Posts Tagged ‘Qe’
Monday, May 13th, 2013
Closing Arguments: Nothing Further, Your Honor
by John Hussman, Hussman Funds
“For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips… The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. The seeds of any bust are inherent in any boom that outstrips the pace of whatever solid factors gave it its impetus in the first place. There are no safeguards that can protect the emotional investor from himself.”
- J. Paul Getty
I’ve often noted that even a run-of-the-mill bear market decline wipes out more than half of the preceding bull market advance. I doubt that the present instance will be different. Indeed, cyclical bear market declines that occur in the context of secular bear markets average a market loss of about 39%, wiping out about 80% of the prior bull market advance. We presently estimate a nominal total return for the S&P 500 of just 3.2% annually over the coming decade. It is not pessimism, but optimism – and optimism born of a century of evidence – that we expect stocks to provide more favorable opportunities for investment over the completion of this cycle. It is that carefully-studied optimism that leads us to reject the notion that investors are forced to crawl to the ground and “lock in” low prospective long-term returns, while ignoring severe intermediate-term risks to capital.
I’ll note in passing that the Shiller P/E reached 24 last week (S&P 500 divided by the 10-year average of inflation-adjusted earnings). Secular bear market lows have typically taken the Shiller P/E below 8 before durable secular bull market advances have taken hold. Valuations are a long way off from that, though I would expect at least one or two more complete bull-bear cycles to emerge before the market achieves valuations that would support a durable secular uptrend. There will be plenty of significant opportunities to periodically accept market exposure even if a secular bull market is nowhere in sight.
The perception that investors are “forced” to hold stocks is driven by a growing inattention to risk. But Investors are not simply choosing between a 3.2% prospective 10-year return in stocks versus a zero return on cash. They are also choosing between an exposure to 30-50% interim losses in stocks versus an exposure to zero loss in cash. They aren’t focused on the “risk” aspect of the tradeoff, either because they assume that downside risk has been eliminated, or because they believe that they will somehow be able to exit stocks before the tens of millions of other investors who hold an identical expectation that they can do so.
Though the discipline to “sit by quietly while the mob has its day” can be nearly excruciating in the excitement of late-stage bull markets, as the market registers multi-year highs amid rich valuations and heavily optimistic sentiment, it’s worth remembering that the 2000-2002 bear market wiped out the entire total return of the S&P 500 in excess of Treasury bills all the way back to May 1996. Assuming that investors stuck it out to finally regain and surpass the market’s 2000 peak in 2007, the 2007-2009 bear market then wiped out the total return of the S&P 500 in excess of Treasury bills all the way back to June 1995.
Think about that. One literally could have sat in Treasury bills through 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, and into early 2009, and have done better than the S&P 500 did over that entire span of time. Moderate losses are frustrating, but deep, major losses from rich valuations are the ones that matter, because it is difficult to recover from them in a durable way. The recent advance is a gift in that regard. Consider that carefully now, not later.
That is not to say that we’re unprepared for the possibility that this bull market will move higher still. If that is to be the case, I would expect that we’ll observe one or more points where a modest retreat from overvalued, overbought, overbullish conditions is joined with an early improvement (or lack of clear deterioration) in trend-following measures. Such points have been the most appropriate times to accept market risk even during the recent bull market advance.
As I noted last week, we’ve done a great deal of “exclusion analysis” to refine the pool of instances with negative return/risk profiles, in order to capture the largest set of constructive instances possible – an effort that has been particularly required in an environment where monetary policy is intentionally aimed at driving speculative activity. While I am quite convinced that the completion of the current, unfinished market cycle will involve steep losses that wipe out most of the preceding bull market gains, I am not at all convinced that this journey will involve a total absence of opportunities to shift to moderate or even significantly constructive investment outlook periodically, though I doubt that we would go without some amount of defense without a more significant retreat in valuations.
Why does none of this analysis move us to a constructive stance today? Examine market conditions. We have a Shiller P/E of 24, 52.1% bulls versus just 19.8% bears, the S&P 500 pushing into its upper Bollinger bands (two standard deviations above its 20-period moving average) at daily, weekly, and monthly resolutions, the S&P 500 at a multi-year, overbought high, and the 10-year Treasury yield above its level of 6-months prior. Identify similar periods in history (even on less restrictive thresholds), and you’ll find a Who’s Who of major market tops: 2007, 2000, 1987, 1972, and 1929 (on imputed sentiment data). There was also an instance in 2011 that was followed by a near-20% market decline. See Capitulation Everywhere and We Should Already Have Learned How This Will End for a review of market outcomes following similar historical conditions.
In short, there will be opportunities to take constructive investment positions, certainly at the completion of the present market cycle, but most likely even in the event that the advancing portion of this cycle continues. Choosing those points, based on demonstrable evidence, is essential. Recklessness, crowd-following, euphoria, fear of missed gains, and monetary superstition has certainly been rewarded lately, in a way that seems indistinguishable from insight and genius. Retaining such windfalls will prove far more difficult.
On quantitative easing
The total capitalization of the U.S. stock market is presently about $17 trillion (about $16.2 trillion as non-financials). The Federal Reserve is purchasing $85 billion of Treasury and mortgage-backed bonds each month. This creates a pool of bank reserves that have to be held by someone at each point in time, until those reserves are retired. This zero-interest cash is a hot potato that certainly creates speculative demand. But it is the superstitious aspect of the belief in QE – as if it has some inexplicable power to remove downside risk – that deserves just as much credit for the recent advance. It is the superstition that QE mysteriously removes economic risk, and the psychological discomfort of low interest rates far beyond its true effect on investment value, that has encouraged investors to abandon their demand for a risk premium to adequately compensate them for the risk they are taking.
How can we know that? Simple. We can demonstrate that QE is not exerting the bulk of its effects through cash flows or the effect of lower interest rates on earnings or present discounted value. This leaves the suppression of risk premiums as the remaining and primary effect of QE. In other words, QE has not increased the value of equities. It has only increased the price, but that increase in price has no significant fundamental underpinning.
To see this, first consider cash flows. Imagine that instead of attempting to boost stock prices indirectly through quantitative easing, the Fed took the candy-land approach of literally handing the $85 billion directly to stockholders to reward them for owning stocks. How much would that direct cash distribution benefit a stock market with a $17 trillion market capitalization? Do the arithmetic. Only 0.5% a month. Yet investors have chased prices at a far more rapid pace as a result of quantitative easing. Remember, of course, that the Fed is not in fact distributing cash to shareholders.
What about the benefit of lower interest rates? Domestic nonfinancial corporate debt is presently $8.6 trillion. Even a 4% reduction in interest rates (400 basis points) comes to $344 billion a year. Assume that benefit accrues strictly to publicly traded companies, and extend that benefit over 5 years. It’s still only worth 10% of market capitalization. As a side note, lower interest rates also suppress income from corporate investments, particularly with large amounts of cash on corporate balance sheets. And though it has become a fad to subtract out cash from market capitalization, it is a profoundly incorrect fad. If it was correct, a company with a billion dollars of market cap could issue a billion dollars of debt, hold the proceeds in cash, and the stock could be considered “free.”
What about higher GDP leading to greater profits and supporting stocks that way? Take the current ratio of corporate profits/GDP of 11% at face value (even though that share is 70% above the historical norm), and let’s even assume that all of these profits go to corporations with publicly traded stocks. How much would GDP have to rise, sustained over 5 years, to justify even a 10% increase in market capitalization? The required amount of additional GDP is 1.7 trillion / 0.11, or $15.5 trillion, or about $3.1 trillion a year sustained over 5 years. The present size of the U.S. economy is about $16 trillion. So yes, if QE could boost the size of the U.S. economy by about 20% and sustain it over 5 years, and the additional earnings could be delivered entirely to stock market investors in cash, it would justify a 10% increase in market capitalization.
Here’s one for geeks: What about the effect of a lower capitalization rate on discounted future cash flows? Simple. Take a given initial cash distribution and assume 6% annual growth, which is about the long-term peak-to-peak growth rate of earnings and nominal GDP over the economic cycle. Discount those cash flows annually into the indefinite future. Now drop the discount rate by about 4% (400 basis points) for 5 years. Even 10 years. Try 15. How much does the present discounted value increase? Not much – about 5-15% depending on your initial discount rate and how long you sustain the change.
We’ve certainly seen people correlate the monetary base with the S&P 500 since 2009, ignoring that two rising lines will always have a correlation of over 90%, and inferring targets for the S&P based on assumptions about base money. But this is little more than extrapolation based on statistical misuse. It may very well be that the promise of more QE will produce a reflexive pursuit of stocks in the same direction, but investors should at least be aware that this pursuit has no fundamental basis, and rests purely on the willingness of investors to abandon any need to be compensated for risk.
What concerns me most here is the lack of effort that investors are taking to analyze and quantify the mechanism by which quantitative easing should work, beyond a vague superstition that “it just does.” The notes I receive suggesting that somehow QE makes all historical economic relationships, profit margin dynamics, and financial relationships irrelevant remind me of some remarks that appeared in Business Week:
“During every preceding period of stock speculation and subsequent collapse there has been the same widespread idea that in some miraculous way, endlessly elaborated but never actually defined, the fundamental conditions and requirements of progress and prosperity have been changed, that old economic principles have been abrogated, that all economic problems have been solved, that industry has suddenly become more efficient than it ever was before … that business profits are destined to grow faster and without limit, and that the expansion of credit can have no end.”
Those remarks unfortunately waited to appear until November 1929.
In short, there is no transmission mechanism by which QE has any large and beneficial effect on the value of equities. There has certainly been an effect on price – but this effect is driven by the willingness of investors to abandon their demand for a risk premium that will actually compensate them for the risk they are taking.
Recall that during the 2008 market plunge, following aggressive monetary easing throughout the year, the Fed initiated its first program of quantitative easing. While the market’s rebound actually took a good part of a year to emerge (and which appears to have been most closely related to a change in FASB accounting rules that suspended “mark-to-market accounting”) investors associated that rebound with ongoing QE. When the next decline occurred in 2010, QE was again initiated, and with investors conditioned to expect QE to produce rising stock prices through some poorly-understood mechanism, the market recovered the loss it had experienced over the preceding 6-month period. Same for the “Twist” in 2011, which was also initiated after a spike in risk premiums. But just as Pavlov’s dogs became conditioned to salivate at the sound of a bell even when they were presented with no meat, investors have now become conditioned to buy stocks in the presence of QE, even without any preceding spike in risk premiums, and even when there is no fundamental basis for doing so.
This doesn’t mean that investors will suddenly change their behavior. It does mean that this behavior does not have any reliable fundamental underpinning, and that in turn suggests that all of this will end badly. It is unlikely that investors can or will – in aggregate – get out of the market with their QE-induced gains.
On profit margins
The facts that savings equal investment and that the deficits of one sector must arise as the surplus of another are not theories. They are identities that must hold true by accounting definition. It does not matter how companies are deriving their profits (domestically or internationally). It does not matter how consumers are obtaining their goods (domestically or internationally). It does not matter how the government is financing its deficits (domestically or internationally). It is true merely and strictly by identity that savings equal investment, and that the deficits of one sector must arise as the surplus of another. The exact way that this comes about is up for grabs, but the end result is not. It is also true empirically in decades of data since the 1940’s that the following aspect of that relationship holds quite robustly: variations in profit margins are essentially a mirror-image of the combined deficit of households and government. This is true not only of levels, but of point-to-point changes. Corporate profit margins will contract as the combined deficit of households and government retreats (even moderately) from the record levels of recent years. The impression that stocks are “reasonably valued” relative to earnings is an illusion driven by profit margins that are 70% above their historical norm. See Taking Distortion at Face Value to review the accounting relationships here.
Almost universally, Wall Street analysts are making the mistake of valuing stocks on the basis of a single year of forward operating earnings, as if the present estimate is a sufficient statistic that is representative of the entire future stream of cash flows. Even profit/GDP shares much less extreme than today’s have always been followed by a contraction of profits over the following 4-year period.
We presently estimate the likely return of the S&P 500 over the coming decade to be about 3.2% annually. There are all sorts of models that Wall Street wishes investors to embrace. Embrace the ones that show a long-term, demonstrated relationship with actual subsequent market returns, both historically and even over the period since 2000. See Investment, Speculation, Valuation and Tinker Bell to review the estimation methods here.
Trend-following measures can be enormously helpful for investors, particularly for risk-management, and particularly in the absence of overvalued, overbullish investment conditions. In the presence of such overextended conditions, the overvalued, overbullish (OVOB) features of the market have historically dominated, on average. Points where those overextended conditions have been cleared, provided that trend-following measures are favorable (or turn favorable), are where the better investment opportunities have typically emerged, particularly when valuations have been favorable as well. See Aligning Investment Exposure With the Expected Return/Risk Profile to review the effect of these considerations, as illustrated below.
On the economy
Successive bouts of quantitative easing have clearly been successful at suppressing periodic spikes in risk premiums, and have been at effective enough to release a few months of pent-up demand, in an amount sufficient to move an economy repeatedly from the border between expansion and recession, but only for a few months each time.
However, Europe has now entered a clear recession, with much of the developed world following suit. Real GDP growth and real final sales have both dropped from year-over-year growth rates above 2% to below 1.9% – a combined occurrence that has rarely emerged except during or immediately prior to recessions. Regional purchasing managers surveys and Federal Reserve surveys have turned uniformly lower in recent reports. Importantly, while non-farm payroll growth was surprisingly robust in April, the gain belied a significant decline in the average hourly workweek. It is the combination of workers and hours worked that determines production and income. If labor hours were held constant, total non-farm payrolls would have declined between 550,000 and 623,000 jobs in April (depending on whether one uses non-farm payrolls x average weekly hours or instead uses the index of aggregate weekly hours). The U.S. may or may not avoid recession, but there is no evidence of a material or durable acceleration in economic growth here. As a simple rule of thumb, I would suggest watching for a spike, sustained over at least a few months, in the Philly Fed index and the new orders component of the Chicago Purchasing Managers Index. We observe nothing of the sort at present.
While I certainly don’t believe that markets have to obey math, it’s very clear that investors have taken on a very familiar pattern of what I’ve called “increasingly immediate impulses to buy the dip” and what physicist Didier Sornette would call a “log-periodic bubble.”
That constant and more immediate tendency to buy dips is a signature that is difficult to entirely dismiss. In itself, it doesn’t always lead to unfortunate outcomes, but in the context of rich valuations, overbullish sentiment, and global economic headwinds, it is worth monitoring. As Barron’s Magazine noted in early 1969, just before the market lost a third of its value in the 1969-1970 plunge:
“The failure of the general market to decline during the past year despite its obvious vulnerability, as well as the emergence of new investment characteristics, has caused investors to believe that the U.S. has entered a new investment era to which the old guidelines no longer apply. Many have now come to believe that market risk is no longer a realistic consideration, while the risk of being underinvested or in cash and missing opportunities exceeds any other.”
Defining the precise date where a “finite-time singuarlity” occurs is difficult to pinpoint in real-time, but I should note that to remain consistent with a Sornette-type bubble, it’s difficult to push the singularity past this month. Again, that doesn’t mean that the market has to conform to the mathematics of a log-periodic bubble here, but the precision of this pattern in recent years is creepy enough to be notable.
Again, even if the recent bull market has much further to go, I would expect that we’ll observe one or more points where a moderate retreat from overvalued, overbought, overbullish conditions is joined with an early improvement (or lack of clear deterioration) in trend-following measures. We’ve certainly adapted our own criteria and methods enough to allow a constructive response even if valuations remain generally rich. Though the market has showed few cyclical fluctuations in recent quarters, the market has ultimately never failed to move in cycles. The points that investors have forgotten that markets move in cycles are the points where they have been most vulnerable. Present conditions are the wrong point to initiate a substantial exposure to market risk.
Nothing further, your honor. I am resting my case.
In Memory of Alan Abelson
For more than 30 years, I’ve started my weekend reading the latest letter from a friend. Alan Abelson was an editor of Barron’s Magazine, and wrote its leading column “Up and Down Wall Street” for nearly half a century. I only knew Alan personally from a handful of enjoyable conversations over two decades – but his writing always made me feel that an old friend was sitting down to share what he had seen over the latest week, and the stories he had heard.
Alan wasn’t just an insightful financial journalist; he was a wonderful writer who would treat his readers to interesting anecdotes, imagery, and playful turns of phrases. He didn’t try to sell you an opinion – he would share what he saw; bring you in as a guest among a whole circle of characters that he knew. Over the years, I felt graced to be among those subjects, with introductions ranging everywhere from lighthearted (“chief cook and bottle-washer”) to generous. You could hardly read a sentence from his hand without noticing the twinkle in his eye.
When he wrote about himself, Alan always used the royal “we.” He deserved to do that – he was a king. Thank you, Alan. I’ll miss you very much. I’ve no doubt that the wisdom, humor, insight, and joy of writing that you’ve shared with your readers have also become part of your heaven.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
As of last week, the market environment remained characterized by an overvalued, overbought, overbullish, rising-yield environment that is places present conditions in the singularly most negative such syndrome we define. See Capitulation Everywhere for a review of these conditions.
At the same time, we’ve done a great deal of what we call “exclusion analysis” to narrow the set of periods when the average return/risk profile of the market is negative to a smaller set that captures the worst of those outcomes, freeing the remaining set of instances for a more constructive investment stance. Generally speaking, the distinction comes down to trend-following and momentum considerations on one hand, and overvalued, overbought, overbullish syndromes on the other. In the absence of those extreme syndromes, favorable trend-following measures are generally enough to warrant some amount of constructive exposure even when valuations are rich. In the presence of those extreme syndromes, the choice is no longer between defensive and constructive, but between levels of defensiveness (matched-strike hedges versus staggered-strike hedges, for example). In general, those distinctions come down not just to trend-following measures (the “slope” of price movements), but to momentum measures (their “acceleration”) as well.
Presently, Strategic Growth Fund is fully hedged, with a “staggered strike” position that raises the strike prices of the index put option side of our hedge, but we continue to keep those strike prices several percent below current market levels, while relatively low implied volatility has reduced the premium cost of these options. As a result, most of the day-to-day movement in the Fund can actually be traced to differences in the performance of the stocks held by the Fund and the indices we use to hedge. If the present bull market has far to go, I expect that we will observe several opportunities where overextended syndromes are absent and favorable trend-following measures are present. In a richly valued market, we view those points as the most reasonable ones to accept market exposure.
Meanwhile, Strategic International remains fully hedged. Strategic Dividend Value is hedged at about 50% of the value of its stock holdings, and Strategic Total Return continues to have a duration of about 3 years (meaning that a 100 basis-point move in interest rates would be expected to impact Fund value by about 3% on the basis of bond price fluctuations), with about 14% of assets in precious metals shares.
Copyright © Hussman Funds
Friday, September 28th, 2012
(Editor’s Note: Don Vialoux is scheduled to appear on BNN Television’s Market Call Tonight at 6:00 PM EDT)
The S&P 500 Index recorded surprising strength yesterday mainly on unconfirmed news that the Chinese central bank recently pumped up to $70 billion into the Chinese economy. The rumor has merit. Historically, the Chinese economy virtually “falls off a cliff” during China’s “Golden week”, a holiday similar to our Christmas season. China’s “Golden Week” is next week. Once again, the Chinese central bank moved in anticipation of “Golden Week”.
The other positive event yesterday was announcement of Spain’s budget. Equity markets responded initially to rumors that the budget was more austere than expected. However, equity markets retreated in late trading when a more rational analysis was made.
On the charts, the S&P 500 Index managed to recover to above its 20 day moving average. However, momentum indicators continue to trend down.
Natural gas prices have recorded an interesting breakout recently.
Updates on Seasonal Trades Recommended Since July
July 2: Accumulate the Software sector
Period of seasonal strength: early July to end of September
ETF: IGV at $62.18. Current price:$63.84
Comment: Selected technicals remain positive: Intermediate uptrend intact, bounced from near its 50 day moving average. Short term momentum indicators are trending down and strength relative to the S&P 500 turned negative last week. The period of seasonal strength is approaching an end. Preferred strategy is sell into strength.
July 6: Accumulate gold bullion
Period of seasonal strength: July12th to October 9th
Gold price: $1,578.90. Current price: $1,779.10
Comment: Technicals remain positive. Intermediate trend is up. Nice bounce from near its 20 day moving average. Strength relative to the S&P 500 Index remains positive. However, momentum indicators are peaking. Hold for now, but prepare to take profits (particularly on a break below $1,738.30. Possible stop is its 20 day moving average. Gold’s weakest month in the year is the month of October.
July 13: Accumulate Canadian gold equities
Period of seasonal strength: July 27th to September 25th
ETF: XGD at $18.01. Current price: $21.77
Comment: Great trade. Favourable seasonal period has ended. Short term momentum indicators have rolled over. Weakest month of the year for gold equities is the month of October. Take seasonal profits on strength.
July 13: Accumulate the Canadian Energy Sector
Period of seasonal strength: July 24th to October 3rd
ETF: XEG at $15.12. Current price: $16.37
Comment: Technicals have begun to deteriorate as the end of the period of seasonal strength approaches. Short term momentum indicators are trending down. Strength relative to the TSX Composite turned negative last week.
Comment: Take profits on strength.
July 27: Sell the Transportation Sector
Dow Jones Transportation Average at 5,126.65. Current price:4,941.20
ETF: IYT at $91.56. Current price: $87.90
Period of seasonal weakness: August 1st to October 9th
Comment: Technicals remain negative. Intermediate trend is down. Trades below its 20, 50 and 200 day moving averages. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index remains negative. Continue to sell/avoid/hold short.
August 6th Sell the Airline sector
ETF: FAA at $28.66. Current price: $29.48.
Period of seasonal weakness: August 1st to October 9th
Comment: Technicals remain neutral/negative. Intermediate trend is neutral. Trades back and forth through its 20, 50 and 200 day moving averages. Short term momentum are trending down. Strength relative to the S&P 500 Index remains negative. Hold for now but liquidate on a break above resistance at $30.20.
August 28: Sell the Semiconductor sector
Philadelphia Semiconductor Index: 397.04. Current level: 385.46
Period of seasonal weakness: End of August to October 9th
Comment: Technicals remain weak despite yesterday’s gain. Intermediate trend is down. The Index fell below its 20, 50 and 200 day moving averages last week. Strength relative to the S&P 500 Index remains negative. Short term momentum indicators are oversold. Hold for now.
Thursday, September 27, 2012
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TOP ASSET CLASSES AND SECTORS: HEAT MAPPING
There is still a push for “risk-on” assets as of the close of last Friday. This week’s close will undoubtedly show a slight uptick in strength for the “risk-off” or defensive assets such as bonds in the “Asset Class” table, telecom or healthcare in the TSX and S&P, and the US or Switzerland in the country rankings.
That said, we anticipate and are positioning for another upside move in the cyclicals before things get muddy later in the year.
For asset managers the most important thing to get right is the allocation between equities, bonds, bullion cash and currencies. (If you are a Broker or Advisor and would like to learn more about CMI Advisory Service please contact us by phone or e-mail. Robert 905.847.1125)
CHARTS of the WEEK
US Long Bonds
Long bonds, as presented here by the 20+yr ETF, show strong support above the cloud with indicators trying to bottom. We currently own 20% in CDN long bonds, but will look to raise overall bond allocation over the next while. Minimal upside for the Loonie will allow us to add US bond holdings.
Similarly the S&P shows strong support below, though the market is over extended at the moment. When comparing the two assets classes – US bonds to US stocks – a balanced approach is warranted by the evidence until further notice.
The TSX on the other hand appears to be now hitting resistance overhead on this weekly chart. A break above these levels would broaden the case that the TSX has only moved up from front-running the QEternity move by the US Fed. The case beyond has yet to be proven.
CDN Oil Stocks
The same pattern is reflected in CDN oil stocks. We own Husky as a conservative way to play the space – decent balance sheet (S&P quality ranking A-) and good yield (4.75% from our ACB)
CDN Gold Producers
Gold producers on the other hand have appeared to make the case, though a correction is in the works. When we look at our individual TSX company rankings on a weekly basis 7 of the top 11 are senior gold producers. Something is afoot; we’ll now gauge the persistence beyond what can just be a seasonal play.
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Buy, Hold…and Know When to Sell
This commentary is not to be considered as offering investment advice on any particular security or market. Please consult a professional or if you invest on your own do your homework and get a good plan, before risking any of your hard earned money. The information provided in CastleMoore Investment Commentary or News, a publication for clients and friends of CastleMoore Inc., is intended to provide a broad look at investing wisdom, and in particular, investment methodologies or techniques. We avoid recommending specific securities due to the inherent risk any one security poses to ones’ overall investment success. Our advice to our clients is based on their risk tolerance, investment objectives, previous market experience, net worth and current income. Please contact CastleMoore Inc. if you require further clarification on this disclaimer.
Eric Wheatley’s Listed Options Column
Good morning everyone,
Last week I looked at two options-related emails my Boss had received prior to his last appearance on BNN. There was a third which needs to be addressed here:
Peter in Mississauga asked “Many investors use the covered call strategy for downside protection but the risk is always there that the underlying could be called away. Recently Novartis (NOV) has had a good run up from $69 to $70.50 but the $70 covered call options expired. Can you discuss your recommended strategy to eliminate the damage? Is covering the current short and selling the covered call one month further out at approximately the same price point a consideration?”
“Eliminate” the “damage”.
For those of you who follow the NFL, you’ll sometimes hear of players who refuse to play because they consider themselves to be underpaid. The media will harp upon the fact that a running back is “only” making a million dollars for the season. What is ignored is that the player, upon signing his contract, received a fifteen million dollar signing bonus. This amount is paid up front and is the guaranteed portion of a contract. Yearly salaries aren’t guaranteed and an underperforming player can be cut from a team at any time without further compensation. Of course, the player who is making a fraction of his colleagues’ salaries feels disrespected, forgetting that he wilfully signed a contract which paid him quite handsomely ahead of time.
Peter in Mississauga is going through the same kind of cognitive dissonance NFL players who hold out do. He sold a call and received cash up front in exchange for giving up his stock’s upside beyond the call’s strike price. After the stock’s price had risen, Peter saw “damage” and wants to “eliminate” it. Of course, the damage is purely psychological and can’t be eliminated ex post facto. This is because, if Peter were to want to buy back his call, he would be paying the intrinsic value by which the stock has risen beyond the call’s strike price so he would still be owning the shares at the strike price on a net basis (on top of having paid a bid/ask spread and the fees for a trade).
As we’ve mentioned previously, covered call writers should WANT the stock’s price to rise. In this case, if NOV goes beyond $70, Peter makes his maximum profit. A proper, rational person doesn’t care whether the stock goes to $70.50 or $150, because the rational person made a good return on the call’s premium PLUS a little upside gain if the call was out-of-the-money when sold. Peter is prey to regret aversion, by which he will rue his writing of a call if the “worst-case” scenario happens. Similarly, people who are regret-averse find it very difficult to take profit on a stock which has risen, fearful that the stock may continue to rise and that they would miss out on further gains. Of course, if you never take profit, you’ll never make money.
As to people who are averse to getting assigned, I have a little story: I manage my mom’s money (I mention this only because my mom wouldn’t mind my exposing one of her holdings). Last week, she got assigned on her XIU October 17 calls when the stock was trading at roughly $17.60. Now, Peter would be pee-owed at this, but I was quite ecstatic. This is because I had gotten a very nice return on the premium – 41 cents per share when the stock was at $16.80 –for three months when I wrote them in July. As it turned out, I got an extra month for free, because the October call was assigned at the September expiry. I’m now able to write further calls right now instead of waiting until October’s expiry. This extra month is far from bad news; of course, Peter’d be looking at the sixty cents he’s forgoing and would sulk.
This week’s Twitter feed:
· Found a wonderful blog by a fellow Montrealer who is a big-shot economist. I’ve dedicated some very prime browser real-estate to him with a dedicated tab
· We are portfolio managers who manage money with a long-term view. Much of that view will be formed by China and its entry into the developed world. Or not. There are still a LOT of growing pains yet to come.
In this week’s French-language blog: my rules on life and investing, gleaned from my many screwups.
Éric Wheatley, MBA, CIM
Associate Portfolio Manager, J.C. Hood Investment Counsel Inc.
Blogue en français : gbsfinancier.blogspot.ca
Little known fact about John Charles Hood #45
John Charles Hood only has one hard and fast rule which he uses in various circumstances: “Don’t get any on you”.
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Don and Jon Vialoux are research analysts for Horizons Investment Management Inc. All of the views expressed herein are the personal views of the authors and are not necessarily the views of Horizons Investment Management Inc., although any of the recommendations found herein may be reflected in positions or transactions in the various client portfolios managed by Horizons Investment Management Inc
Horizons Seasonal Rotation ETF HAC September 27th 2012
Thursday, September 27th, 2012
Global economic fundamentals are awful, bearish divergences are occurring everywhere, investor sentiment is nearing bullish extremes, political risks remain high and last week’s market performance can be summed up in four words – ‘lack of follow through’. As Gluskin Sheff’s David Rosenberg explains, more than two-thirds of the rally points the stock market has enjoyed since the summer-time lows occurred around central bank policy announcements. So the market is really a one-trick pony here, breathing in the fumes of central bank liquidity.
David Rosenberg, Gluskin Sheff: BUMPY ROAD
What the stock market lacked last week can be boiled down to two words — follow through. It’s as if all the QE and then some got priced in the week before. Not even the ballyhooed introduction of the iPhone 5 managed to elicit much excitement. It was interesting to see the Dow fail to hold onto its early gains on Friday and close with a 17 point loss and to see the sector leaders narrow to a group of defensives like health care and telecom services_ The financials and materials segments were very soft and yet in the past these were the major beneficiaries of Quantitative Easing. For the week, the S&P500 dipped 0.4% — which was not supposed to happen. What was supposed to happen, as the elites told us, was that the lagging hedge funds were going to throw in the towel and chase this market. Everyone expects this to be a major source of buying power.
Alas, but at what price level?
At the same time, what if the bulls who lucked out this year because they hung onto Ben Bernanke’s arm decide to take profits or at the least lock in their gains? Or what if there is no progress made on the fiscal front and we go into year-end with the gnawing realization that top marginal capital gains tax rates will be heading back to 43.4% on January 1 from the current 15%? It may be a widely-held view but it is no slam dunk that we finish off 2012 with the double- digit returns — twice what is normal — that have been posted thus far (for more proof, have a look at Money Managers Take a Timeout From Stocks in today’s WSJ. And the best quote goes to “nothing the Fed has done has increased earnings expectations’).
Further on the political front, it shouldn’t be lost on those who are proponents of capitalism that President Obama now enjoys a 49% approval rating — it is up six points in the past year (and election handicappers should note that this is the exact same thing that George W. Bush had at this same juncture of the 2004 campaign — which he won handily against another gaffe-prone opponent).
Interestingly, prices are up impressively this year, but trading volumes are down around 20%. Yet another non-confirmation.
And its not as if the equity market has been rallying off news at it pertains to the fundamentals like the economic data and corporate earnings. Indeed, more than two-thirds of the rally points the stock market has enjoyed since the summer-time lows occurred around central bank policy announcements. So the market is really a one-trick pony here, breathing in the fumes of central bank liquidity.
The global economic fundamentals are awful. China’s industrial sector is in decline_ France’s PM I data is at a 41-month low, and while Germany did manage to pull off an upside surprise, the whole euro area now has its manufacturing sector behaving as though it is 2009 all over again_ Italy just sharply cut its economic growth forecast (and the stock market there was clocked for a 4% loss last week), shortly after the Japanese government downgraded its own assessment of the economy. Declines occurred in U.S. household employment, real wages, Industrial production and core retail sales. In other words, this is not QE1, when the recession was coming to an end. This is not QE2 or Operation Twist when the economy stopped looking as though it was going to do a “double dip-. No. this latest round of central bank manipulation is happening at a time when there is no sign of an imminent turnaround in the economy, and the weakness has gone viral. The real problems for investor risk appetite comes if we see signs that inflation is heading higher which will limit what the Fed can do, or if we see the economy falter which would then expose Bernanke as the non- wizard that Toto exposed behind the curtain and the Fed as pushing on a string.
Investor sentiment is not at a bullish extreme yet, but it’s getting there — at just over 54% bullish sentiment in the latest Investors Intelligence survey. The wedge between the bulls and bears is flirting with the 30-percentage-point spread that typically signals interim market tops.
Earnings expectations are far too optimistic and destined to come down. The consensus has operating EPS accelerating to a 13.4% growth rate in 2013 from 5.4% this year. But with margins at cycle high levels (9.4%, rivaling the 2006 record, just as the market was about to put in its last gasp to a new high) ;and 30% above long-run norms, it will be difficult to see EPS growth that strong absent a return to vigorous corporate pricing power. And with the P/E multiple for the overall market already back to the high end of the range for the past two years, what I see at best is a sideways moving market from here. Some pundits will use interest rates as an excuse, but the weekend WSJ provided some nifty insight showing that the market multiple historically was 12x when the 10-year real bond yield was negative (versus around 14x now).
I don’t know but a 12x multiple on a forward earnings stream that will likely be flat around $100 in the coming year doesn’t sound like a market that has a whole lot of upside from here (or until we get another announcement from a major central bank).
There are various non-confirming developments taking place, and Dow Theory advocates know exactly what I am talking about as the Dow Transports slumped 5,9% this past week, the largest decline since November of last year That this ultra-cyclically sensitive sector is down 2,2% for the year at a time when the S&P 500 is up 16% is one of the great anomalies for 2012.
The railroad stocks not only sagged 7% last week but were also the fourth worst performer in the IBD’s 197 industry group. This is a warning sign, make no mistake, underscored by the last week’s guidance cuts by both FedEx and Norfolk Southern,
As someone from Miller Tabak put it to the WSJ this weekend:
This is a major divergence that should not be ignored. It tells me the risks of being in the market at these levels is growing. The Transports are the first major index to reflect an underlying change in the market. The market is now saying ‘yes, the economy does matter’. You can’t close your eyes and buy everything anymore.
Pretty heady stuff.
China is another anomaly as its stock market suffered its steepest decline in nearly a year as the Shanghai index closed last week at its lowest price since 2/2/12. It is down 8% for the year, and this is likely important insofar of what it is pricing in for the world’s second largest economy. It’s more that just the islands dispute with Japan and the looming political transition – profits there are in a recession, having contracted 2.7% this year and the diffusion measures of industrial activity flashed an 11th month in a row of receding manufacturing sector.
And what about Europe. Yet another non-validation. The stock market there, with an 11x forward multiple, 20% below normal, is close to telling us that the recession is getting worse. Since Super Mario embarked on his newest bond buying program in September 6th, Spanish two-year bond yields – the benchmark for global risk trades – have jumped 40 basis points.
What makes QE3 different and maybe even less potent than its predecessors is that the trend in global economic activity is still down. In the prior QEs, activity was already reviving and actually this may have played a more significant role in stimulating investor ‘animal spirits’ than the actual liquidity boost. Let’s not also forget that earnings, both operating and reported, are now contracting sequentially. And the ISM is in a multi-month sub-50 pattern. This was not the case during these other QE episodes and serves up a greater hurdle for market performance this time around.
Wednesday, September 26th, 2012
Upcoming US Events for Today:
- New Home Sales for August will be released at 10:00am. The market expects 380K versus 372K previous.
- Weekly Crude Inventories will be released at 10:30am.
Upcoming International Events for Today:
- German Consumer Price Index for September will be released at 8:00am EST. The market expects a year-over-year increase of 1.9% versus 2.1% previous.
- China Industrial Profits for August will be released at 9:30pm EST.
Markets traded sharply lower on Tuesday as doubts over the efficacy of QE3 began to flourish following comments from Federal Reserve Bank of Philadelphia president Charles Plosser who indicated that “we are unlikely to see much benefit to growth or to employment from further asset purchases.” Cyclical stocks saw the greatest declines, led by Caterpillar, which cut its earnings forecast for the next few years. Shares of Caterpillar were the worst performer in the Dow, falling 4.25% during the session. Seasonal tendencies for the industrial titan remain flat to negative into the month of October, leading into the period of seasonal strength that kicks off in full force in November and December.
Prior to Tuesday, the S&P 500 Index had not seen a declining session exceed 1% since July 20th. Investors would have to look all the way back to June 25th, shortly after the summer rally began, to find a decline in the S&P 500 index larger than the one realized on Tuesday. Still, after seven days of negative pressures within equity markets, benchmarks, such as the S&P 500, have yet to get back to levels last seen prior to the September 13th Fed announcement, the last definitive up-tick day. Equity benchmarks are now looking to initial support at 20-day moving average levels, a dividing line between short-term strength and weakness.
This intermediate average has shown to be a launching point for this rally ever since the beginning of August. However, positive catalysts have also solidified this average as a point of support as optimism pertaining to central bank intervention propels equities higher. A positive catalyst might not materialize in order to save the market this time around with news pertaining to earnings and economic concerns seeming to take the steam out of what was a powerful rally within stock and commodity markets. Commodities have corrected rather sharply over the past few days and equity markets are seeming to follow. The current pullback has the potential to be a multi-week event, but, following this correction, the positive trend is expected to resume as the period of seasonal strength for equity markets begins into October and November.
Yesterday we showed you an indication of volatility and how it typically coincided to significant peaks in equity markets whenever the range of activity was substantially low. Another indicator provides similar hints of market peaks. The percent of stocks in the S&P 500 trading above 50-day moving averages has itself fallen below its 50-day moving average line. Crossovers such as this have typically preceded further declines within the S&P 500, implying that weakness has just begun to influence markets lower. Given the volatility of this indicator, it is also prudent to monitor the percent of stocks in the S&P 500 Index trading above 200-day moving averages, which provides similar buy and sell indicators based on 50-day moving average crossovers. As of yet, a crossover has not been revealed, but the push in that direction is apparent. The theory behind the indicator is that as more and more stocks within the S&P 500 give up levels of support presented by significant moving averages, selling pressures then escalate, leading markets lower until equilibrium is once again attained.
Gauges of risk sentiment are also showing that investors are once again starting to become risk averse. Defensive sectors, such as Staples and Health Care have been outperforming the market over the past few sessions. Even Utilities, the recent market laggard, is starting to show signs of rebounding from a bottom, also outperforming the market over the last few days. A ratio of Consumer Discretionary to Consumer Staples is showing signs of decline, indicating investor hesitation with holding higher beta, cyclically sensitive equities. Even fixed income investors are choosing safer alternatives, opting for investment grade bonds over high yield. Risk aversion is a typical characteristic within a declining trend, suggesting concern for risk assets, at least for the short-term.
Sentiment on Tuesday, as gauged by the put-call ratio, ended bullish at 0.93. The ratio has come well off of the lows recorded last week of 0.68, the lowest level in over a year. Investors had increasingly become bullish during recent weeks, shedding negative equity bets and tilting the market bias too far in one direction. A correction in equities and sentiment was/is inevitable.
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
Horizons Seasonal Rotation ETF (TSX:HAC)
- Closing Market Value: $12.63 (up 0.08%)
- Closing NAV/Unit: $12.65 (up 0.03%)
|2012 Year-to-Date||Since Inception (Nov 19, 2009)|
* performance calculated on Closing NAV/Unit as provided by custodian
Click Here to learn more about the proprietary, seasonal rotation investment strategy developed by research analysts Don Vialoux, Brooke Thackray, and Jon Vialoux.
Wednesday, September 26th, 2012
by Axel Merk & Kieran Osborne, CFA, Merk Funds
September 26, 2012
Central bankers around the world may be providing a backstop to the financial markets in much the same way Greenspan did during the “Goldilocks” years, but when the short-term euphoria wears off, will the negative repercussions be even more severe? Bernanke’s Federal Reserve (Fed) appears to specifically target equity market appreciation as part of its offensive in bringing down the unemployment rate; expectations are high: every time the market sells off, the Fed might simply print more money. We fear central bankers have overstepped their reach, and the implications of their actions may be much worse than the anticipated benefits.
To an extent, the effects of today’s monetary policies resemble the “Greenspan Put” (named after former Fed Chair Alan Greenspan) in the years leading up to the crisis. Today’s central bankers have been quite straight forward in communicating their stance: they appear willing to step in with evermore liquidity should the global economy show any signs of further weakness. Bernanke’s Fed has gone even further: the Fed has stated it’s accommodative policies will “remain appropriate for a considerable time after the economic recovery strengthens”. In other words, financial markets will be awash with liquidity for an extended period, even if we see signs of a sustainable economic recovery.
At first glance, this may appear a positive development for investors holding stocks and other risky assets. After all, Bernanke appears willing to underwrite your investments over the foreseeable future. Indeed, Bernanke appears to specifically target equity market appreciation, on many occasions noting one of the key benefits of quantitative easing (QE) has been to increase stock prices. Notably, while he believes the Fed’s QE policies have had a positive impact on stock prices, he considers it has not caused increases to inflation expectations or commodity prices. We disagree, which we elaborate below. Ultimately, the Fed may have reached too far, bringing risks to economic stability and elevated levels of volatility; the full implications of its actions may be somewhat dire down the road.
From the Bank of Japan and the People’s Bank of China to the European Central Bank (ECB), the Bank of England (BoE) and the Fed, central bankers are either putting their money where their mouth is (quite literally) or strongly insinuating that continued, ongoing easing policies are needed to prevent another significant downturn in global economic activity. While all the excess printed money may or may not have the desired effect of stimulating the global economy, the money does find its way somewhere; unfortunately, most central bankers appear to fail to realize that they simply cannot control where that money ends up.
Fed Chair Bernanke’s Achilles’ heel since the onset of the financial crisis has been the housing sector. It’s no surprise why the Fed bought over a trillion dollars worth of mortgage backed securities (MBS) since 2009: to re-inflate home prices and in so doing, bail out all those underwater with their mortgages. The problem was, it didn’t work – house prices continued to weaken across the nation, and have stagnated to this day. Now, the Fed has announced another MBS purchase program, this time open-ended, under the auspices of “QE3”. Do they believe the time is now ripe for MBS purchases to positively impact the housing market and thus the economy? Unfortunately, the first MBS purchase program failed to have its desired effect; we do not foresee how QE3 will be any better at stimulating house price appreciation.
One of the things we believe such actions do stimulate are inflation expectations. Indeed, the jump in market-implied future inflationary expectations in reaction to the Fed’s QE3 decision was quite remarkable:
In contrast to Bernanke’s views that QE does not cause commodity price appreciation, in our assessment, much of the freshly printed money only serves to inflate the value of assets that exhibit the greatest level of monetary sensitivity: commodities and natural resources. These are essential in the manufacture and production of goods and services purchased by U.S. consumers on a daily basis. As such, inflated commodity and resources prices ultimately pressure consumer price inflation, as the consumer’s “everyday basket of goods” becomes evermore expensive. The ongoing weakness in the U.S. dollar only serves to compound these inflationary pressures. A weak dollar, we believe, is part of Bernanke’s strategy to stimulate the U.S. economy through stimulating exports. While we fundamentally disagree that this is sound monetary policy for the U.S. to pursue, the inflationary ramifications are clear: the U.S. imports a great deal from abroad; every time the dollar depreciates against a currency of a country from which the U.S. imports, the price of those imports rises.
Not only have the Fed’s actions heightened inflationary risks, but we also believe it implicitly heightens the risk that the Fed gets monetary policy wrong. For instance, Fed Chair Bernanke believes that the Fed’s non-standard policies since 2008 may have helped lower 10-year Treasury yields by over 1.5%1. In so doing, the Fed has taken away a key metric used to gauge the economy and thus set appropriate monetary policy: free market interest rates. The Fed has historically relied on long-term yields, such as the 10-year and 30-year Treasury yield, as part of its assessment of the overall health of the economy. In manipulating those same yields, the Fed can no longer rely upon them to provide valuable information on the health and trajectory of the economy. In other words, the more the Fed meddles in the market through non-standard measures, the more the Fed is in the dark regarding the appropriateness of monetary policy. Such a situation inherently creates an additional level of uncertainty over the U.S. economy, U.S. monetary policy, and may continue to underpin weakness in the U.S. dollar.
The vast amounts of liquidity provided via the Fed’s quantitative easing programs will, at some point, have to be reined in. Whether due to inflationary pressures or a sustainable recovery, only time will tell, but the need to rein in liquidity may create massive headaches down the road. Given the ongoing high level of leverage employed in the economy, such monetary tightening runs the risk of undermining any economic recovery and potentially causing it to crash back down, as the likelihood of it negatively affecting consumer spending is high. With a still-leveraged consumer, rising rates may be overly painful, dramatically slowing consumer spending and, in turn, the economy. Such dynamics may have an outsized impact on the U.S. economy, given consumer spending makes up approximately 70% of U.S. GDP.
All of which underpins our view that there is a significant risk that the Fed has gotten monetary policy wrong. We consider the Fed’s actions have not only heightened inflationary risks, but have also inherently created risks to appropriate monetary policy going forward. Both of which will likely contribute to ongoing high levels of market volatility over the foreseeable future.
With so many dynamics yet to be played out globally, and with central bankers becoming evermore active in meddling with economic dynamics around the world, investors may want to consider preparing for the potential ramifications of such policies. While we may disagree with the policies being pursued, central bankers appear to be at least predictable in their decisions. We believe the currency market provides the most effective way to position oneself to protect and profit from the implications of such monetary policies.
In the current environment, the general equity market seems to be moving on the back of the next anticipated move of policy makers, and less so on fundamentals, but company-specific risks remain. With the outlook for the economy still on tenterhooks, many companies have been missing earnings forecasts. Currencies don’t have this additional layer of risk. As a result, currencies may be the “cleanest” way of positioning oneself for the next policy move. Historically, currencies have also exhibited much lower levels of volatility relative to equities, when no leverage is employed. As such, investors may want to consider adding a professionally managed basket of currencies to their existing portfolios.
Please sign up to our newsletter to be informed as we discuss global dynamics and their impact on gold and currencies. Engage with me directly at Twitter.com/AxelMerk to comment on Merk Insights and to receive provide real-time updates on the economy, currencies, and global dynamics.
Axel Merk is President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds.
Kieran Osborne is Senior Analyst at Merk.
Copyright © Merk Funds
Wednesday, September 26th, 2012
by Ed Ylagan, Mawer Investment Management
This past week I have been battling a cold which has, as many of you can imagine, turned my daily routine into a bit of a grind. Despite the fits of coughing, sneezing, and lack of sleep, I have generally been of the opinion that one is best served by allowing their body to recover from a cold on its own accord. That being said, this particular cold packed enough punch to break my resolve and I have since undertaken some “easing” measures to hasten my recovery.
The first round of my treatment program was the deployment of lozenges to combat my irritated throat. Although tasty and mildly soothing, I soon realized that throat lozenges were pitifully inadequate to deal with the problem. As such, I launched round two and turned to Lemon Neo Citran coupled with early bedtimes. After a brief period of temporary relief, I am unhappy to report that this combination also proved unsuccessful. As I enter the third round of my coughing and sneezing easing armed with a particularly potent brand of cough syrup, I can’t help but observe parallels between my own treatment tactics and the Quantitative Easing (QE) measures of the U.S. Federal Reserve.
Last week Ben Bernanke, the Chairman of the Federal Reserve, announced that the U.S. Central Bank would engage in a third round of QE in order to hasten the recovery of the U.S. Economy. In particular, Mr. Bernanke alluded to the persistent high unemployment rate as a “grave concern”. Now, the good news is the Federal Reserve recognizes that the pain caused by high unemployment is intolerable and thus, requires treatment. The bad news is that the QE measures taken by the Federal Reserve may be likened to my throat lozenges, Neo Citran, and cough syrup in that although each initiative offered temporary relief, all may prove to be disappointingly ineffective in the long-run. And worse, there could be unintended consequences.
Copyright © Mawer Investment Management
Tuesday, September 25th, 2012
by Jeffrey Saut, Raymond James
September 24, 2012
At 10:00 A.M. that day in London, Alexander telephoned … he wanted to know why the dollar was plunging. When the dollar moved, it was usually because some other central banker or politician somewhere had made a statement … but there was no such news. I told Alexander that several Arabs had sold massive holdings of gold, for which they had received dollars. They were selling those dollars for marks and thereby driving the dollar lower … I spent much of my working life inventing logical lies like this. Most of the time when markets move, no one has any idea why. A man who can tell a good story can make a good living as a broker. It was the job of the people like me to make up reasons, to spin a yarn. And it’s amazing what people will believe. Heavy selling out of the Middle East was an old standby. Since no one ever had any clue what the Arabs were doing with their money or why, no story involving Arabs could ever be refuted. So if you didn’t know why the dollar was failing, you shouted out something about the Arabs. Alexander, of course, had a keen sense of the value of my commentary. He just laughed.
… Michael Lewis, “Liar’s Poker”
So wrote Michael Lewis in his bestselling book Liar’s Poker that was first published in 1989. Recall that fresh out of Princeton, and the London School of Economics, Michael Lewis landed a job at the esteemed institutional brokerage firm of Salomon Brothers. Over the ensuing three years he rose from a trainee to an institutional salesman making millions of dollars. Subsequently, he left Salomon and penned the aforementioned book, which is an insider’s expose of an unprecedented era of greed and gluttony. While that era died, along with the secular bull market, I still find many of his humorous insights to be right on the mark. I remembered said quip last week when someone asked, “Who is buying stocks and preventing the stock market from correcting?!” Without even thinking I responded, “The buying is coming out of the Middle East because the rising turmoil is causing a flight to safety; and the safest place in the world is the U.S.A.” My caller then asked, “Really, why is that?” My response went like this:
In additions to being a country of laws, as well as the world’s reserve currency, you are not going to wake up one morning and find out you no longer are using euros but drachmas [the previous Greek currency] that have been devalued by 50%. Indeed, the U.S. is in the best position seen in years. To wit, there are four basic inputs that are needed to drive economic activity: 1) labor, 2) energy, 3) raw materials, and 4) financial capital. Plainly, with the current high unemployment rate we have a huge reservoir of labor. Second, the collapse in natural gas prices, and new technology in drilling, has caused our energy analysts to opine that the U.S. is moving toward energy independence. Third, worries about a Chinese economic slowdown has pressured most raw material prices down to levels far below where they were a few years ago (exception, precious metals). As for financial capital, in this country we have record low interest rates and if rates are inflation-adjusted the effective cost of capital is zero.
“You’re just a cockeyed optimist,” was my caller’s response. That’s patently untrue, I wrote about the Dow Theory “sell signal” in September 1999, as well as the Dow Theory “buy signal” in June 2003. Then there was the Dow Theory “sell signal” in November 2007; and, I was very bullish in March of 2009. As my father used to tell me, “If you think the market is going up be bullish and if you think it’s going down be bearish.” Manifestly, I have been pretty bullish for more than three years with intermittent “cries” for caution along the way. As often stated, all you had to get right for the past three years has been to raise some cash in the spring and put it back to work sometime during the summer. That reoccurring strategy has worked because economic numbers began to soften every spring for the last three years. That brings on worries of another recession, which causes analysts to cut their earnings estimates followed by a decline in stock prices. When no recession shows up, they start raising their estimates and the stock market rallies. And, believe it or not, that’s what is happening currently, as can be seen in the attendant Net Earnings Revisions chart from our friends at the Bespoke Organization (please see page 3). However, despite this improving earnings backdrop investors continue to shun stocks, worried about Euroquake, our dysfunctional congress, Middles East unrest, China’s slowing economy, etc. Meanwhile, many pundits have heightened those worries by talking about the weakness of the D-J Transportation Average ($TRAN/4910.79), as well as a Dow Theory “sell signal.” The last time this same crowd trumpeted a Dow Theory “sell signal” was back in May when the Industrials fell below their mid-April lows confirmed by a similar move from the Trannies. At the time I was adamant that according to my work there had been NO Dow Theory “sell signal,” which is the same stance I am taking now. In my opinion, the Trannies were affected last week by a downgrade of the railroad stocks from a major brokerage firm, a depression in the coal industry (less rail traffic), and the weather (hurricane Isaac). Regrettably, it will be a few months before we see if that is the correct “call.”
Certainly many of the sectors, as well as indices, think that is the correct “call” because the Biotechnology, Consumer Discretionary, Consumer Staples, and Healthcare sectors have traded to new all-time highs. Ditto, the S&P Equal Weighted Index, the S&P 400 Mid Cap Index, the S&P 600 Small Cap Index, and the Value Line Arithmetic Index have traded to new all-time highs. If past is prelude it should not be too long before the S&P 500 (SPX/1460.15) does the same thing. Of course this differs with the election year chart I have been using this year, which telegraphed a peak for the SPX at the beginning of September follow by a pullback into mid/late-October and then a rally to higher highs. And, it looked like we were going to get a continuation of that election year trading pattern until the Federal Reserve announced QEternity. On that announcement the 98% correlation with the typical election year trading pattern completely fell apart as the INDU vaulted 206 points. The Dow Delight, however, left ALL of the macro sectors I monitor severely overbought; as well, the NYSE McClellan Oscillator was about as overbought as it ever gets.
Accordingly, in last Monday’s missive I wrote:
An overbought condition can be resolved in one of two ways. First, the SPX can pause and move sideways while the overbought condition is remedied. Second, the SPX can pull back to what had previously been an overhead resistance level, but now becomes a support zone. In the current case that would entail a pullback to 1400 – 1422 for the SPX. Importantly, when the stock market generates an overbought condition of last week’s magnitude it suggests there is more strength coming in the future after the overbought condition is rectified. Indeed, uptrends typically do not end on really high overbought readings from the NYSE McClellan Oscillator. So, while two weeks ago I thought we were reaching for a short-term “trading top,” I believe that following some kind of pullback, or sideways movement, the major market indices will go higher.
In Tuesday’s verbal strategy comments I modified the strategy by noting that given Monday’s trading pattern we were probably going to get a sideways correction; and that’s exactly what we got last week, which brings us to this week.
The call for this week: Speaking to the divergence of the Industrials and the Transports, Bespoke had this to say:
Over the last six months, the Dow (DJIA) is up 3.47%, while the Transports are down 7.90%. While wide, the 6-month spread in performance between the two is not out of the ordinary, as shown in the chart (see page 3). At the same time, peaks and troughs in the performance spread have not really been bullish or bearish for the future direction of the overall market either. While the spread could widen more, it’s likely that we’ll see a reversal in the relative underperformance of the Transports in the near future, but that doesn’t mean the Dow is doomed (see chart).
Obviously I agree, yet it still does not feel like the stock market is ready to leap higher until we spend a few more sessions working off the overbought condition …
Copyright © Raymond James
Monday, September 24th, 2012
September 21, 2012
The Schwab Center for Financial Research presents Bond Insights, a bi-weekly analysis of the top stories in today’s bond markets. This issue includes our observations on the Federal Reserve’s announcement of its latest version of quantitative easing (QE3), we discuss bank bonds and if we believe they could present an opportunity for fixed income investors in the current environment, we take a look at the many differences and similarities in the way municipal governments are managing credit challenges and we discuss the impact of low interest rates on bond investments.
“To Infinity and Beyond”
The Federal Reserve’s announcement of its latest version of quantitative easing (QE3) managed to exceed the market’s expectations even though it was widely anticipated. The Fed announced an open-ended bond purchase program of $40 billion per month concentrated entirely in mortgage-backed securities and extended the time period it plans to keep interest rates on hold until mid-2015. Fed Chairman Bernanke made it clear that the committee’s goal is to reduce the unemployment rate, which he called, “a grave concern.” Long-term Treasury bond yields surged to a four-month high on the news. Is this the start of the long-awaited bear market in bonds?
- It is too soon to tell. Rising bond yields are consistent with the market’s response to previous rounds of QE. In the initial phases of QE1 and QE2, bond yields rose as well because investors shifted into riskier assets and out of Treasuries. As the Fed’s bond buying ended however, interest rates drifted lower again as the pace of economic growth and inflation ebbed. With QE3 the Fed is leaving the time frame for bond buying open ended.
- One view on the impact of a third round of asset purchases is… that the Fed’s actions will ignite inflation pressures through the weaker dollar and rising asset prices, sending bond yields higher. Another view is that the bond buying will prove ineffective because the economy’s problem is not a lack of liquidity but a lack of demand. Therefore, interest rates will decline again once it is clear that the economy is not responding to monetary policy.
Market Reaction to Fed Easing
Source: St. Louis Federal Reserve and Bloomberg, monthly data as of September 18, 2012.
- We believe both views have some validity. The previous rounds of quantitative easing were larger on a per-month basis at over $70 billion per month, but the commitment to an indefinite time period may signal that the Fed is willing to tolerate more inflation in exchange for stronger growth. If QE3 results in a weaker dollar, then rising import prices can put upward pressure on the consumer price index (CPI). But rising prices of imported goods, such as oil, may lead consumers to lower consumption in other areas. With weak income growth, demand could remain lackluster and inflation pressures contained.
- It may come down to a matter of timing. Inflation expectations are already rising, but higher inflation may not surface until later when the economy has less excess capacity. That means watching for improvement in labor markets and a pick up in demand while watching inflation expectations.
- In our view, the major risk in current monetary policy is… that the Fed overstays its welcome by pumping too much liquidity into the economy for too long, allowing inflation to become embedded. That is a risk they appear willing to take in exchange for the potential to prevent a renewed recession and/or deflation.
- Bottom line: Whichever view you adhere to, long-term Treasury bond yields at or below the rate of inflation offer very little value beyond diversification, in our view. There is clearly more room for rates to rise than to fall. However, we don’t advise trying to time the interest rate cycle. We continue to favor laddered portfolios where the average duration is in the short-to-intermediate term region. We also believe investors should consider holding high quality bonds for the bulk of their portfolios, limiting the higher-yielding, more aggressive sectors of the market to no more than 20% of the fixed income allocation.
Bank Bonds—Post Downgrades
It’s been almost three months since Moody’s downgraded fifteen global banks on June 21. Although the downgrades had been well-publicized in advance, the degree of downgrades was uncertain. As it turned out, the downgrades were not as severe as markets may have expected. Meanwhile, the stock market has risen, domestic bond yields are higher, and central banks across the globe have taken measures to boost their slowing economies. Given this, how has the financial sector of the bond market fared since the downgrade, and do financial bonds present an opportunity now for fixed income investors in the current environment?
- Financial institution bonds have outperformed other sectors of the bond market. From the date of the downgrades through September 18, the Barclays U.S. Corporate Bond—Financial Institutions Index generated a total return (price change plus interest income) of 4.33%. For the same time period, the industrial and utility sub-sectors of the Barclays U.S. Corporate Bond Index saw total returns of just 1.93% and 1.05%, respectively.
Barclays U.S. Corporate Bond Yields by Sector
Note: Option-adjusted spread (OAS) is the basis point spread relative to Treasuries, net of the cost of any embedded options
Source: Barclays, monthly data as of September 17, 2012.
- Tighter yield spreads are one of the main drivers behind the strong performance. When bonds are perceived to have greater risks they will trade at higher yields relative to bonds with lower credit risk, such as Treasuries, in order to compensate. Yield spreads on financial institution bonds have narrowed since the downgrades. This may seem counterintuitive, but the market may have been expecting deeper downgrades. Only one of the institutions was downgraded by three notches. The rest were smaller. The yield spread of the financial index above the Treasury index dropped from 2.6% the day before the downgrade to 1.8% on September 18. This is the lowest spread since July 2011.
- What has happened to banks since the downgrades? Not much, in our view. From a purely bank-specific point of view, it’s been quiet. Second quarter earnings appeared neither to excite nor disappoint the markets, and aside from the large trading loss at a major bank earlier in the year, domestic banks have done their best to stay out of the headlines. But many macro factors have supported the financial sector. The S&P 500® Index is up over 8% since the downgrades, the Federal Reserve announced another round of quantitative easing, U.S. government bond yields are higher, and the European Central Bank took steps to address its debt crisis. Banks are often considered leveraged plays on an economy and when the central banks provide more liquidity to the economy, riskier segments of the market generally tend to do well. When riskier segments of a market begin to perform well, financials often tend to follow suit.
- But there are still a few unknowns in the financial sector. Although risk premia may have fallen, financial companies still face a number of headwinds, in our view. Financial regulation has yet to be finalized. Without some rules set in stone, many firms will hold off making investment decisions. And the economy can still be described as “sluggish,” which may continue to weigh on corporate earnings. Many banks have been cautious lately about their future earnings, citing earnings growth as one of their main concerns. Although financial firms’ balance sheets may be strengthening, lower earnings growth may affect investor confidence, in our opinion.
- Bottom line: Financial bonds may make sense for investment grade corporate bond investors, but we would caution not to overweight the sector. This can be difficult, as financial institutions make up over 32% of the corporate bond index.
Although financials have generated a positive total return over the past few months, it may be difficult to continue the strong pace. Financial bonds currently offer a higher yield, on average, than their industrial and utility counterparts, but we believe investors should take a diversified approach when buying individual corporate bonds.
California, New York and Illinois Rating and Outlook Changes
We’ve seen several notable rating and outlook changes recently for a handful of large states, including California, New York and Illinois. These rating changes remind us that there are as many differences as similarities in the way municipal governments are managing credit challenges. Even at the state level, it’s not a homogenous market. A key factor to watch is “structural budgetary balance”—whether you’re looking at states or local municipalities. Structurally balanced means that the revenues and expenditures essentially match without the need for one-time cuts that go away later and don’t address long-term challenges.
- California’s A- rating outlook positive from Standard & Poor’s. California is S&P’s lowest-rated U.S. state, at A-. But the agency revised their outlook on the rating to positive from stable in February of this year and affirmed their rating and outlook on September 13. The state’s outlook was revised to positive in part because the legislature successfully passed a timely state budget in June 2012, according to S&P—a feat they’ve had trouble achieving recurrently in prior years. Credit quality also hinges on the sustainability of recent cuts, they say. Will those budget cuts carry over into future years to limit the need for additional cuts if revenues don’t rise? A tax-raising measure (Prop 30) on the fall ballot would also boost revenue and limit the need for $2.5 billion in education cuts. The state legislature also passed reforms in late August to reduce pension contributions for new employees, a factor cited as a positive factor by both S&P and Moody’s. The state plans to sell $1.6 billion in General Obligation (GO) bonds on September 25.
- New York’s AA outlook from S&P is also positive, revised from stable at the end of August. Like California, S&P based their change in outlook on “movement toward structurally balanced budgets in the past two years.” This “structural” alignment of revenues and expenditures is one of the key factors agencies look at when assessing credit quality. The size of the state’s budget deficits have also been shrinking with lower projected “out-year gaps”—a positive for any state, especially if state revenues continue to gradually improve, led (for most states) by income and sales tax.
- Illinois rating downgraded to A from A+ with negative outlook… also by S&P in August. Pension reform, and lack of any “meaningful action” on that front, was the primary reason for S&P’s rating downgrade in late August, according to the agency report. Analysts have often pointed to Illinois—along with California, one of the lowest rated by both S&P and Moody’s—for their relative lack of progress in addressing a sizable unfunded future pension liability (amounting to $82.9 billion at the end of fiscal 2011, with a 43.4% “funded ratio”—meaning the ratio of assets/investments set aside to match the total estimated future pension costs) and lack of progress in containing costs or raising revenues to improve “structural budget performance.” Moody’s affirmed their A2 rating with stable outlook in August, but also cited the failure to enact pension reform as a “credit negative.” We see the same theme: the need to balance revenues and expenditures on an ongoing basis, balancing funding for current and long-term obligations.
*No change in rating or outlook in 2012
**Source: Standard & Poor’s
***Source: Bond Buyer
- Do ratings matter? If you’re skeptical of bond ratings as an indication of credit quality, you’re not alone. Ratings are opinions, not a guarantee of credit quality. But we still see them as a useful tool in monitoring which issuers are making changes to manage long-term budgetary balance. Rating changes may not lead to an immediate change in performance. But right now, investors are already being compensated in the form of higher yields (as shown in the table above.) Over the long-term, however, investors focused on ability to pay—we believe—should focus on issuers with a pattern of managing credit quality. You can find rating reports when searching for individual bonds on schwab.com. Or speak with your Schwab Financial Consultant or a Schwab fixed income specialist.
- Bottom line: For U.S. states, we see ratings as a reminder of the differences in credit quality in the muni market. This includes U.S. states, where credit quality hinges on structural balance between revenues and service obligations.
Interest Rates Are Low—Should You Sell Your Bonds?
If you’ve been holding bonds and bond funds for more than a few years, it’s likely that you have gains in your portfolio. Just in the last two years, ten-year Treasury yields have fallen from nearly 4% in early 2010 to under 2%. And as yields fall, prices rise. With interest rates at low levels, we concede that there isn’t much room for rates to fall further. And if they start to rise, bond prices will fall, erasing paper gains from bonds with higher coupons pricing at premiums now. But selling bonds that have appreciated means losing the income that they generate and replacing that income will be difficult in most cases— without taking more risk. How do you know when its time to sell?
- What’s your goal? If you are looking for total return in your portfolio, then it might be time to take some profits in portions of the fixed income portfolio that appreciated most in price, since it doesn’t appear that bond prices have a lot of upside from here. Certain sectors, in particular long-term bonds, will also experience losses if rates rise. For investors in bond funds, the downside in price can be a particular concern since the net asset value (NAV) of the fund will decline if interest rates rise, all else being equal. Unlike individual bonds, you may not get back the full amount of the principal you’ve invested, depending on when you need the money or need to sell.
- If you sell bonds or bond funds that have appreciated in value, however, you will lose the income that they generate. And replacing that income may mean taking more risk. For income-oriented investors, this is a challenge. For example, if you purchased an investment grade corporate bond with a 5% coupon several years ago, it might be trading 10% or more above its par value. If you sell now and realize that 10% capital gain, then you’ve added to the cash balance in your portfolio. But you’ve taken away the regular 5% coupon as well. The average yield on investment grade bonds is now under 3%, as measured by the Barclays US Corporate Bond Index, so the additional principal you have available to invest may not make up for the reduced income you will receive.
- To get the equivalent yield, you would probably have to invest in lower quality bonds. This may include high yield bonds and other sectors that may not be appropriate for your risk profile. Extending maturities is another way to increase yield, but that adds risk. Long-term bonds with less credit risk, starting with Treasuries, are also the sectors that have appreciated in value the most. Moreover, you will have a capital gain from the sale of your bond, which is taxable. If you are an income-oriented investor, the trade off may not make sense.
- For total return investors, it’s always a good idea to revisit your asset allocation and determine if it’s in line with your long-term goals. If the fixed income portion of your portfolio has risen in value and out of balance with the targeted allocation, it may be a good time to re-balance by selling some bonds or bond funds and re-allocating to other sectors where you may be underinvested. But other investors may hold fixed income investments primarily for the income that they generate, or they are under-allocated to bonds based on their time horizon and tolerance for equity risk. In this case, selling bonds to realize gains will reduce income and may actually increase the risk in the portfolio by pushing into lower credit quality investments or investments with equity risk. When looking at the strategic asset allocation, buy-and-hold investors might also choose to measure the allocation to bonds in terms of the par value rather than the market value.
- Bottom line: If you buy and hold bonds, the gain on your bond portfolio is a temporary reflection of the shift in interest rates—the market’s reflection of the benefit in holding bonds with higher coupons than available at par in the market today. The gain on its own is not necessarily a reason to reallocate away from fixed income or sell individual bonds, in our view. Those gains will gradually decline as the bonds approach maturity. In the meantime, you would realize those gains over time in the form of a higher coupon. The choice to sell, or hold, should depend on your objective—do you prefer income that you might not be able to easily replace, or do you prefer to take gains and then reallocate to other investments that are more in line with a long-term strategic allocation? For help, talk with your Schwab Financial Consultant or a Schwab fixed income specialist.
For other articles, please visit schwab.com/onbonds.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.
Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.
Past performance is no guarantee of future results.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Examples provided are for illustrative purposes only and not intended to show actual investments or to be reflective of results you should expect to attain.
Barclays U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch. This index is part of the U.S. Aggregate.
S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.
Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Monday, September 24th, 2012
by John Hussman, Hussman Funds
Imagine there’s a $100 bill taped to the far corner of the room, near the ceiling and way above your head. You will receive that $100 bill ten years from today. Suppose that you reach your hand out directly in front of you and pay $46.31 today for that future $100. Assuming no credit risk, you have now bargained for an 8% annual return.
Now reach higher, about eye-level, and offer $67.56 for that future $100. You have now bargained for a 4% annual return.
Now reach far above your head, jump as high as you can, and offer $84.49 today for $100 ten years from today. You are now an investor in 10-year Treasury securities, which presently yield 1.7% annually.
Every security on Earth works like this. The higher the price you pay for a given set of expected future cash flows, the lower your prospective future rate of return. Higher prices essentially take from future prospective returns and add to past returns. Conversely, lower prices take from past returns and add to future prospective returns.
At the top of your jump, as you hover like Michael Jordan in mid-air, let’s ask all of the other investors who already hold Treasury securities whether they are “wealthier” because of the elevated price you are paying. At first glance, the obvious answer seems to be yes: each of those investors, individually, could sell their Treasury bond at a price that would enable them to command a greater amount of current output than they could before.
But if you think carefully, you’ll realize that regardless of today’s price, someone will have to hold that security until it delivers $100 a decade from now – no more, no less. So the price change itself does not create aggregate wealth. Unless something happens to materially change that future cash flow, it is not at all clear that elevating current prices makes investors – in aggregate – any wealthier in terms of consumption. While any individual investor could sell the bond in order to consume today (abandoning the reason they had saved in the first place, which was to provide for their future consumption a decade from now), some other investor now has to defer consumption to purchase the bond and hold it to maturity.
An increase in price alters the profile of investment returns by turning prospective future returns into past returns (and vice versa when prices fall), but economic wealth is only created by the generation of additional goods and services (and cash flows from an investment standpoint) that actually emerge in the future. Security prices are a place-holder until the expected future goods, services and cash flows actually arrive. Raising the price that investors pay today for in return for some fixed payment in the future does not create wealth in aggregate.
Any one investor can realize what they count as “wealth” by selling, but only if someone else buys that claim on future goods, services and cash flows. If those things ultimately never arrive, the perceived wealth simply vanishes. In that case, the people who cash out at rich prices certainly get a transfer of wealth from the people who buy at those same rich prices and see their investments vanish, but that does not mean that new wealth was created. Despite the transfer of wealth between sellers who cash out and buyers who hold the bag, security price changes don’t create new aggregate wealth in and of themselves – only increases in goods and services do.
That’s why, when security prices plunge, the lost money doesn’t “go” anywhere or to anyone. It’s air until the goods show up. If a dentist in Poughkeepsie buys a single share of Apple a dime higher than the last guy did, nearly $100 million of market capitalization is suddenly created. Nobody suddenly pumped $100 million into the stock market. One person just paid up a little. All of that is the reason we insist on valuing securities based on the long-term stream of cash flows that we actually expect to be delivered into the hands of investors over time, not based on ephemeral measures like Wall Street’s estimates of next year’s earnings.
Now consider the effect of monetary policy. Suppose that every central bank on Earth is printing money. This may seem like a fine thing when there is so much economic difficulty and credit risk that zero-interest money is willingly absorbed in whatever quantity is produced, but is likely to be inflationary in the back-half of this decade when those cash-seeking motives ease. Alternatively, it will likely lead to significant upward pressure on long-term rates later, as central banks are forced to slash their balance sheets by selling long-term Treasury debt and other assets in order to mop up the liquidity.
Now ask again, if the future cash flows are still the same in nominal terms, and the prospective future price level of goods and services is higher, and the point of saving is to provide for future consumption, are bond market investors actually “wealthier” as a result of all of the manipulation of asset prices? No. To the contrary, they are poorer. In aggregate, the real wealth of fixed-income investors has been assaulted.
One would like to believe that stock market investors will at least be no worse off if inflation eventually emerges in the back half of this decade. After all, inflation would have a tendency to raise future revenues. This is generally true, but historically, inflation has been very hostile to stock prices – particularly during the transition from lower to higher inflation rates – because inflation also raises wages and interest costs, and produces significantly more conservative valuations. Moreover, assuming that government deficits and private savings do not remain in their dismal state indefinitely, we are likely to observe significantly narrower profit margins in the future, compared with present margins, which are about 70% above historical norms (see Too Little to Lock In for the accounting relationships here).
The upshot is simple. The elevated prices of financial assets have already eaten the future. At present, a 10-year investment in U.S. Treasury debt is associated with a prospective total return of just 1.7% annually over the whole of that investment horizon. A 30-year investment will achieve a 2.9% annual total return over three decades. An investment in bonds comprising the Dow Jones Corporate Bond Index will achieve an annual total return of 2.8% annually. We estimate that the S&P 500 is likely to achieve a 10-year average annual total (nominal) return of about 4.1% annually. What has happened here is that the prospect for meaningful future returns has been removed, in order to elevate prices in the present.
Unfortunately, this does not mean that real output will be more plentiful in the future, or that savers who are hoping to provide for the future will be prompted into consuming much more today. Historically, a 1% increase in the value of the stock market is associated with a transitory increase of just 0.03-0.05% in GDP over the following year, quite to the contrary of what Mr. Bernanke wishes the public to believe. As former Fed Chairman Paul Volcker said last week “Another round of QE is understandable, but it will fail to fix the problem. There is so much liquidity in the market that adding more is not going to change the economy.”
That’s particularly important given that we continue to infer that the economy has already entered a recession – something that will probably take several more months to be broadly recognized. We’re seeing fresh lows on the most leading economic component that we infer using unobserved components methods (see the note on extracting economic signals in Do I Feel Lucky?), matching weakness that emerged in late 2000 and late 2007. On a slightly positive note, we don’t yet see the near free-fall in these measures that occurred later in 2001 and 2008 as economic weakness rapidly gained momentum.
As for the financial markets, any single investor interested in present consumption can reasonably count himself or herself as wealthier at this moment, in that higher-risk securities can be sold at elevated prices to others reaching their hands far above their heads, in the belief that they will later find someone who is willing and able to jump higher still. Unfortunately, the tragedy of the commons is that behavior that can be followed by a single individual is not always behavior that can be followed by all individuals taken together.
My impression is that we may not be far off from finding out (once again) what happens when they try.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
Our estimates of prospective stock market return/risk were unchanged last week, after reaching the single lowest estimate we’ve observed in a century of market data. As I noted last week, this is not because any single data point is beyond its own historical extremes – valuations were far richer in 2000; overbought conditions were more extensive in 1929 and the late-1990’s; the most extreme bullish sentiment was in January 1977 (immediately rolling into a bear market). The problem is that the combinations of indicators – the syndromes – that we presently identify have repeatedly appeared in subset after subset of historical data, and are uniformly associated with negative market outcomes. Think of it this way – if you throw together a pile of saltpeter, a pile of sulfur, and a pile of charcoal, neither item by itself may be of particular concern, but what you may not realize is that you’re sitting on dynamite.
So we have a strongly negative average outcome on the basis of dozens of individual models or “learners” that comprise our ensemble methods, and at the same time, the disagreement or dispersion between those learners is unusually small. The result is a steeply negative return/risk estimate. As always, this particular instance might turn out differently than the average. Presently, though, we have little basis for that expectation.
Strategic Growth Fund remains fully hedged, and while we continue to carry a staggered-strike put position (which raises the strike price of the put side of our hedges closer to the prevailing level of the market), we have not aggressively raised strikes, and with option volatility (VIX) at just under 14%, the cost and time-decay of that position is just over 1% of assets looking out to next year. Given that we expect an unusually high risk of “tail events” given the extreme negative return/risk estimates we observe, put option premium at a 14% VIX seems strikingly inexpensive. Strategic International remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return carries a duration of about 1.4 years (meaning that a 100 basis point move in Treasury yields would be expected to impact the Fund by about 1.4% on the basis of bond price fluctuations), and on the recent surge in precious metals shares, we have cut our exposure to less than 4% of assets – inflation is likely to be a significant problem in the back-half of this decade, but not without a significant recession, weakness in key commodity consumers like China, credit strains, and other challenges to the “money printing = buy gold” hypothesis first. The Fund also holds a few percent of assets in utility shares, and we closed our foreign currency holdings on the recent surge in the FX markets.
Copyright © Hussman Funds
Monday, September 24th, 2012
The Economy and Bond Market (September 24, 2012)
Treasury yields rose for a fourth week in a row. Additionally, the benchmark 10-year yield is on the verge of breaking above the technically significant 200-day moving average.
- Existing home sales advanced to their highest level since 2010, according to new data from the National Association of Realtors. The pace of sales jumped 7.8 percent in August to an annual pace of 4.82 million units, eclipsing expectations for a more modest 2.0 percent gain.
- The current account deficit in the U.S. narrowed more than forecast in the second quarter, helped by a pickup in exports and a bigger income surplus. The gap, the broadest measure of international trade because it includes income payments and government transfers, shrank 12 percent to $117.4 billion from $133.6 billion in the prior quarter, a Commerce Department report showed today in Washington.
- The Empire Fed Manufacturing Index came in at its lowest level since April 2009, and was well below expectations. The report confirms the biggest 6 month drop since records began. Manufacturing in the Philadelphia region contracted in August for a fourth consecutive month as orders and employment declined.
- The index of U.S. leading economic indicators fell in August, led by a decline in new orders for manufacturing. The Conference Board’s gauge of the outlook for the next three to six months decreased 0.1 percent after a revised 0.5 percent increase in July, the New York-based group reported today.
- The European Central Bank (ECB) appears ready to implement further QE in the near future to improve financial stability in the region.
- With further weak economic data out of China, odds of additional easing measures continue to move higher.
- Interest rates are likely to remain very low for the foreseeable future.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
- China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.