The ‘Crude’ Reality of Unrest

Monday, February 28th, 2011

The ‘Crude’ Reality of Unrest

by David Andrews, CFA-Director, Investment Management and Research, Richardson GMP

Investor sentiment turned decidedly more cautious this week with major North American indexes retreating amid the growing pro-democracy movement in the Arab world. Following the mostly peaceful demonstrations in Tunisia and Egypt, the pro-democracy rallies in Libya turned ugly as protesters were met with a stiff and inhumane response from pro-Gaddafi supporters. Mercenaries and Militia were reportedly firing on unarmed crowds amidst the incoherent ramblings of embattled leader, Muammar Gaddafi. Gaddafi went so far to suggest the protesters were being drugged and under the influence of Al Qaeda. The unstable situation saw the price of Brent crude oil surge to 2-1/2 year highs near $120 a barrel.

As a result, Canadian commuters felt the sting at the gasoline pumps this week as prices seemed to increase a few cents a litre each night. Stock market investors also felt the pinch with the TSX slipping below the recently attained 14,000 level. Three consecutive down sessions on the holiday shortened week (Canadian and U.S. exchanges were closed Monday) were followed by a Friday reprieve as Saudi Arabia announced it would increase its crude oil production in an attempt to offset any global supply disruption from Libya. The influential Materials and Financial stocks surged and helped boost the index by 1.25% on the day and back above 14,000. For the week, the TSX lost a little more than half of one percent. The major U.S. indexes fell about 2 percent on the week as investors bet higher oil costs may unseat the early stages of the economic recovery.

Speaking of the economy, there were a few positive signs of things getting better with U.S. consumer confidence at 3 year highs in February despite higher food and fuel costs. U.S. weekly employment data also showed fewer Americans filed for jobless claims suggesting the employment situation is continuing the slow process of healing. If employment and confidence are a silver lining, housing continues to be the dark cloud. January new home sales were again below already depressed expectations. In Canada, retail sales in December fell but most of that was due to the auto sector. Ex autos, retail sales were up 0.6% which was expected.

IS Gold Set To Rally?

Despite the fact that Gold is trading near its record high, some suggest that Bullion will outperform Oil as surging inflation will underscore the metal’s role as an investment hedge. The chart to the left shows the price of both Gold and Oil since 2008. The chart below is the ratio of Gold to Oil, or how many barrels an ounce of gold will buy. At its peak in late 2008, an ounce of gold bought you about 28 barrels of crude oil. Currently, oneounce buys about 15 barrels. Notwithstanding OPEC’s spare production capacity, energy markets have priced in a considerable risk premium. If tensions ease and or production comes on stream, oil prices could drop rather quickly. Gold has fallen 1.6% this year following a 30% rally in 2010. Crude is up about 5% this year following last year’s 15% rise.

The Trading Week Ahead

Canadian stock market investors are expecting the rest of the Big Banks will be able to follow the solid start to bank earnings season set by CIBC and National Bank. Following a softer second half of 2010, the banks are poised to benefit from better market conditions for their retail and wholesale lending businesses. Investors looking for dividend increases will have to wait on National and Commerce but they may not have to wait on the others. Bank of Montreal reports Tuesday and is followed by TD and Royal on Thursday. (Scotia reports March 8th).

U.S. reporting season has concluded with another upbeat quarter and substantial positive earnings surprises. The biggest positive surprises were in the Materials sector where elevated commodity prices boosted the bottom line. Consumer goods, specifically Automobiles, provided the biggest earnings disappointment in the fourth quarter on the S&P500.

The economic calendar will likely continue with the theme of improving consumer and business confidence but scant signs of improvement in the U.S. housing market. Pending homes sales in January are expected to once again come in lower. The February employment report is released on Friday. For the past three months we have overlooked disappointing results and explained them away by bad weather. We did not have weather issues of significance this month so the non farm payrolls on Friday could be significant.

Commodities prices, specifically oil & gold, will be influenced by the evolving and volatile demonstrations in the Middle East and North Africa. Risk premiums for both oil and gold remain rather elevated helping to push the loonie higher. Watch for no move in policy by the Bank of Canada on Tuesday, but the wording of the statement will be scrutinized for signs of their next move likely around mid 2011.

Copyright (c) Richardson GMP

Tags: Brent Crude Oil, Canadian Market, CIBC, Commodities, Consumer Confidence, Crude Oil Production, Democracy Movement, Employment Data, Employment Situation, energy, financial stocks, Food And Fuel, Gasoline Pumps, Global Supply, Gold, Incoherent Ramblings, Investor Sentiment, Jobless Claims, Muammar Gaddafi, oil, Oil Costs, Peaceful Demonstrations, Positive Signs, Silver, Stock Market Investors, Supply Disruption, Unstable Situation
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Lessons From a Lost Decade

Monday, November 1st, 2010

Lessons From a Lost Decade

by John P. Hussman, Ph.D., Hussman Funds

Over the past decade, stock market investors have experienced enormous volatility, including two separate market declines in excess of 50%. Despite periodic advances, at the end of it all, as a reward for their patience, investors have achieved an average annual total return of approximately zero. If the past decade has been a lesson for investors, that lesson should have two components. The first is that valuations matter. Though valuations often have little impact on short-term returns over periods of less than a few years, they are undoubtedly the single best predictor of long-term market returns. Moreover, high valuations are ultimately followed by far deeper periodic losses than emerge from low valuations. Put simply, greater risk does not imply greater reward if the risks that investors take are overvalued and inefficient ones.

The second lesson is that the effects of wasteful misallocation of capital cannot be fixed by policies that encourage the wasteful misallocation of capital. Fortunately or unfortunately, policies can often help to prop up unsustainable patterns of activity in order to “kick the can down the road.” This can postpone major economic adjustments, but often makes the ultimate adjustment even worse.

Put simply, policies and investment practices that are effective and friendly to the short-term can often be destructive and violent to the long-term, particularly when those policies and practices encourage the misallocation of capital. Presently, investors are resting their financial security on hopes about quantitative easing – a policy that is essentially intended to skew the allocation of capital and provoke risk-taking in an environment where risk premiums are already thin.

Valuations

When starting valuations are elevated, investors require similarly elevated terminal valuations – 3 years, 5 years, 7 years, 10 years and further into the future – in order for stocks to achieve acceptable long-term returns. Investors and analysts entirely miss the point when they propose that stocks are “fairly valued” based on a short-term condition, whether it is the prevailing level of 10-year bond yields (which can change significantly over periods of much less than 10 years), the current inflation rate, or the expected level of next quarter’s profits. Once valuations become elevated, particularly on profit margins that are also already elevated, investors require terminal valuations to be stretched to the limit, years and years into the future, in order for their speculation to be bailed out. At present, stock valuations are elevated on a variety of smooth metrics. In contrast, stocks appear reasonably valued only on metrics which place excessive weight on short-term factors, and which can therefore be shown to perform poorly in historical data.

Based on our standard methodology (see The Likely Range of Market Returns in the Coming Decade for the basic approach) we estimate that the S&P 500 is priced to achieve a 10-year total return of just 5.05% annually. Using our forward operating earnings methodology (see Valuing the S&P 500 Using Forward Operating Earnings), the projected 10-year total return is just 4.69% annually. With the S&P 500 dividend yield at 1.96%, the 10-year projection from dividend-based models is even lower, at about 2.30% annually (though prospects are good that faster growth of index-level dividends will bring that estimate closer to earnings-based projections, see No Margin of Safety, No Room for Error).

Overall, the projected returns for the S&P 500 are now lower than at any time in U.S. history prior to the bubble period since the late-1990′s (which has resulted in predictably dismal returns for investors). At present, investors rely on a continuation of this bubble to achieve further returns. With respect to the bubble period, the current projected returns match those we observed at the April 2010 high, and are at about the same level as we observed before prices collapsed in 2008. Valuations were even more extreme, of course, at the bubble peak of 2000, which was predictably followed by a decade of zero returns.

Tags: 3 Years, Decade, Economic Adjustments, Financial Security, Hussman Funds, Investment Practices, Losses, Lost, Market Declines, Misallocation, Patience, Periods, Quantitative Easing, Risk Premiums, Stock Market Investors, Stocks, Unsustainable Patterns, Valuations, Volatility
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Stock Market Investors Take Note … Forget Payroll Friday; It’s All About Claims Thursday!!!

Thursday, June 17th, 2010

This article is a guest contribution from James Paulsen, Chief Investment Strategist, Wells Capital Management.

Just a short note on jobs and the stock market. Investment concerns remain elevated. The current “risk cocktail” is a mixture of ongoing European sovereign debt concerns, a Chinese economic slowdown, and a soft patch in the U.S. recovery. During the next several months, however, contemporary anxieties will either be augmented or extinguished by the direction of weekly initial unemployment insurance claims.

Since 2000, as illustrated in Exhibit 1, movements in the U.S. stock market have been remarkably similar to the trend of weekly reported initial unemployment insurance claims. This chart suggests the fate of the stock market during the balance of this year may be tied to unemployment claims. They continue to trend sideways at about the 450,000 level (a result that would reinforce the trendless stock market, which has existed since year-end); they may surprisingly sustain a rise back toward 500,000 (a meltdown scenario for the stock market, which would heighten “double-dip” fears and keep

vulnerability to any perceived Armageddon fears at a fever pitch); or they may soon resume a declining trend towards the 400,000 level (a move that could spark a fresh rally in the stock market, probably carrying the S&P 500 to new cycle recovery highs before year-end).

Exhibit 1
Stock Market vs. Unemployment Claims

Note: Both scales shown as a natural log.

While employment indicators have been somewhat mixed in recent months, we continue to believe job creation is back and expect job conditions to improve during the rest of the year. Exhibit 2 illustrates the primary reason for our optimism on the job market — profits! This chart overlays the annual rate of growth in private nonfarm payrolls with the annual growth rate in profit per private job. In the last year, profit per job has risen by about 35 percent, more than any other time during at least the last 45 years. Why, when labor is more profitable than at almost any time in the last half century, would companies suddenly stop creating jobs?

Initial unemployment claims should soon resume their downward trend and hopefully refocus investors once again on “fundamentals” rather than “fears.” So place your bets on Exhibit 1 for the last half of this year, stop worrying over “payroll Fridays” and start paying attention to “Claims Thursday”!

Download PDF of this note.

Copyright (c) Wells Capital Management

Tags: 45 Years, Anxieties, Armageddon, Chief Investment Strategist, Double Dip, Economic Slowdown, Employment Indicators, Fever Pitch, Investment Concerns, Job Creation, Optimism, Private Nonfarm Payrolls, Scales, Sovereign Debt, Stock Market Investment, Stock Market Investors, U S Stock Market, Unemployment Claims, Unemployment Insurance Claims, Vulnerability, Wells Capital Management, Year End
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Value Emerges in Asia, But Beware of Catching a Falling Knife

Tuesday, June 1st, 2010

As stock markers correct, the valuation of Asian equities has been driven down to historically attractive levels, with the price/earnings ratio (based on profit in the next 12 months) falling below the 15-year average by one standard deviation. “History suggests that oversold situations like this usually harbinger positive market returns in the next 12 months,” said US Global Investors – Weekly Investor Alert.

Source: US Global Investors – Weekly Investor Alert, May 28, 2010.

But it is unsure whether the fall in stock prices has run its course and one should be careful not to catch a falling knife. Eoin Treacy (Fullermoney) summarized the situation as follows: “Stock market investors are not out of the woods just yet. Technical damage has been done and the consistency of medium-term uptrends has deteriorated. This means that at the very least they will have to hold last week’s lows and rally further, sustaining moves back above their 200-day moving averages if a further test of underlying trading is to be avoided.” Caution remains.

Tags: Asia, Asian Equities, Caution, China, Consistency, Driven, Fullermoney, Global Investor, Global Investors, Harbinger, India, Investor, Lows, Moving Averages, Price Earnings Ratio, Rally, Standard Deviation, Stock Market Investors, Stock Prices, Uptrends
Posted in Markets | 1 Comment »

James Paulsen: A New Inflation-Expectations Monitor?

Friday, May 21st, 2010

This article is a guest contribution by James Paulsen, Chief Investment Strategist, Wells Capital Management.

A New Inflation-Expectations Monitor!??!

Inflation expectations are constantly monitored by both investors and economic policy officials. Stock and bond investors have long feared potential inflationary risk and the Federal Reserve always faces a decision either to lean toward growth or against inflation.

There are many popular inflation-expectation gauges including those implied by TIP bond prices, yield curve movements, and inflation surveys. However, another has emerged in recent years (the correlation between the daily movements of the stock and bond markets), which is not widely followed nor fully understood, but which nonetheless seems importantly tied to perceptions of inflation, to the efficacy of economic policies, and to the impact of rising interest rates on the stock market. Investors and policy officials should monitor the message of the “Stock/Bond Correlation!”

Stock/Bond Correlation???!

Exhibit 1 illustrates the trailing six-month rolling correlations since 1968 between the daily percent changes in the S&P 500 Stock Price Index and daily changes in the ten-year government bond yield. Correlation coefficients range between +1 (both variables move directly and perfectly together) and -1 (both variables move perfectly inversely to one another), and a coefficient near zero implies the variables mostly move independently.

Exhibit 1
Trailing Six-Month Rolling Correlations of Daily
Percent Changes in S&P 500 Stock Price Index and
Daily Changes in the Ten-Year Government Bond Yield

Tags: Bond Investors, Bond Markets, Bond Prices, Bond Yield, Bond Yields, Chief Investment Strategist, Correlation Coefficients, Correlations, Economic Policies, economic policy, Federal Reserve, Government Bond, Inflation Expectations, Negative Correlation, Policy Officials, Rising Interest Rates, Russia, Stock Bond, Stock Market Investors, Stock Price Index, Stock Prices, Wells Capital Management
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Sell in May and Go Away? Or Stay? (David Kotok)

Wednesday, May 12th, 2010

Tags: American Investors, American Stock Market, Cumberland, Discrepancy, Existence, Fed Funds Rate, Federal Reserve, History Of Stock Market, Interest Rate, Monetary Policy, Phenomenon, Portfolio Values, Seasonal Effects, Seasonal Factors, Stock Market Investors, Stock Market Performance, Zero Interest
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Bill Gross, Investment Outlook, December 2008

Wednesday, December 3rd, 2008

In his latest Investment Outlook, Bill Gross, head honcho at PIMCO, discusses the advent of transitioning from the levering world of pre-2008 into the delevering world we now find ourselves in. He points out that in the “new” world we should no longer apply the measures of the past for concluding that stocks are cheap, and that it is a transgenerational idea we need to retool for.

Gross points out the “Q” ratio and Robert Shiller’s 10 year average P/E ratio (above) as evidence that stocks are arguably cheap, but goes on to discredit the reliability of these indicators, saying:

“Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks and indeed, discussions in PIMCO’s Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:

1. Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios – the ability of companies to make money by making paper – are coming down, not going up. In addition, the availability of cheap financing – absent government’s checkbook – will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.
2. Globalization’s salutary growth rate of recent years may now be stunted. While public pronouncements from almost all major economies affirm the necessity for increased trade and policy coordination, and avoiding the destructive tendencies of one-off currency devaluations as a local remedy for global problems, investors should not bank on the free trade mentality of recent years to support historic growth rates. Already we are seeing separate ad hoc policy responses with very little cooperation. Not only does the EU’s approach differ from that of the U.S., but France is in many ways an odd man out within its own community. Asia is legitimately suspicious of any U.S. endorsed approach given the failure of America’s capitalistic model.
3. Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered.
4. The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.

My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”

In a recent article we noted that the trailing P/E ratio of the S&P500 had ticked up in the year-to-date to November 10, 2008, while the overwhelming majority of global equity markets had experienced substantial P/E compression. This suggested that the E (for earnings) had declined as much as P (for price)in the S&P500. Is the S&P500 due for P/E compression?

You may read the Bill Gross’ Investment Outlook newsletter in its entirety here.

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Posted in Credit Markets, Economy, Gold, Markets, Outlook | 2 Comments »