Three Years and Counting (Kashkari)

Thursday, June 14th, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.

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

Copyright © PIMCO

Tags: Asset Classes, Attractive Returns, Balance Sheets, Confusions, Downside, Equity Investors, Erian, Financial Markets, Global Economy, Growth Markets, Inflection Points, Investment Approach, Investment Professionals, Low Interest Rates, Market Volatility, Portfolio Manager, Quality Companies, Sidelines, Stewards, Term Equity
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Rosenberg Defines European Insanity

Wednesday, June 13th, 2012

The situation in Europe goes from bad to worse. Gluskin Sheff’s David Rosenberg is back to his bearish roots as he remind us that ‘throwing more debt after bad debts ends up meaning more debt‘. As he notes, the definition of insanity is (via Bloomberg TV):

When you realize that of the potential $100 billion to spend, 22% of that has to be provided by Italy and their lending to Spain is at 3% but Italy has to borrow at 6%. They have to lend to Spain $22bn at 3% – it is just madness. Everybody is getting worried again. The solution that they seem to have come up with seems to be worse than the problem in the first place.

As we have pointed out vociferously over the past few days, even though the assistance is being earmarked for the banks, the Spanish government assumes the responsibility and so this once ‘low national debt’ sovereign is following in Ireland’s footsteps as its debt/GDP takes a 10pt jump to 89% (based on the government’s data) and much higher in reality (when guarantees and contingencies are accounted for). As Rosie explains succinctly, this is right at the Reinhart-Rogoff limit of 90% at which debt begins to erode the nation’s economic fabric.

It is probably not long before this credit – two notches away from junk and having to raise money at 6.75% when its economy is contracting at nearly a 2% annual rate – is going to require external assistance as it follows Ireland onto the sidelines.

The situation in Europe indeed goes from bad to worse.

Tags: Bad Debts, Contingencies, David Rosenberg, Definition Of Insanity, Economic Fabric, External Assistance, Few Days, Footsteps, GDP, Gluskin Sheff, Guarantees, Madness, National Debt, Notches, Roots, Rosie, S David, Sidelines, Sovereign, Spanish Government
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Jim Rogers: “Volume Is Not Going To Come Back. We’ve Had A Great 30 Years. That’s Finished!”

Tuesday, May 15th, 2012

 
Jim Rogers is hedging his gold (and silver) positions reflecting that this is normal, following such a tremendous run, and that this is good for the precious metal in the long-run. In his discussion with Maria Bartiromo this afternoon, he notes India’s anti-gold ‘protectionism’ (and its potential balance of payments issues) that are trying to force the hoarding into risky ‘productive’ assets (as others might say). The immutable commodity maven suggests JPMorgan (and its peers) could be behind the drops in the overall commodity complex as the uncertainty of their positions (and liquidation potential to raise cash as bank examiners begin their forensics) becomes more important. He holds the USD, which he hates; has a number of equity shorts; and is most fearful of banks – specifically admitting he is a serial seller of calls on JPMorgan.

His advice, and perhaps Maria should look into it given their ratings recently, is to become a farmer; own farmland; and speculate on agriculture. On the dismal ‘ethical’ state of our leaders and management, the thoughtful Rogers opines, “You can read world history for decades. There are always people doing things wrong. We have not changed our human nature and we will continue to have scandals and problems” and in a follow-up to CNBC’s standard ‘money-on-the-sidelines’ argument he crushes the money-honey’s dreams: “Finance had a great 30 years. That’s finished. Now to advance, we have too many people, too many MBAs, too much leverage and too many governments that don’t like us”. A must-see rebuttal to the ‘normal’ CNBC hopium with more on China’s slowdown, a US recession, Europe and a Greek exit, QE3, and ‘tractors’.

Tags: Balance Of Payments, Bank Examiners, Cnbc, Farmland, Forensics, Gold And Silver, Hoarding, Human Nature, Jim Rogers, Maria Bartiromo, Maven, Money Honey, Precious Metal, productive assets, Protectionism, Qe3, Rebuttal, Sidelines, Slowdown, World History
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Do Emerging Markets Win, Place or Show in Your Portfolio?

Monday, May 7th, 2012

Do Emerging Markets Win, Place or Show in Your Portfolio?

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

Since the stock market’s gate opened at the beginning of 2012, emerging countries were off to a fast start. Stocks in Brazil, Colombia and India galloped to the lead, increasing more than 10 percent within the first few weeks of the year.

By the time the end of April came around, Colombia had sprinted to the lead, followed closely by Thailand and the Philippines. All increased more than 20 percent in the first four months of 2012.

However, rather than focusing on the leaders of the pack, spectators seemed to have directed their attention toward the S&P 500 Index, as it galloped to its best first-quarter gain since 1998.

The recovery in U.S. stocks is significant and helps restore confidence in equities. We’re pleased to see markets improving, especially following a rough finish in 2011. Yet there lingers a persistent negativity toward emerging markets growth and commodities that prevents many investors from jockeying their portfolios into a position for growth. Rather, they remain spectators on the sidelines, with equity fund outflows continuing.

In contrast, Eastern Europe exploded on the upside and far outpaced not only the U.S. market, but also Europe. The chart below shows investment results across three different markets. Since the beginning of the year through April 30, the iShares S&P Europe 350 ETF has trailed, while the SPDR S&P 500 ETF has placed second. Among these three investments, the Eastern European Fund (EUROX) has kept the lead for most of the quarter and took first place as of April 30.

You can see above that EUROX and the European market were climbing steadily since the beginning of the year, but by April, began to fall because of the eurozone’s debt grief and concerns over China.

Over the past four months, Russian stocks, which are heavily weighted in energy companies, have underperformed many emerging markets, increasing only about 6 percent. HSBC Global Research believes that the low valuations seem to be “pricing in a lot of political risk” surrounding the protests against Russia’s newly elected presidential candidate. Investors need to see the opposition movements against Vladimir Putin as very different from the Middle East discontent, says HSBC. The firm says Russia’s protests are “largely liberal” without “religious dimension” which suggest future reforms to reduce the political discontent are more likely.

HSBC also thinks that the government will try to improve the investment climate. Putin suggested in a recent speech that he would like to increase Russia’s rating in the World Bank’s Ease of Doing Business report. Currently, Russia ranks 120th; Putin would like to set a goal of 20th place.

What may be hurting investor sentiment toward Russia in the short term is the political strain that has recently surfaced between Russia and the U.S. and NATO involving missile defense installations in Europe. This is precisely the reason we believe investors need to hold actively managed investments with experts who understand the political situation to skillfully maneuver around emerging Europe.

China, the Workhorse of the Global Economy

While China did not win, place or show among major markets during the first few months of the year, its H shares gained nearly as much as the S&P 500. Yet, the negativity that I’ve frequently discussed continues, even though the country is the Clydesdale of our global economy.
In the first quarter, China’s GDP growth was 8.1 percent, a likely trough for the year, according to a Merrill Lynch-Bank of America conference call recently. The firm listed several reasons that China will see an improved GDP over the next three quarters:

1. Although spring made an early appearance in many parts of North America, this past winter in China was the coldest in 27 years. This extremely chilly weather slowed down economic activity.
2. Credit growth has bottomed out and bank lending has been reaccelerating. BCA Research echoed this thought in its China Investment Strategy this week, saying there’s been a “sharp turnaround in bankers’ confidence in recent months, which is also being reflected in rising bank lending of late.”

1. Home developer price cuts and lower mortgage rates offered to first-time buyers have driven a significant recovery in home sales. In our recent webcast on China, Andy Rothman from CLSA made some excellent comments related to mortgages, agreeing with ML-BofA, saying that each month it was getting easier for new home buyers to get mortgages, and along with lower interest rates for mortgages, this was a clear sign of “the government’s process of easing up on the housing sector.”
2. With leadership transition close to conclusion, local infrastructure construction activity is poised to increase.
3. As shown below, crude steel, steel products and cement output has shown initial signs of recovery in the recent month.

While China’s Government Purchasing Managers’ Index (PMI) for April came in slightly below market consensus, the number remains above the three-month number for the fifth consecutive month since December 2011. We believe the government’s PMI is a far better indicator of overall manufacturing activity than the HSBC data because it takes into account domestic demand.

From the PMI’s inception in January 2005, the majority of the time the PMI is above the three-month average, Chinese and U.S. stocks, as well as copper and WTI crude oil, all see gains over the following three months. So far this year, each has proved true.

BCA Research says that the latest PMI substantiates that the “Chinese economy may be reaccelerating,” pointing to three trends: Monetary easing is working, external demand seems strong and may be accelerating, and the government has increased fiscal expenditures on social housing and infrastructure projects, which is supportive of ML-BofA’s view above.

The race in the stock market isn’t over until it’s over. While a top contender may ultimately win in the Run for the Roses, the assumed “long shot” might come from behind and race to first place. Rather than place all your money on the market you believe will win, place or show, we believe diversification among markets is the way to go.

Which countries are you betting on to top markets in 2012? Email us at editor@usfunds.com.

See Our Popular Periodic Table of Emerging Markets.

Expense ratios as stated in the most recent prospectus. Performance data quoted above is historical. Past performance is no guarantee of future results. Results reflect the reinvestment of dividends and other earnings.  Current performance may be higher or lower than the performance data quoted. The principal value and investment return of an investment will fluctuate so that your shares, when redeemed, may be worth more or less than their original cost. Performance does not include the effect of any direct fees described in the fund’s prospectus (e.g., short-term trading fees of 2.00%) which, if applicable, would lower your total returns. Performance quoted for periods of one year or less is cumulative and not annualized. Obtain performance data current to the most recent month-end at www.usfunds.com or 1-800-US-FUNDS.

For investment objective and risks regarding the SPDR S&P and the S&P Europe 350 ETFs, see the “Additional Disclosures” section at the bottom.

Tags: BRICs, Chart Below Shows, Chief Investment Officer, Eastern Europe, Emerging Markets, energy, Equity Fund, ETF, Eurox, Eurozone, Four Months, Frank Holmes, Investment Results, Ishares, Leaders Of The Pack, Negativity, Russian Stocks, S Market, Sidelines, Spdr, Spectators, U S Global Investors
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Recovery: Who Are We Kidding?

Friday, April 13th, 2012

by Axel Merk, Merk Funds

April 10, 2012

The global economy is healing, so we are told. Yet, the moment the Federal Reserve (Fed) indicates just that – and thus implying no additional stimulus may be warranted – the markets appear to throw a tantrum. In the process, the U.S. dollar has enjoyed what may be a temporary lift. To make sense of the recent turmoil, let’s look at the drivers of this “recovery” and potential implications for the U.S. dollar, gold, bonds and the stock market.

In our assessment, what we see unfolding is the latest chapter in the tug of war between inflationary and deflationary forces. During the “goldilocks” economy of the last decade, investors levered themselves up. Homeowners treated their homes as if they were ATMs; banks set up off-balance sheet Special Investment Vehicles (SIVs); governments engaging in arrangements to get cheap loans that may cost future generations dearly. Cumulatively, it was an amazing money generation process; yet, central banks remained on the sidelines, as inflation – according to the metrics focused on – appeared contained. Indeed, we have argued in the past that central banks lost control of the money creation process, as they could not keep up with the plethora of “financial innovation” that justified greater leverage. It was only a matter of time before the world no longer appeared quite so risk-free. Rational investors thus reduced their exposure: de-levered. When de-leveraging spreads, however, massive deflationary forces may be put in motion. The financial system itself was at risk, as institutions did not hold sufficiently liquid assets to de-lever in an orderly way. Without intervention, deflationary forces might have thrown the global economy into a depression.

The trouble occurs when the money creation process takes on a life of its own, because the money destruction process is rather difficult to stop. However, it hasn’t stopped policy makers from trying: in an effort to fight what may have been a disorderly collapse of the financial system, unprecedented monetary and fiscal initiatives were undertaken to stem against market forces. Trillion dollar deficits, trillions in securities purchased by the Fed with money created out of thin air (when the Fed buys securities, it merely credits the account of the bank with an accounting entry – while no physical dollar bills are printed, many – including us – refer to this process as the printing of money).

Will it work? The Fed thinks it might. But nobody really knows. We do know that a depression works in removing the excesses of a bubble. However, the cost of a depression may be severe, both in social and monetary terms. Critics of the “let ‘em fail” argument say that businesses and jobs beyond those that have engaged in bad decisions will be caught by contagion effects and may ultimately be bound to fail too. Fed Chair Bernanke, a student of the Great Depression, frequently warns against repeating the policy mistakes of that era. So does the reflationary argument work, i.e. does printing and spending money help bring an economy back from the brink of disaster? We cannot find an example in history where it has. As Bernanke points out, policy makers have learned a great deal by studying crises of the past. Our reservation comes from the following observation: central bankers at any time have always been considered amongst the smartest of their era, yet – with hindsight – they may have engaged in terrible mistakes. While we certainly wish that Bernanke is right, we nonetheless maintain a degree of skepticism and believe it is any investor’s duty to take the risk that the world does not evolve the way he envisions into account. Our policy makers also might be well served to be more humble, as they are putting the world’s savings at risk.

Yet, the reason central bankers are bold, not humble, is because they fear hesitation will lead to deflationary forces taking the upper hand yet again. Bernanke’s contention, that one of the biggest mistakes during the Great Depression was to tighten monetary policy too early, stems from that fear. In its recently released minutes, the Federal Reserve Open Market Committee (FOMC) placed that fear in today’s context: “While recent employment data had been encouraging, a number of members perceived a non negligible risk that improvements in employment could diminish as the year progressed, as had occurred in 2010 and 2011, and saw this risk as reinforcing the case for leaving the forward guidance unchanged at this meeting.”

In our view, the reason why the Fed is committed to keeping rates low until the end of 2014 is precisely because the Fed does not want to be perceived as tightening too early. Why the end of 2014? Well, because it’s not today or tomorrow. We believe nobody – not even at the Fed – knows whether the end of 2014 is the right date. The problem with that policy will be when the market no longer buys it. The market just needs to see one member of the FOMC turn more hawkish, as a result of improving economic data, to interpret that we may be starting down the road of monetary tightening. Yet, if the market thinks the Fed may tighten, deflationary forces take over, possibly unraveling all the “hard work” the Fed has done.

Will tightening ever be bearable for the economy again? U.S. financial institutions are in a stronger position than they were in 2008. Conversely, governments around the world – not just the U.S. government – are in far weaker positions, given the large amounts of debt they have incurred, in an effort to manage the financial crisis. Many consumers have downsized (read: lost their homes / filed for bankruptcy), but there continues to be downward pressure on the housing market, as millions of homes remain in the foreclosure process and are only slowly making it to the market. Bernanke may have chosen the end of 2014 as the earliest time to raise rates because it represents a date when the housing market may have freed itself from much of the foreclosure pipeline. Indeed, Fed research suggests that residential construction won’t fully recover until 2014. We don’t think that is a coincidence. To Bernanke, a thriving home market appears to be key to a healthy consumer and thus a healthy and sustainable recovery in consumer spending.

Tying monetary policy to the calendar has created alarm with economic “hawks” – not just the Fed itself, with the lone hawkish voting FOMC member, Richmond Fed President Jeff Lacker, openly dissenting. But if one follows Bernanke’s line of thinking, what’s the alternative? The alternative would be to firmly err on the side of inflation, as the Fed thinks inflation is the one problem it knows how to fight. Except that a central bank must never communicate that it wants to induce inflation, as it may derail the markets. So the 2nd best option, from Bernanke’s point of view, may be to commit to keeping rates low until the end of 2014; the “risk” that the economy might perform better than expected (and thus earlier tightening warranted) appears to be shoved aside. Just to make sure the markets behave, the Fed also introduced an inflation target, assuring the markets not to worry, all will be fine on the inflation front.

Unfortunately, we don’t think Bernanke’s plan will work. The reason is that inflation may not be as easily fought as Bernanke thinks. The extraordinary policies that have been pursued have not only planted the seeds of inflation, but have re-introduced leverage into the system. While Bernanke claims he can raise rates in 15 minutes, we believe there is simply too much leverage in the economy to raise rates as much as former Fed Chair Paul Volcker did in the early 1980s to convince the markets the Fed is serious about inflation. Given the increased interest rate sensitivity of the economy, much less tightening would likely be necessary. We are not as optimistic as many current and former Fed officials that it will be possible to engineer a sustainable economic growth while adhering to the Fed’s inflation target. The Fed is ultimately responsible for inflation; however, we have also learned that the modern Fed is unlikely to risk severe economic hardship to achieve its price stability mandate.

What does it all mean for the markets? Deflationary forces have favored the U.S. dollar and been a negative for gold. As indicated, however, we don’t think the Fed will sit by idly as the markets price in tightening before the economy is “ready”. As such, a flight into the dollar out of gold might be an opportunity to diversify out of the dollar into a basket of hard currencies, including gold. With regard to the bond market, we are rather concerned that the long end of the yield curve has been extraordinarily well behaved until just a few weeks ago. The reason for our concern is that periods of low volatility in any asset class usually means that money has entered the space that might leave on short notice: we call it fast money chasing yields. We don’t need a crisis for investors to run for the hills in the bond market; we may just need a return to more normal levels of volatility. As such, investors may want to consider keeping interest risk low, i.e. staying on the short-end of the yield curve, both in U.S. dollars and other currencies. With regard to the stock market, it may do well should the Fed think of another round of easing, but let’s keep in mind that the stock market has had a tremendous rally in recent months.

If investors consider investing in the stock market because of the Fed’s monetary policy, why not express that same view in the currency market? After all, currencies – when no leverage is employed – are historically less volatile than domestic (or international) equities. Currencies may give investors the opportunity to take advantage of the risks and opportunities provided by our policy makers without taking on the equity risk.

Please subscribe to Merk Insights by clicking here to be informed as we analyze the global dynamics playing out. Also, please click here to register for the Merk Webinar: Quarter 1 Update on the Economy and Currencies which will take place on Thursday, April 19th at 4:15pm ET / 1:15pm PT. We manage the Merk Funds, including the Merk Hard Currency Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard Currency Fund, Asian Currency Fund, Absolute Return Currency Fund, and Currency Enhanced U.S. Equity Fund, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

Tags: Central Banks, Cheap Loans, Deflationary Forces, Dollar Gold, Financial Innovation, Future Generations, Global Economy, Gold Bonds, Goldilocks Economy, Investment Vehicles, Last Decade, Liquid Assets, Matter Of Time, Money Creation, Plethora, Rational Investors, Sidelines, Stimulus, Tantrum, Tug Of War
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Comfortably Numb: Have Investors Become Too Complacent?

Wednesday, April 4th, 2012

Comfortably Numb: Have Investors Become Too Complacent?

April 2, 2012

Let’s get right to the point: It was the best first quarter for the stock market since 1998. The total return of the S&P 500 index® was 12.6% for the quarter; up nearly 30% from the October 3, 2011 low. What was particularly notable about the surge since then has been the attendant plunge in volatility.

Complacency?

As you can see in the chart below, the CBOE Volatility Index (VIX) has dropped dramatically from its high of 48 last August (when Washington’s fearless leaders failed to construct a debt deal, leading to Standard & Poor’s downgrade of US debt) to 15 recently.

Plunging Volatility

Source: FactSet, as of March 30, 2012.

Many investors—notably those painfully on the sidelines—have suggested this shows a high level of complacency. And the fact that trading volume has been weak has been another pillar in the bears’ case for why the “rally isn’t for real.” (See more on trading volume later in this report.)

Most readers know I have been optimistic, and remain so. But, the contrarian in me does have some sympathy for the case that optimism has become elevated enough to offer a headwind for the market in the near term.

I am a big fan of the sentiment work done by Ned Davis Research (NDR) and SentimenTrader.com. NDR noted recently in a report that the recent backup in Treasury yields has accompanied a rise in optimism by investors, and this combined indicator did flash a short-term sell signal for the market. That said, NDR argues, and I concur, that yields remain extremely low and as such, are not “biting” stocks yet.

Elevated optimism = near-term headwind

Below is NDR’s most widely-followed sentiment measure, its Crowd Sentiment Poll, and as you can see, accompanying the market’s rally has been a surge in optimism into the “uncomfortable” zone. Given a bit choppier action lately by stocks, I am hopeful we will see a waning of this optimism, at least back into the neutral zone.

Elevated Optimism

Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2012 © Ned Davis Research, Inc. All rights reserved.), as of March 27, 2012.

Another sentiment metric showing elevated optimism is SentimenTrader’s Smart Money/Dumb Money Confidence index, shown below.

Smart Money Warming Up to Market

Source: FactSet, SentimenTrader.com, as of March 30, 2012.

Although no where near the recent extremes of smart money pessimism and dumb money optimism, it bears watching. The good news is that the gap has begun to narrow in a favorable way. Remember, as the labels suggest, the smart money tends to be right at extremes of sentiment, while the dumb money tends to be wrong.

Crash worries still abound

But not all sentiment metrics are created equal. One I discovered recently is put together by the folks at Yale and it measures the perceptions about the likelihood of a stock market crash among individual and institutional investors. I quibble with the way they pose the question, making the chart a little difficult to decipher, but let me explain. First, see the chart below:

Crash Likelihood Still Seen as High

Source: FactSet, Yale School of Management/International Center for Finance, as of February 28, 2012.

The question is asked in a way that the reading expresses the percentage of survey respondents that believe a crash will not occur. In other words, as per the latest readings, less than 25% of the survey’s respondents, either individual or institutional, believe the market won’t suffer a crash. Put another way, more than 75% believe there’s a high likelihood of a crash. This is a clear sign that the “wall of worry” the stock market likes to climb is still very much intact.

Investors loving bonds

Much of what I’ve highlighted above are sentiment measures of attitudes, not actions. One clear way to judge the latter is to look at mutual fund flows. Given that the past five years have seen a record $1.3 trillion spread in favor of bonds over stocks, I agree with the notion that investors have yet to become overly enthused by stocks.

All About Bonds

Source: FactSet, Investment Company Institute, as of February 28, 2012.

I also think fund flows help explain why trading volume has been so low. Simply, the retail investor has not been engaged with this market rally and much money has remained on the sidelines. Add to that the fact that high-frequency traders (HFT), which accounted for over 70% of last year’s trading volume at times, are under a magnifying glass held by the Securities and Exchange Commission (SEC) for questionable trading practices. This has likely kept many of the HFTs in hibernation.

Businesses happy; consumers less so

Let me step off the market path for a moment and share another interesting sentiment analysis. Last Wednesday, the Business Roundtable recently released its first quarter CEO Economic Outlook Survey, preceded the day before by the release of the Conference Board’s measure of consumer confidence. CEOs are now as optimistic as they were during much of the pre-recession period. Although they cite headwinds including Europe, China, oil prices and US political uncertainty, they do not believe they will materially impact their business.

On the other hand, consumer confidence pulled back from a still-weak reading in the latest report. It had risen sharply in February. The level of confidence, with a headline of 70, is well below where the index stood during prior economic expansions.

For what it’s worth, CEO confidence has historically acted in a similar manner as the aforementioned “smart money” and its high level of confidence is comforting. On the other hand, very weak periods of consumer confidence have typically been accompanied by higher stock market gains, as the consumer has historically acted in a similar manner as the aforementioned “dumb money.”

Schwab’s survey says

Finally, we have a new survey from Schwab of its active traders. The latest Charles Schwab Active Trader Sentiment Survey polled 421 individual investors who trade frequently and found 51% now consider themselves bullish—the highest level since we began tracking active trader sentiment in April 2008. This is up from only 25% in October 2011. Only 14% say they are currently bearish.

In sum, my optimism in the medium-to-long-term has not been dented by the latest sentiment readings. Last week was the 26th consecutive week of better-than-expected economic news. Of the 17 indicators that ISI tracks that did a good job tracking 2010 and 2011 double-dip recession concerns, only two are presently weakening, with First Call’s earnings revision index notably strong. However, I do think the market has become more vulnerable to negative news in the short term.

Important Disclosures

Tags: Cboe Volatility Index, Charles Schwab, Chief Investment Strategist, China, Complacency, Contrarian Indicator, Debt Deal, Factset, Fearless Leaders, Headwind, Liz Ann, Ndr, Ned Davis Research, Optimism, Plunge, Senior Vice President, Sentimentrader, Sidelines, Stock Market, Treasury Yields, Volatility Index Vix
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Are Stocks Giffen Goods? (Tchir)

Tuesday, April 3rd, 2012

by Peter Tchir, TF Market Advisors

So when will retail investors start buying stocks? One of the final legs propping up this rally is the belief that retail investors will finally pile into stocks. There is hope that all this “money on the sidelines” will find its way into the stock market. The S&P at 1,350 was supposed to do the trick. Certainly 1,400 on the S&P was going to be enough to chase retail investors into stocks. Basically the argument that retail will capitulate and finally invest in stocks is based on the assumption that higher prices increase demand – aka, a Giffen Good.

Is it realistic to assume that investors will decide to purchase more of something just because the price has gone up? They did it in 2000 with internet stocks, that infatuation ended badly. They did it with housing in the mid 2000′s, which ended even worse. If anything, Americans have become more focused on buying things on sale and getting things at a bargain. Why shouldn’t that apply to stocks as much as it applies to anything else?

We have hit multi year highs, yet most people seem to shrug it off. If the retail investor was about to increase their allocation to stocks, do you not think there would be more hype in the media about how well stocks have done? Expecting “the masses” to buy just because something is already up 20% seems a little silly, if not downright arrogant. The retail investors are not stupid. They can also see that the stock market has decoupled from the economy. While professional investors can easily accept that, retail investors still have some level of conviction that the stock market should reflect economic activity and not just central bank printing and government spending. Retail investors can see that the U.S. debt has continued to grow and that in spite of lip service to deficit reduction, we are creating a bigger deficit. They are nervous about what will happen when finally the spending gets pulled in. They are also very nervous (as are many professional investors) that they will be the last purchase of stocks before the central banks stop pumping fresh money into the system in their never ending attempt to inflate asset prices.

If there is one sector where the upward price movement is sucking in more money it is amongst corporations themselves. The number and size of buyback announcements seems to be increasing. That makes sense, since if any group has shown an ability to buy high and sell low, it is corporations themselves. In 2007 and the first half of 2008, companies, including AIG, were buying back their own stock aggressively. From the second half of 2008 and all of 2009, most companies couldn’t afford to buy back shares and many had to issue. It is just wrong to expect individuals to be as frivolous with their money as corporations are.

I continue to believe that retail is reasonably allocated to equities, under the new allocation model. The new allocation model takes into account debt before determining what is investible. Then there is an actual allocation to ultra-safe “rainy day” money. That “investible” money is then allocated at a much more realistic percentage to equities and fixed income and “other investments”. A myriad of new investment vehicles have helped make it easier for investors to participate in the fixed income market and other asset classes, helping to ensure that the allocation to those remains higher than it was through the 90′s and the first part of this century.

I do not believe stocks are a Giffen good, at least when it comes to retail, so expecting “dumb” money to come in and take out the “smart” money may be just as paradoxical as a Giffen good.

The market is a little weaker again this morning, so I better type quickly, since the “Europe went home” rally now starts before Europe goes home.

Chinese service PMI came in strong, but no one really cares about China as a service economy, so that news was largely shrugged off.

Eurozone PPI came in slightly higher than expected and last month was revised slightly higher as well. Nothing too earth shattering, but rising inflation with falling employment makes for a very bad combination.

Spanish bond yields are once again under pressure – as they should be. Italy is also feeling weaker again. In 10 years Spain is back to 5.40% and Italy is at 5.15%, out by 5 and 7 bps respectively. We have seen support, whether normal market support, or central bank purchase support around the 5.20% and 5.45% levels in the past few days, so need to keep a close eye on these levels. Spain is underperforming more noticeably in the 5 year sector, but still trades at 4.19% compared to Italy at 4.32%. Yes, Spain yields more in 10 years than Italy, but less in 5 years. Spanish 5 year CDS is at 436, but Italian 5 year CDS is at 388. So the 5 year bond inversion is clearly an anomaly and a function of supply and demand and an obvious sign of how inefficient bond prices are. There are so many “technicals” at work in the bond market that it is extremely hard to separate what part of price is reflecting risk as perceived by the market and what part is influenced by other non market factors. That is one reason CDS is so popular – it is fungible and not constrained by who holds what issue.

CDS indices are all a little bit better today. European ones were largely catching up to the afternoon move tighter here. IG18 is trading even richer to fair value. This shows a lack of conviction in the rally by the market as a whole since it looks like investors want to set their longs in the most liquid product giving them the greatest ability to exit if necessary. At 7 bps rich with a spread of 90, investors are overpaying for that liquidity. Look for IG18 to continue to lag.

Other anecdotal evidence of this tentative conviction can be seen in the bond markets, where once again, new issue trading is dominating daily flows. Investors have their core longs in bonds, add beta via the index, and look for alpha on new issue allocations and flipping. While not bad in of itself, it is not a sign of a truly healthy market. The ETF’s continue to get some inflows, but the pace has slowed dramatically and much of it can be accounted for by dividend re-investment and “arb” activity. While the ETF’s remain at a premium, “arbs” are buying the bonds that the ETF is willing to accept and exchanging them for new shares, which they then sell into the market. That form of share creation is far less indicative of strength in the market, than when people are truly just buying shares and leaving dealers and ETF managers scrambling to find bonds. That is a subtle, but important difference.

Sources: Bloomberg, TFMA

 

Copyright © TF Market Advisors

Tags: Amp, Assumption, Buying Stocks, China, Conviction, Deficit Reduction, Economic Activity, ETF, ETFs, Giffen Good, Giffen Goods, Hype, Infatuation, Internet Stocks, Invest Stocks, Lip Service, Mining, Professional Investors, Retail Investor, Retail Investors, Sidelines, Spite, Stock Market, Tf
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David Rosenberg: The Truth On Sideline Cash

Wednesday, March 21st, 2012

The money-on-the-sidelines argument has reached deafening and self-confirming as anchoring bias among any and every swollen long-only manager seems to have made them ignore the realities of the situation. David Rosenberg, of Gluskin Sheff to the rescue with good old fashioned facts – as much as they might disappoint the audience. Barton Biggs quote in the USA Today article points out how bullish he is and how cash levels are very high and “idled money is ready to be put to work”. However, as Rosie points out equity fund cash ratios are at a de minimus 3.6%, the same level as in the fall of 2007 and near its lowest level ever. The time when cash was heavy and ‘ample’ was at the market lows in 2009 when the ratio was very close to 6%. Bond fund managers, it should be noted this includes the exuberant HY funds, are now sitting on less than 2% cash so if retail inflows continue to subside as they did this week, buying power could weaken over the near-term. What David points out that is more interesting perhaps is the converse of most people’s contrarian dumb money perspective – the household sector appears to have used the rally of the past three years, for the most part, to diversify out of the equity market (getting out at price levels they could only dream of seeing again). As we have pointed out again and again, the retail investor has been a net redeemer in equity funds for nine-months running and has been rebalancing since the March 2009 lows in a clearly demographic shift towards income strategies as the memory of two bursting bubbles within seven years is seared into most private investors’ minds.

Tags: Article Points, Bond Fund, Bursting Bubbles, David Rosenberg, Demographic Shift, Dumb Money, Equity Fund, Equity Funds, Fund Managers, Household Sector, Hy, Income Strategies, Lows, Private Investors, Redeemer, Retail Investor, Sheff, Sideline, Sidelines, Usa Today
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PIMCO’s El Erian: “Too Early to Declare Victory”

Wednesday, February 8th, 2012

PIMCO’s Mohamed El-Erian visited with CNBC this morning, and offered his usually interesting thoughts on the macro economy and investment themes. Interestingly, he touted precious metals in this interview (relative to equities) which is the first time I’ve really heard him tout them.

8 minute video – email readers will need to come to site to view:

• This year’s market gains will need more than an improving economic picture and investor willingness to shrug off the European debt crisis, Pimco’s Mohamed El-Erian said. “It’s too early to declare victory,” the co-CEO for the world’s largest bond fund told CNBC in an interview Tuesday.
• He outlined three issues that must be addressed if the 2012 rally is to continue:

1) Geopolitical risk that remains both in Europe and the Middle East.

2) A “handoff to more sustainable policies” beyond the monetary easing from the world’s central banks.

3) Getting “long-term investors” off the sidelines and putting their money to work in riskier assets than bonds.

• As those headwinds remain, El-Erian advises investors to dedicate a smaller portion of their portfolios to stocks and a larger allocation toward precious metals. On bonds, he advocates shorter duration, with a target of seven years or less, which is where the Federal Reserve has focused its debt-buying efforts.
• “They’re both willing and able,” El-Erian said of the Fed and other central banks and aggressive monetary policies. “The issue is the effectiveness. Even the central bankers are beginning to announce that it is not just about the benefits, it’s also about the costs and risks.”
• “The central banks are absolutely committed, but we must not extrapolate that they will remain highly effective,” he continued. “They need help. They are a bridge and they have to be a bridge to somewhere. So far the other government agencies are on the sidelines.”
• “There’s more to do,” El-Erian said. “It’s critical that nothing be done to interrupt this wonderful cyclical bounce. We want the cyclical bounce to translate into a secular bounce, because that’s what the markets need to sustain the wonderful returns so far this year.”
• El-Erian contrasted the situation in Europe from the Lehman Brothers collapse in 2008, and said that while central banks “have become much more proactive” with refinancing operations, the current economy may not be as prepared for economic shock. Regarding the “Lehman moment,” El-Erian said, “If you define it as the economy being able to take the shock, that’s in fact a higher risk because we are in a worse place than we were in ’08.”

Disclosure Notice

Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog

Tags: Bond Fund, Central Banks, Cnbc, Debt Crisis, Handoff, Headwinds, Improving Economic Picture, Investment Themes, Macro Economy, Mohamed El Erian, Monetary Policies, Other Government Agencies, PIMCO, precious metals, S Central, S Market, Sidelines, Sustainable Policies, Target, Term Investors
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U.S. Equity Market Cheat Sheet (October 24, 2011)

Saturday, October 22nd, 2011

Wall St. looking east from Nassau St., c. 1911 – click image to enlarge

U.S. Equity Market Cheat Sheet (October 24, 2011)

The domestic stock market as measured by the S&P 500 Index was higher this week by 1.12 percent. Eight sectors increased and two decreased. The best-performing sector for the week was financials which increased 3.92 percent. Other top-three sectors were energy and utilities. Technology was the worst performer, down 2.15 percent. Other bottom-three performers were materials and telecommunication services.

Within the financials sector the best-performing stock was State Street Corp., up 14.40 percent. Other top-five performers were Travelers Co., Morgan Stanley, ACE Ltd. and AON Corp.

The financial sector has been the best performer over the past month as investors appear to be looking past a potential financial crisis in Europe. The U.S. Global domestic equity funds have been significantly underweight financials and this has hampered performance in recent weeks. We believe government policy is a precursor to change and until there is true clarity on what steps governments will take to resolve the current situation in Europe, we will follow our models and largely stay on the sidelines.

At U.S. Global Investors we employ a “GARP” (growth at a reasonable price) approach to investing. At a very basic level, we look for companies growing revenues by at least 10 percent and generating high returns on capital. We use this model to initially select investments and to monitor existing positions to determine whether or not they still conform to the model. So far this earnings season, with one exception, holdings have continued to meet the model based on the new third quarter earnings reports with many posting revenue gains well in excess of 10 percent. The one exception was a health care stock which was subsequently sold.

Strengths

• The consumer electronics group was the best-performing group for the week, gaining 15 percent on strength in its single member, Harman International Industries Inc. The firm reported quarterly earnings which handily exceeded the analysts’ consensus estimate.
• The oil & gas storage & transportation group outperformed, up 14 percent on strength in member El Paso Corp. The pipeline company rose approximately 25 percent after Kinder Morgan agreed to buy El Paso in a cash and stock deal valued at $21.1 billion.
• The homebuilding group gained 9 percent. On Wednesday the Commerce Department announced that U.S. housing starts in September increased 15 percent from August levels to 658,000 starts at an annual rate, above the consensus expectation of 590,000 starts. This was the highest annual rate since April 2010.

Weaknesses

• The casinos & gaming group was the worst-performer, down 7 percent on weakness in member Wynn Resorts Ltd. The firm reported quarterly revenue and earnings below the consensus estimate. Strength in the firm’s Asian operations was offset by weakness in its Las Vegas operations where net casino revenue was down 8.3 percent year-over-year.
• The computer hardware group underperformed, falling 6 percent, led down by the group’s largest member, Apple. The firm reported quarterly revenue and earnings below the consensus estimates. The shortfall was due largely to consumers postponing purchases of the iPhone in September in anticipation of a new model expected to be introduced in October. ExxonMobile has now regained its position as the largest company by market capitalization with Apple’s fall this week.
• The gold group gave up 6 percent, led down by its single member, Newmont Mining Corp. The price of gold declined for the week.

Opportunities

• There may be an opportunity for gain in merger & acquisition (M&A) transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.
• We are right in the midst of earnings season and many bellwether companies are reporting next week including Caterpillar, Dupont and ExxonMobil.

Threats

• A mid-cycle slowdown in the domestic economy would be negative for stocks.
• An escalation in concerns over sovereign debt obligations in Europe would be negative for stocks.

Tags: Ace Ltd, Aon Corp, Cheat Sheet, Consumer Electronics Group, Domestic Equity Funds, Domestic Stock Market, Earnings Reports, Earnings Season, Financial Sector, Gold, Government Policy, Harman, Harman International, Harman International Industries, Harman International Industries Inc, Morgan Stanley, Nassau St, October 24, Performing Group, Precursor, Quarter Earnings, Sidelines, State Street Corp, Telecommunication Services, U S Global Investors
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