Oil: Does Supply and Demand Matter?

Tuesday, August 14th, 2012

by William Smead, Smead Capital Management

If you are a long-time follower of our writing at Smead Capital Management (SCM), you are aware of our belief that a titanic shift is in process in the world economy. The fastest growing economy of the last ten years, China, is slowing down very quickly and the US is grudgingly growing during its deleveraging process. Since the US is four years ahead of most of the rest of the world in the cleansing/deleveraging process, we believe the US will ultimately lead the world out of the current growth funk.

We believe the long-term demand for oil will be greatly influenced by where the world gets its best future growth. As the chart below shows, the US has cut by 50% the amount of energy which is required to generate each dollar of Real Gross Domestic Product (GDP):

Source: Carpe Diem: 2011: Most Energy-Efficient Economy in History, April 2, 2012

From a personal standpoint, it is easy to see how dramatically US drivers are adapting to the $90 dollar price per barrel of oil and gas prices hovering in the $3.25-4.00 per gallon area. My wife and I bought a mid-sized sedan recently which advertised 23 mpg city and 33 mpg highway. After two months and 4000 miles of driving, I’ve confirmed that the highway mpg is consistently running around 35 mpg. A comfortable, mid-sized car which seats four full-sized adults and blends at 28 mpg means that we are going to use much less gas than we used to.

China, on the other hand, has been using a disproportionate part of the world’s commodities to produce about 10% of the world’s GDP. Professor Michael Pettis, from Peking University, computed that China used 40% of many of the world’s main commodity inputs in the year 2010. China’s use of oil rose 92% from 2000 to 2010 and coincided with a price increase of 242%. These facts are very typical of an emerging market nation whose economy becomes dependent on fixed asset investments for continued growth. If we are right and growth slows more than expected, China will demand significantly less oil than they have in the past five years and certainly their reduced demand is a huge factor at the margin.

If Europe was humming along in a favorable way, Japan was bristling with growth and Latin America didn’t have any problems, you might be able to make up lost US and China oil demand elsewhere. We haven’t even mentioned the damaging effect China’s slowdown will have on oil demand in the countries which have “suckled on China’s bounteous teat” like Australia, Singapore, Canada and Indonesia. Lastly, Brazil and Russia are hugely at the mercy of the price of oil for their prosperity. All in all, demand for oil sits in a very precarious position at best.

On the supply side of the equation, we have rarely seen so many holes poked in the ground and in the ocean looking for oil. From shale in North America to offshore drilling near Brazil, new supplies of oil are coming out of the woodwork. Iran, Syria and Egypt have done their best to keep a supply-fear premium in oil, but so much oil is being produced elsewhere in the world that it is diffusing the supply disruption threat.

Lately, Oil prices seem to trade in high correlation with the US stock market. When US stocks (as represented by the S&P 500 Index) bottomed in late May and early June of this year, oil hit the $77 per barrel mark. Those stock market worries seemed to have been about the possibility of a recession coming soon. To us at SCM, this infers that market participants believe that US economic growth, if it happens, will cause heavy additional use of oil and gasoline. Or it could mean that asset allocators and hedge fund managers are using oil as a trading vehicle to participate in market upswings. These thoughts raise some important questions.

First, where is the economic growth likely to come from in the US? Second, in what industries does the US have big competitive advantages over the rest of the world? At SCM, we believe that the backbone of US economic growth over the next ten years will come from our largest population group, the children of the baby boomers. There are 85 million boomer kids, slightly more than the 83 million baby boomers. They have been a little slower to get married, a little slower to have children and little slower to buy a house than previous generations. They are tech savvy and their attitudes associated with commodity usage have been formed in the last ten years. They are more likely to spend time online, shop online and socialize online. They are less likely to own two cars and less likely to have a landline phone when they do buy a house.

However, with hormones working like they always have and housing affordability the highest in my lifetime, we could see an explosion of household formation in the US over the next five years. Maybe, even “Jeff who lives at home” (recent popular movie) will buy a house. The boomer kids won’t have actors like Seth Rogen and Zach Galifinakis (playing unmarried slobs) as their favorite actors forever. Housing is starting to percolate in the US and you can almost feel the animal spirits start to build. We don’t believe there is any correlation between marriage, babies and buying a home with gasoline usage. Gasoline usage goes up when the kids get their own social life and that is a problem for ten years from now.

The other source of growth in the US is its dominant position in the connection between the virtual/technology world and the real economy. US Companies like Apple (AAPL), eBay (EBAY), Amazon (AMZN), Facebook (FB) and others are dominating the way technology is shaping how we live and spend money. These are US companies leading this phenomena and it is the fastest growing part of the world economy. It is not a sector of the economy which uses much oil and probably causes less oil usage per dollar of GDP produced.

We at SCM believe that supply and demand do matter when it comes to oil prices. We envision reduced demand from China and permanently lower demand in the US. Lower demand combined with spiking supply levels from all the new sources of oil spell lower prices to us. Historically, the US economy and US stock market are inversely correlated with oil prices. We’d like to think that is what comes about over the next three years. It could be the economic stimulus package we’ve been waiting for.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities we recommend will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

Tags: Asset Investments, Brazil, Capital Management, Dollar Price, Emerging Market, Energy Efficient Economy, Fastest Growing Economy, Gross Domestic Product, Last Ten Years, Michael Pettis, Mpg City, oil, oil and gas prices, Peking University, Personal Standpoint, Price Per Barrel Of Oil, Professor Michael, Russia, Sized Adults, Sized Car, Smead, Time Follower, World Economy
Posted in Markets | Comments Off

IMF’s Lagarde: World Economy Highly Unstable

Friday, June 1st, 2012

The IMF is raising its forecasts for global growth from levels it expected in January, but there is still a “high degree of instability” in the world economy, Managing Director Christine Lagarde says in an interview with the WSJ’s David Wessel.

Tags: Christine Lagarde, David Wessel, Global Growth, Imf, Managing Director, S David, World Economy, Wsj
Posted in Markets | Comments Off

Chuck Royce: Why the Rally Can Last

Tuesday, April 3rd, 2012

by Chuck Royce, Royce Funds

Can the current rally last through the end of the year?

I think it can. What’s interesting to me is that we’re seeing one of those rare occasions when one of our predictions for the market as a whole worked out almost exactly the way we thought it would. For a while now, we have been noting the disjunct between the very negative and alarmist headlines and the more optimistic view our own analyses and contacts with managements were revealing. It seemed to us as early as last September that the economy was in better shape than the conventional wisdom was suggesting.

“I think we’re on our way to a positive and satisfactory year.
I also believe that we’re on our way to seeing three- and five-year
average annual total returns that will look better than what
most investors have seen recently.”

There were—and are—problems that need to be worked out, but we were hopeful that eventually the world’s bankers and politicians would formulate solutions, at least for the most immediately pressing issues, such as Greek default. The announcement of a bailout plan for Greece created a great sense of relief throughout the capital markets. Once it became clear that Europe would not go bust, investors felt better about the growing stability in the world economy. This positive development, along with the improving economy and the underperformance of the stock market over the last five years, leads me to think that the rally can last. The year’s remaining quarters may not be as robust as 2012′s first three months, but I remain cautiously optimistic and still think that this decade will be better for stocks than the previous one.

So you’re still a strong believer in equities?

Absolutely. I think we’re on our way to a positive and satisfactory year. I also believe that we’re on our way to seeing three- and five-year average annual total returns that will look better than what most investors have seen recently. To me, it all comes down to equities remaining the most effective choice for assets that carry risk. I agree strongly with the notion that a carefully constructed stock portfolio is the best way to build long-term returns that can outpace inflation and preserve purchasing power.

Returns for the major U.S. indexes—and many around the globe—were closely correlated in the first quarter. When do you expect this to change?

It’s certainly more pleasant to participate in a correlated rally than it was last year to be part of a widespread bear market. I expect correlation to remain fairly high through the intermediate term, though I don’t see that refuting the argument that we still need to shop the market for what we think are the highest quality small-cap companies trading at attractive valuations. So as much as correlation has been a fact of life for most of the current market cycle, we continue to invest with an eye toward non-correlated equity results, particularly when looking at companies outside the U.S. We build our portfolios anticipating that they will outperform and, more importantly, provide strong absolute returns over the long term. At some point, we expect correlation to abate and more differentiated returns to materialize.

Do you still see quality stocks, regardless of market cap, as potential market cycle leaders?

We do. Quality as we define it—companies with strong balance sheets, positive cash flow, and high returns on invested capital—has done well on an absolute basis both in the current rally and since the small-cap high in July 2007. However, during the rally off the October 3, 2011 small-cap low, quality small-cap stocks have lagged. This hasn’t been altogether surprising since most rallies, especially those in the aftermath of the financial crisis, have not favored quality. However, our thought is that quality will likely begin to lead when we start to see more differentiated returns. When those investors who have been avoiding stocks return to the market, we suspect that many will be looking for those attributes that we typically seek.

Should there be room in asset allocation plans for global or international small-caps?

We think that any diversified asset allocation plan should include some global or international stocks. The reality is that we are in an increasingly global economy. Equity portfolios that hold mostly or exclusively domestic companies are invested in stocks that derive a substantial amount of revenue from outside the U.S. More important from our perspective is the vast size and return potential of the universe. We see it as too important an area to ignore.

What do you see as Royce’s strengths culturally?

We also believe strongly in eating our own cooking. Each of our portfolio managers is a large shareholder in the funds that he or she manages, which is an absolute necessity. I don’t think you can manage effectively without some skin in the game.

First, company culture is an important and necessary topic. It’s especially important for financial services firms in light of the op-ed piece that Greg Smith wrote recently in The New York Times. We have always cherished certain values here at Royce, and those values inform everything that we do. For example, our long-term orientation doesn’t simply apply to our portfolios, it also applies to the holding periods we have for stocks, the tenure of portfolio managers on our funds, the length of time we want all of our employees to be with the company, and even the objectives and tenures of the management teams that we meet with. We look for companies capable of establishing long-term goals for their businesses because we typically plan on holding companies for at least a few years. There are several that we have owned for more than a decade.

We also believe strongly in eating our own cooking. Each of our portfolio managers is a large shareholder in the funds that he or she manages, which is an absolute necessity. I don’t think you can manage effectively without some skin in the game. Our employees who are not part of the investment staff are also shareholders, so it’s a company-wide practice that we encourage. Somewhat related to this is the fact that many managers serve on multiple portfolios, which had fostered a highly collaborative culture. There are no rewards for having the best idea and no penalties for coming up with ones that don’t work. We evaluate our people with the same long-term standard that we use for portfolios, so each manager will have his or her share of hits and misses. Making mistakes is part of learning how to be successful, so we allow for that and are never shy about admitting when we’ve screwed up. We can’t expect shareholders to make a long-term commitment to us without being transparent about our process and practices.

Finally, I think that discipline and consistency are vital parts of our culture. Maintaining our discipline has been crucial to building long-term returns, whether we’re talking about the ’87 crash, the early ‘90s recession, the Internet Bubble or the 2008 crisis. Through all of those points and more, we stuck to what we think we do best. It wasn’t always easy, but our sense through each trying time was that eventually we and our shareholders would be rewarded for our patience.

Important Disclosure Information

The thoughts expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of micro-cap, small-cap and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see “Primary Risks for Fund Investors” in the prospectus.) Securities of non-U.S. companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic or other developments that are unique to a particular country or region. (Please see “Investing in Foreign Securities” in the prospectus.) Therefore, the prices of securities of foreign companies, in particular countries or regions may, at times, move in a different direction than those of securities of U.S. companies. (Please see “Primary Risk of Fund Investors” in the prospectus.)

Copyright © Royce Funds

Tags: Bailout Plan, Believer, Bust, Capital Markets, Conventional Wisdom, Decade, Disjunct, First Three Months, Gold, Greece, Last September, Optimistic View, Politicians, Quarters, Rally, Royce Funds, Shape, Stock Market, Stocks, Those Rare Occasions, World Economy
Posted in Brazil, Markets | Comments Off

A False Sense of Security (Hussman)

Sunday, March 25th, 2012

“The world economy has stepped back from the brink and we have causes to be a little bit more optimistic. But optimism should not give us a sense of comfort and certainly should not lull us into a false sense of security.”

IMF Managing Director Christine Lagarde, March 17, 2012

As we examine the present evidence relating to both the financial markets and the global economy, the aspect that strikes us most is the extent to which Wall Street continues to emphasize superficially positive data in preference for deeper analysis, to extrapolate short-term distortions as if they were long-term trends, and to misconstrue freshly printed wallpaper and thin supporting ice as if they were solid walls and floors.

Two propositions we heard last week were characteristic of this false sense of security. One was a remark by an analyst that stocks were in a “secular bull market” here. The other was a Wall Street “factoid” being passed around, suggesting that the “equity risk premium” on stocks has never been higher.

Let’s address these in turn. When people talk about bull and bear markets, they often use the terms “cyclical” and “secular.” One cyclical bull and one cyclical bear market comprise the normal garden-variety market cycle of about 5 years in duration (though with quite a bit of variation around that norm, see “notes on secular and cyclical markets” in Hanging Around, Hoping to Get Lucky ). Taking very broad averages, a cyclical bull market lasts about 3.75 years, averaging a trough-to-peak gain of about 150%, and a cyclical bear market lasts about 1.25 years, averaging a decline of just over 30% from peak-to-trough. If you do the compounding, you’ll observe that the typical bear market wipes out more than half of the preceding bull market gain.

However, those averages mask an additional source of variation, which depends on “secular” conditions. If you examine market history as far back as the late-1800′s, you’ll find that market valuations have moved in broad advancing and declining phases, with each phase lasting about 17-18 years in duration (that still should be treated only as a tendency, and there’s no reason I know for treating it as a magic number). As an example, stocks moved from extremely low valuations in 1947 to quite rich valuations by 1965, producing a long “secular” bull market where each successive cyclical bull market topped out at higher and higher valuation multiples. In contrast, from 1965 to 1982, valuation multiples went through a long contraction, where each successive cyclical bear market bottomed out at lower and lower valuation multiples.

The effect of these longer valuation “waves” is this: during long secular bull phases, the cyclical bull markets tend to be longer and more rewarding, and the cyclical bear markets tend to be shorter and less damaging. In secular bulls, the market is running with the wind at its back. The secular bull market period from 1982 through 2000 was a good example of this tendency.

In contrast, during long secular bear phases, the cyclical bull markets tend to be shorter and less rewarding, while the cyclical bear markets tend to be longer and more violent. In secular bears, the market is swimming against the tide. The secular bear period that began in 2000 has been a good example of this tendency.

As Nautilus Capital observes, the average cyclical bull market in a secular bear market period has produced an average gain of only about 85%, lasting less than 3 years on average. In contrast, the average cyclical bear in a secular bear has been unusually violent, averaging a 39% loss over a span of about a year and a half. Compound the two, and that’s enough damage to drag the cumulative full-cycle return down to just 13%, on average.

Needless to say, the assertion that stocks are in a “secular” bull market is really an assertion that investors can let down their guard, in the sense that downturns are likely to be muted and advances will be extended. But from our standpoint, if you’re going to pick a secular team, it would be best to have reliable data to back up the choice.

So what distinguishes a secular bull from a secular bear? Valuations. Not just any valuation measure however – it’s important to demonstrate that the valuation measure you choose actually has a strong and demonstrable long-term relationship with subsequent market returns (which is where Wall Street’s disingenuous use of toy models like simple price-to-forward earnings multiples and the “Fed Model” makes us nearly apoplectic).

Below, I’ve annotated our usual valuation chart to provide a better sense of what drives the long “secular” movements in the stock market. The chart uses our standard valuation methodology to estimate prospective market returns.

It should be quickly evident that secular bull markets don’t simply come out of the blue. They emerge precisely because stocks become priced to achieve extraordinarily high long-term returns. Both the 1947-1965 secular bull and the 1982-2000 secular bull began at points where stocks were priced to achieve 10-year returns of close to 20% annually. In contrast, the 1965-1982 secular bear began with prospective 10-year returns of just 5.9% (though slightly higher than the 4.4% yield on Treasury bonds at the time), and of course, the secular bear that began in 2000 emerged from bubble valuations, where we projected negative 10-year total returns at the time.

It seems to be an article of faith among some analysts that the 2009 low represented the start of a new secular bull market, but two features are noteworthy. The first is that the valuation achieved in 2009 was nowhere near the valuation that typically ushers in a new secular bull market. The second is that the brief undervaluation we observed in 2009 was quickly eliminated. At present, we project total returns for the S&P 500 of just over 4% annually over the coming decade. This is even worse than the valuation where the 1965-1982 secular bear started (though certainly less extreme than the 2000 peak). Though interest rates are lower today than in the 1965-1982 period, satisfactory returns from present levels will require investors to sustain rich valuations indefinitely.

Again, it’s worth emphasizing that our standard valuation methods are (and have remained) well-correlated with subsequent market returns – a very basic criterion that is painfully lacking among many popular valuation measures such as the Fed Model. It strikes me as absolutely bizarre that so many Wall Street “professionals” offer up the Fed Model and the “forward operating earnings times arbitrary multiple” approach so freely, when it takes nothing but some data and a few hours of effort to demonstrate that those approaches are nearly worthless (see for example the August 20, 2007 comment Long Term Evidence on the Fed Model and Forward Operating P/E Ratios – not that many analysts agreed with our valuation concerns at that point either).

A related assertion we’ve heard a lot lately is that “the equity risk premium on stocks has never been higher.” In the finance literature, the “equity risk premium” is essentially the return that stocks are priced to achieve, in excess of the risk-free interest rate. Of course, these estimates vary wildly depending on the method you use (many common ones which, again, have virtually no correlation with actual subsequent returns). A few popular methods include 1) the Fed Model (forward operating earnings yield minus the 10-year Treasury yield); 2) dividend yield plus projected earnings growth, minus the 10-year Treasury yield; 3) historical stock returns minus the 10-year Treasury yield, which is a particularly misleading measure of the returns stocks are priced to achieve in the future, or; 4) any of the above using the prevailing T-bill yield instead of 10-year yields.

Among the problems with these typical approaches is that stocks are not 3-month or 10-year instruments, but have a duration that is essentially the inverse of the dividend yield (so at present, the duration of stocks is roughly 50 years, compared with a 10-year Treasury, which has a duration closer to 7 years). So the appropriate “risk free” return in these estimates should really be either a Treasury yield of equivalent maturity – none which are available, or at least an estimate of the average expected short-term risk free rate expected over the same horizon. Needless to say, estimates of the equity risk premium get a false benefit if you use today’s unusually suppressed, short-duration risk-free rates.

The larger difficulty is the estimate of the prospective return on stocks. If you want to use a 10-year Treasury yield as a benchmark, you would also want to use a 10-year projected return for the S&P 500. On that note, and using reliable valuation methods (see above), the difference between the expected 10-year total return on stocks and the 10-year Treasury yield is presently less than 2% (nominal).

How does this compare historically? It’s notable that the estimated equity risk premium was severely negative during the late-1990′s market bubble. Not surprisingly, stocks have performed terribly versus risk-free Treasuries as a result. Excluding bubble-era data, we estimate that the normal historical equity risk premium (on a 10-year horizon) has been just over 6%, reaching 17% in the late-1940′s as a secular bull market was beginning, and holding in the 5-9% range even during the high-inflation 1970′s. Including the late-1990′s bubble period in the calculation brings the average down to just over 4.5%.

When has the equity risk premium been as low as it is today? Prior to the late-1990′s bubble period, the estimated equity risk premium has been below 2% only during the two-year period leading up to the 1929 peak, between 1968-1972 (when the equity risk premium finally normalized as a result of the 1973-1974 market plunge), and briefly in 1987, before the market crash of that year. We know how each of these periods ended. The only real variation is in how long the preceding overvaluation was sustained.

Profit margins and a false sense of security

One of the aspects of the market that is most likely to confuse investors here is the wide range of opinions about valuation, with some analysts arguing that stocks are cheap or fairly valued, and others – including Jeremy Grantham, Albert Edwards, and of course us – arguing that valuations are very rich.

The following chart may help to bridge that gulf. Essentially, analysts who view stocks as “cheap” here are invariably basing that conclusion on current and year-ahead forecasts for earnings. In contrast, analysts who view stocks as richly valued are typically those who view stocks as a claim not on this years’ or next years’ earnings, but instead are a claim on a long-term stream of deliverable cash flows. Simply put, there is presently a massive difference between short-horizon earnings measures and longer-term, normalized earnings measures.

What’s going on here is that profit margins have never been wider in history. But profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDP – where government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.

Now, if you look at the red line (right scale, inverted), you’ll notice that unusually high profit shares are invariably correlated with unusually low growth in corporate profits over the following 5-year period. Thanks to continuing deficits and extraordinary monetary interventions, this effect has been largely postponed in recent years, allowing profits to expand to present extremes. We are not arguing that profit margins necessarily have to decline over the near-term, and our concerns don’t rest on the assumption that they will. It is sufficient to recognize that the bulk of the value of any stock is not in the early years of earnings, but in the long tail of future cash flows – especially if payouts are low. Stocks are essentially 50-year instruments here in terms of the cash flows that are relevant to their valuation. There are a lot of factors and quiet math that affect the P/E multiple that can be appropriately applied to earnings. Slapping an arbitrary multiple onto elevated earnings reflecting extraordinarily inflated profit margins ignores all of it.

The upshot is that if investors are willing to believe (without the use of off-label hallucinogens) that current profit margins are the new normal, and will be sustained indefinitely, then Wall Street’s valuations based on current and forward earnings estimates can be taken at face value. This assumption of a permanently high plateau in profit margins is quietly embedded into every discussion of “forward earnings” here.

As a side note, analysts continue bemoan the “inexplicable” gap between the economic malaise of “Main Street” and the optimism of Wall Street. Compare the previous graph to the one below, which shows how the “Muppets” are doing (and people wonder why I’m cynical about corporate culture). An economy that is this far out of balance is one that is unlikely to avoid toppling over to some extent. Capitalism and free markets work, and America remains the most creative and innovative nation on the planet, but until policy makers and regulators wake up, it will be impossible to escape the long-term consequences of distorted markets, reckless bubble-seeking Fed Chairmen, repressively low interest rates that penalize saving and lower the bar for productive investment, a self-serving financial system, and bailouts that remove all consequences for misallocating capital that could otherwise create jobs and raise living standards.

The iron law of equilibrium

A final observation. We continue to hear endless variations of this comment – “The Fed is creating huge amounts of money, and all of that money has to go somewhere.”

Actually no, it does not. The iron law of equilibrium is that once a security is issued – whether that piece of paper is a share of stock, a bond certificate, or a dollar bill – that security has to be held by someone in exactly that form, and in no other form, until it is retired. If IBM issues one share of stock, that share of stock can change hands between any number of people, but someone has to hold that share until it is retired. If the Fed creates a dollar of base money, that base money can change hands between any number of people, but someone has to hold that dollar until it is retired. There is no “getting out” of cash and into stocks in aggregate. There is only an exchange of ownership between existing pieces of paper that will each continue to exist until each is retired.

So the proper question isn’t where all of these pieces of paper will go – they still have to be held by someone exactly as they are. They may change hands, but in equilibrium, they don’t go anywhere. They can’t go anywhere in aggregate. The only real question is this: how low do you have to drive the returns on all other competing assets until the “someone” holding that dollar bill has no incentive to try to trade it for some other piece of paper? This, precisely this, and only this, is what the Fed is manipulating with its massive interventions. By creating enormous amounts of paper, and hoarding higher duration securities like Treasury securities, the Fed is trying to force investors into risky assets until the prospective returns on all competing assets are driven so low that investors and banks holding cash are willing to just sit on it. In short, the Fed has focused its efforts on creating a bubble in risky assets, on the misguided, semi-psychotic, and empirically disprovable notion that this will make people feel wealthier and get them to spend and borrow – despite the fact that their incomes can’t support it without massive government transfer payments.

Aside from periodic jolts of enthusiasm that release some amount of pent-up demand for a few months at a time, what this policy has actually produced is near-zero prospective returns on nearly every class of assets. These assets will now go on to actually achieve tepid returns for an extended period of time, provided that things work out well, and a collapse in the prices of risky assets if investors ever get the inclination to demand a normal return as compensation for the risk they are taking.

Market Climate

The Market Climate for stocks remains characterized by an unusually hostile set of indicator syndromes, most notably, an “overvalued, overbought, overbullish, rising-yields” syndrome that has historically been unfavorable for stocks regardless of prevailing Fed policy or trend-following indicators. Even in recent years, the effect of Fed policy and other interventions has been evident after significant market weakness (essentially limiting the follow through and helping to re-establish rich valuations), but those interventions have not prevented the weakness itself – not in 2007-2009, not in 2010, and not in 2011. Our primary risk estimates are now in the worst 0.5% of what we observe in historical data. We have increasingly used the word “warning” in our weekly comments for that reason. Strategic Growth and Strategic International remain fully hedged. Strategic Dividend Value is hedged at 50% of the value of stocks held by the Fund, which is its most tightly hedged stance. Strategic Total Return maintains a generally conservative stance as well, with a duration of just under 3 years in Treasuries, and about 5% of assets allocated between precious metals shares, utility shares, and foreign currencies. I strongly expect that we will have significantly better opportunities to accept financial risk in expectation of return than the near-zero prospects the Federal Reserve has forced upon investors at present.

Meanwhile, our economic concerns persist, as detailed last week and in prior comments. Despite a low-level rebound in various coincident measures, we continue to observe general weakness in the most informative leading measures (as we saw again in data from Europe and China last week as well). Based on the typical lead-time of these measures, we are now in a window where we would expect deteriorating coincident data over the coming 2-3 months. As I’ve noted in prior comments, to the extent that we observe economic data coming in better than expected during this window, the inferred state of the economy is likely to improve, and we would then be able to suspend our recession concerns. Regardless, it’s important to recognize that our defensiveness about the stock market here is distinct from those economic concerns, and our risk estimates would remain quite high (based on factors including the prevailing overvalued, overbought, overbullish, rising-yields syndrome), even if we were to zero out our recession concerns.

Tags: Bear Market, Bear Markets, Bull And Bear, Christine Lagarde, Distortions, Equity Risk Premium, False Sense Of Security, Financial Markets, Garden Variety, Global Economy, Hussman, Imf, Market History, Market Valuations, Secular Bull Market, Sense Of Security, Source Of Variation, Term Trends, Trough, World Economy
Posted in Markets | Comments Off

Equity Gains Likely to Continue, But at a Slower Pace (Doll)

Wednesday, February 29th, 2012

by Bob Doll, Chief Equity Strategist, BlackRock

Markets Climb to 12-Month Highs

Stock prices rose again last week, although at a more labored pace than has been the case for most of 2012. For the week, the Dow Jones Industrial Average rose 0.3% to 12,982 (and did move above the psychologically important 13,000 level a few times), the S&P 500 Index advanced 0.3% to 1,365 and the Nasdaq Composite climbed 0.4% to 2,963. With these gains, markets have reached new 12-month highs and have rallied close to 25% from their low point of October 2011.

A Quiet Week for the Economy, But Good News Nonetheless

It was a relatively subdued week in terms of economic data, with the highlight perhaps being the weekly initial unemployment claims, which were unchanged (a stronger-than-expected result). This data helps confirm that improvements in the labor market have been gaining traction. This Friday we will see the February employment report and most economists are calling for a new jobs number of 200,000 or higher with a flat or perhaps slightly lower unemployment rate.

One area of the economy that has long been troubled is the residential housing sector, but this area of the economy is beginning to show some limited signs of improvement. New home sales, mortgage applications and home building levels are all showing some gains and the large inventory of unsold homes is beginning to clear. We believe that the housing market remains in the midst of a multi-year bottoming process that began in 2009 and we expect that residential construction will be a modest positive contributor to growth in 2012, as it was last year.

From a global perspective, the world economy has experienced a decent start to 2012, but the ongoing recovery does have some risks and question marks. Fiscal policy remains tight in some quarters of the globe and there is still room for easing (as we saw with the Bank of Japan’s recent decision to enact some new quantitative easing measures). Additionally, ongoing debt deleveraging remains a concern, as does the recent move higher in oil prices. Of course, we would also add the ongoing European debt crisis to the list of issues that could potentially disrupt the global economy’s positive momentum.

Climbing Oil Prices Spark Concerns

Several of the risks that we have been discussing for some time now have ebbed over the last several months, such as the removal of the uncertainty over the US payroll tax cut extension, some additional clarity over the Greek debt restructuring and China’s policy easing and likely economic soft landing. An additional risk, however, has surfaced in the form of higher oil prices. The oil price spike from early 2011 is fresh in investors’ minds and the recent advance in oil prices has some wondering whether history will repeat itself. Last year’s price spike came as a result of social and political unrest throughout the Middle East and in North Africa and this year escalating geopolitical tensions with Iran has been the primary culprit.

While higher oil prices are unambiguously a negative for global economic growth and have the potential to act as a drag on equity markets, the scale of the recent increase has still been relatively modest. To put it in context, oil prices have advanced by around 20% over the last few months. In contrast, oil jumped 50% between September 2010 and March 2011. While higher oil prices bear watching, we would not consider oil a significant risk unless the price increase grows more severe.

Further Gains for Stocks?

The impressive advance we have seen in stock prices over the past several months has largely come about from a string of positive economic news and the absence of the emergence of additional downside risk. In other words, a few months ago, stocks were priced for a weaker macro environment than the one that has come to pass. So what will it take for stocks to continue to move higher? We believe we would need to see some broader improvements in economic data and/or further political progress in terms of reducing macro uncertainty.

Regarding that second point, last week’s announced Greek debt restructuring deal should help reduce some uncertainty, assuming the measures are successfully implemented. There was little market response to the announced deal as it generally met investors’ expectations and there is still more work to be done on this front. We expect the situation in Greece to worsen from both a fiscal and social perspective, but we also believe that the debt restructuring will move forward.

Equity risk premiums have fallen in recent months as markets have rallied and we do believe that there is room for further advances. At the same time, however, we expect the pace of price appreciation to become slower and more uneven. As we have been saying for the last couple of weeks, we would not be surprised to see some sort of pullback or correction in the near term, but we also believe that stock prices will end the year higher than where they are today.

About Bob Doll

Bob Doll is Chief Equity Strategist for Fundamental Equities at BlackRock^® a premier provider of global investment management, risk management and advisory services. Mr. Doll is also Lead Portfolio Manager of BlackRock’s Large Cap Series Funds. Prior to joining the firm, Mr. Doll was President and Chief Investment Officer at Merrill Lynch Investment Managers.

You should consider the investment objectives, risks, charges and expenses of any fund carefully before investing. The funds’ prospectuses and, if available, the summary prospectuses contain this and other information about the funds, and are available, along with information on other BlackRock funds by calling 800-882-0052. The prospectus and, if available, the summary prospectuses should be read carefully before investing.

The information on this web site is intended for U.S. residents only. The information provided does not constitute a solicitation of an offer to buy, or an offer to sell securities in any jurisdiction to any person to whom it is not lawful to make such an offer.

Sources: BlackRock, Bank Credit Analyst. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 27, 2012, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Copyright © BlackRock

Tags: Bank Of Japan, Bob Doll, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Economic Data, Employment Report, Fiscal Policy, Global Perspective, Housing Market, Initial Unemployment Claims, Mortgage Applications, Nasdaq Composite, New Jobs, Question Marks, Residential Construction, Stock Prices, Strategist, Unemployment Rate, World Economy
Posted in Markets | Comments Off

Chanos: How China Could Fail the World Economy

Wednesday, February 22nd, 2012

1. Hedge fund manager Jim Chanos says slowing demand in China will continue and may have ripple effects around the global economy.

2. China skeptic Jim Chanos says the air has already started to come out of China’s housing bubble.

Source: CNNMoney, February 21, 2012.

Tags: China Air, China Economy, China Housing, Economy China, Global Economy, Hedge Fund Manager, Housing Bubble, Jim Chanos, Ripple Effects, Skeptic, World Economy
Posted in Markets | Comments Off

“2012 – The Year of the Dragon” (Saut)

Wednesday, January 4th, 2012

“2012 – The Year of the Dragon”

January 3, 2012

Tonight when I chase the dragon
The water will change to cherry wine
And the silver will turn to gold
Time out of mind

… Steely Dan, 1980

Year-end letters are always difficult to write because there is a tendency to either discuss the year gone by; or worse, try to precisely predict what is in store for the new year. Nevertheless, 2012 has arrived, and as the Year of the Dragon, I thought I would share these thoughts with you from California Psychics, written by Psychic Verbena (as paraphrased by me):

“The last Year of the Dragon, which occurred in 2000, was fraught with fear. There was a lot of hand wringing about the collapse of our technological world, the Y2K bug and other millennial prophecies that turned out to be more hype than bite. The Year of the Dragon is [here] and fear and trepidation are once more an issue. This time it’s the Mayan Calendar and the alleged 2012 Armageddon prophecy. Is the Chinese Year of the Dragon, which comes around every 12 years, truly something to be feared?

Unlike the wicked, fire-breathing dragons of Western mythology, China’s celestial dragon symbolizes potent and benevolent power. Dragons are ancient, majestic, wise, and intelligent, and Dragon years are considered particularly auspicious for new businesses, marriage and children. Dragon years also tend to boost individual fortunes and the world economy. It’s also true, however, that all five of the Chinese Dragon years — Wood, Fire, Earth, Metal and Water — tend to magnify both success and failure.

What influence might the Water Dragon, which rules from January 23, 2012 to February 9, 2013, have on the powerful energies already anticipated at that time? Like all Dragons, the Water Dragon is an innovative, fearless leader. But the Water Dragon is also far more sensitive to others’ needs, and is more likely to be progressive and diplomatic, as well as socially and environmentally conscious. Because Water bestows a more peaceful disposition, this Dragon will act wisely and intelligently, and unlike his fellow Dragons, is willing to set aside his ego for the good of all.

This Dragon is a successful negotiator, and while he is adept at marketing, he also knows how to apply force skillfully when necessary. … If you subscribe to the dawn-of-a-new-era theory of 2012, then it’s easy to see how the influence of the Water Dragon will increase the likelihood of success for progressive movements gaining momentum all across the globe. … But of all the Dragon years, the 2012 Water Dragon is most likely to bestow the Chinese Five Blessings of harmony, virtue, riches, and fulfillment and longevity, adding even more weight to the growing belief that 2012 will be about breakthroughs, not disasters.”

From Verbena’s lips to God’s ears because I am really pulling for a year steeped with “harmony, virtue, riches, fulfillment, longevity,” and “adding even more weight to the growing belief that 2012 will be about breakthroughs, not disasters.” As stated in last week’s letter, I remain steadfast in the belief there will be no recession, nor will Euroquake pull us into one. I also embrace the theme that the nation is moving in the direction of energy self-sufficiency and that an American manufacturing renaissance is taking place. Moreover, there appears to be the hint of a housing recovery, as well as a technology revolution. Combine these beliefs with the demographics of a baby boom echo, which should foster a new cadre of investors, and I think the S&P 500 (SPX/1257.60) will have a mid- to high-single-digit return in 2012. If you layer in a 3-4% dividend yield on top of said return, the allure of equities becomes pretty compelling.

However, that is not true for Barron’s requisite curmudgeon Alan Abelson, who writes in this week’s edition, “It’s so darn tough, try as we might, to dig up genuine cheerful news.” Barron’s Bellyacher goes on to lament, “Scouring the economic and financial landscape for bright spots can also be something of an exercise in futility.” To which I reply, “How can we all eat at the same table and then disagree about what’s been served?!” Indeed, of the 45 economic indicators I track only three are not showing stronger growth readings. Those three are Michigan Consumer Confidence, The Case Shiller Home Price Index, and The Average Work Week. More specifically, railcar loadings tagged new all-time highs recently, credit card delinquencies have plunged to a record low, regional PMIs (Purchasing Managers Index) are stronger, pending home sales are improving, job surveys are better, real retail sales are on track for a +7% rise quarter over quarter (annualized rate), and unemployment claims are falling. So I ask it again, “How can we all eat at the same table and then disagree about what’s been served?!”

Continuing on the fundamental tack, it’s worth noting there is a global interest rate easing cycle underway and that crude oil is back below $100 per barrel. These are not unimportant observations because every stock market rally since last summer has been thwarted when oil traveled above $100 per barrel. Moreover, with the extension of the existing tax and unemployment benefits, real GDP is more likely to approach 3% in 2012. Speaking to earnings, while fourth quarter earnings have yet to be reported, based on current estimates the SPX is on track to earn a record $97. Surprisingly, for the past 11 months my estimate for the SPX has been $96, yet many of Wall Street’s finest scoffed at such an optimistic number. My estimate for 2012 has been $106 for nearly a year, and I still feel comfortable with that estimate provided we don’t talk ourselves into a recession.

As for the technicals, by my work we experienced another Dow Theory “buy signal” last week when both the DJIA (INDU/12217.56) and the DJTA (TRAN/5019.69) bettered their October 2011 closing reaction “highs.” This week we may see another positive occurrence called a “golden cross,” that is if the DJIA’s 50-day moving average (@11934.29) crosses above its 200-DMA (@11946.57). That said, the NYSE McClellan Oscillator is short-term overbought and the stock market’s internal energy has not yet been fully recharged. Accordingly, after the equity markets pop their collective “corks” with an early January upside blow off, it would not surprise me to see a pullback attempt. One thing is for sure, the volatility remains legion, for as the eagle-eyed folks at the Bespoke Investment Group write:

“Throughout 2011, we made numerous mentions of the record number of ‘all or nothing’ days in the stock market. We define an all or nothing day as one where the daily net Advance/Decline reading for the S&P 500 is greater than +/- 400. Up until recently, these types of days were relatively rare and there were some periods where more than a year went by without any all or nothing days. In the last few years, however, we have seen an explosion of occurrences, culminating with this year’s record reading of 70 days! To put that number in perspective, from 1990 through 2004, there were only 67 all or nothing days!”

Such a volatile environment clearly calls for risk management and with these thoughts we wish you a healthy and prosperous new year.

The call for this week: Since the day after Thanksgiving I have stuck with the strategy that the Santa Claus rally had begun. On November 25th the SPX was changing hands around 1158. We are now 100 points higher. Consequently, I would not chase the dragon right here since I anticipate that an upside blow off is due …

Tags: California Psychics, Celestial Dragon, Cherry Wine, Chinese Dragon, Chinese Year Of The Dragon, Earth Metal, Fear And Trepidation, Fearless Leader, Fire Breathing Dragons, Gold Time, Mayan Calendar, Millennial Prophecies, Success And Failure, Technological World, Time Out Of Mind, Water Dragon, Wood Fire, World Economy, Y2k Bug, Year Of The Dragon
Posted in Markets | Comments Off

Sprott: Investment Outlook (October/November 2011)

Friday, October 28th, 2011

Oil or Not,
Here They Come

By Kevin Bambrough
Contributing Author: Paul Dimitriadis
Sprott Asset Management

Oil has been markedly absent in the financial headlines lately. While the recent clamor over EU solvency and weak global growth has temporarily displaced its media attention, oil’s crucial importance to the world economy has not dwindled in the slightest. Oil remains the world’s greatest single energy source today, providing over 1/3 of our energy supply. Although it is well understood that the oil price is critical to the global economy, we sometimes neglect to appreciate how tightly oil supply is correlated to global growth. By historical standards, the world has been coping with constrained oil production and high oil prices for most of the past six years. This tightness in oil supply has been a significant factor limiting global growth, and it would appear that no matter what financial solutions are eventually engineered by our politicians, global growth will remain significantly restricted by the real economy’s ability to produce oil. Limited global supply growth means that the Western world now faces significant competition for oil from emerging markets whose citizenry are willing to work much harder for far less. This will continue to result in a narrowing gap of per capita consumption between emerging and developed economies as the emerging economies continue to gain relative economic strength, wage growth, currency appreciation and purchasing power. We believe strategic investments in oil producers and service companies will offer an effective way to profit from this trend.

Production – Where’s the Growth?

We begin with a review of global oil production. We first wrote about Peak Oil back in 2005; and speculated that we were approaching the pinnacle of global crude oil production.1 As Figure 1 below illustrates, since that time, global oil production has grown very little, appreciating by a mere 2% in total production. This production plateau generated the 2008 oil price spike to nearly $150 per barrel. Subsequently, despite the economic stagnation experienced by developed economies, the price of Brent Crude Oil has averaged over $78 per barrel, four times higher than the ~$18 average that Brent traded at in the 1990s.2

Despite this extremely large and sustained increase in price, oil production has failed to grow meaningfully. Over the past ten years, most experts have consistently overestimated future production growth and have continually revised their forecasts lower as a result. Figure 2 from the U.S. Energy Information Administration (“EIA”) below charts production forecasts made in 2000, 2005 and 2010. Over the last decade the EIA has revised its global oil production estimates lower for 2015 and 2020 by 14% and 18%, respectively. In light of these downward revisions, it still seems extremely optimistic that supply will increase significantly in the coming years.

Figure 3 above illustrates that the International Energy Agency (“IEA”) estimates have been just as inaccurate, forcing it to reduce its global oil production estimates year after year.

Tags: Author Paul, Canadian, Canadian Market, Commodities, Crude Oil, Crude Oil Production, Dimitriadis, Economic Strength, Emerging Economies, Energy Supply, Financial Headlines, Global Economy, Global Growth, Global Oil Production, Global Supply, India, Investment Outlook, Oil Producers, Oil Supply, Outlook, Peak Oil, Solvency, Sprott Asset Management, Strategic Investments, Trend Production, World Economy
Posted in Canadian Market, Commodities, India, Markets, Oil and Gas, Outlook | Comments Off

The Economy and Bond Market Cheat Sheet (October 17, 2011)

Saturday, October 15th, 2011

The Economy and Bond Market Cheat Sheet (October 17, 2011)

The yield on the 10-year U.S Treasury note increased by 17 basis points to end the week at 2.25 percent.

Strengths

• Retail sales rose 1.1 percent in September, the largest gain in seven months and above the 0.7 percent consensus.
• The U.S Department of Agriculture announced Thursday that China had purchased 900,000 metric tons of corn. It was one of China’s biggest-ever purchases of corn on overseas markets.
• The NFIB Index of Small Business Optimism increased to 88.9 in September, the first gain in seven months, from Augusts’ 88.1 which was the weakest since July 2010. The index averaged 100.7 in the six-year expansion that ended in December 2007.

Weaknesses

• This week the International Energy Agency, the Organization of Petroleum Exporting Countries, and the U.S Energy Information Administration all lowered forecasts for oil demand in 2012, assuming a slowdown in global economic growth.
• New unemployment claims remain high.  New claims fell by 1,000 last week to 404,000, slightly below the 405,000 consensus, but claims at this level still suggest weak hiring.
• Economists polled by Reuters expect the rate of growth in the world economy to slow to 3.6 percent in 2012 from 3.8 percent this year.

Opportunities

• With the economy weak and concerns brewing about an additional financial crisis, the Fed will remain accommodative for some time and bonds appear well supported in the current environment.
• Globally central banks have become attune to the risks of a global slowdown and will likely act to bolster economic growth.

Threats

• The threat of a more significant global economic slowdown than many expected just a couple of months ago has increased sharply.
• The threat of another global financial crisis cannot be ruled out.

Tags: Basis Points, Bond Market, Bonds, Business Optimism, Central Banks, Department Of Agriculture, Energy Information Administration, Global Economic Growth, Global Economic Slowdown, Global Financial Crisis, Global Slowdown, International Energy Agency, Nfib Index, Oil Demand, Organization Of Petroleum Exporting Countries, Overseas Markets, Petroleum Exporting Countries, U S Energy, U S Treasury, Unemployment Claims, World Economy
Posted in Bonds, Brazil, Markets | Comments Off

Is Inflation the Answer?

Friday, September 9th, 2011

by Raghuram Rajan, a former chief economist of the IMF, is Professor of Finance at the University of Chicago’s Booth School of Business and the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy, the Financial Times Business Book of the Year.

CHICAGO – Recently, a number of commentators have proposed a sharp, contained bout of inflation as a way to reduce debt and reenergize growth in the United States and the rest of the industrial world. Are they right? To understand this prescription, we have to comprehend the diagnosis. As Carmen Reinhart and Kenneth Rogoff argue, recoveries from crises that result from over-leveraged balance sheets are slow and typically resistant to traditional macroeconomic stimulus. Over-levered households cannot spend, over-levered banks cannot lend, and over-levered governments cannot stimulate.

So, the prescription goes, why not generate higher inflation for a while? This will surprise fixed-income investors who agreed in the past to lend long term at low rates, bring down the real value of debt, and eliminate debt “overhang,” thereby re-starting growth. It is an attractive solution at first glance, but a closer look suggests cause for serious concern. Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.

Perhaps if a central bank announced a higher inflation target, and implemented a financial-asset purchase program (financed with unremunerated reserves) until the target were achieved, it could have some effect. But it is more likely that the concept of a target would lose credibility once it became changeable. Market participants might conjecture that the program would be abandoned once it reached an alarming size – and well before the target was achieved. Moreover, the central bank needs rapid, sizeable inflation to bring down real debt values quickly – a slow increase in inflation (especially if well signaled by the central bank) would have limited effect, because maturing debt would demand not only higher nominal rates, but also an inflation-risk premium to roll over claims. Significant inflation might be hard to contain, however, especially if the central bank loses credibility: Would the public really believe that the central bank is willing to push interest rates sky high and kill growth in order to contain inflation, after it abandoned its earlier inflation target in order to foster growth?

Read the complete article

Tags: Asset Purchase, Attractive Solution, Balance Sheets, Bonds, Booth School, Business Book, Carmen Reinhart, Central Banks, Chief Economist, Conjecture, Debt Overhang, Fault Lines, Financial Asset, Financial Times, First Glance, Inflation Target, Low Interest Rates, Market Participants, Raghuram Rajan, Times Business, World Economy
Posted in Bonds, Brazil, Markets | Comments Off