Equity Investing: From Style Box to Global Unconstrained (Pyne)
May 16th, 2012
Equity Investing: From Style Box to Global Unconstrained
by Andrew Pyne, PIMCO
- PIMCO sees greater potential benefit to global portfolios in strategies that are unconstrained by a benchmark, and with managers who think about absolute return at least as much as they think about relative return.
- We believe the style box approach resulted in too great a focus on returns relative to a very narrow index and led investors to have too short of an investment time horizon in which to evaluate their managers, and that the cycles of style performance and the narrow benchmarks in the style box world encourages manager turnover and undermines long-term portfolio return potential.
- Even though many managers have become less active, many continue to charge active fees, and as a result, we believe, the style-box framework basically became an expensive index strategy.
- At PIMCO, our active equity strategies are positioned for this evolving equity landscape. All of our strategies are global, unconstrained by the benchmark (seeking at least 80% active share), and consider downside risk mitigation as a critical part of the client experience.
Most investors are probably familiar with the “style box” approach to equity investing, but they may not know that the unintended consequences of this construct may result in underperformance.
In our view, style boxes have constrained managers and limited their opportunity set. Instead, PIMCO sees greater potential benefit to global portfolios in strategies that are unconstrained by a benchmark, and with managers who think about absolute return at least as much as they think about relative return. We believe that stepping outside the style box allows an active investment manager the opportunity to lower volatility and improve downside risk mitigation.
Inside the style box
Let’s quickly review how the style box was often constructed, simplifying to three basic steps.
First, the world was divided by region, style and market cap. Second, an emphasis was placed on the investor’s home market (in this example the U.S.), with international equity added for diversification. And third, managers were hired to fill a very specific and narrow role within the portfolio (see Figure 1).
For example, to fill the large cap value box, often several managers were hired – for manager diversification – and each manager typically was instructed to stay within that market segment. They were told not to drift down the market cap spectrum, as mid cap and small cap managers were playing those roles within the portfolio, and they were told not to drift over to growth, as that was the territory of other managers. And importantly, these managers were measured against a market cap and style specific benchmark, in this example the Russell 1000 Value index.
The attractiveness of the style box was twofold. In theory, it allowed investors to precisely control their equity exposures and to hire “specialist” managers who were expected to deliver strong performance in their specific area of focus. However, we believe this style box approach has failed investors.
Unintended consequences of the style box approach
We believe this approach resulted in too great a focus on returns relative to a very narrow index and led investors to have too short of an investment time horizon in which to evaluate their managers. By measuring managers against just a slice of the market, the cycles of style performance often dictated manager success.
Consider investor behavior in the technology bubble of 1999 to 2000. As tech stocks dominated the market, aggressive or momentum-oriented managers tended to outperform their more valuation-sensitive growth-at-a– reasonable-price (GARP) competitors. These GARP managers on average had good absolute returns that in many cases exceeded that of the broad market, but industry flows show that investors tended to hire the more aggressive growth managers to fill their growth boxes. As the bubble burst, though, the valuation discipline that kept many GARP managers largely out of tech stocks helped lessen, for many, dramatic losses. GARP managers appeared “smarter,” having navigated the tech bubble better, and as a result they eventually replaced the momentum players as the growth managers in many investment portfolios.
This dynamic of the timing of manager selection has repeated itself over time, as observed in a 10-year study of manager performance pre– and post-hiring and firing (Figure 2).
These charts suggest an element of performance chasing in the hiring and firing of equity managers. PIMCO believes that the cycles of style performance and the narrow benchmarks in the style box world encourages manager turnover and undermines long-term portfolio return potential.
Another drawback of the style box construct is that it may have been the catalyst for managers to “play the game” and become benchmark oriented. It seems many active managers recognized that assets and revenues were at risk if they deviated too far from the benchmark, and so they became closet indexers.
Research shows that managers have become less active over time (see Figure 3). According to Antti Petajisto of the NYU Stern School of Business, December 2010, thirty years ago, nearly all U.S. equity fund assets were with managers defined as “active” or “highly active,” based on their active share, or the percentage by which their holdings differ from the benchmark. The chart above shows the rise of index funds, which makes sense – we know there has been an increase in passive investing – but surprisingly, assets in closet indexers have grown at an even higher rate, such that closet indexers today represent approximately one-third of all U.S. equity fund assets! At the other end of the spectrum, assets in highly active managers, who tend to invest based on research conviction and do not have a benchmark orientation, have declined from 60% of overall fund assets to less than 20% today. In other words, it is easier to find managers that are benchmark constrained than managers that are highly active.
Even though many managers have become less active, many continue to charge active fees, and as a result, we believe, the style box framework basically became an expensive index strategy.
The dangers of benchmark hugging
The problem with a benchmark orientation is that it can cause managers to be reactive to the market. Consider that indexes frequently become distorted – think of the weighting of Japan in international equity indexes in the late 1980s, the weighting of technology in the U.S. equity and growth benchmarks in the late 1990s, and of financials in value benchmarks prior to the financial crisis in 2008.
The closet indexer defines risk primarily in benchmark terms, or tracking error, and therefore tends to follow the benchmark weights, i.e., buying more Japan equity as it becomes a larger part of the index, buying more technology and financials as they become larger parts of the index. While these managers are focused on minimizing benchmark risk, they may be creating significant absolute risk, and when these bubbles burst their investors learned the painful lesson that low tracking error does not necessarily mean low risk.
The performance problems associated with benchmark orientation and measuring managers relative to a narrow index can create a significant challenge for investors. A recent McKinsey & Company study (August 2011) cites a growing awareness that the structure and mindset that is entrenched in the investment management industry needs to change, that benchmarks create the wrong incentives, that manager focus should not be just on beating the index, and that fighting the relative investment mindset is a constant battle.
The case for global unconstrained
Why global? Remember that traditionally equity portfolios tended to be built with a home-market focus, with international equity added as a diversifier. However, correlations between stocks globally have increased over the last decade and have stayed at this elevated level (see Figure 4).
In addition, the lines between what it means to be a U.S company and a non-U.S. company are blurring, with over 30% of S&P 500 company revenues coming from outside the U.S., according to Goldman Sachs (2010). As the world has become more interconnected, and as diversification benefits fade, we believe the equity classifications of “domestic” and “international” have become outmoded. The implication is that as the world is evolving, managers who are not constrained to a specific region and have a global opportunity set may be better positioned to find the most attractive investment ideas regardless of company domicile.
Why unconstrained? Below we show a measure of performance of global managers vs. those that are regionally constrained and the performance of all cap managers vs. those that are market cap constrained (see Figure 5). The performance shown is the information ratio, or excess return over a benchmark, or alpha, divided by the standard deviation of that alpha. Information ratio is one of the risk-adjusted returns employed by consultants and institutions.
Tags: Absolute Return, Active Share, Benchmark, Benchmarks, Box Approach, Client Experience, Downside Risk, Equity Strategies, Index Strategy, Investment Manager, Investment Time, PIMCO, Portfolio Return, Relative Return, Risk Mitigation, Style Boxes, Term Portfolio, Time Horizon, Unintended Consequences, Volatility
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Technical Take: Market Internals Have Broken Down
May 16th, 2012
by Guy Lerner, The Technical Take
Figure 1 shows a weekly chart of the S&P Depository Receipts (symbol: SPY). The indicator in the lower panel is constructed from the 9 SP500 sector ETF’s (data hidden). The indicator assesses the relative strength of each sector utilizing a 13 week look back period. As you can see, the indicator is rolling over.
Figure 1. SPY/ Relative Strength/ weekly
Now look at figure 2 which is the same graph, but this time I have added an analogue of our “dumb money” indicator in the lower panel. (When the value is “up”, that means there are too many bears, which is a bull signal.) Going back to 2000, the breakdown in the indicator is associated increasing number of bears. The gray vertical lines indicate those two times where the breakdown in market internals failed to bring about the bears. As market internals (i.e., sector ETF’s) are breaking down, it is my expectation that investors will turn bearish. Shortly after that, it will be time to buy.
Figure 2. SPY/ Relative Strength/ Investor Sentiment/weekly
Taking another perspective, I still contend that it is too early to “BTFD”. Looking at this data, we still need to wait for investors to turn bearish.
Copyright © The Technical Take
Tags: Amp, Analogue, Bears, Copyright, Depository Receipts, Dumb Money, Expectation, Figure 1, Graph, Guy Lerner, Investor Sentiment, Investors, Nbsp, Perspective, Relative Strength, S&P500, Spy, Vertical Lines
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Credit Markets – Transformers vs Decepticons (Tchir)
May 16th, 2012
by Peter Tchir, TF Market Advisors
In the movies there are these great battles fought out between the transformers and decepticons. As cool as the battles are, there must be some innocent bystanders wondering what the heck is going on amid all the destruction. That to me is how the credit markets are trading right now.
None of the core stories have changed. Europe is a mess and has gotten weaker. The U.S. economy is doing okay, and ZIRP is here to stay even if QE3 isn’t imminent. Into that already complex world we have thrown the JPM trade into the mix. There seems to be a battle between JPM and those against JPM. That battle is causing carnage across the credit markets. We are seeing big and weird moves on a regular basis. IG gaps out while stocks do nothing. MAIN goes wider while XOVER is tighter, only to go back to moving in lock-step. JNK saw its single biggest share redemption. Both HYG and JNK chug along all day only to have big fades late into the day. MUB has a steep drop only to bounce right back. Whatever battle between the big guys is going on drags everyone else into it. Stop losses are being hit. The price move is causing concern that this is just like 2011 again.
It isn’t like 2011 right now for a couple of key reasons. The transformers and decepticons aren’t battling over the fundamentals, they are battling over positioning. That is real and has consequences, but once that battle is over, the market will look at the fundamentals. So that is one key difference, that in addition to the usual fight between the bulls and the bears, this massive unwind, or potentially fake unwind, or unwind of the hedge of the alleged unwind, or something, is adding to the volatility and making the fixed income market seem more scary than it is.
LTRO is the other big difference. For all the talk about LTRO being a “carry” game to buy sovereign debt, LTRO at its core was designed to ensure that banks have enough money. While the debate rages about what Greece will do, and how bad the situation in Spain and Italy is, there is virtually no talk about banks not being able to fund themselves. People can look at 2 year swap spreads for signs of stress, and they are there, but be careful not to over-react. LTRO is there so that we don’t see a “run” on the banks. I doubt another LTRO would be created merely to try and support sovereign debt, but if there is a need to get money to banks, the ECB will do that. The ECB, without a doubt, is lender of last resort to banks, and is happy and able to fulfill that functions, so that is a big difference between now and 2011.
Greece leaving the Euro would be a big deal because of what it would do for all the corporate loans that have been made. That is yet another reason that leaving the Euro will take more time than people want to think. Even if it was easy at the sovereign level, which it isn’t, and the corporate level it has the potential to cause immense confusion. All of this can be addressed over time, but real plans need to be put in place and solutions to problems thought out, and some resources set aside to deal with unexpected problems. While that preparation is going on, look for the ECB, and the Troika to soften their tone as they decide that they cannot easily deal with the losses they would face on their own Greek exposure.
So, I would be looking to add exposure to credit, particularly U.S. high yield, and possibly in IG, as I think the market has been driven around too much by noise of this alleged unwind (I still think there is a real possibility that prior to the press conference JPM prepared themselves well for the obvious market reaction and is benefitting greatly from the widening and the volatility).
The fact that we tried to rally and then failed yesterday is a sign of how tenuous the overall market is, but right now I can’t help but think the same stories will have less of an effect, and that we are close to the point where Europe manages to take some steps that at least seem to help the problems, if not resolve them.
Tags: Big Guys, Carnage, Credit Markets, Decepticons, Enough Money, Fades, Fixed Income Market, Great Battles, Hyg, Innocent Bystanders, Jpm, Key Reasons, Mub, Price Move, Sovereign Debt, Steep Drop, Transformers, Volatility, Weird Moves, What The Heck
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India's Temple of Gold
May 16th, 2012
Via Nic Colas of ConvergEx,
Summary: India is known for its historically high per capita demand for gold, particularly before festivals and the wedding season, which peaks in the months of October to December. With more than ¼ of the entire global world market for the metal, the country has long been leading world demand, though fellow BRIC member China is catching up. But recent developments in India have gold bugs stirring – protests, boycotts, and a proposal for a tax on the sale on gold jewelry has severely dampened demand ahead of one of the most lucrative festivals in the country. And with global gold prices down more than 10% since their February high of $1,787.75, there seems to be good reason to worry about India’s role in the decline. But a longer-term analysis of Indian demand, global gold prices, and global GDP yield some surprising results about the country’s connection to the metal. While acceleration in gold prices and Indian GDP seem to link up as do Indian demand and global GDP growth, increases in demand have little correlation to gold price growth. Similarly, rampant inflation has almost no role in stifling demand for the metal. If these correlations hold true in 2012, gold investors might be able to sleep a little easier.
Gold trend-adjusted seasonal performance...
Note from ZH: We did a little seasonality check (chart above — black dotted line) and noted three things: 1) 2012 (orange) so far is looking a lot like 2009 (green) — which neared its trough around this period; 2) Trend adjusted, the period from late February to early June is a weak cycle (red arrow on regression channel) which is followed by a trend-adjusted upwards bias through the summer; and 3) Trend adjusted, the period from mid-October to early December is a very strong cycle
Note from Nic: A recent article in The New Yorker about a surprising find in an ancient Indian temple got me thinking about gold, the subcontinent, and Charlie Munger’s recent comment that “Civilized people” don’t buy precious metals, but rather financial assets like stocks. Gold has, in fact, been in a bit of a freefall of late, so I asked Sarah to pick up these disparate thoughts and see where they lead. Her note, on Indian gold demand, follows here...
In the summer of 2011, while U.S. politicians were hotly debating the latest increase in the Federal debt ceiling, Indian authorities were facing quite the opposite situation: what to do with $22 billion worth of gold and rare jewels discovered under a temple in the southern state of Kerala. Rumors that the Sree Padmanabhaswamy temple sat on top of a horde of riches go back centuries, the result of millennia of donations to the gods, but the stories were only confirmed after a former Indian Police Service officer petitioned the Indian Supreme Court to order the opening of the temple to ensure “transparency in the running of the Trust” which overseas temple finances. The discovered wealth – which exceeds the annual education budget for the entire country – is now in limbo as two parties face off for ownership of the fortune. The Travancore Royal House, charged with the maintenance of the temple since the 18th century, assert that the riches belong to the gods they were offered to – and many Hindus in the region support their cause. Others think the wealth should be distributed to the poor; that $22 billion (and it could be far more once definitely valued) could potentially feed, clothe, and shelter every citizen of the region for years to come. The decision is ultimately up to the Indian Supreme Court, who have already stationed two dozen police officers around the temple for 24/7 surveillance. Just in case.
The $22 billion treasure found in Kerala is astounding, to say the least, but it represents barely half of the $46.4 billion Indians spent on gold in 2011. And while you may have read about Western central banks, Chinese citizens, and scores of other buyers for the yellow metal, India in fact outpaces every other country on the planet in gold consumption:
- In 2011, India was the clear leader in global gold demand with 27.1% of the market, according to the World Gold Council’s statistics.
- 61% of this spending went to jewelry, while 39% went to coins, bars, and other investments. This ratio has been converging for several years: in 2006 73% went to jewelry and 27% to other investments.
- China has been slowly closing in on the lead, however, with 22.3% of the global gold market last year. 67% of this went to jewelry and 33% to other investments.
- Gold ETFs got their start in India in 2007, and the seven such funds on offer to Indian citizens now have $1.9 billion in assets under management.
- The next closest country in the ranks after India and China is the US, representing a much smaller 5.7% of global demand.
Clearly, India and China together are imperative to the global gold trade, as they account for almost half of all global demand.
In fact, as we show in the charts following above and below and the few data points below, the gold trade is a useful proxy for Indian economic growth, and demand from both of these countries is strongly connected to global GDP acceleration.
- Annual Indian GDP acceleration or deceleration has a 0.4 inverse correlation with acceleration or deceleration in gold prices. In other words, when gold prices increase by a greater amount than the year before, it’s likely that Indian GDP will decelerate that same year. We’ve used the last six years as the baseline for this comparison, encompassing both the turmoil of the Financial Crisis in western economies and India’s volatile GDP growth rates of anywhere from 6–10% over the period in question.
- China’s acceleration, on the other hand, is virtually unconnected to gold prices with a 0.03 R² over the same period. Clearly India is significantly more dependent on gold’s price appreciation than their neighbors to the East.
- When this same correlation is lagged by one year – 2011 gold price acceleration matched up with 2010 GDP acceleration, for example – the correlation is essentially perfect: 0.9965. So if the Indian economy accelerated in 2011, you can probably expect gold prices to follow suit in 2012, and vice versa. In China, this correlation is much weaker at 0.53, but still significant for a one variable economic analysis.
- Annual acceleration and deceleration in Indian and Chinese gold demand also have an almost perfect correlation to annual global GDP growth: 0.94 and 0.95, respectively. Essentially, when demand in these two countries drops, based on this correlation you might see global GDP fall as well.
Given this data, it is understandably concerning to fans of the yellow metal that Indian gold demand has not been as robust as expected so far this year. Part of the slowdown is due to a series of shutdowns by gold merchants, who closed shop for 20 days at the end of March to protest a rise on an excise tax on gold jewelry sales and a doubling of the import duty on the metal to 4%. And though the excise tax is now off the table, by one estimate (from the Bombay Bullion Association) gold merchants were seeing 50% less volume than the year ago period just before the Akshay Tritiya festival in late April, a traditionally strong period for gold sales. Some of the decline can also be attributed to rising inflation, according to some analysts: at 7.18% year-over-year so far in 2012, the rupee is down 8% in dollar terms and therefore represents a diminished source of gold purchases which are dollar-based.
But there are several reasons not to be pessimistic about gold prices even with the recent relative decline in Indian demand:
- Gold prices are heavily correlated to the U.S. dollar – a strong greenback hurts gold demand around the world by lifting local prices. The Indian Rupee has fallen victim to the global “Risk off” trade in recent weeks, falling below 54/dollar for the first time since last December. At the same time, the Reserve Bank of India has reportedly launched aggressive interventions in the currency market to support the local currency. And while we’re reluctant to base any investment analysis on the counter-market moves of any central bank’s activities, there is a lot at stake for the RBI in this case. India, you see, has very little in the way of energy reserves and must import most of its oil – 80% by some counts – from overseas. And those products are also priced in dollars, just like gold. A stronger Rupee is therefore critical to continued economic growth, with gold demand in India an incidental beneficiary of this dynamic.
- China is more than making up for the loss. Indian demand dropped by –7.2% in 2011, from 1,006.3 total tons in 2010 to 933.4. Chinese demand increased 21.7%, from 666.8 to 811.2. That’s a net gain of 71.5 tons. And with an annualized demand increase of 22.9% since 2006, it’s likely that China may surpass India as the largest gold consumer in the world in the next few years.
There is even cause to be bullish, if our Indian GDP correlation can be believed. The IMF projects that the Indian economy will decelerate by –0.9% this year, to 6.9% from 7.8% in 2011. If we plug in this –0.9% deceleration into the formula derived from “Change in annual Indian GDP growth vs. change in annual gold price growth”, we find that gold prices may actually accelerate by 2.8% in 2012 – meaning they will grow an additional 2.8% to the 27.2% appreciation from last year, resulting in a 30% increase. Based on yesterday’s closing prices, that puts the metal at $2,022.15 – just above the $2,000 mark some analysts have forecast.
The thought that a decline in the rate of Indian economic output would cause an increase in local demand is not as tortured as it might seem. The appeal of gold is largely based on its long-proven value as a store of wealth. The vaults at the Indian temple where we started this note weren’t filled with IOUs from Roman traders or shares of stock from the old East India Company. That’s good news for the Hindu gods that first received these gifts, as well as their modern adherents who may benefit from the centuries of donations. Gold does hold its value over long periods of time, and no country has a better case study of that fact at the moment than India. So even if the economy there does slowdown in 2012, the resultant uncertainty doesn’t preordain a decline in gold demand. It may even help.
While none of this guarantees that gold will experience some kind of meteoric rise to $2k, especially given all the other factors that contribute to prices, I think it’s safe to say that the supposed softening demand in India shouldn’t be too concerning. China is emerging as a critical consumer of gold on the world stage, and may even surpass India this year if trends continue. The country has more than offset declines in demand from their southeastern BRIC partner, and has helped drive up world consumption at a time when many other countries – particularly our own – are dropping out. The US has bought 42% less gold than it did in 2006. So when it comes to declining gold prices, don’t jump to blame India. After all, it isn’t even wedding season yet...
Copyright © ConvergEx Group
Tags: Boycotts, Charlie Munger, Colas, Gdp Growth Increases, Global Gdp, Global World, Gold Bugs, Gold Investors, Gold Jewelry, Gold Price, Gold Prices, Indian Temple, Member China, Performance Note, Period 2, Rampant Inflation, Red Arrow, Seasonal Performance, Seasonality, Wedding Season
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Europe's Plan B, Greek Bank Runs, and Why We Need New Sunglasses (Grant)
May 16th, 2012
Via Mark J. Grant, Author of Out of the Box,
“I'm not upset that you lied to me, I'm upset that from now on I can't believe you.”
–Friedrich Nietzsche
The words were spoken by many; Juncker, the German Finance Minister, Merkel, Barroso, Monti and you can just keep going. They all said the same thing about the Greek PSI, “This is the best and final offer.” Each intonation was made with great moral suasion; each speech was directed toward the world’s institutional investors as we were reminded again and again that there was no “Plan B.” In the end most money managers swallowed the bitter pill, given such forceful pronouncements and took the deal offered on the $261 billion swap only to watch the value of the new bonds sink into horizon but no choice was given so there was nothing else, really, that could have been done.
“Trust ... plays a key role in economic exchange and politics. In the absence of trust among trading partners, market transactions break down. In the absence of trust in a country's institutions and leaders, political legitimacy breaks down. Much recent evidence indicates that trust contributes to economic, political and social success.”
–The scientific journal, Nature
Of all of the events of yesterday, of all of the news, the most significant in my view was the announcement that Greece had paid off the $554 million bond maturity that was due yesterday and paid it off in full; 100 cents on the Dollar. With approximately $6 billion left in international bonds outstanding governed under some law besides Greek law two things are now obvious; there was a Plan B and it was just implemented and that Brussels and Berlin supported the Greek pay-off as there was not one peep of objection from any capital in Europe. What we were told, consequently, was not the truth and no financial paradigm can last for long when they lie to investors and breach the trust that had been placed in them.
"If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia. That suggests that trust is worth $12.4 trillion dollars a year to the U.S., which, in case you are wondering, is 99.5% of this country's income.”
–Steve Knack, Senior Economist at the World Bank
With the yield on the Italian ten year hovering around 6.00% now and the yield on the Spanish 10 year fluctuating around 6.50% the markets are clearly reacting to the breach of faith that has been demonstrated by Europe. This morning the Prime Minister of Spain said that “Spain faces the serious risk of being shut out of the markets.” This comment, by the way, may be the precursor to Spain turning to the EU/ECB/IMF for help and then between the total breakdown in governance in Greece and a plea for financial assistance from Spain is a spot, a line in the sand, where not only Angels but any rational man should well have great fear to tred.
If indications become reality then we are faced with a leftist government in Greece that will either renegotiate a new bailout agreement with Europe or it will head back to the Drachma or be forced there by the refusal of European Union to provide any additional funds. In Spain we are faced with bare bones arithmetic where the country cannot bailout its Regional debt and its back debt because they do not have the capital to do either; much less both. Both countries can flop about for a brief period of time but the conclusions are unavoidable I am afraid and so a very unpleasant landscape awaits us in the coming days. I have warned about all of this for quite some time and I have hammered upon it in recent days as equities, credit/risk assets, the Euro have all declined in value as I had predicted. There may well be a bounce or two along the way but I continue to maintain that dark days lie ahead based not only upon fundamentals but based upon a union in Europe that has been deceptive in presentation and deceitful in practice. Much of this could have been avoided, should have been avoided, but whether it was the European bank stress tests, the inaccurate debt to GDP ratios or the statements on the Greek bailout; Europe has systemically, methodologically and purposefully tried and tried hard to mislead not only investors but the public in the most shameful of manners. The liabilities that they have deemed “contingent” which have not been counted or used as a part of any balance sheet are now beginning to come home to roost and the falsification by omission can no longer be denied as real losses are taken. The lies of the State always give way to the truth of the numbers in the end and the end is nigh on a number of fronts. Long live the Emperor without any clothes but the poor fellow is naked no matter what is said.
In the last 10 days there has been a run on the Greek banks with the President of Greece announcing this morning that almost $1.27 billion has been pulled from their coffers in the last 10 days. The same kind of situation is beginning in Spain as people and institutions react to the unfolding truth. Bloomberg reports this morning that Mr Papoulias said he had been warned by the central bank and finance ministry that the country faced “the risk of a collapse of the banking system if withdrawals of deposits from banks continue due to the insecurity of the citizens generated by the political situation”. Wolfgang Schauble, the German finance minister, stated his view quite clearly this morning, warning that unless Greece delivers a government that honors the terms of the bail-out, that “the country will have to leave the Euro.” Christine Lagarde, head of the IMF, warned she was “technically prepared for anything” and said the effect was likely to be “quite messy” with risks to growth, trade and financial markets. “It is something that would be extremely expensive and would pose great risks but it is part of options that we must technically consider.” If Greece defaults on its debts it is a $1.3 trillion dollar number, forget the drivel that you read in the press because it will not just be the sovereign debt but the municipal debt, the derivatives, the bank debt, the corporate debt and all of the obligations of the country that will fall into the sinkhole of no return.
Actually the correct response to all of this will surprise you. You must go out and get the correct pair of sunglasses. That is the answer.
“Joo Janta 200 Super-Chromatic Peril Sensitive Sunglasses have been specially designed to help people develop a relaxed attitude to danger. At the first hint of trouble, they turn totally black and thus prevent you from seeing anything that might alarm you.”
–Douglas Adams, The Restaurant at the End of the Universe
Tags: Absence Of Trust, Bitter Pill, Bond Maturity, Economic Exchange, Friedrich Nietzsche, German Finance Minister, Greek Bank, Greek Law, Institutional Investors, International Bonds, Intonation, J Grant, Journal Nature, Juncker, Market Transactions, Money Managers, Moral Suasion, New Sunglasses, Political Legitimacy, Social Success
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Month of May: Sell and Go Away, or Hang in There? (Sonders)
May 15th, 2012
May 14, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Key Points
- We believe the stock market's correction is likely to be less severe this year relative to 2010 or 2011.
- Be aware of the possible perils of following a "sell in May" trading strategy.
- For now, macro concerns—including Europe and the looming "fiscal cliff"—are trumping better micro news.
The stock market is in correction mode and investors are on edge. There are likely several reasons for the weakness, including what we pointed out in our early-April report on elevated optimistic sentiment. Since sentiment tends to work a contrarian magic on the market, we were anticipating a period of consolidation after the stellar six-month, 30% run off the early October 2011 low—and we're getting it.
Of course, we're also yet again dealing with the eurozone debt crisis, but also choppier economic indicators in the United States recently, a volatile election season and concerns about the so-called "fiscal cliff" heading into the end of this year. But one of the questions I've gotten most often recently has been about the seasonal phenomenon called "sell in May and go away," and whether the market's in store for another summer swoon like we've had the past two years.
Macro trumping micro
I'll start with "sell in May," but before I do, I want to address an important general observation. As we've noted many times recently in reports and media appearances; and as detailed in a terrific recent report by Wall Street research firm Wolfe Trahan, macro is trumping micro. One of the reasons for this is the decline in guidance investors are receiving from company managements.
In the past, guidance was often an anchor of reason in volatile times. Events like European elections or spiking eurozone sovereign bond yields might not have been such big market-moving events when we could rest on US companies' guidance as to the future. Add to that rapid-fire trading, shortened time horizons, greatly increased access to information, greatly increased speed of news' dissemination, and much more globalized economic and financial systems, and you have a recipe for increased volatility around macro events.
Sell in May?
Much is made every year of the "sell in May" phenomenon. Its basis is rooted in the fact that the best performance for the market has generally come in the November through April period, while the worst has come between May and October.
There is some truth to the adage. According to data compiled by Ned Davis Research (NDR), through the beginning of May this year the average performance for the period from May 1 through October 31 each year since 1950 was 1.2%. The average performance for the period from November 1 through April 30 each year since 1950 was 7.0%.
As compelling as those numbers may seem, there are many things to consider, especially if it's your inclination to develop a trading strategy around those seasonal patterns. First, the calendar months individually tend to fall into either the "hot" or "cold" columns for performance, as you can see in the table below. Three of the six months that fall into the "all out" period spanning from May through October are actually historically strong months, while three of the six months that fall into the "all in" period spanning from November through April are actually historically weak months.

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 © Ned Davis Research, Inc. All rights reserved.), as of 1928-April 30, 2012.
As you can see, all of the seasons seem to be adequately represented in both columns. And what we know for a fact is that time horizons have become much shorter over the recent years, and the reaction function gets triggered more often. It's likely that many investors may find their patience tested when experiencing either a great month (or two) during the May-October "all out" period and/or a poor month (or two) during the November-April "all in" period. Of course, the seasonal trading strategy must consider transaction costs and tax implications.
Sector performance May-October
For investors who like to take a tactical approach to the seasonal tendencies, a sector bias strategy may be worth considering. Before I get to the details, let me remind our clients that we moved toward a more sector-neutral strategy back in early April when we became more cautious about the market in the short term. Presently the only outperform rating we have is on the information technology sector, while the only underperform rating we have is on the utilities sector.
As you can see in the table below, courtesy of The Leuthold Group, cyclical groups have tended to outperform during the market's traditionally strong November-April period, while defensive sectors have been the relative winners during the customarily weaker May-October period. In fact, the size and persistence of these effects have been impressive (at least since 1989, the span of the analysis).
S&P 500 Sector Seasonality

Source: The Leuthold Group, October, 1989-April, 2012. Defensive sectors: consumer staples, health care and utilities. Cyclical sectors: consumer discretionary, industrials and materials.
Buy in May in election years?
There's also the rub of this being an election year, during which sitting out the May through October period has historically not worked well. Using the Dow Jones Industrial Average because of its longer history, the market has been up 4.5% during election years in the May-October span versus 2.6% for all years (including election years). And for what it's worth, according to NDR, the market has bucked seasonal weakness even more when the incumbent president has won, with a median gain of 7.6% versus 0.5% when the incumbent president has lost.
NDR provides a clue as to why this is the case: A correction has occurred during the second quarter of election years, on average (sound familiar?). But the correction has tended to be concentrated in the second quarter, setting the stage for a summer rally.
2012's positive offsets to present weakness
I actually think the scenario noted above is more likely than not this year. Muscle memory has many investors fretting a repeat of 2011 and 2010, when economic weakness in the spring led to brutal corrections each year, to the tune of –19% and –16%, respectively. But there's a long list of positive offsets this year relative to the past two years:
- Inflation is coming down, especially among commodity prices.
- Credit growth is quite strong, especially for consumers.
- Housing has improved markedly.
- The US manufacturing sector is humming.
- NFIB's small business survey made recent upside breakout.
- Job growth is much better.
- Consumer confidence is improving.
- Private-sector leverage ratios are much improved (debt servicing costs are extremely low).
- Recovery in state/local government spending.
- The US economy somewhat decoupling from rest of world; at least Europe.
- US bank capital/health is much better than Europe's.
- The European Central Bank's Long-Term Refinancing Operations have reduced likelihood of global financial contagion.
- Germany appears more willing to accept higher inflation, opening the door to easier monetary policy for the eurozone.
- Valuations are quite cheap, especially on forward earnings.
- Investor sentiment has improved sharply with the correction to-date (meaning pessimism has kicked back in).
I don't think the present correction is over, but do believe it could be kept to within the normal 5–10% range. Since the current bull market began in March 2009, the S&P 500 has had 15 corrections of more than 5% that were preceded by at least a 5% rally (consistent with this year's pattern). The table below highlights their duration and ultimate percentage drop.
S&P 500 5% Corrections

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 © Ned Davis Research, Inc. All rights reserved.), as of May 11, 2012.
Wall of worry being rebuilt
Tempering my short-term concern has been the aforementioned improvement in sentiment conditions. That said, I think there's likely a bit more pessimism needed to establish a short-term bottom for the market. As you can see, the well-watched NDR Crowd Sentiment Poll (CSP) has moved decisively lower, but not yet to the extreme pessimism zone:
Bye-Bye Optimism

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 © Ned Davis Research, Inc. All rights reserved.), as May 8, 2012.
NDR noted in a recent report several key reasons to expect the correction to be within the normal 5–10% range:
- Initial reversals in CSP extremes are consistent with median declines of about 8% within six months.
- The first half of election years have shown median declines of just less than 10%.
- Once "pre-waterfall" highs have been exceeded, as occurred in February of this year, median market declines have ranged between –3% and –7% within six months.
Saving the worst for last
I think investors and the media may be underestimating the impact the coming "fiscal cliff" is having on market and business psychology. The fiscal cliff refers to the near-simultaneous January 2013 expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester (automatic spending cuts) established in last summer's debt-limit agreement.
The range of estimates for its ultimate impact are, unfortunately, quite wide. The lowest estimate I've seen comes from NDR, using Congressional Budget Office assumptions, with the impact at a relatively "low" 2.4% of US gross domestic product (GDP). Most estimates tend to cluster around 3.5% of GDP.
It's impossible to know what's right because different assumptions are being used. But the consensus is closing in on a worst-case scenario of about 4% of GDP. ISI recently put the numbers into three distinct buckets, each with about $200 billion of impact:
- Provisions likely to create a fiscal drag (approximately (≈) $221 billion or 1.4% of GDP):
- Cuts to discretionary spending (≈$84 billion)
- Tax increases on upper-income Americans included in the Affordable Care Act (≈$21 billion)
- Payroll tax cut (≈$116 billion)
- Bush tax cuts (≈$200 billion or 1.3% of GDP, although likely impact would be spread over several years)
- Items unlikely to be allowed to take affect and thus aren't likely to create a fiscal drag (≈$179 billion or 1.1% of GDP):
- Huge increase in number of Americans paying the alternative minimum tax (≈$94 billion)
- Sequester cuts (~$85 billion)
There are three additional items that don't fall neatly into ISI's three buckets, including tax extenders, extended unemployment insurance benefits and the "doc fix," which would together total about $75 billion. These items are not expected to create a significant fiscal drag.
I actually think this is having a larger impact on psychology than many believe, especially on the confidence of corporate leaders and their ability to plan (and guide Wall Street's analysts) for the future.
Muscle memory may fail us this year
In sum, there's much to fret about, and volatility is likely to remain elevated until this correction has run its course. But a lot has changed in the past two years—much for the better—particularly for domestically oriented US companies. There's at least a little bit of decoupling underway, certainly between the United States and Europe, and that's likely to assist in keeping the correction from mirroring the ones in 2010 and 2011.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Tags: Anchor, Bond Yields, Charles Schwab, Chief Investment Strategist, Debt Crisis, Economic Indicators, Election Season, European Elections, Liz Ann, Media Appearances, Micro News, Perils, Seasonal Phenomenon, Senior Vice President, Sentiment, Stock Market, Swoon, Trading Strategy, Trahan, Volatile Times
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The Hidden Rally in Canadian Equities (Lee)
May 15th, 2012
The Hidden Rally in Canadian Equities
Using a Low Beta Strategy to Increase Portfolio Efficiency
Alfred Lee, CFA, CMT, DMS, Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
alfred.lee[@]bmo.com
May 15, 2012
Recent Developments:
- Canadian equities got off to a strong start this year with the S&P/TSX Composite Index (TSX) rallying 6.1% on a total return basis in the two months ended February 29, 2012. The optimism of a global economic recovery has stalled since then and Canadian equities have been weak as a result, with the TSX falling 6.6% on a total return basis. U.S. equities, on the other hand, which we have recommended overweighting over the last 16 months, have been more resilient in the face of the resurfacing of European sovereign debt issues. The S&P 500 Composite Index (SPX) was down only 0.5%, also outperforming the MSCI World Index's –3.5% loss since March 1, 2012. (Chart A)
- Traditional Canadian equity benchmarks have shown weakness as of late, given the large exposure to sectors such as energy and materials. These commodity intensive areas tend to be highly sensitive to economic conditions as they are widely used in construction and urbanization projects. With increased political gridlock, especially in the Eurozone nations, there may be less clarity in the direction of policy that will be implemented in addressing the economic malaise. As a result, commodity and commodity-related areas have recently shown both weakness and increasing volatility, despite the fundamentals in some sub-groups, such as copper, remaining favourable. The implied volatility levels of the TSX have recently moved above that of the SPX, as indicated by the S&P/TSX Implied Volatility Index (VIXC) and the CBOE/S&P 500 Implied Volatility Index (VIX) respectively. (Chart B)
- Though the fundamentals of the TSX remains attractive, with a current price-to-earnings (P/E) ratio of 13.8x, momentum has remained weak over the last several quarters. However, there have been areas within the Canadian equity market that have shown significant strength. On a relative level, the consumer discretionary, consumer staples, utility and health care sectors have all gained considerably against the TSX so far this quarter, which has largely gone unnoticed. Low beta sectors, or those that are less sensitive to market movements, have been strong year to date (Chart C). These areas, however, tend to be under-represented in major Canadian indices and also in the portfolio of many Canadian investors. Also, interesting to note, a comparison of relative strength trends, show that both the energy and material sectors underperformed the TSX even during the first quarter, when the appetite for risk was strong.
Investment Idea:
- The portfolios of many Canadian investors remain highly exposed to commodity related areas. While we are not suggesting that investors abandon commodities, especially considering that further stimulus would cause commodity prices to rally sharply, we are however recommending also adding exposure to less-cyclical areas to reduce potential volatility that may arise. Moreover, given the aforementioned relative strength trends, some traditional measures of Canadian beta may struggle as commodity related sectors have lagged the TSX. Investors should therefore have exposure to both commodity and non-commodity related areas to reduce volatility in their Canadian equity exposure.
- The BMO Low Volatility Canadian Equity ETF (ZLB) is an efficient way for investors to diversify into less cyclical areas and sectors under-represented in traditional market-cap weighted indices. Some of the largest sector weightings in ZLB are consumer staples (20.9%), consumer discretionary (12.5%) and utilities (11.0%). Therefore, ZLB may be used as a complementary position for many investors, giving them exposure to a wider range of sectors.
- In addition, given ZLB has a much lower beta than the TSX (0.48 vs. 1.00 respectively), it may be used as a complementary position to reduce equity volatility and potentially improve the risk-adjusted returns of an overall portfolio strategy.
Chart A: VIXC Has Moved Above VIX

Source: Bloomberg, BMO Asset Management Inc.
Chart B: VIXC Has Moved Above VIX

Source: Bloomberg, BMO Asset Management Inc.
Chart C: Market-Cap Weighted Indices Are Underweight Sectors That Have Outperformed

Source: BMO Asset Management Inc.
*All prices as of market close May 11, 2012 unless otherwise indicated.
Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual's circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.
BMO ETFs are managed and administered by BMO Asset Management Inc, an investment fund and portfolio manager and separate legal entity from the Bank of Montréal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unit holder that would have reduced returns. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.
Tags: Alfred Lee, Asset Management Inc, BMO, Canadian Equities, Canadian Equity, Cboe, Cmt, Composite Index, Debt Issues, Economic Malaise, Implied Volatility, Intensive Areas, Investment Strategist, Msci World Index, Political Gridlock, Return Basis, Sovereign Debt, Structured Investments, Volatility Index, Volatility Levels
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Key ETF Performance QTD and YTD
May 15th, 2012
The second quarter of 2012 has so far been a complete reversal of the first quarter. As of earlier this morning, just one stock-related ETF in our matrix below was up for the quarter — Utilities (XLU). Major US index ETFs are all down 4–5% for the quarter, while sectors like Energy (XLE) and Financials (XLF) are down 7%+.
International markets have done much worse than the US. Brazil (EWZ), France (EWQ), Germany (EWG), India (INP), Italy (EWI), Spain (EWP) and Russia (RSX) are all down double digit percentages since the start of April, and they're down 5%+ over the last week alone. The only asset class that is solidly in the green for the quarter is fixed income, which many investors shunned like the plague as recently as March. Oh how quickly things change.

Tags: asset class, Etf Performance, Ewg, Ewi, Ewp, Ewq, Ewz, First Quarter, Inp, International Markets, Investment Group, Percentages, Plague, Qtd, Rsx, Second Quarter, Sectors, Us Brazil, Xle, Xlf
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Jim Rogers: "Volume Is Not Going To Come Back. We've Had A Great 30 Years. That's Finished!"
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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Last Month a Disaster for Commodities
May 15th, 2012
I went to circle back today to look at what has been among the weakest areas of the market, and chart after chart came up in the commodity space. Here is a chart of the performance of the futures in various markets (mostly commodities) over the past month (via Finviz) and it's a mess. Ironically, natural gas – the most hated commodity of most of the first quarter, was the standout. Reversion to mean trade. Coal is not listed, but that group looks as bad as solar stocks… ironic since the latter was supposed to supplant the former at some point.
There is an in depth story on the sector in the WSJ today as well.
- Commodities fell to nearly two-year lows last week, measured by a widely used benchmark, prompting investors to ponder whether the massive rally that began in 1999 may be faltering.
- China is cooling down at the same time the U.S. is struggling to heat up, clouding the outlook for the world's two biggest consumers. And producers of some raw materials have ramped up supplies enough to create at least temporary gluts, particularly if appetites falter.
- For more than a decade, investing in commodities was practically a sure thing. Prices rose in nine of the 12 years starting in 1999. Even down years had explanations, such as the Sept. 11 attacks in 2001 and the global financial crisis in 2008.
- On Friday, the Dow Jones–UBS Commodity Index, which tracks futures contracts for 20 basic goods, fell 1% to the lowest level since September 2010. U.S. crude oil, gold and cotton—all components of the index—helped lead the way down, as each hit fresh lows for 2012. The index is down 4% this year after a 13% drop last year, putting it on track for the first consecutive declines since 1997 and 1998.
Tags: Appetites, Commodities Prices, Commodity Index, Commodity Space, Crude Oil, Declines, Dow Jones, Futures Contracts, Global Financial Crisis, Gluts, Investing In Commodities, Lows, Massive Rally, Natural Gas, Raw Materials, Sept 11 Attacks, Standout, Sure Thing, Ubs, Wsj
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What Now? And is There Anything New to Talk About? (Tchir)
May 15th, 2012
by Peter Tchir, TF Market Advisors
So now what?
Greece. Will they pay the bond due today or not? Will they form a new government or not? Does anyone care? That is becoming the question. The market is gradually becoming numb to the news. I don’t think Greece can leave just yet. It would cause too much confusion, and no one within Greece or outside has done enough to prepare. They will get some concessions. They will stick to the program for now. Europe needs an organized exit. A lot comes down to the ECB. They could make a lot of concessions, at almost no cost in their fantasy world of accounting, and take a lot of pressure off. Without a government, Papademos will continue the existing plan. The PSI bonds continue to be weak and are trading to epic disaster levels, but I guess they are about the only Greek thing out there that has enough value left to be worth shorting.
JPM has the shareholder meeting today. Never has there been so much noise over an announcement that isn’t even a full month’s worth of income. The other Morgan, MS lost money in Q3 and Q4 of last year and yet Gorman isn’t being asked to resign? Which is worse, to have 6 months of losses, or 1 month of breakeven? The entire conversation has become devoid of reality. The fact that it is CDS, Europe, Volcker, and Fortress involved has created a frenzy around the story that is blown all out of proportion. I have heard all the arguments about how the issue is bigger than the money, but that is a feeble argument. In a month, once the story has played out, people will look at the earnings, how little they play in the DVA game, how conservative their reserves seem, that they are buying back stock, and get a nice dividend yield, and like the stock. TFMkts Best Ideas took off the IG 9 10yr versus IG18 short and is likely to leg out of the HY17 versus HYG trade which at least in part had to do with JPM’s alleged position.
Spain and Italy are still real problems. Their economies remain weak and their banks are a total mess. We didn’t need Moody’s to tell us that (I guess better late than never on the part of Moody’s, though more and more people would like to see Moody’s and Never be a used together a lot). In spite of how bad it is, we seem to have reached a crescendo for this round of selling. Without ECB intervention in the bond markets, I don’t see any catalyst for a big move tighter as there are no natural buyers, but there are also few natural sellers left, other than shorts, and certainly Spain is getting to the point that fear of ECB intervention makes piling on a very dangerous proposition. A period of stability could cause a nice wave of CDS selling as the short base has grown and the reality of how expensive it is to short these countries kicks in. There was some talk about smashing together 4 bad banks and making one gigantic bad bank. I really have no clue what that would do, but it would be viewed as “taking some action” and markets like “action”. Although nothing is resolved, and I think most scenarios lead to another round of weakness, the current sell-off seems to have reached a peak and is likely to rally on any good news, no matter how feeble. With Spanish stocks being universally shunned, TFMkts Best Ideas has on IBEX versus the DAX. TFMkts Best Ideas covered Italian short yesterday and is now completely out of Spanish and Italian bond shorts. It is short the 10 year bund, and really thinking of selling CDS on Spain.
China had mediocre data all last week that didn’t seem to come into play. China eased and no one seemed to care. As talk about JPM and Europe winds down, China could have a big influence on the market again. Again, I doubt the rate cut will do much, but since that is recent, the market may gravitate to that, especially if they are able to conjure up some data that the “soft landing” crowd can glom on to. I remain relatively neutral on what sort of landing China will have, but after the rate cuts, and last night’s bounce, China may help any rebound story.
The U.S. economy, only a few weeks ago was at the core of the bull story. Now no one is talking about it. For those of us who thought the 1st quarter data was overstated and wasn’t reflective of the real economy, it looks like we were right. The economy is allegedly slowing down on many fronts. I use the term “allegedly” because I think it was never that strong, and might not be quite this weak, so the slowing is a function of data adjustments. The economy, I believe has been more stable than that, and chugging along at a mediocre, but stable pace. The data is weak enough to keep ZIRP in place even if not weak enough to warrant QE3. But not so bad that companies can’t generate some profits. High Yield and Leveraged Loans remain attractive to me though expect a bit more volatility as the JPM unwind continues. While the IG9 long position has attracted the most attention recently, there were positions across a variety of indices across the globe, including positions in the high yield market. They may also have loans they choose to sell to monetize some gains and because they had to reduce the size of the hedge against them. TFMkts Best Ideas has longs in S&P, IG18, and a treasury short. If anything I will be looking to add risk here.
The morning trading is half hearted at best. Early rally, faded, re-rallied, re-faded. I think that description applies to virtually every “risk-on” asset out there. The markets are still a little better across the board, but no enthusiasm. With all the uncertainty, and the weakness over the past week, that makes sense. I’m not sure the market is going to be squeezed higher without some real news or big liquidity injection, but right now, it feels that a lot of the bad news has been absorbed to the point that a drift higher is the next direction, though with some headline induced gaps up and down.
Copyright © TF Market Advisors
Tags: Bonds, Concessions, Confusion, Dividend Yield, Earnings, ECB, Fantasy World, Fortress, Frenzy, Gorman, Ig, Jpm, Losses, Proportion, Psi, Q3, Q4, Shareholder Meeting, Tf, Volcker
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Berkshire 2012: The Times They Are A-Changing and Other Observations (Matthews)
May 15th, 2012
Berkshire 2012: The Times They Are A-Changing and Other Observations<
Editor’s Note—
This year we’re utilizing a shorter, snappier way to summarize the Berkshire Hathaway annual meeting as a way to spare readers the redundancies in Buffett and Munger’s question-and-answer session.
After all, the commentary overlap with past meetings is probably 75% nowadays—we’ve even developed a sort of Berkshire shorthand for our note-taking, writing simply “Graham story” when Buffett launches into his dissertation on the importance of certain chapters in Ben Graham’s “The Intelligent Investor,” for example; “MBA joke” whenever Buffett or Munger make fun of the meaningless (and dangerous) risk-evaluating models of the academic world; and “IBK joke” when they go after investment bankers, another favorite target.
Nevertheless, the meeting was, as always, interesting.
For one thing, attendance was down, noticeably, even if Buffett wouldn’t say so—probably a side-effect of his high, and highly controversial, political profile these days. Also, there was the added (and, we thought, welcome) presence of insurance analysts asking questions for the first time since the very old days when a few professionals would show up at the Berkshire cafeteria and fire away.
Overall, there was a detectable “thrill is gone” sense hanging over the weekend. Buffett himself did not show up at some of the side-parties that many of his most loyal shareholders routinely schedule, as he did in the past, and even the press complained about the tight restrictions on their cameras.
But Charlie Munger, pushing 90, was in great form, and Bono was spotted in the crowd, a step up from last year when George Lucas made it.
So there.
—JM, May 2012
Berkshire Hathaway 2012
Biggest Change: Tighter security and more of Buffett The Analyst than Buffett The New-Age Spiritual Guru.
Gone, unfortunately, was Buffett’s pre-meeting stroll to a seat in the middle of the floor of the arena to watch the kick-off movie (instead he was kept inside the Board of Director’s gated pen, up front near the stage, where beefy guards with earpieces and zero smiles stood watch).
Gone, fortunately, were questions like “What should I do with my life?” and “Do you believe in Jesus Christ and do you have a personal relationship with God?” (That was actually asked—and answered by Buffett—a few years ago: you can read the answer in our book.)
Best Change: Three insurance analysts asking geeky business questions about Berkshire’s operations—the first time in years Buffett has been questioned in depth about the guts of Berkshire Hathaway.
And while there was grumbling from the sightseeing-types in the crowd about the technical discussion (as well as from ace financial analyst/money manager John Hempton, who thought it was not technical enough and wrote about it here, although I knew what John thought before he wrote that because I sat with him), the fact is Buffett has gotten away with very few hard questions about Berkshire’s operations in the years since he became a CNBC staple.
Expect fewer attendees next year, and the year after, and the year after…but better questions.
Most Fun: Getting to see and hear Warren Buffett discuss the insurance businesses in detail thanks to those geeky questions. He didn’t create the track record of a lifetime by luck.
Least Fun: Two rants, both by people from Boston (where else?)—one about the Liberty Mutual scandal and the other about Fannie Mae/Freddie Mac, both of which Buffett and Munger handled far more patiently than the crowd.
Also, way too many questions about Berkshire’s lagging stock price (it’s a conglomerate with a bunch of low P/E business for gosh sakes, not a closet mutual fund run by Warren Buffett any more.) Speaking of which...
Most Delicious Moment: Charlie Munger blowing off a well-known hedge fund manager who used the microphone to talk up Berkshire’s stock before lobbing a softball, “what-am-I-missing” type of question about the lagging stock price.
Rather than respond in Typical Public Company CEO Fashion about how Berkshire was “executing its strategic objectives” or complaining the stock was “not reflecting the underlying values of the business” or reassuring us that management would “pursue all means to enhance shareholder value,” as most CEOs would do, Munger simply said: “I wouldn’t worry too much. I think you aren’t really welcome in this room if that sort of short-term orientation turns you on.”
And that ended the discussion about Berkshire’s stock price.
Least Appreciated Line: “If you make your buy and sell decisions based on what a business is worth, you’ll make money.”—Warren Buffett.
Most Appreciated Line: (In response to a question about succession at Berkshire after Buffett’s death.) “The good fortune is not going to go away just because Warren happens to die. It won’t help him, but...”—Charlie Munger.
Weirdest Moment in the Opening Movie: The cartoon, in which the University of Nebraska football team (Buffett’s favorite) plays a University of Washington team made up of robots coached by failed/disgraced presidential candidate Herman Cain. (I am not making this up.)
Worse, during his half-time pep-talk, Coach Cain made a bunch of 9–9-9 jokes and then urged his men to hit hard, yelling “Take that, sucka!” like a, well, like a stereotypical African-American.
Who thought that would be funny?
Best Comment on the Opening Movie: “Are they that corny every year?”—John Hempton.
Oh Puh-leeze Moment: When Warren Buffett defended “the Buffett Rule” with talk of “shared sacrifice” and the curious claim that his rule applied only to “a very few” people, meaning those with “the 400 largest incomes in the U.S.” which of course is no longer the case, as everyone in the place knew.
You-Could-Hear-A-Pin-Drop Moment: When Buffett casually said Todd Combs and Ted Weschler, the recently hired money managers at Berkshire, are being paid “one million dollars a year,” plus incentive fees. Buffet’s no fan of “shared sacrifice” when it comes to incentivizing his own moneymakers…
A Lesson For Every Money Manager Department: Buffett’s revelation that in all of his and Munger’s years of managing Berkshire together (47 and counting), “We’ve never talked about macro stuff.”
Most Surprising Applause Line: Becky Quick’s question on behalf of a man who first noted that his 84 year old father wouldn’t buy Berkshire stock because of Buffett’s constant yapping about a Buffett tax, and then asked what impact Buffett’s high profile might be having on the stock price. (This got spontaneous, fairly loud applause despite the Buffett-friendly crowd.)
Least Surprising Applause Line: Buffett’s response to the young man, which was “I don’t think anyone should have their citizenship restricted” simply because they run a public company, plus this zinger about the young man’s 84 year old father: “Maybe he oughta own Fox.” (This got louder applause than the question, naturally.)
Feel-Good Question, Literally and Figuratively: From Andrew Ross Sorkin, on behalf of “many” in the crowd who had urged him via email to ask, “Warren, how’re you feeling?”
Feel-Good Answer, Literally and Figuratively: Buffett’s response to Sorkin, “I feel great.”
Best Munger Retort: (To Sorkin after Buffett said “I feel great.”) “I’m jealous. I probably have more prostate cancer than he does.”
Least Interesting Question: About gold. ‘Nuf said.
Most Interesting Question: “How do the large sovereign debts get balanced, and do they concern you?”
Buffett’s answer was, “I don’t know how it plays out in Europe…I would totally avoid buying medium or long term government bonds.” Munger added, “He’s asking the really intelligent question of the day and we’re having a hard time answering it.”
For the record, this “really intelligent question” actually drew applause from the crowd when it was asked, which tells you what’s on people’s minds regardless of which party they’re voting for in November.
Also, for the record, the fellow who asked it was from Boston, which just goes to show not everyone in that Commonwealth is certifiable.
Least Convincing Answer: Buffett, asked by the fearless (and good friend of Buffett) Carol Loomis whether buying the Omaha World-Herald newspaper was “some self-indulgence?”
The Oracle spent a good five minutes explaining how the paper “still tells me some things I can’t find out about elsewhere,” such as—and I am not making this up—the obituaries and the wedding notices. Nobody was buying it.
Most Convincing Answer: Buffett and Munger, when asked by one of those geeky insurance analysts whether Berkshire would ever be subject to the Investment Company Act of 1940.
Buffett said he’s read the Act “20 times” (and when Buffett says he’s read something 20 times, he’s not kidding), and “I see no way Berkshire comes close to that.” Munger said flatly, “We are NOT just an investment company.”
Something Every Investor Should Always Keep in Mind: Asked about why Berkshire keeps such a large cash reserve, Buffett said, “We don’t ever want to go back to ‘Go.’”
Worst Answer: Buffett, when asked how Amazon.com will affect Berkshire’s various businesses, said, among other things, “It won’t affect Nebraska Furniture Mart.”
Best Answer: Munger, to the same question, “I think it’s terrible for most retailers—not slightly terrible, really terrible.”
Most Concise Answer: Munger, when asked how a business can “build barriers” around itself: “It’s tough. We sort of buy barriers, we don’t build them.”
The Single Most Revealing Comment About What Made Berkshire A Growth Stock And Why It Is No Longer One: “There were times when Ajit [the genius who runs Berkshire’s reinsurance business] would generate billions of float and Warren would generate 20% returns on that float, and that would happen over and over and over…and that was fun.” —Charlie Munger
One More Mungerism Before We Go: “I rejoiced the day I got rid of a stock quoting machine. I like this idea of owning businesses forever.”
And Warren Buffett’s Successor as CEO of Berkshire Hathaway Is Who? The answer is clear. Read all about it in the forthcoming 99c mini-eBook on Amazon.com, “Buffett’s Successor: Who it Will Be, Why it Matters.” To be published by eBooks on Investing this summer.
Jeff Matthews
Author “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”
(eBooks on Investing, 2012) Available now at Amazon.com
© 2012 NotMakingThisUp, LLC
Tags: Academic World, Answer Session, Berkshire Hathaway, Berkshire Hathaway Annual Meeting, Buffett, Charlie Munger, Dangerous Risk, Insurance Analysts, Intelligent Investor, Investment Bankers, Jeff Matthews, Loyal Shareholders, Political Profile, Redundancies, Shorthand, Spare Readers, Spiritual Guru, Target, Tight Restrictions, Tighter Security
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Balance, Grasshopper (Saut)
May 15th, 2012
by Jeffrey Saut, Chief Investment Strategist, Raymond James
May 15, 2012
I received so many requests to put last Tuesday’s verbal strategy comments into written form, and that’s exactly what I have done this morning. To wit, I was always entranced with the 1970’s TV show “Kung Fu” starring David Carradine as Kwai Chang Caine. The show centered on an orphaned American boy (Kwai Chang) that is admitted as a student to the Shaolin temple in China. There his mentor, Master Po, teaches him the ways of the Shaolin priests. In addition to learning the martial arts Kwai Chang, affectionately named “grasshopper,” is also instructed in the ways of life. In one such lesson Master Po says, “Balance, grasshopper, balance” – implying that everything in life needs to be “in balance.” Similarly, investors’ portfolios need to be “in balance,” or more appropriately rebalanced periodically.
Portfolio rebalancing, when done correctly, is an art form. Simply stated, portfolio rebalancing is the strategic redistribution of asset classes within a portfolio to keep said portfolio’s objectives in line with its original objective. As John Valentine, of Valentine Capital, notes:
To provide a simplified allegory, think of investment planning for the future as an automobile, conveying an investor to his or her financial goals. The investment portfolio is its motor, the asset allocation model is the fuel mixture and the assets invested are the fuel. The more efficiently the motor runs, the greater the speed with which the whole vehicle travels toward the destination. Should the fuel mixture, or asset allocation run too rich, the motor wastes precious fuel. Should it run too thin, the car has trouble achieving enough forward momentum. ... Many individuals on the road to their financial goals fail to make these periodic adjustments and still eventually arrive. Not surprisingly, the investor who rebalances his portfolio at regular intervals may arrive sooner and with more fuel in his tank. ... Rebalancing a portfolio is crucial to the investor seeking to reduce the volatility in a portfolio and increase cash flow simultaneously. ... The longer a portfolio is left unbalanced, the more compromised its asset allocation may become. There are two potentially negative repercussions associated with a compromised allocation. Being overexposed to the downside and underexposed to the upside. Don’t let this happen to you!
Regrettably, most individual investors don’t have the discipline, or the skill sets, to actively rebalance their portfolios. That’s why individuals are best advised to seek professional assistance in rebalancing their portfolios, or for that matter seek a professional advisor to help them with all of their investment needs. Manifestly, correct asset allocation can increase investment returns and lower risk when “bets” are scaled to the advisor’s skill level. Most good investment professionals have successful “hit rates” of around 60%. That means they make a lot of mistakes and therefore should make smaller allocation bets. History suggests that large bets will eventually cause large losses and the end of an asset allocation program. Nevertheless, most clients and many advisors want to make bigger bets than their provable skills justify.
Clearly, asset allocation plays a key role in the investment process; however, I have some other thoughts I think you should consider. For example, a lot of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (growth, value, foreign, small cap, etc.) and/or sector performance. Since opportunities by style and sectors tend to regress, past performance is often negatively correlated with future relative performance. Still, many investors feel compelled to go with past performance and therefore rotate into previously strong styles, and strong sectors, which then regress leaving them with losses. A good advisor can mitigate this tendency, but a good advisor is harder to pick than a good stock.
To this point, good advisors often internalize decisions while amateurs learn all the rules and procedures. It follows that amateurs can often precisely explain what they are doing and why they are doing it. An expert, however, often just knows when they are right. Since investors typically want to hear a logical and clear-cut investment process, many tend to end up with an eloquent amateur rather than a sometimes-incomprehensible expert. Ladies and gentlemen, never underestimate the effectiveness of an eccentric or unusual advisor since “knack” tends to win out over learned skill in the investment arena. Most important is getting the big picture right and the best long-term predictor of future “big picture” equity returns is the current value of the market – things like, price/earnings, price/dividends, price/sales, price/replacement cost (Tobin’s Q ratio), etc. Currently, all of these measurements indicate the equity markets are reasonably priced.
To this rebalancing portfolios point, I recommended doing so after the “buying stampede” ended in late January. My suggestion was to raise some cash before the envisioned 5–8% correction. At last Wednesday’s intraday low the S&P 500 (SPX/1353.39) was off 5.5% from its April 2 high, and in my verbal strategy comments I recommended starting to put some of that cash back to work in equities. While the “set up” wasn’t perfect, because we never got that pornographic plunge type of hour into the 1320–1340 support zone, at Wednesday’s low of ~1343 the SPX was close enough for government work. Moreover, the NYSE McClellan Oscillator was probing oversold territory (see chart on page 3) and there was a huge downside non-confirmation. Verily, last week the SPX broke below its April 10 reaction low of 1357.38, yet all of the other indices I monitor did not violate their respective recent reaction lows (read: downside non-confirmation). Then there is the continuing divergence between the McClellan Oscillator and the pricing action of the SPX, which often occurs at an intermediate-term bottom. And, then there was this from my friend Jim Kennedy, captain of the astute Atlanta-based hedge fund consulting firm of Divergence Analysis, whose proprietary stock market analyzing software I use and embrace:
After we sent out our email prices continued to slide last Friday. At the close, our S&P 500 and NYSE models closed the day with some divergence bottoming signals. Monday should be the test as to whether prices hold here and rally, or fail (see his charts on page 3).
Plainly, I agree with Jim’s comments for as stated, “While the ‘set up’ wasn’t perfect, it was close enough for government work.” I too think the first part of this week is critical because the SPX has tested overhead resistance at 1366 twice and has not had any success in traveling above that level. This lack of rebound energy suggests the SPX could drop into the often mentioned 1320–1340 support zone, which should mark the bottom for this correction and provide another good entry point for long stock positions. Last week, however, the only major index that was positive was the D-J Utility Index ($UTIL/472.01). Meanwhile, of the 10 macro sectors only Healthcare, Utilities, and Telecommunication were up on the week. The strength in Telecommunication was likely driven by the upside chart breakouts in AT&T (T/$33.59/Market Perform), Verizon (VZ/$41.16/Market Perform), and Centurylink (CTL/$39.52/Strong Buy). Speaking to industry groups, of the 63 groups I monitor the ones currently on “buy signals” for the short/intermediate term are: REITs, Insurance P/C, Banks, Restaurants, Building Materials, Specialty Chemicals, Food, Healthcare Supply/Equipment, and Pharmaceuticals. Some names from Raymond James’ research universe that screened positively on both their fundamental and technical metrics according to my work, and are favorably rated by our fundamental analysts, include: Allstate (ALL/$34.83/Strong Buy), Simon Property (SPG/$156.08/Outperform), Abbott Labs (ABT/$62.04/Outperform), Cerner (CERN/$79.92/Outperform), Intuitive Surgical (ISRG/$558.95/Outperform), Huntington Bancshares (HBAN/$6.54/Strong Buy), and Kimco Realty (KIM/$19.61/Outperform).
The call for this week: The stock market has been consolidating its huge gains from the October 4 undercut low for roughly three months in a ~75 point range (1350–1420). That consolidation has allowed the market’s internal energy to be rebuilt and the oversold condition to be worked off. Because of that process, I continue to think the odds that we will see a move below the 1320–1340 zone remain pretty dim. Accordingly, I suspect the stock market is going to put in an intermediate bottom probably this week.
Tags: Allegory, Art Form, Asset Allocation Model, Asset Classes, Chief Investment Strategist, David Carradine, Financial Goals, Fuel Mixture, Grasshopper, Investment Planning, Investment Portfolio, jeffrey saut, John Valentine, Last Tuesday, Periodic Adjustments, Portfolio Rebalancing, Precious Fuel, Raymond James, S Tv, Shaolin Temple In China
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Bernie Horn and John Dorfman: Finding Value Globally and in the U.S.
May 15th, 2012
Two value investors with exceptional long-term track records discuss the unusual opportunities they are finding in the global markets. Bernard Horn, finalist for Morningstar’s International Stock Fund Manager of the Year award, explains the international strategy he is following in his Polaris Global Value Fund and Thunderstorm Capital’s John Dorfman tackles bargains available in the U.S.
Tags: Bargains, Bernie Horn, Global Markets, Global Value, International Stock, International Strategy, John Dorfman, Morningstar, Polaris, Stock Fund, Thunderstorm, Value Investors
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The Flaws of Finance (James Montier)
May 15th, 2012
by James Montier, GMO
This paper is based on a speech delivered at the 65th Annual CFA Institute Conference in Chicago on May 6, 2012.
As a child, watching my parents write postcards whilst we were all on holiday was an instructive experience. My mother would meticulously write out the card, scattering a few interesting holiday tidbits within the text. My father, whose sum total of postcards sent was invariably just one (to his office), opted for a considerably more efficient approach. His method is shown at the left in Exhibit 1.
I think we can construct a similar diagram to explain the Global Financial Crisis (GFC), represented at the right in Exhibit 1. In essence, the GFC seems to have sprung from the interaction of the following four “bads”: bad models, bad behaviour, bad policies (which is really just bad behaviour on the part of central banks and regulators), and bad incentives.
In an effort to rethink finance, I want to examine each of these factors in turn, beginning with bad models. Bad Models, or, Why We Need a Hippocratic Oath in Finance
The National Rifle Association is well-known for its slogan “Guns don’t kill people; people kill people.” This sentiment has a long history and echoes the words of Seneca the Younger that “A sword never kills anybody; it is a tool in the killer’s hand.” I have often heard fans of financial modelling use a similar line of defence.
However, one of my favourite comedians, Eddie Izzard, has a rebuttal that I find most compelling. He points out that “Guns don’t kill people; people kill people, but so do monkeys if you give them guns.” This is akin to my view of financial models. Give a monkey a value at risk (VaR) model or the capital asset pricing model (CAPM) and you’ve got a potential financial disaster on your hands.
The intelligent supporters of models are always quick to point out that financial models are, of course, an abstraction from reality. Just as physicists can study worlds without frictions, financial modelers should not be attacked for trying to reduce the complexity of the “real world” into tractable forms.
Finance is often said to suffer from Physics Envy. This is generally held to mean that we in finance would love to write out complex equations and models as do those working in the field of Physics. There are certainly a large number of market participants who would love this outcome.
I believe, though, that there is much we could learn from Physics. For instance, you don’t find physicists betting that a feather and a brick will hit the ground at the same time in the real world. In other words, they are acutely aware of the limitations imposed by their assumptions. In contrast, all too often people seem ready to bet the ranch on the flimsiest of financial models.
Read the whole letter in the slidedeck below (Fullscreen for the easier read, or download)
Tags: Asset Pricing, Bad Behaviour, Bads, Capital Asset Pricing Model, Capital Asset Pricing Model Capm, Central Banks, Cfa Institute, Eddie Izzard, Financial Disaster, Financial Modelling, Financial Models, Global Financial Crisis, Hippocratic Oath, James Montier, Line Of Defence, National Rifle Association, Rebuttal, Sum Total, Value At Risk, Value At Risk Var
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Goldman's Jim O'Neill Frazzled That Reality Refuses To Go Away
May 14th, 2012
Just because it is always amusing to watch the cognitive dissonance in the head of a permabull, here is Jim 'Soon to be head of the BOE... allegedly' O'Neill's latest missive to (what?) GSAM clients. Yes, the same O'Neill who week after week, letter after letter kept on saying that 2012 is nothing like 2011, finally being forced to admit that 2012 is, as we have been saying since January 1, nothing but 2011, as the central planners' script writers prove painfully worthless at coming up with anything original. That, of course, and that the lifelong ManU fan had to suffer the indignity of interCity rivals picking up the trophy this year after a miraculous come back win against QPR. Oh, the horror...
Is it One of Those May’s Again?
Not another one, surely? It is almost too simple to be true. I have been saying to people all year that we would have a great rally into May. Then, it might be quite a challenge for the Summer and, like clockwork, we could come back in the Autumn to take the markets to fresh highs. I had expected that the S&P would get to the 1470–1480 area before the correction would set in. In this sense, it has happened quicker, because of the fact that “May” started in April, just as it did last year? While I have read a few articles recently trying to dismiss the “May” factor, the evidence is annoyingly persuasive that if the May to October months could just be 6 month holiday periods, and we picked up our investments as though nothing had
changed, the long term annualized return would be notably higher. Of course, it is difficult to find a coherent reason why this occurs so often. And, as some doubters correctly point out, it often doesn’t occur.
Anyhow, as can be seen in the attached chart, the momentum in the S&P has clearly turned lower, but interestingly, we sit just above trend line support (and well above the 200-day moving average). So, this is probably just a correction.
For some of us spoilt Manchester United fans, for the best part of the past 20 years at least, we have been able to take solace with the May issue, because around about this time, we are usually picking up the Premier League Trophy, and often there is a European Champions League Final to be thrown in as well as an FA Cup Final. Alas, this year, the cupboard might be empty and, of course, City could be picking up the League for the first time in 44 years.
Europe. Could it get any Messier?
I went to visit a rather weird play with my wife early last week, and I found myself thinking at one point “This is nearly as screwed up as the Euro Area.” I did warn last weekend that the French, and especially the Greek election, might have some impact this past week. It is quite ironic, as a couple of people pointed out to me given that I am always dismissing Greece’s economic relevance, that I suggested it might be more important in the short term than the French election. I shall discuss the French election issue more below, but given we all knew this was coming for months, and that Hollande won with the majority reasonably similar to the polls, I am not sure what was really new last week on this score (except for the German reaction).
Greece
Greek voters appear to now face another election in a few weeks with some simple choices. Do you want to remain in the EMU and stick with the commitments and support that your international allies have generously given you? Or, do you want to recreate the Drachma and run the risk of a massive banking collapse and lots of other unpredictable consequences? Polls appear to suggest the far left is likely to do well, so these questions are pretty real ones. As for the Euro, as I argued last week, it is not entirely clear to me that, once the dust settles, Greece leaving would be material either way. But we shall see.
French Election and Germany.
As I said above, there was not really a lot of new information about Hollande’s plans last week. Therefore, in some ways, it was all discounted. Quite a few contacts of mine suggested that, despite the rhetoric, France under Hollande will not do anything dramatic against the spirit of the Fiscal Compact, although they will push the issue of a supplementary plan for a Growth Pact. And as I reminded many of my colleagues, they are probably more fundamentally “pro Euro” than Sarkozy, which many people seem to have forgotten. Importantly, in this regard, this Administration is another one now in power in Europe that supports a true
Euro bond at the core of a more integrated Europe.
As I found myself thinking as the week wore on, this means that the German elections in the Autumn of 2013 are going to be really important. Anyone who wants to be in a coalition with either the SPD or Greens (or both) is going to have to support the idea also. I suspect Chancellor Merkel will be more than happy to support it. A number of meetings that I coincidentally had this week added to my confidence on this score.
Against this “big picture” background, the most interesting aspect of the French election is how German policymakers responded. Suddenly there is a fresh tone of what I would regard as welcome realism and open mindedness. First of all, Finance Minister Schauble talked about the need for higher German wages, which would help rebalancing within the EM. And a few days later, some Bundesbank officials acknowledged that Germany would probably have to accept inflation above 2 pct for some time. As one of the people I was referring to above put it to me, it would be through “gritted teeth,” but the reality is that they really have no alternative if the EMU is to persist following the shifting ground demanded by European voters. All of this should be good, and it will probably mean that the ECB will be less hawkish as a result.
Tags: Amp, Annualized Return, Autumn, Boe, Central Planners, Cognitive Dissonance, Coherent Reason, Goldman, Holiday Periods, Indignity, January 1, Manu, Missive, Momentum, Moving Average, O Neill, Rally, Rivals, Script Writers, Trend Line
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The Axis of Weeble is Definitely Wobbling
May 14th, 2012
Weebles wobbling, spinning tops running out of energy, running out of room to kick the can, whatever analogy you want to use, the world seems like an incredibly dangerous place.
Greece is going to leave the Euro. That is now pretty much everyone’s expectation. I continue to believe that although they are highly likely to leave, it isn’t for a few more months, and that there will be some real effort from the Troika, led by the ECB to resolve this situation. This isn’t about helping Greece. This is about saving what is left of Europe. What does a new currency really do for Greece? It sounds exciting and the conventional wisdom is that it lets them inflate their way out of their problem. I think all it will do is inflate them into a “Mad Max” world. How is Greece going to be able to afford gas and food if they revert to the Drachma on short notice? Greece doesn’t export enough to get a huge immediate benefit. Yes, it will be cheaper to produce in Greece, but very little is set up to take advantage of that right now.
But it is the ECB and the rest of Europe that need to worry. Greece needs further debt cuts even more than it needs a new currency. Not only would the ECB’s and IMF’s existing holdings be converted to the new currency, Greece may decide to default outright. The ECB and IMF are both staring at massive losses. If Greece goes to the Drachma and doesn’t change the debt to Drachma, then they will have killed themselves. That just isn’t possible. So switching to drachma, and then possibly even defaulting is what is necessary. How will the ECB and IMF deal with it? The ECB might have to make a capital call. That would send tremors through the system. The IMF will deal with it, but expect talk about countries pulling out of the firewall. There is talk about having the EFSF make the ECB whole. That’s not even taking money from one pocket and shifting it to another, it’s the same damn pocket. The market will not like that.
Shorting Germany, preferably bunds, is my favorite way to play this (with French bonds a close second). I think the next leg if it occurs wipes out the myth of Germany as “safe haven”. If Greece goes, losses to the Troika will be real and any attempt to paint over them will be too obvious. The staggering size of the commitments that will ultimately flow onto the shoulders of Germany and France will end the idea that somehow their credit is somehow better. The guarantees matter, and these bonds will be affected.
I still expect some “surprise” headlines bringing all the people involved to some form of resolution, that won’t obviously fix everything, but will buy time. Notice Draghi has not once said anything about this, and really he seems far and away the most competent person at the ECB.
Then back here, we can focus more on JP Morgan. Since 2007, JPM had a loss in one quarter only. They lost 9 cents in Q4 2008. The just made 1.70 in Q1 of this year. Citi had 9 quarters of losses in that period. Their worst quarter was –23.80 per share compared to a tiny 1.11 per share in Q1. MS had 6 quarters of losses, with the biggest being 3.61 AND they lost money in 2 quarters last year. Yes, $2 billion is a big number. It may have grown, it may turn out smaller. In any case, it is unlikely JPM will have a loss this quarter. This group and the overall risk management of the firm is part of why they have done so well relative to their peers. If you want to focus on the fact that $2 billion is a huge number to a normal person, that is fine, but you may be getting more angry than you should. The reality is that JPM, with $2.3 trillion in assets is huge, and every business they are in is big, and P&L swings will be large in $ terms, but seem completely reasonable in percentage terms.
Yes, regulatory scrutiny will intensify, but this is a problem at all big banks. The specific risk of this trade has been overdone. Unfortunately it is hard to tell how much of the price move is specific to one aspect or the other, so I can’t quite get comfortable with the situation in terms of getting long JPM, but will be looking at outperformance trades.
Futures have already had a wild ride, and I would expect that to continue throughout the day. MAIN is out to 169 +12 bps on the day. XOVER is at 718 +36 bps on the day. It is ugly, with minimal liquidity – even the best market makers are back to making 1 bp markets in MAIN. IG18 is opening at 112, which is 3.5 bps wider, and HY18 is at 94 3/8, so down about 5/8. The moves in XOVER and HY relative to MAIN and IG seem more normal than Friday, when we saw almost amazing outperformance in the HY space (where JPM is allegedly short).
Spain and Italy are under attack again. Ten year yields have hit 6.26% and 5.70% respectively while CDS is at 640 and 480 respectively. Scary numbers, though Spanish 10 year may be getting to the point where we see some ECB intervention in the secondary markets.
So with problems across the globe and the mood so dim, I can’t help but think we are set up for a rally on the back of any scrap of good news. I don’t see Greece hitting the breaking point just yet, and the market will digest the JPM loss as it thinks more rationally, and Spain and Italy are not so heinous that they should respond well to any ECB intervention.
Tags: Analogy, Axis, Conventional Wisdom, Currency, Dangerous Place, Drachma, ECB, Efsf, Expectation, Firewall, Gas And Food, Greece, Imf Deal, Mad Max, Massive Losses, Max World, Spinning Tops, Tremors, Troika, Weeble, Weebles
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Panic Is Not a Strategy—Nor Is Greed (Sonders)
May 14th, 2012
Panic Is Not a Strategy—Nor Is Greed
Updated May 10, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Key Points
- Originally publishing in 2008, it's time for a refresher about the perils of panic.
- Asset allocation, diversification and rebalancing are as close to a "free lunch" as you can get as an investor.
- In a world where time horizons have shrunk precipitously, think longer-term.
If markets are good at one thing, it's reminding investors that they don't go up uninterrupted forever. We witnessed several bruising corrections in 2011 before the market's strong rally between October 2011 and April 2012. As the chart "Fear Spikes Again" below illustrates, the CBOE Volatility Index® has picked up again, but remains below the unparalleled heights of the 2008 credit crisis and the more-recent elevation in 2011.
Fear Up, But Well Down From Highs

Source: FactSet, as of April 20, 2012. The CBOE Volatility Index ("VIX") is a registered trademark of the Chicago Board Options Exchange. The VIX Index shows the market's expectation of 30-day volatility. For more information on the VIX, visit www.cboe.com/micro/vix/
We're always quick to remind investors that neither panic nor greed is an investment strategy, and that the best foundation to help protect a portfolio against the unpredictable is having—and sticking with—a long-term strategic asset allocation plan.
Mindset matters: strategic trumps tactical
In reality, investors should rarely, if ever, react to a dramatic short-term move in the market. As intriguing as it may seem to try to catch bottoms and get out at tops in order to reap big profits (or so you think), the "tactical" (or shorter-term) approach to investing has its limitations ... and its risks.
We believe it's the "strategic" asset allocation decision—and the ability to stick with it through the discipline of rebalancing—that will ultimately reap the greatest rewards. These decisions are not a function of short-term market gyrations or forecasts (mine, yours or anyone else's), but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is by far the most important set of decisions a client will ever make.
Never before has information about the global economy and markets been more readily available and disseminated. As a result, global markets have become very interconnected. In turn, our reaction mechanisms have kicked in, and investor time horizons have shortened dramatically—but not necessarily to our advantage. Yes, the long term is really just a series of short-term events, but it's how we react to them that decides our ultimate fate as investors.
Asset allocation and diversification: investors' "free lunch"
One of the most important areas where Schwab offers advice is the development of a long-term strategic asset allocation plan. Many investors assume that their position along the risk spectrum from conservative to aggressive is largely based on their age and time horizon. But a more important factor is their risk tolerance. Also important is judging the difference between an investor's financial risk tolerance (their ability to financially withstand volatile markets) and their emotional risk tolerance—a spread that's often quite wide and only acknowledged during tumultuous market environments.
I've known plenty of older investors who thrive on the risk associated with an aggressive investment stance. I've also known plenty of young investors who can't stomach any losses. Too often, investors use a rearview mirror to make their investing decisions, by looking at past performance as a guide to future results. A mirror is a valuable tool but only when turned on yourself to judge your own circumstances—tolerance for risk, time horizon, income needs, etc. As I've often said, there are very few free lunches in investing. Asset allocation, diversification and periodic rebalancing are as close as you get.
Risk tolerance: Know what you can stomach
In the chart "Schwab's Strategic Asset Allocation Models" below, you'll see our long-term recommendations regarding different asset classes for three types of investors: conservative, moderate and aggressive.1 Note the vast differences in allocations to riskier asset classes, including international equity, as you move up the risk spectrum.

Clearly, over the long term, given the better performance by the riskier asset classes, a more aggressive allocation has historically reaped higher rewards in terms of returns. But there is a dark side to an aggressive posture's higher returns—the risk taken in getting there.
Tags: Allocation Plan, Cboe Volatility Index, Charles Schwab, Chicago Board Options, Chicago Board Options Exchange, Chief Investment Strategist, Credit Crisis, Diversification, Free Lunch, Greed, Investment Strategy, Liz Ann, Perils, Rewa, Senior Vice President, Strategic Asset Allocation, Term Approach, Time Horizons, Unparalleled Heights, Vix Index, Volatility Index Vix
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Here We Go Again....or Not? (Sonders)
May 13th, 2012
Here We Go Again....or Not?
May 11, 2012
by Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and,
Michelle Gibley
CFA, Director of International Research, Schwab Center for Financial Research
Key Points
- Softer economic data has prompted concerns that the market may be headed for a summer swoon—similar to the previous two years. We believe the backdrop is decidedly different (and better) this time around but investor and business confidence will continue to be important.
- Some appear to be hoping for weaker data in order to spur the Fed to enact another round of quantitative easing (QE3). We believe the bar is much higher and that the Fed should look to return to a more normal monetary stance. Complicating the overall picture and the Fed’s job is the coming "fiscal cliff" out of Washington at the end of this year.
- The political situation in Europe has injected even more uncertainty into an already tenuous environment. Public cries for a reduction in austerity, despite many proposed measures not taking affect yet, raises questions as to the sustainability of the eurozone as is. Spending cuts are important, but must be accompanied by serious structural changes that encourage growth and innovation to provide hope for the future.
NOTE: The next Schwab Market Perspective will be published one week later than normal—June 1, 2012.
We've seen this movie before … or have we? After starting out the previous two years in a positive direction, stocks experienced disappointing downturns beginning around this time of each year and continuing throughout the subsequent summers. Recently we've seen economic data soften, global concerns rise, Treasury yields fall, and stocks correct, prompting more questions as to whether we're seeing a very unwelcome sequel. We believe not.
Before getting into why we don't believe we're in store for Summer Swoon III (a sequel, like many, that no one wants to see), we want to again point out that trying to time the market is largely a losing game for investors. And we also continue to remind investors that sticking to a disciplined long-term plan is key, rather that chasing crowd psychology or past returns. We're reminded of the continued chasing mentality that almost inevitably leads to disappointment as ISI Research reported that bond mutual fund inflows were at a record high during the first four months of the year, while equity fund outflows were the third largest on record.
Currently, investor apprehension is rising, indicated by increasing volatility and a stock market in correction mode, as the possibility of a replay of the previous two years is considered. However, we believe there are several important fundamental differences that help to support a renewed market advance before too long. First, we aren't dealing with any major natural crises such as the Japanese earthquake and tsunami we saw last year; or the spike in food inflation that unleashed the "Arab Spring." In fact, commodity prices are largely moving lower, allowing central banks around the world to ease monetary policy, as we’ve seen in Brazil, Australia, and India among others. And while there are still major concerns regarding the debt crisis in Europe, discussed in further detail below, the European Central Bank (ECB) has made moves that indicate they will be aggressive to preserve some semblance of stability in the European markets. Finally, in the United States we're seeing further signs of housing stabilization, a continued improving job situation, and a rebound in auto sales, which is now a larger driver of GDP than residential investment.
But there's the impact of "muscle memory" given the past two years' volatility; and perception can become reality. There is a risk that investors increasingly lose confidence in the economic recovery, pressuring stocks, and causing businesses to again pare back. In the short term, market performance can have more to do with sentiment than fundamentals, again illustrating the folly of short-term timing.
Temporary Softness or a New Trend?
Data has been mixed lately, with regional manufacturing surveys largely disappointing: the Chicago PMI fell to its lowest level since November 2009, although remaining in expansionary territory and the Dallas Fed Index slipped into negative territory. The national index provided more encouragement as the ISM Manufacturing Index rose to 54.8, the best level since June 2011, while the forward looking new orders component rose to 58.2, the best level since April 2011. This is distinctly better than the trend in most global PMIs. However, more concern came in the form of the ISM Non-Manufacturing Index, which softened to 53.5 from 56. But while the important service sector showed some softness, we continue to see consumers improve their balance sheets, which should help to support spending going forward.
Consumers' debt position is much improved

Source: FactSet, Federal Reserve. As of May 7, 2012. Includes mortgage and consumer debt, auto lease payments, rental payments, homeowners insurance, and property tax payments.
Key to consumer spending continuing to hold up is likely the continued improvement in the job market, which has been in question lately. Jobless claims started to creep higher before experiencing a relatively sharp reversal recently and remaining well below the critical 400,000 level. However, payroll growth continued to be disappointing as a soft reading for March was followed with another one in April. We saw ADP report a mere 119,000 private jobs were added, while the Bureau of Labor Statistics (BLS) reported that nonfarm payrolls expanded by a weak 115,000 positions; although the previous two months were revised higher. The unemployment rate fell to 8.1% due largely to a drop in the labor participation rate, which now stands at 63.6%—the lowest level since 1981.
Tags: Austerity, Backdrop, Business Confidence, Charles Schwab, Chief Investment Strategist, Economic Data, Eurozone, Global Concerns, Liz Ann, Market Perspective, Monetary Stance, Political Situation, Positive Direction, Research Key, Sector Analysis, Senior Vice President, Sequel, Sustainability, Swoon, Treasury Yields
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Will ECRI's Call for Recession Prove Accurate?
May 13th, 2012
ECRI's Lakshman Achuthan was making the rounds yesterday, with yet another defense of his firm's recession call – the first claim which came early last fall. I do think (from memory) he has pushed out the time frame a bit from when the initial call came, but since early this year has claimed we will see it by mid year. Perhaps the very warm winter hurt the call as well – who knows with these black boxes. Below we have a video with CNBC and there is one nugget in there I did not know. Conventional wisdom is a recession is back to back quarters of negative GDP… but according to the NBER (and Achuthan) that is but one of a group of potential signals.
The Committee does not have a fixed definition of economic activity. It examines and compares the behavior of various measures of broad activity: real GDP measured on the product and income sides, economy-wide employment, and real income. The Committee also may consider indicators that do not cover the entire economy, such as real sales and the Federal Reserve's index of industrial production (IP).
10 minute video – email readers will need to come to site to view
Tags: Black Boxes, Cnbc, Conventional Wisdom, Economic Activity, Economy, Federal Reserve, GDP, Lakshman, Lakshman Achuthan, Measures, Memory, Nber, Nugget, Quarters, Real Gdp, Recession, Signals, Time Frame, Video Email, Warm Winter
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