uninterrupted forever. We witnessed several bruising corrections in 2011 before the market’s strong rally between October 2011 and April 2012. As the chart “Fear Spikes Again” below illustrates, the CBOE Volatility Index® has picked up again, but remains below the unparalleled heights of the 2008 credit crisis and the more-recent elevation in 2011.

Fear Up, But Well Down From Highs

Source: FactSet, as of April 20, 2012. The CBOE Volatility Index (“VIX”) is a registered trademark of the Chicago Board Options Exchange. The VIX Index shows the market’s expectation of 30-day volatility. For more information on the VIX, visit www.cboe.com/micro/vix/

We’re always quick to remind investors that neither panic nor greed is an investment strategy, and that the best foundation to help protect a portfolio against the unpredictable is having—and sticking with—a long-term strategic asset allocation plan.

Mindset matters: strategic trumps tactical

In reality, investors should rarely, if ever, react to a dramatic short-term move in the market. As intriguing as it may seem to try to catch bottoms and get out at tops in order to reap big profits (or so you think), the “tactical” (or shorter-term) approach to investing has its limitations … and its risks.

We believe it’s the “strategic” asset allocation decision—and the ability to stick with it through the discipline of rebalancing—that will ultimately reap the greatest rewards. These decisions are not a function of short-term market gyrations or forecasts (mine, yours or anyone else’s), but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is by far the most important set of decisions a client will ever make.

Never before has information about the global economy and markets been more readily available and disseminated. As a result, global markets have become very interconnected. In turn, our reaction mechanisms have kicked in, and investor time horizons have shortened dramatically—but not necessarily to our advantage. Yes, the long term is really just a series of short-term events, but it’s how we react to them that decides our ultimate fate as investors.

Asset allocation and diversification: investors’ “free lunch”

One of the most important areas where Schwab offers advice is the development of a long-term strategic asset allocation plan. Many investors assume that their position along the risk spectrum from conservative to aggressive is largely based on their age and time horizon. But a more important factor is their risk tolerance. Also important is judging the difference between an investor’s financial risk tolerance (their ability to financially withstand volatile markets) and their emotional risk tolerance—a spread that’s often quite wide and only acknowledged during tumultuous market environments.

I’ve known plenty of older investors who thrive on the risk associated with an aggressive investment stance. I’ve also known plenty of young investors who can’t stomach any losses. Too often, investors use a rearview mirror to make their investing decisions, by looking at past performance as a guide to future results. A mirror is a valuable tool but only when turned on yourself to judge your own circumstances—tolerance for risk, time horizon, income needs, etc. As I’ve often said, there are very few free lunches in investing. Asset allocation, diversification and periodic rebalancing are as close as you get.

Risk tolerance: Know what you can stomach

In the chart “Schwab’s Strategic Asset Allocation Models” below, you’ll see our long-term recommendations regarding different asset classes for three types of investors: conservative, moderate and aggressive.¹ Note the vast differences in allocations to riskier asset classes, including international equity, as you move up the risk spectrum.

Clearly, over the long term, given the better performance by the riskier asset classes, a more aggressive allocation has historically reaped higher rewards in terms of returns. But there is a dark side to an aggressive posture’s higher returns—the risk taken in getting there.

Tags: Allocation Plan, Cboe Volatility Index, Charles Schwab, Chicago Board Options, Chicago Board Options Exchange, Chief Investment Strategist, Credit Crisis, Diversification, Free Lunch, Greed, Investment Strategy, Liz Ann, Perils, Rewa, Senior Vice President, Strategic Asset Allocation, Term Approach, Time Horizons, Unparalleled Heights, Vix Index, Volatility Index Vix
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Marc Faber: The Perils of Money Printing’s Unintended Consequences

Saturday, March 17th, 2012

 
 

 
 
Marc Faber does not mince words. He believes that the money printing policies of the Federal Reserve and its sister central banks around the globe have put the world’s currencies on an inexorable, accelerating, inflationary down slope.

The dangers of money printing are many, in his eyes. But in particular, he worries about the unintended consequences it subjects the populace to. Beyond currency devaluation, it creates malinvestment that leads to asset bubbles that wreak havoc when they burst. And even more nefarious, money printing disproportionately punishes the lower classes, resulting in volatile social and political tensions.

It’s no surprise, then, that he’s feeling particularly defensive these days. While he generally advises those looking to protect their purchasing power to invest capital in precious metals and the equity markets (the rationale being that inflation should hurt equity prices less than bond prices), he warns that equities appear overbought at this time.

On Inflation

First of all, I do not believe that the central banks around the world will ever, and I repeat ever, reduce their balance sheets. They’ve gone the path of money printing, and once you choose that path you’re in it and you have to print more money. If you start to print, it has the biggest impact. Then you print more — it has a lesser impact, unless you increase the rate of money printing very significantly. And, the third money-printing has even less impact. And the problem is like the Fed: They printed money because they wanted to lift the housing market, but the housing market is the only asset that didn’t go up substantially. In general, I think that the purchasing power of money has diminished very significantly over the last ten, twenty, thirty years, and will continue to do so. So being in cash and government bonds is not a protection against this depreciation in the value of money.

On His Love for Central Bankers

Basically the US had a significant increase in the average household income in real terms from the late 1940s to essentially the mid-1960s. And then inflation began to bite, and real income growth slowed down. Then came the 1980s, and in order not to disappoint the household-income recipients, you essentially printed money and had a huge debt expansion. So if you have an economic system and you suddenly grow your debt at a very high rate, it’s like an injection of a stimulant of steroids. So the economy grew at a relatively fast pace, but built on additional debt. And this obviously cannot go on forever, and when it comes to an end, you have a problem. But the Fed had never paid any attention. The Fed is about the worst economic forecaster you can imagine. They are academics. They never go to a local pub. They never go shopping — or they lie. But basically they are a bunch of people who never worked a single day in their lives. They’re not businessmen that have to balance the books, earn some money by selling goods, and pay the expenditures. They get paid by the government. And so these people have no clue about the economy. And, so what happens is they never paid any attention to excessive credit growth — and let me remind you, between 2000 and 2007, credit growth was five times the growth of the economy in nominal terms. In other words, in order to create one dollar of GDP, you had to borrow another five dollars from the credit market. Now this came to an end in 2008. Now the Fed never having paid any attention to credit growth, they realized if we have a credit-addicted economy and credit growth slows down, we have to print money. So that’s what they did. But believe me, it doesn’t take a rocket scientist to see that if you print money you don’t create prosperity. Otherwise, every country would be unbelievably rich, because every country would print money and be happy thereafter.

On the Unintended Consequences of Money Printing

In the short term, it has been working to some extent, in the sense that equity prices are up and interest rates are down. And, so companies can issue bonds at extremely low rates. But every money-printing exercise in the world leads to unintended consequences at a later point. And this is the important issue to remember. We don’t know yet for sure what the unintended consequences are. We know one unintended consequence, and this is that the middle class and the lower classes of society, say 50% of the US, has rather been hurt by the increase in the quantity of money in the sense that commodity prices in particular food and energy have gone up very substantially. And, since below 50% of income recipients in the US spend a lot, a much larger portion of their income on food and energy than, say, the 10% richest people in America and highest income earners, they have been hurt by monetary policy. In addition, the lower income groups, if they have savings, traditionally they keep them in safe deposits and in cash because they don’t have much money to invest in the first place. So the increase in the value of the S&P hasn’t helped them, but it helped the 5% or 10% or 1% of the population that owns equities. So it’s created a wider wealth inequality, and that is a negative from a society point of view.

Click the play button below to listen to Chris’ interview with Marc Faber (runtime 40m:45s):

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Or click here to read the full transcript.

Tags: Balance Sheets, Banke, Bond Prices, Central Banks, Currency Devaluation, Depreciation, Federal Reserve, Government Bonds, Havoc, Housing Market, Marc Faber, Money Printing, Perils, Political Tensions, Populace, precious metals, Printing Policies, Purchasing Power Of Money, Thirty Years, Unintended Consequences, Value Of Money
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To Trade or Not to Trade: The Perils of Chasing “Premium” Opportunities

Thursday, March 1st, 2012

As I have discussed before, the fixed income ETF industry has taken off in the past few years, with new investors discovering the funds every day.  This has generated a lot of attention and many good questions as investors dig into this new asset class to figure out how it works and how best to use it.  And as with any new instrument, there are some in the market who don’t yet fully understand how fixed income ETFs work.

A recent article published by a well-known news source nicely captures both the highs and lows of bringing a new product to market; the praise for the quality of what we are doing, along with the misconceptions about the fund mechanics.  While this piece does mention flattering things about MUB (iShares S&P National AMT-Free Municipal Bond Fund), it notes that MUB is trading at a price above its NAV (a “premium”) and recommends that investors sell MUB and buy another fund instead.

Unfortunately, almost before the ink on the article was dry the premium flattened and the “trade” had already disappeared.  But this isn’t the first time we’ve encountered this situation, and it likely won’t be the last.  There are a few reasons why the logic here is flawed – the first is that it reflects a lack of understanding about how fixed income ETFs trade.

So what happened in this case?  MUB’s price premium to its NAV reflects market supply and demand for municipal bond exposure.   For the last couple of weeks there has been a scarcity of new municipal bond supply, which led investors to bid up the price of the muni exposure that they could buy, which led to MUB’s price premium.  MUB reflected the actionable price of muni bonds in the market.  And as supply and demand forces shift, bond prices and fixed income ETF premiums can move quickly.

This week we saw municipal bond supply start to reappear with $6 billion in new issuance.  This new issuance helped balance supply and demand in the muni market, and on Wednesday MUB’s premium declined.

But in addition to the perils of chasing a fleeting premium, when you look at the trade more closely you see that it doesn’t consider a number of realities that an investor would face if they tried to execute. Specifically:

• An investor would incur transaction costs in putting on and then reversing the trade.  We estimate that round trip costs would be 32 basis points. (Source: Bloomberg, based on spreads of MUB and TFI as of 2/23/2011).
• The trade may result in a capital gain if the holder has seen MUB appreciate.  The impact could be substantial given how well muni bonds have performed over the past year.  Say an investor bought MUB on 12/31/2011 at $108.25, and then sold it at the 2/22/2012 closing price of $113.77.  The apparent gain of $5.52 would be subject to short term capital gains taxes of approximately $1.55. Capital gains tend to be an especially sensitive issue for investors who are looking to municipal bonds for their tax efficiency. (Capital gains tax rate assumed to be 28%).
• An investor would incur commissions and ticket charges as they would on any exchange transaction (the amount varies by custodian).

Depending on when an investor acquired MUB, these costs could outweigh any apparent gain from selling MUB at a premium.

Can fixed income ETFs be used to take advantage of tactical opportunities?  Absolutely, and many investors use them to do so.  But before putting on any trade, even one recommended by purported experts, think hard about what you are ultimately trying to accomplish with your investment. Consider the suitability of an opportunity, for many investors municipal bonds represent a strategic rather than tactical investment. And of course take into account all of the costs that would be incurred in a trade.

I expect that as the fixed income ETF market continues to grow that investors and market participants will gain a deeper understanding of the fund mechanics and trading behavior. Hopefully then more conversations can focus on what is really important to investors, building better investment portfolios.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data for iShares Funds current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.

For standardized MUB performance, please click here.

For standardized TFI performance, please click here.

Investment comparisons are for illustrative purposes only and are not meant to be all-inclusive. To better understand the similarities and differences between investments, including investment objectives, risks, fees and expenses, it is important to read the products’ prospectuses.

The MUB capital gains example is strictly for illustrative purposes and does not represent any actual investment outcome.

Bonds and bond funds will decrease in value as interest rates rise. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Federal or state changes in income or alternative minimum tax rates or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value.

Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. ETFs are obliged to distribute portfolio gains to shareholders.

Tags: Amp, asset class, Balance Supply, Bond Prices, Fixed Income, Highs And Lows, Ishares, Issuance, Logic, Mechanics, Misconceptions, Muni Bonds, Municipal Bond Fund, Nav, News Source, Perils, Premiums, Recent Article, Scarcity, Supply And Demand
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David Rosenberg: “It’s a Gas, Gas, Gas!”

Monday, February 27th, 2012

Once again, if one wants to get nothing but schizophrenic noise from several momentum chasing vacuum tubes which very way may take the market to all time highs on 1 ES contract churned back and forth, by all means focus on the “market” which for the past three years is merely a policy vehicle of the monetary-fiscal fusion regime (thank you Plosser for confirming what we have been saying for years). For everyone else, here is the traditionally solid economic commentary from David Rosenberg. Considering that the central planners have pumped $7 trillion, or 50% of their balance sheet, in the stock market in the past 4 years, to offset precisely the warnings that Rosenberg issues on a daily basis, we are far beyond debating whether or not those who observe the economy realistically are right or wrong. The only question is whether the central banks can continue to expand their balance sheet at an exponential phase to offset the inevitable. Answer: they can’t.

From Gluskin Sheff’s David Rosenberg

IT’S A GAS, GAS, GAS!

“There are fluctuations in the market that don’t mean anything.”

Ira Gluskin, February 14, 2012

If there was a Rule #11 added to Bob Farrell’s list of gems, this would be it. We have added this ditty before from Ira, and will continue to do so as a reminder. A reminder of what you ask? A reminder of how the stock market can be divorced from economic realities for a period of time. The stock market ignored the perils of the busted tech bubble for a good eight months back in 2000, ultimately to its own chagrin. It ignored the meltdown in the housing and mortgage market for at least 10 months back in 2007. The examples can go on, but hopefully the point is taken.

At any given moment of time, the market is driven by a variety of factors. Some are more important than others, and they include technicals, seasonals, sentiment. fund flows, valuations and, Of course, the fundamentals. The key driving force this year has been the expanded P/E multiple, in line with a 16 reading on the VIX index, as the markets seem to believe that the massive expansions of global central balance sheets will end up saving the day for dilapidated sovereign government balance sheets and woefully undercapitalized European banks. Too bad the Graham and Dodd classic text on value investing didn’t include a chapter on central bank money-printing.

From our lens, liquidity-based rallies are fun to trade, but tend to have a relatively short shelf life. Imagine what is on everyone’s minds for the coming week is not the economic data or earnings results but instead the second LTRO round on Wednesday — this is what investors are biting their nails over: will it be 1 trillion euros or ‘just’ 300 billion? Page M10 of Barron’s dubs this the ‘LTRO put’, which “sparked a massive risk-on rally in global markets”. Incredible how easy it is to avert a bear market why didn’t the Fed do this in 2007 and 2008, simply print money — and help us avoid the Great Recession?

What about the fundamentals? Well, let’s have a look at earnings. It is completely ironic that we would be experiencing one of the most powerful cyclical upswings in the stock market since the recession ended (the S&P 500 is now up 25% from the October 3rd nearby low) at a time when we are clearly coming off the poorest quarter for earnings, in every respect. The YoY trend in operating [PS is now below 6%, and without Apple, growth has basically vanished altogether (down to a mere +2.8%). Corporate guidance over the past three months is at the lowest point since August 2009 — before the term ‘green shoots’ was invented! Only 44% of companies beat their revenue targets, the weakest since the first quarter of 2010: and 64% surpassed their profit estimates and this too is the lowest since the third quarter of 2008.

If memory serves me correctly, you did not want to go long the market heading into either the second quarter of 2010 or the fourth quarter of 2008 with these factoids in hand. I have to admit that I find it perplexing as to why so many folks dub this a tech-led rally when we came off a week that saw both Hewlett- Packard and Dell disappoint in their Q4 earnings results — the former with a 7% YoY revenue dive.

All that said, the S&P 500 did manage to close out the week at 1,365.74 and establish a level not seen since June 5, 2008 (only 200 points shy of setting a new all-time high —Jeremy Siegel must be licking his chops). If you are wondering why it is that consumer sentiment jumped to 75.3 in February (better than the reading that was widely expected), this is the reason. The University of Michigan index does a much better job tracking the equity market than it does the labour market or consumer spending for that matter.

Page 13 of the weekend FT quotes a strategist as saying

“… we also had a combination of a couple of good earnings reports and little bright signs coming from the housing and labour markets. Some people are even talking about the S&P 500 hitting the 1,400 mark.”

Actually, earnings growth and earnings estimates are going down on net. As is corporate guidance, what little of it there is. The bright signs from housing are really a commentary on the balmy weather skewing the seasonally adjusted data and there is certainly no sign of any recovery in prices (it’s incredible how so many people get excited over a 321,000 new home sales tally — never mind that they are still near record lows in per capita terms). To be sure, the new housing inventory is down to a six-year low of 5.6 months supply, but taking into account the supply coming down the pike from foreclosures, the entire backlog in the pipeline is at least double that posted number.

…

The precious metals market is hardly signalling good times ahead — rather more turbulent times ahead — as gold finished last week near a three-month high (silver has been behaving even better and platinum has hit its best level in five months).

Meanwhile, what is largely being ignored is the rapid move up in oil prices as Iran-based tensions escalate further. The WTI crude price rose to nearly $110/bbl and more importantly. Brent has soared over $125/bbl (highest level since August 2008), and forward contracts are pointing to gasoline breaking back above $4 a gallon in the next two to three months (already there in California and within 10 cents in New York state). The nationwide average has already risen 37 cents in just the past month and 7 cents last week alone — it hasn’t been long enough to show through in the confidence surveys, though let’s face it, we are seeing early signs already of some fraying at the edges in the retail sector — despite the apparent improvement in the labour market (indeed, it is income that people spend, and growth on this front, let’s be honest, has been less than stellar).

Meanwhile, as if to represent the consensus of opinion out there. page A2 of the weekend WSJ quotes a pundit as saying “$4 probably isn’t going to be the threshold that changes peoples’ behavior this time. I think people have gotten used to $4″.

What claptrap. Its not that people have gotten used to $4 — it’s only there in the Golden State, Hawaii and Alaska … wait until it grips the whole country. And consumers have yet to fully process this rapid move up in gas prices, but recall what happened a year ago. To be sure, there was no recession, but economic growth came to a virtual halt in the first half of the year because of the impact that energy costs exerted on the GDP price deflator. Second, it is not the level but the change in prices at the pump that influences the growth rate of the economy — every penny at the pumps siphons away around $1.5 billion from consumer wallets into the gas tank. Moreover, a little history lesson for the pundit quoted above. According to work conducted by the University of California at San Diego and cited on page 14 of the weekend FT. all but one of the 11 post-WWII recessions followed an oil shock (the lone exception was the 1960 downturn). Recall what happened the last two times Brent hit current levels — in 2008 (recession) and 2011 (stall speed). Neither outcome was very good.

The key is how long this elevated energy price environment sticks around in terms of overall economic impact. Brent had already been hovering near $110/bbl for 12 months but this most recent price run-up has actually taken the 200-day moving average higher now than it was in the 2008 recession year. Let’s keep in mind that the jump in crude prices has occurred even with the Saudis producing at its fastest clip in 30 years — underscoring how tight the backdrop is. Even with slowing demand in the weak economies of the ‘developed world’, continued rapid growth in emerging markets is providing an offset on the demand side (which does little good for the American or European consumer).

Meanwhile, estimates of spare capacity are all over the map but what we do know is that just to meet the burgeoning demands of the emerging market world requires a further 1 mbd this year of production — and yet supplies are being withdrawn. It will not be very difficult to see oil retest $150 a barrel, and we are talking WTI here, not Brent.

…

It is also fascinating to watch the action in the much-despised Treasury market (the net speculative short position on the 10-year 1-note is 63,328 contracts on the CBOT while the comparable for Dow contracts is net long 14.803 contracts). Despite the slate of supply last week ($99 billion of new issue activity) the yield on the 10-year T-note closed at 1.98%. Someone out there (Bernanke?) is
coming in and buying whenever the yield pops above 2% — a level that simply is not being sustained on apparent break-outs. The long bond yield actually finished the week lower in yield at 3.1% from 3.14% (the 10-year was down 2bps).

At a time when energy prices are spiking, this is a clear sign that the bond market is treating this as a deflationary shock rather than a durable increase in inflation. That makes total sense to us. It’s not as if global consumption is going up — even with higher auto sales, Americans are spending less time on the road: miles driven are down 1% over the past year. And the IEA (International Energy Agency) has cut its 2012 forecast for global oil demand twice since the beginning of the year. This is an exogenous supply shock, pure and simple.

…

And now the consensus is that the recession in the euro area will be mild because of one month’s worth of diffusion indices. Such is human nature — extrapolate the most recent economic indicator into the future. The region suffers from a credit shock, a fiscal shock, and now an oil shock and at the same time, an overvalued currency. What is the euro doing at an 11-week high and how does this help the region export its way out of its economic downturn? Yet there are still a net short 137,479 speculative euro contracts on the CME, which could have a further impact as they cover in the near-term; there are 17,136 net long yen contracts and 29,101 net long speculative U.S. dollar contracts.

Brent crude oil hit a record high in euro terms (in Sterling as well) last week and has surged 11% in just the past month on this basis, and even if prices stay where they are, what energy is going to absorb out of Eurozone GDP this year will be 5.5%, which would surpass the 2008 recession shock of 4.8% (the highest drainage from the economy in three decades — see Soaring Oil Price Threatens Recovery on page 14 of the weekend FT).

…

The U.S. economy is either generating jobs in low-paying service sector jobs or the employment that is coming back home in manufacturing is doing so at lower wage rates than when these jobs left for Asia years ago. So much for wage stickiness. Throw in rising gasoline prices and real incomes are in a squeeze, and there is precious little room for the personal savings rate to decline from current low levels. On a year-to-year basis, real after tax incomes are running fractionally negative and in the past that was either associated with an economy in recession, about to head into recession or just coming out of recession. So perhaps there is no contraction in real GDP just yet. but there is one in real incomes.

What else do people spend? Their wealth. And here too, courtesy of a flat equity market performance and renewed declines in home values, household net worth also contracted in the past year. So here we have real incomes and wealth both deflating and the masses believe that recession is off the table because of a liquidity-induced four-month rally in the stock market. Go figure.

Tags: All Time Highs, Bob Farrell, Central Banks, Central Planners, Chagrin, Daily Basis, David Rosenberg, Ditty, Economic Commentary, Economic Realities, Eight Months, Fund Flows, Gluskin Sheff, Inevitable Answer, Meltdown, Mortgage Market, Perils, S David, Stock Market, Vacuum Tubes
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Is Modern Central Banking Ancient History?

Tuesday, October 25th, 2011

This post is a guest contribution by Manoj Pradhan of Morgan Stanley, via Investment Postcards

Two of the three principles of modern central banking were designed for a regime that developed economies will not see for the foreseeable future. The principles – (i) inflation targeting improves growth prospects in the medium run; (ii) inflation targeting effectively means inflation forecast targeting; and (iii) a ‘conservative’ central banker (i.e., one who dislikes inflation more than the average economic agent) can deliver lower and less volatile inflation – are almost unquestioned among the central banking orthodoxy. However, these principles were espoused in an era of low debt when monetary policy was the dominant force. In the era we now live in, where debt, deficits and deleveraging (a DDD regime) are the dominant drivers of the economy and policy – an era of so-called ‘fiscal dominance’ – the first and the last tenets can cause more harm than good. Inflation targeting and an aggressive approach to taming inflation in such times can create more volatile inflation and higher sovereign risks.

G3 monetary policy is still ultra-expansionary and on its way to becoming even more so, given the current disinflationary risks. However, inflation clocking in at over 5% in the UK and over 3% in the US and euro area gives hawks and dissenters plenty of ammunition. There remains a risk that monetary policy could ignore the perils of trying to curb inflation in an era of fiscal dominance. Tellingly, Chairman Bernanke’s speech yesterday, The Effects of the Great Recession on Central Bank Doctrine and Practice, contained not one mention of fiscal concerns, let alone fiscal dominance. That the single greatest peacetime build-up in debt burdens in our lifetimes should go unmentioned in such a speech is strange at the very least.

Fiscal dominance – what does it mean? In the simplest characterisation of fiscal dominance, the fiscal position of the economy effectively ‘sets’ a target that monetary policy has to follow. Monetary policy plays a subordinate role, keeps interest rates low and allows inflation to erode the real value of government debt. By contrast, monetary dominance implies that fiscal policy plays a passive role while monetary policy goes about keeping inflation under control without a concern about the adverse effect of higher interest rates on the ability of governments to sustain the debt burden. Such a regime clearly existed before the onset of the Great Recession in the advanced economies (excluding Japan) and continues to exist in the emerging market economies even now. Since the Great Recession, however, things have changed.

Fiscal dominance isn’t a new concept. In 1981, one of this year’s Nobel Laureates, Thomas Sargent, and co-author Neil Wallace argued that trying to achieve too little inflation in a debt-ridden economy only meant inflation had to be ramped up further down the road to reduce the real debt burden.

More recently, the fiscal theory of the price level has argued that monetary policy needs to accommodate fiscal dominance by providing lower real interest rates as inflation rises. These papers spurred great debate, but the practical contribution of that research is going to be evident only now given that much of the developed world is in the clutches of sovereign risk and there is a prospect of many years of deleveraging of public debt.

Taylor Rules missing the point: Perhaps the best way to highlight the stark contrast between the two regimes is to consider Taylor Rules. Used (and often abused) to assess where policy rates should be, given macro fundamentals, the underlying structure of the Taylor Rule is often ignored. In its construction, the microeconomic foundations of the Taylor Rule assume that the government sets policy in order to keep the budget balanced. This takes an awkward fiscal position of questionable sustainability out of the equation, quite literally.

Why does disinflation perversely lead to more volatile inflation? If we now turn to Taylor Rules under a regime of fiscal dominance, we see that an aggressive pursuit of inflation targeting leads to undesirable volatility of inflation – a point made very convincingly by Kumhof et al (2008). Why? The standard Taylor Rule would recommend, all else equal, that the central bank raises policy rates faster than inflation, thereby raising real interest rates in order to slow down the economy and reduce inflation. However, when there is a high level of indebtedness, higher real interest rates reduce the attractiveness of sovereign debt in two ways. First, the cost of servicing this debt rises. Second, higher real rates reduce output and production, which makes it tougher for economies to ‘grow’ their way out of debt. The result is a rise in risk premiums and a higher probability of default.

Eventually, monetary policy is forced to turn its strategy around because it has to ensure fiscal solvency to prevent a catastrophe. In order to do so, it is eventually forced to push up inflation even higher than it was before in order to generate seignorage revenues. Clearly, applying what is considered ‘normal’ monetary policy when there is a regime of fiscal dominance therefore risks aggravating not just the fiscal situation but inflation dynamics too.

Allowing the central bank to explicitly respond to fiscal variables improves matters, but the best result comes from eliminating fiscal dominance altogether, through fiscal action.

Lessons from Latin America: The interplay of monetary and fiscal policy under such different ‘regimes’ is not a purely theoretical consideration. The history of Latin American economies in dealing with debt issues presents us with an all too familiar experience from the recent past showing the very real concerns that markets and investors should have about the future path of monetary policy. Writing about the Brazilian central bank’s desire to pursue its inflation-targeting mandate in 2002-03, Blanchard (2004) proposed that targeting inflation by raising real interest rates in a “high debt, high risk-aversion” environment would have served to make government debt less attractive, leading to an increase in sovereign risk. The ‘correct’ solution was a fiscal one, and a credible fiscal reform did indeed resolve the crisis. Echoes of this experience can be found in the economic and market reaction to the ECB’s tightening of monetary policy in early 2011. In the wake of the rate hikes, the ability of peripheral countries to service their debt in a higher interest rate environment likely added to the concerns surrounding sovereign risk.

Fiscal policy is the right way to tackle inflation: In both discussions, that of the Taylor Rule and the Latin American experience, the onus of dealing with inflation falls on fiscal and not monetary policy. Meaningful fiscal consolidation, as and when possible, eases out the regime of fiscal dominance, thereby allowing central banks to revert to aggressively dealing with inflation. In the period of transition between a realisation of the need for fiscal consolidation and its achievement, monetary policy serves its inflation-fighting credentials best by not fighting inflation aggressively.

Could central banks already be incorporating fiscal dominance? Given that we are reading tea leaves from the cups of monetary policy statements and actions, it is certainly possible that we may be underestimating the importance that central banks actually assign to fiscal dominance which is not reflected in their official speeches and statements.

In addition, central banks might not actually consider inflation to be a home-grown problem, and hence are willing to tread relatively softly on inflation at this point of time. Considering the Bank of England, domestically generated inflation is very low while imported inflation accounts for the bulk of the UK’s inflation problems. Could such an inflation profile also be applicable to the US and the euro area, where growth and pricing power remain weak? If so, central banks may be inclined to pay less attention to inflation, given that the bulk of it comes from outside national borders, while monetary policy would have the greatest impact within the economy.

Finally, central banks may be using the ‘flexible inflation targeting’ approach that Chairman Bernanke discussed in his speech yesterday, whereby stabilising output in the near term (particularly under exigent circumstances) is seen to be an important part of stabilising inflation expectations in the medium run. This flexibility could provide central banks the opportunity to assign greater importance to ensuring that growth becomes entrenched rather than worrying about inflation becoming sticky.

Despite these considerations, it appears that central banks are playing down the impact of fiscal dominance. Some within monetary policy committees stand more ready than others to take action to address inflation. The dissenters within the FOMC show that the higher and more persistent-than-expected rise in core inflation is clearly causing discomfort – this despite the fact that the US economy still appears to be short of reaching escape velocity as far as sustainable growth is concerned. The decision by the Bank of England to engage in a further round of quantitative easing just a few days before inflation breached 5% will clearly raise more questions in some quarters. However, the most important ‘revealed preference’ of monetary policy-makers to tackle inflation comes from the ECB’s decision to raise policy rates in early 2011 despite risks to growth and fiscal sustainability. The resolve of central banks to deal with inflation may now be subdued, but it is far from dormant.

The added complication – the ‘conservative’ central banker: Rogoff’s seminal paper in 1985 drilled home the result that a person/body with a greater distaste for inflation than the ordinary economic agent could deliver both lower and less variable inflation. This important result was often used to pick ‘conservative’ central bankers who would deal with inflation aggressively. It is interesting to note that this line of thinking preceded the advent of inflation targeting but was not abandoned once inflation targeting was widely adopted. The need to preserve the conservative credentials of the central bank was also the rationale for asking for independence from outside influence, including the government. Granting the monetary policy committee, a non-elected body, independence from the preferences of elected representatives does not sit well with the principles of democracy (Blinder, 1993), but the importance of acting decisively against inflation was deemed strong enough to bypass such concerns.

When inflation targeting arrived, the presence of a conservative central banker leading an independent central bank only served to bring inflation down faster. In a regime of monetary dominance, this combination worked very well. Under fiscal dominance, however, it will likely only make an aggressive pursuit of the inflation target more likely and therefore more disruptive.

Is modern central banking history? Some hope from the EM experience: The experience of emerging market economies shows some reason for optimism, but not in the near future. The lessons in indebtedness of the Latin America and the Asian Financial Crisis of the late 1990s were taken very seriously by policy-makers. Under the discipline of a punishing market, EM economies lowered their debt burdens and now boast levels of indebtedness, growth and fiscal solvency that are very attractive compared to the fiscal profile.

Ironically, the fact that EM central banks were not quite as independent as their counterparts in the advanced economies actually helped during periods of fiscal dominance. EM central banks, with their famous preferences for growth relative to inflation, did little to upset the applecart during tenuous times, allowing fiscal policy-makers more legroom to reduce indebtedness. Once the regime of fiscal dominance had been eliminated, EM central banks quickly adopted inflation-targeting policies to further improve macroeconomic fundamentals. Of course, the fact that EM central banks are still only quasi-independent is part of the reason why EM inflation expectations and inflation itself have not moderated even lower.

The one stark difference in the EM experience is that the deleveraging process was carried out against the backdrop of very strong global growth, a luxury that DM economies do not have. Eliminating fiscal dominance may therefore take longer. In this ongoing period of transition, DM central banks may have to take their cue from the EM experience and try to mimic their preference for growth rather than for lower inflation.

Summary: The era of fiscal dominance that we are now living through requires a different strategy of monetary policy. Pursuing traditional inflation targeting aggressively is likely to lead to more, not less volatile inflation. Should it try to reduce inflation, the central bank would have to raise real policy rates, which would end up making sovereign debt unattractive. The subsequent u-turn by the central bank as it tries to stabilise the risk around sovereign debt would require even higher inflation further down the road. The ‘solution’ to dealing with higher inflation is therefore better fiscal and not more aggressive monetary policy. Going by the experience of emerging markets, a successful fiscal consolidation wipes out the constraint of fiscal dominance and restores traditional monetary policy and inflation targeting. Until that happens, though, monetary policy can best burnish its inflation-fighting credentials by not fighting inflation aggressively.

Source: Manoj Pradhan, Morgan Stanley, October 21, 2011.

Tags: Aggressive Approach, Bernanke, Brazil, Central Banking, Characterisation, Conservative Central Banker, Debt Burdens, Dissenters, Dominance, Dominant Force, Fiscal Concerns, Fiscal Position, Foreseeable Future, Growth Prospects, Lifetimes, Monetary Policy, Morgan Stanley, Orthodoxy, Peacetime, Perils, Sovereign Risks
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The Death of Equities = The Birth of a New Bull?

Tuesday, October 26th, 2010

The Fundamentals of Recoveries (October 2010)

Commentary on the health of equity markets today and the perils of investing while looking backwards. Will McKenna interviews Tim Armour and Jim Dunton, portfolio managers, with Capital Research and Management Company.

Featuring:
Tim Armour, Portfolio manager, Capital Group*
Jim Dunton, Portfolio manager, Capital Group*

*Portfolio manager with Capital Research and Management Company; does not manage Capital International portfolios.

1. Recovery off to a slow start – but it’s just the start (VIDEO, 5:12)
2. The perils of investing while looking backwards (VIDEO, 3:04)
3. Opportunities across a wide swath of companies (VIDEO, 3:29)
4. Strong corporate fundamentals an encouraging sign (VIDEO, 3:01)
5. Reflections on the presidential cycle (VIDEO, 1:53)

You may watch all of the above videos by clicking HERE, or on the image below. To view all 5 chapters visit “Select Chapter.”

The fundamentals of recoveries

by Capital International Asset Management

1. Recovery off to a slow start — but it’s just the start

Craig Strauser: Hello. I’m Craig Strauser. Welcome to this edition of Capital International Perspectives. In this program, you’ll hear the latest insights from veteran portfolio counselors Tim Armour and Jim Dunton. When my colleague Will McKenna sat down with Tim and Jim to talk about market recoveries, the topics ranged from company fundamentals and investment opportunities today to presidential cycles and the tendency of investors to gaze into the rearview mirror when calculating their next move.

To start things off, Will asked Jim and Tim to assess the current recovery.

Will McKenna: Let’s start by talking about the current investment environment. Jim, you’ve invested through a number of full market cycles in your more than 40 years in the business. How would you characterize where we are at this stage of the recovery, and where do you see us going from here?

Jim Dunton: There’s a large body of economic evidence on a worldwide basis that any kind of recession that emanated from a financial crisis [like the one] that we’ve just gone through was going to evolve into a deeper recession than any that we would typically experience; there would be a longer recession than any that you typically experience, and, what’s more, the recovery itself would be much slower than normal.

Well, that’s exactly what we’re going through. We now are one year into the [U.S.] recovery, and it’s been very slow — like 3% real GDP. But it’s also important to bear in mind that it is underway. And once recoveries get started, they typically go a long time. The last cycles were seven years, 10 years, nine years; the one before that, eight. The typical cycle is seven to 10 years long, not one year long. So, one year into the recovery — which is where we are now — is not exactly the time to get overly concerned that the recovery has ended. We, in fact, just started.

But I think if you look also at the details, you would feel comforted by the fact that [U.S.] employment is, in fact, gaining ground; it has been all year. The number of hours that are worked is increasing. The number of people employed is increasing. And, importantly, the temporary workers are probably up sixfold from what they normally are in a recovery, which means that a lot of companies are hiring temporary people until they find out what the full status of the current economic programs are, the stimulus programs, the tax programs, the health programs — as to what all that is going to cost corporations before they want to fully employ people.

We’re through, I think, the worst of the recession, and we’re in a recovery mode, which I believe, from my point of view, is going to go on for the next eight or 10 years. So, I think we are slowly gaining ground — slowly gaining ground — but gaining ground nonetheless.

And it’s important that you recognize that what the end of the cycle looks like is more inflation [and] higher interest rates; that’s the typical end of a cycle many years from now. But it does suggest that between here and there are rising corporate profits, rising inflation, rising interest rates and probably a very healthy stock market over that period.

Tim Armour: The overarching issue, I really think — as with any recovery — is that it will be an up-and-down process. There’ll be bits of information or bits of data that come out that are either positive or data that appears that we’re either slowing down again or retrenching, which looks negative. I think one really has to keep an eye on the long run and see what’s happening with corporations, what’s happening with consumers. In the U.S., there’s been a reliquification on the consumer end of things. Consumers went into this period pretty indebted. The savings rate is up a lot in short order, and consumer spending — although not strong by any definition — certainly has maintained a reasonable level.

At some point here, we need to see employment growth in the U.S. pick up and consumers return to spending at a somewhat higher rate if we’re going to really see GDP [gross domestic product] growth here in the U.S. be stronger. But my expectation is that will happen ultimately; it’s more a question of time. And looking at past cycles, you can find any experience along that spectrum of either a more rapid recovery or a slower one. Having lived through some of these in the past, I think, makes us more comfortable that, really, the way to invest in this kind of period is identify the best companies out there, with good fundamentals, and don’t worry so much about the economic backdrop.

2. The perils of investing while looking backwards

Will McKenna: Given what they’ve been through over the past couple of years, a lot of investors are nervous about putting their money in the stock market today. What perspective could you offer, given your experience, about the wisdom of investing in stocks in this environment?

Jim Dunton: Cycles generally develop as I’ve outlined, and that is that you go from paranoia and fear through the evolution of employment growing again, of business getting back together, of resources being used up. And as they’re used up, inflation appears, and the [U.S.] Fed needs to control that. The standard cycle — it’s happened that way every time. There’s no reason to expect this time to be any different.

It is true, of course, that in the last 10 years, the average investor has been hit by two terrible recessions and two very significant stock market declines. It’s enough to scare the average person, for sure. And in the current period, of course, there’s just a plethora of commentary about the difficulty of getting the economy going, of the difficulty of getting people back to work and so forth. But that happens every time. That is what the bottom of a recession — the early part of the recovery — looks like. So, it doesn’t feel any different to me, having been through a lot of them.

Stock market participants are generally always chasing the last good story. And, of course, the last good story is the [U.S.] bond market — which, in fact, has had positive returns for the last 10 years and the equity market has not. Unfortunately, people seem to invest by looking in a rearview mirror. And that’s very unfortunate, because we saw the same thing happen in the period in the late 1990s in the tech blow-off, or in the Nifty Fifty in the 1970s, in the oil run-up in the 1980s. I mean, all these things were chased by people looking backwards.

Tags: Armour, Brazil, Capital Group, Capital Research And Management Company, China, Colleague, Company Fundamentals, Counselors, Dunton, Economic Evidence, Group Portfolio, India, International Asset Management, International Group, International Perspectives, International Portfolios, Investment Environment, Investment Opportunities, Market Cycles, Mckenna, oil, Perils, Portfolio Manager, Portfolio Managers, Rearview Mirror, Silver, Video 3, Wide Swath, Worldwide Basis
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Howard Marks: “I’d Rather Be Wrong”

Sunday, March 28th, 2010

This article is a guest contribution by Howard Marks, Oaktree Capital.

I’d Rather Be Wrong

Today’s positions seem unusually unyielding.  The Republicans’ conservative base demands adherence to the no-tax pledge, while liberal Democrats demand that their representatives prevent cuts in spending for domestic programs. These hardened (and polar) positions greatly narrow the possible grounds for problem-solving.

Just a few weeks ago, I published “Tell Me I’m Wrong,” my latest list of things in the investment environment that I find worth worrying about.  I’m going to devote a few pages here – I promise this’ll be the shortest memo in years – to a point I touched on in “What Worries Me” (August 28, 2008) but omitted from the more recent piece.

This memo will be about one of the inarguably most depressing topics of our time: the seeming inability of governments and politicians to solve – or even tackle – the financial problems we face. Here’s the situation in Washington:

• Many of our most sweeping financial problems, such as deficits, national debt, healthcare costs, Social Security and Medicare, are long-term problems.
• It’s important that we tackle them early, since limiting their further growth can reduce the eventual cost and difficulty of fixing them.
• But the process of solving them will be unpleasant in the short term, entailing bad-tasting medicine, while the benefits will only be seen in the long term, when today’s politicians will have left the stage.
• Finally, most politicians’ main concern seems to be getting themselves and other members of their party elected.  Voting for short-term pain in order to solve long-term problems is generally viewed as the wrong way to go about that.

This memo is inspired by two excellent newspaper articles that appeared within the last month: “Party Gridlock Feeds New Fear of a Debt Crisis,” by Jackie Calmes (The New York Times, February 17)[*] and “Perils of the California Model” by David Wessel (The Wall Street Journal, March 4).[†] Indicating their importance, The Times piece ran in the upper right-hand corner of the front page, always the place for the top story of the day, and the Journal story was carried on page A2.  I’ve included links below in the hope they’ll increase your likelihood of reading them.  As Calmes wrote in The Times (in both cases below, emphasis added):

After decades of warnings that budget profligacy, escalating health care costs and an aging population would lead to a day of fiscal reckoning, economists and the nation’s foreign creditors say that moment is approaching faster than expected, hastened by a deep recession that cost trillions of dollars in foregone tax revenues and higher spending for safety-net programs.

Yet rarely has the political system seemed more polarized and less able to solve big problems that involve trust, tough choices and little or no short- term gain. The main urgency for both parties seems to be about pinning blame on the other, before November’s elections, for budget deficits now averaging $1 trillion a year, the largest since World War II relative to the size of the economy.

Two weeks later, Wessel put it this way in The Journal:

The stalemate over health-care legislation, despite widespread acknowledgment that the status quo is unsustainable, underscores the inability of the political system to cope with complex, long-term fiscal issues. . . .

Today, the deficits projected are bigger than ever, baby boomers are beginning to retire, health-care costs keep rising and, surely, we’re closer to the day when Asian governments grow reluctant to lend ever-greater sums to the U.S. Treasury at low interest rates.

The Congressional Budget Office projects current policies would take the deficit from today’s 10% of gross domestic product to over 20% by 2020 and over 40% by 2080.  Yet today’s politics appear more toxic, and the ranks of congressional leaders with the skill and desire to fashion compromises instead of talking points are depleted.

Here we have remarkably similar themes voiced in what some would call “a Democrat newspaper” and in a stalwart of the pro-business Republican establishment.  Both articles complain that the current trends in politics reduce the likelihood that major problems will be tackled and solved . . . a rare example of agreement across the aisle.

That brings me to the subject of one of today’s greatest stumbling blocks, the absence of that elusive ideal: bipartisanship. Let’s discuss this issue in principle.  It’s likely that the “ins” always think the fact that voters gave them control means they should mostly get their way, and that “bipartisanship” consists of the “outs” going along with them.  The outs, on the other hand, don’t take the election results to mean the minority has no rights, and they feel perfectly within their rights to use Congress’s rules and processes to fight for their point of view (which, on us-versus-them issues, equates to thwarting the efforts of the ins).

The Times article points out ironically that when control of government is divided between the two parties, they both feel some responsibility for solving problems, while today, with full control seemingly in the hands of the Democrats, the Republicans are free to view their only role as dissenting and obstructing.  And as the party in control, the Democrats evidently feel no obligation to yield on their positions.

Frankly, I wouldn’t be so unhappy if I were sure today’s battles were being fought over principles.  What worries me most is the appearance that, instead, they’re being fought for personal and political advantage and to win elections.

Today I think few legislators from either party will vote for anything that would let members of the other party claim to have accomplished something.  That may be an exaggeration, but I think it’s more true than false.  And I think that’s behind the recent decisions by a number of senior legislators not to run for re-election.  I’ve had the privilege of getting to know Byron Dorgan, the senator from North Dakota, and I have no trouble believing that was behind his decision.  We’ve spoken about his frustration with the contentious environment in Washington.  More recently, Evan Bayh of Indiana also said he wouldn’t seek another term in the Senate because it’s impossible to get anything done in dysfunctional Washington.  Here’s how he put it in a February 21 Op-Ed piece in The Times:

There are many causes for the dysfunction: strident partisanship, unyielding ideology, a corrosive system of campaign financing, gerrymandering of House districts, endless filibusters, holds on executive appointees in the Senate, dwindling social interaction between senators of opposing parties and a caucus system that promotes party unity at the expense of bipartisan consensus.

Today’s positions seem unusually unyielding.  The Republicans’ conservative base demands adherence to the no-tax pledge, while liberal Democrats demand that their representatives prevent cuts in spending for domestic programs. These hardened (and polar) positions greatly narrow the possible grounds for problem-solving.

Read the whole article here.

Tags: Adherence, Calmes, Debt Crisis, February 17, Gridlock, India, Investment Environment, Liberal Democrats, Medicare, National Debt, New York Times, Oaktree Capital, Perils, Politicians, Republicans, Seeming Inability, Social Security, Social Security And Medicare, Tax Pledge, Topics Of Our Time, Wrong Way
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WealthTrack: Dennis Stattman’s Outlook (BlackRock)

Thursday, November 12th, 2009

This week on WealthTrack Consuelo Mack sits down with global investor Dennis Stattman, founding manager of the BlackRock Global Allocation Fund. Now in its 20^th year, this Morningstar favorite has consistently delivered market and peer beating returns with less risk. In a wide ranging discussion, Stattman discusses the investment perils and opportunities he is tracking around the world.

Note: The transcript of this interview is not available yet, but will be posted here as soon as it arrives.

Source: Wealthtrack, November 6, 2009.

Tags: Advertisement, Blackrock Global Allocation, Blackrock Global Allocation Fund, Consuelo Mack, Global Investor, Investment, Morningstar, Outlook, Perils, risk, Wealthtrack, Wide Ranging Discussion
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