Perception vs. Reality (Sonders)

Tuesday, August 31st, 2010

Key points

• Mar­ket vol­ume con­tin­ues its tra­di­tional August swoon, mak­ing it dif­fi­cult to gauge much from stock mar­ket action. Eco­nomic data con­tin­ues to tell a mixed story, as growth slows and risks rise.
• Con­fi­dence is key to con­sumer spend­ing, busi­ness invest­ment and stock mar­ket per­for­mance. The Fed­eral Reserve and the gov­ern­ment are attempt­ing to instill that con­fi­dence in the Amer­i­can pub­lic, but so far have had lit­tle success.
• Emerg­ing mar­kets con­tinue to show signs of growth and China's mar­ket has been per­form­ing well. Ger­many also has posted some nice num­bers lately, but Japan remains a concern.

With the Dow Jones Indus­trial Aver­age post­ing triple-digit gains and losses dur­ing the past cou­ple of weeks, it can be easy to get caught up in over­re­ac­tion. How­ever, these mar­ket moves have occurred on some of the low­est trad­ing vol­ume days of the year, mean­ing that they're hardly a ref­er­en­dum on the over­all con­sen­sus of mar­ket participants.

In fact, dur­ing the past month, there's been lit­tle con­sen­sus as the over­all mar­ket indexes are roughly flat. Bears have pointed to dete­ri­o­rat­ing eco­nomic data as a sign of an impend­ing double-dip reces­sion, while bulls have directed atten­tion to a good earn­ings sea­son, increas­ing merger-and-acquisition activ­ity and con­tin­ued accom­moda­tive mon­e­tary policy.

This again illus­trates the folly, in our opin­ion, of try­ing to time the mar­ket. Where the mar­ket goes in the near term is vir­tu­ally impos­si­ble to pre­dict. Fol­low­ing the recent Fed­eral Open Mar­ket Com­mit­tee meet­ing where the Fed demon­strated its com­mit­ment to con­tin­ued extremely accom­moda­tive mon­e­tary pol­icy, the mar­ket ini­tially responded rel­a­tively well, only to sell off dur­ing the next trad­ing day.

Addi­tion­ally, we want to again cau­tion investors about read­ing too much into so-called tech­ni­cal indi­ca­tors. While they can be a tool in your over­all mar­ket analy­sis, there's lit­tle evi­dence that the major­ity of indi­ca­tors can be con­sis­tently relied upon.

Recent atten­tion has been paid to the "Hin­den­berg Omen," a rel­a­tively com­pli­cated set of tech­ni­cal con­di­tions which has pre­ceded every mar­ket crash since 1987 that was recently breached. How­ever, it's impor­tant to note—but is rarely reported—that this indi­ca­tor has flashed mul­ti­ple times dur­ing the past 20+ years when there hasn't been a crash. In fact, more than 75% of the time the Omen has been a false sig­nal, accord­ing to The Wall Street Journal.

We con­tinue to advo­cate a long-term view on equity invest­ments. If you need money in the near term, don't invest it in equities—short-term per­for­mance can be too volatile.

That doesn't, how­ever, mean to just buy and ignore your invest­ments. It's impor­tant to use dips and ral­lies to add or sub­tract to posi­tions as nec­es­sary and to mon­i­tor your invest­ments to track changes in approach, style or per­for­mance and adjust as necessary.

Eco­nomic growth slow­ing, but remains pos­i­tive
Although rhetoric sur­round­ing a double-dip reces­sion has increased through­out the sum­mer, we remain rel­a­tively opti­mistic that eco­nomic growth will remain pos­i­tive (albeit low) and that from a sen­ti­ment and val­u­a­tion per­spec­tive, the stock mar­ket appears rel­a­tively attrac­tive. While volatil­ity will con­tinue, alter­na­tives to stocks are rel­a­tively unattractive.

Yields on bonds are near all-time lows, while inter­est rates on cash deposits remain at vir­tu­ally zero. Mean­while, the div­i­dend yield on the Dow is approx­i­mately 2.9%, greater than the 10-year Trea­sury yield of approx­i­mately 2.5%. Main­tain­ing a bal­anced, diver­si­fied port­fo­lio is impor­tant and we believe that for most investors, it makes sense to keep some of your port­fo­lio in stocks.

While we don't think we're slip­ping back into reces­sion, risks are ris­ing and war­rant watch­ing. Ini­tial job­less claims remain stub­bornly high, with a recent read­ing again hit­ting the 500,000 mark, the high­est level since Novem­ber of last year.

Hous­ing also con­tin­ues to lan­guish, as hous­ing starts were up 1.7% in July, but more forward-looking build­ing per­mits were down 3.1%. Adding con­cern, exist­ing home sales fell 27.2% in July to the low­est level in 15 years, as inven­to­ries surged to 12.5 months worth of supply.

These results should be taken with a grain of salt, how­ever, as the April expi­ra­tion of the Fed­eral tax hous­ing credit con­tin­ues to dis­tort num­bers. We con­tinue to believe that his­tor­i­cally low mort­gage rates and record afford­abil­ity will help sup­port the hous­ing recovery—but that it will be a slow process and could bounce along the bot­tom for some time.

Pos­i­tive news also exists (though it's get­ting less atten­tion) as both Insti­tute for Sup­ply Man­age­ment sur­veys remain in expan­sion­ary ter­ri­tory and the recent indus­trial pro­duc­tion read­ing gained a sur­pris­ingly strong 1% month over month. We still believe pos­i­tive eco­nomic growth is the most likely course, as we turn to the Index of Lead­ing Eco­nomic Indi­ca­tors (LEI), which posted a 0.1% gain in July and are still in ter­ri­tory indi­cat­ing eco­nomic expansion.

Lead­ing eco­nomic indi­ca­tors still sig­nal­ing expan­sion

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Source: Fact­Set, US Con­fer­ence Board, as of August 24, 2010.

In fact, accord­ing to BCA research, of the 10 under­ly­ing com­po­nents that make up the LEI, six are either flat or ris­ing, indi­cat­ing some decent under­ly­ing strength.

And we don't want to over­look the his­tor­i­cally best pre­dic­tor of reces­sions, the spread in the yield curve. There's been talk lately that the low end of the curve has been held arti­fi­cially low through the actions of the Fed, thereby ren­der­ing the pre­dic­tive power of the yield curve mute.

We cau­tion against the "this time is dif­fer­ent" mentality—we've heard it many times in the past, and rarely has it truly been dif­fer­ent. As of now, the yield curve (though flat­ten­ing mod­estly as eco­nomic growth has weak­ened) remains rel­a­tively steep, indi­cat­ing low prob­a­bil­ity of an impend­ing recession.

Yield curve not sig­nal­ing reces­sion

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Source: Fact­Set, Fed­eral Reserve, as of August 24, 2010.

Con­fi­dence is key
One of the major keys to improv­ing the hous­ing and labor mar­kets, as well as boost­ing eco­nomic growth, is for con­fi­dence in the eco­nomic sys­tem to return. There are small signs that it's slowly return­ing, although they remain tenuous.

The recent Fed­eral Reserve Senior Loan Offi­cer Sur­vey on Bank Lend­ing Prac­tices showed that lend­ing stan­dards eased some­what dur­ing the past three months. In fact, for the first time since 2006, big banks' stan­dards for small busi­nesses eased, poten­tially free­ing up credit for the all-important small-business sector.

How­ever, loan demand remains roughly unchanged, indi­cat­ing con­tin­ued uncer­tainty. Busi­nesses wary of eco­nomic prospects, polit­i­cal pol­icy and tax sta­tus are extremely hes­i­tant to invest in cap­i­tal or hire new workers—and if your com­peti­tors aren't hir­ing or invest­ing, there's less incen­tive for you to do so.

The Fed is still try­ing to reas­sure mar­kets that it will remain stim­u­la­tive for the fore­see­able future. In fact, dur­ing its last meet­ing, the Fed made the largely sym­bolic ges­ture of rein­vest­ing pro­ceeds from paid-off agency secu­ri­ties rather than let its bal­ance sheet decrease by even that small amount.

While we don't know if this is the best course of action, and worry that the Fed has stayed at the well too long (ren­der­ing low rates some­what inef­fec­tive) the Fed is undoubt­edly com­mit­ted to doing its best to avoid a repeat recession.

Con­fi­dence in the eco­nomic poli­cies of the gov­ern­ment, both fed­eral and local, seems to be near its low­est lev­els in recent mem­ory. States and munic­i­pal­i­ties con­tinue to strug­gle with large bud­get deficits, requir­ing the cut­ting of ser­vices and lay­ing off work­ers, while the fed­eral gov­ern­ment can't seem to decide on its best course of action.

On the one hand, talk con­tin­ues of another stim­u­lus pack­age, while, accord­ing to The Wall Street Jour­nal, approx­i­mately $164 bil­lion of the $230 bil­lion allo­cated toward infra­struc­ture projects dur­ing the last round of stim­u­lus remains unspent.

The Obama admin­is­tra­tion is search­ing for ways to entice busi­nesses to hire more work­ers, while at the same time issu­ing new reg­u­la­tions and poli­cies that make it more expen­sive to do busi­ness. Mean­while, talk of rais­ing taxes on many small busi­nesses continues.

While we've always tilted toward the side of free mar­kets, it appears to us that the gov­ern­ment needs to pro­vide some cer­tainty going for­ward, what­ever its approach may be. Busi­nesses can adapt to many things, but they need to know the ground rules before they feel con­fi­dent enough to move forward—confidence they appar­ently don't have right now.

Emerg­ing mar­kets buoy global growth
Con­fi­dence is also an issue inter­na­tion­ally, with increas­ing con­cerns about the prospect of a global double-dip reces­sion. How­ever, we look to the strength of emerging-market economies to help keep global growth pos­i­tive. Emerging-market economies have grown in impor­tance, advanc­ing 2.5% in 2009, almost enough to off­set the 3.2% decline dur­ing the developed-economy reces­sion, as the world econ­omy fell 0.6% in aggre­gate in 2009.

Growth in advanced economies will likely be at low lev­els in 2010 and 2011, and while a global dou­ble dip is a grow­ing risk, we believe it's still a low-probability event.

Mean­while, emerg­ing mar­kets are fore­casted to grow faster, as they're largely unbur­dened by the high lev­els of gov­ern­ment and con­sumer debt that exists in much of the devel­oped world, and banks tend to be health­ier. Addi­tion­ally, con­sumers have become an impor­tant part of the growth in many emerg­ing coun­tries as house­hold incomes rise, as we've dis­cussed in arti­cles on Brazil and India.

China slow­ing, but no hard land­ing
Many emerg­ing mar­kets tend to have their growth tied to eco­nomic prospects in China, which has been a pri­mary source of global growth. While exports are an impor­tant part of the Chi­nese econ­omy (but could slow in com­ing months), fixed invest­ment is the high­est per­cent­age of China's gross domes­tic prod­uct (GDP) at nearly 50% in 2009, pro­pelled by prop­erty con­struc­tion and gov­ern­ment stim­u­lus spend­ing on infrastructure.

We expect infra­struc­ture and prop­erty con­struc­tion in China to slow over the near term as gov­ern­ment stim­u­lus lev­els off and the hous­ing mar­ket is affected by mea­sures intended to cool spec­u­la­tion. Encour­ag­ingly, steep prop­erty price declines have cat­alyzed sales, but we expect addi­tional sup­ply in com­ing months, fur­ther sup­press­ing prices. The Chi­nese prop­erty mar­ket ben­e­fit­ted from rapid loan growth and wealthy indi­vid­u­als' spec­u­la­tive invest­ments, as there are few invest­ment options in China.

With prop­erty prices falling, the gov­ern­ment ordered bank stress tests. Chi­nese banks lack trans­parency, but we don't think a col­lapse in the bank­ing sys­tem is likely. Banks announced plans to raise $96 bil­lion this year to strengthen their bal­ance sheets, and a major­ity are state-owned, boost­ing their viability.

China's econ­omy is slow­ing, but the gov­ern­ment strives to main­tain 8% growth to keep employ­ment high and to avoid civil unrest. Unlike many devel­oped coun­tries, China has the pock­et­book to issue new stim­u­lus if growth slows too much.

It's prob­a­bly too soon for China to restart stim­u­lus, but we con­tinue to believe fur­ther tight­en­ing has been delayed. The out­per­for­mance of the Shang­hai Com­pos­ite rel­a­tive to the S&P 500® index dur­ing the past the six weeks is notable, as this mar­ket has led in recent years.

China out­per­forms as tight­en­ing delayed

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Source: Fact­Set, Shang­hai Stock Exchange, Stan­dard & Poor's, as of August 25, 2010.

We remain con­struc­tive on emerging-market equi­ties, as their higher growth out­look and below-average mul­ti­ples gives them the abil­ity to con­tinue to out­per­form developed-market stocks.

A tale of two exporters: Japan's dom­i­nance slips, Ger­many sur­prises to upside
Busi­nesses allowed inven­to­ries to plunge so they could con­serve cash given high uncer­tainty dur­ing the reces­sion. As a result, the global recov­ery was dri­ven by man­u­fac­tur­ing and exports, ben­e­fit­ting from inven­tory build­ing, as well as low lev­els of pos­i­tive demand.

How­ever, now that inven­tory build­ing appears to be lev­el­ing off and with global growth slow­ing, many economies can no longer rely solely on exports for growth. Many coun­tries need inter­nal con­sump­tion to take the eco­nomic baton and help make the recov­ery self-sustaining.

As such, the lack of con­sumer spend­ing by Japan's aging pop­u­la­tion, amid a defla­tion­ary envi­ron­ment wherein spend­ing is post­poned, reduces Japan's out­look. Addi­tion­ally, the surg­ing yen has reduced exporters' prospects.

In fact, Japan ceded the posi­tion as the second-largest econ­omy in the world to China dur­ing the June quar­ter, and China's higher growth implies that this sit­u­a­tion is likely to persist.

Japan loses no. 2 posi­tion to China

Click to enlarge
Source: Fact­Set, Inter­na­tional Mon­e­tary Fund, as of August 25, 2010. Note: 2010 fig­ures are estimates.

While Japan seems poised to ben­e­fit from China's growth, and China accounted for 20% of the Japan's June exports, Japan imports more from China than it exports. For the time being, the two coun­tries appear to be work­ing as part­ners to pro­duce goods des­tined for con­sump­tion elsewhere.

On the other hand, Germany's econ­omy has been sur­pris­ingly strong, with its promi­nent export sec­tor ben­e­fit­ing from a declin­ing euro. The pace of GDP growth is likely to slow from the 9% quarter-over-quarter (q/q) annu­al­ized pace in the sec­ond quar­ter, which also ben­e­fit­ted from a con­struc­tion rebound after being held back by poor weather in the first quarter.

How­ever, Ger­man pri­vate con­sump­tion in the sec­ond quar­ter rose 2.4% q/q annu­al­ized, the first increase since the sec­ond quar­ter 2009. In con­trast to the near-term out­look for Japan, if Ger­man con­sumers con­tinue to spend, the recov­ery could enter a self-sustaining phase and boost Europe over­all, as Ger­many con­sti­tutes about a quar­ter of the region's economy.

Cen­tral bank action influ­ences cur­rency out­look
The Fed's move to main­tain the size of its bal­ance sheet effec­tively delays its exit strat­egy. Addi­tion­ally, com­ments from the Bank of England's chief, Mervyn King, indi­cate that the BoE appears to be con­sid­er­ing the pos­si­bil­ity of extend­ing fur­ther stimulus.

Mean­while, the Euro­pean Cen­tral Bank (ECB) remains opposed to pro­vid­ing stim­u­lus, barely budg­ing even in the face of a mar­ket riot over gov­ern­ment debt in the sec­ond quarter.

How­ever, the Bank of Japan's lack of action has con­founded mar­ket watch­ers. Japan may have entered a liq­uid­ity trap amid a defla­tion­ary envi­ron­ment, wherein injec­tions of money fail to cat­alyze lend­ing and spend­ing as pur­chas­ing deci­sions are post­poned. A surg­ing yen increases the prob­a­bil­ity of action by the BoJ, using either uncon­ven­tional mon­e­tary stim­u­lus or cur­rency intervention.

Double-dip reces­sion fears have cre­ated demand for the safe-haven sta­tus of the US dol­lar. Addi­tion­ally, the euro worked off some of the sharp rebound after plung­ing amid the euro-area debt cri­sis this year. With the euro com­pris­ing 58% of the US Dol­lar Index (which mea­sures the per­for­mance of the US dol­lar against a bas­ket of cur­ren­cies), we expect the index to fall as the dol­lar weak­ens, as the Fed could exit mon­e­tary stim­u­lus later than the ECB.

Impor­tant Disclosures

The MSCI EAFE® Index (Europe, Aus­trala­sia, Far East) is a free float-adjusted mar­ket cap­i­tal­iza­tion index that is designed to mea­sure devel­oped mar­ket equity per­for­mance, exclud­ing the United States and Canada. As of May 27, 2010, the MSCI EAFE Index con­sisted of the fol­low­ing 22 devel­oped mar­ket coun­try indexes: Aus­tralia, Aus­tria, Bel­gium, Den­mark, Fin­land, France, Ger­many, Greece, Hong Kong, Ire­land, Israel, Italy, Japan, the Nether­lands, New Zealand, Nor­way, Por­tu­gal, Sin­ga­pore, Spain, Swe­den, Switzer­land and the United Kingdom.

The MSCI Emerg­ing Mar­kets IndexSM is a free float-adjusted mar­ket cap­i­tal­iza­tion index that is designed to mea­sure equity mar­ket per­for­mance in the global emerg­ing mar­kets. As of May 27, 2010, the MSCI Emerg­ing Mar­kets Index con­sisted of the fol­low­ing 21 emerging-market coun­try indexes: Brazil, Chile, China, Colom­bia, the Czech Repub­lic, Egypt, Hun­gary, India, Indone­sia, Korea, Malaysia, Mex­ico, Morocco, Peru, Philip­pines, Poland, Rus­sia, South Africa, Tai­wan, Thai­land and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unman­aged, do not incur fees or expenses and can­not be invested in directly.

Past per­for­mance is no guar­an­tee of future results.

Invest­ing in sec­tors may involve a greater degree of risk than invest­ments with broader diversification.

Inter­na­tional invest­ments are sub­ject to addi­tional risks such as cur­rency fluc­tu­a­tions, polit­i­cal insta­bil­ity and the poten­tial for illiq­uid mar­kets. Invest­ing in emerg­ing mar­kets can accen­tu­ate these risks.

The infor­ma­tion con­tained herein is obtained from sources believed to be reli­able, but its accu­racy or com­plete­ness is not guar­an­teed. This report is for infor­ma­tional pur­poses only and is not a solic­i­ta­tion or a rec­om­men­da­tion that any par­tic­u­lar investor should pur­chase or sell any par­tic­u­lar secu­rity. Schwab does not assess the suit­abil­ity or the poten­tial value of any par­tic­u­lar invest­ment. All expres­sions of opin­ions are sub­ject to change with­out notice.

The Schwab Cen­ter for Finan­cial Research is a divi­sion of Charles Schwab & Co., Inc.

Tags: Acquisition Activity, Brazil, BRIC, BRICs, Canadian Market, Charles Schwab, China, Double Dip Recession, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Earnings Season, Economic Data, Federal Open Market Committee, India, Liz Ann Sonders, Market Indexes, Market Moves, Market Participants, Market Volume, Merger Acquisition, Merger And Acquisition, Open Market Committee, Overreaction, Russia, S Market, Stock Market Action, Stock Market Performance, Technical Indicators, Volume Days
Posted in Brazil, India, Infrastructure, Markets, Outlook | Comments Off

Bernanke Presents Fed’s Options and Indicates Deflation Not a Significant Risk

Tuesday, August 31st, 2010

August 27, 2010

Chair­man Bernanke kicked off the annual sym­po­sium in Jack­son Hole with a blue­print for the future course of mon­e­tary pol­icy. In his opin­ion, "the recov­ery of out­put and employ­ment in the United States has slowed in recent months, to a pace some­what weaker than most FOMC par­tic­i­pants pro­jected ear­lier this year." (The cen­tral ten­dency of the Fed's fore­cast in July for 2010 is 3.0% to 3.5%). He also noted that "despite the weaker data seen recently, the pre­con­di­tions for a pickup in growth in 2011 appear to remain in place."

Bernanke listed four options the Fed has in its arse­nal with the costs and ben­e­fits of each alter­na­tive. First, the Fed can pur­chase longer term secu­ri­ties and increase the size of the bal­ance sheet. How­ever, Mr. Bernanke indi­cated that this strat­egy works best dur­ing times of "finan­cial stress." He also added that large pur­chases of addi­tional secu­ri­ties would leave the pub­lic less con­fi­dent about the Fed's abil­ity to man­age a smooth exit. The reduc­tion of con­fi­dence would trans­late into an "unde­sired increase in infla­tion expec­ta­tions." Bernanke stressed that the Fed has devel­oped sev­eral tools to ensure a smooth exit and Fed offi­cials have spo­ken exten­sively about these tools to mod­er­ate con­cerns of the pub­lic. Sec­ond, Mr. Bernanke noted that the Fed could com­mu­ni­cate to investors that it "antic­i­pates keep­ing the tar­get for the fed­eral funds rate low for a longer period than is cur­rently priced in the mar­kets." The main draw­back of this tool is that it may be a chal­lenge to con­vey the FOMC's inten­tions with pre­ci­sion. Third, the Fed could reduce inter­est rates it pays on excess reserves (cur­rently 25 bps). Bernanke sees this route as fraught with the poten­tial of reduc­ing liq­uid­ity of the fed­eral funds mar­ket. Fourth, he men­tioned a con­tro­ver­sial solu­tion — announc­ing a medium term infla­tion tar­get that is above a level con­sis­tent with price sta­bil­ity. Bernanke con­sid­ers this option inap­pro­pri­ate for the United States and sees it suit­able in sit­u­a­tions of an extended period of defla­tion. He sup­ported this opin­ion with the fact that infla­tion and infla­tion expec­ta­tions are within a range of price sta­bil­ity in the United States and would not require this strat­egy. Given these opin­ions about the alter­na­tives the Fed has, it appears that pur­chases of secu­ri­ties will prob­a­bly pre­vail, if necessary.

Bernanke's descrip­tion of the cir­cum­stances under which the Fed would con­sider fur­ther eas­ing of mon­e­tary pol­icy is the crux of the speech. These remarks offer guid­ance per­tain­ing to the course of near term mon­e­tary policy:

"First, the FOMC will strongly resist devi­a­tions from price sta­bil­ity in the down­ward direc­tion. Falling into defla­tion is not a sig­nif­i­cant risk for the United States at this time, but that is true in part because the pub­lic under­stands that the Fed­eral Reserve will be vig­i­lant and proac­tive in address­ing sig­nif­i­cant fur­ther dis­in­fla­tion. It is worth­while to note that, if defla­tion risks were to increase, the benefit-cost trade­offs of some of our pol­icy tools could become sig­nif­i­cantly more favorable.

Sec­ond, regard­less of the risks of defla­tion, the FOMC will do all that it can to ensure con­tin­u­a­tion of the eco­nomic recov­ery. Con­sis­tent with our man­date, the Fed­eral Reserve is com­mit­ted to pro­mot­ing growth in employ­ment and reduc­ing resource slack more gen­er­ally. Because a fur­ther sig­nif­i­cant weak­en­ing in the eco­nomic out­look would likely be asso­ci­ated with fur­ther dis­in­fla­tion, in the cur­rent envi­ron­ment there is lit­tle or no poten­tial con­flict between the goals of sup­port­ing growth and employ­ment and of main­tain­ing price stability."

Real GDP Growth Slows in Q2, Second-Half Likely to Mimic This Trend

Real GDP of the U.S. econ­omy grew at annual rate of 1.6% in the sec­ond quar­ter, revised down from the advance esti­mate of 2.4%. The upward revi­sion of imports to a 32.4% increase from the ear­lier esti­mate of a 28.8% gain was the major rea­son for the down­ward revi­sion, in addi­tion to a smaller accu­mu­la­tion of inven­to­ries ($63.2 bil­lion vs. $75.7 bil­lion in the advance esti­mate) and a nearly flat read­ing of out­lays on non-residential struc­tures (+0.4% vs. +5.2%). Partly off­set­ting pos­i­tive con­tri­bu­tions came from upward revi­sions of con­sumer spend­ing (+2.0% vs. +1.6% in the advance report) and equip­ment and soft­ware spend­ing (+24.9% vs. +21.9% in advance estimate).

Cor­po­rate prof­its increased 4.6% in the sec­ond quar­ter vs. a 10.6% gain in the first quar­ter. Domes­tic non-financial indus­tries (+8.1%) made the larger con­tri­bu­tion to cor­po­rate prof­its in the sec­ond quar­ter, while prof­its of the finan­cial indus­try inched down 0.1% and prof­its from abroad rose 1.4%.

A tepid increase in real GDP is pro­jected for the second-half of the year, putting the Q4-to-Q4 increase at 2.2% after a nearly flat read­ing in 2009. Bernanke indi­cated that the Fed stands ready to pro­vide addi­tional finan­cial accom­mo­da­tion to main­tain the pace of eco­nomic activ­ity, if nec­es­sary (See remarks about Bernanke's speech above).

The opin­ions expressed herein are those of the author and do not nec­es­sar­ily rep­re­sent the views of The North­ern Trust Com­pany. The North­ern Trust Com­pany does not war­rant the accu­racy or com­plete­ness of infor­ma­tion con­tained herein, such infor­ma­tion is sub­ject to change and is not intended to influ­ence your invest­ment decisions.

Copy­right © North­ern Trust

Tags: Arsenal, Balance Sheet, Blueprint, Bps, Central Tendency, Drawback, Excess Reserves, Fed Officials, Federal Funds Rate, Financial Stress, Fomc, Inflation Expectations, Inflation Target, interest rates, Jackson Hole, liquidity, Monetary Policy, Preconditions, Price Stability, Term Inflation
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Has the Fed Defused the Neutron Bomb? (Kolivakis)

Tuesday, August 31st, 2010

Via Pen­sion Pulse.

Bruce Friesen of Global Invest­ment Solu­tions for­warded Ran­dall Forsyth's arti­cle which appeared in Barron's ear­lier this week, Defla­tion: the Neu­tron Bomb of Bal­ance Sheets:

Low inter­ests rates have made these the best of times for bor­row­ers but the worst for savers and investors.

Blue-chip cor­po­ra­tions never had it so good with the likes of Dow Jones Indus­trial Aver­age mem­bers Inter­na­tional Busi­ness Machines (IBM) able to issue new three-year notes at 1% and John­son & John­son (JNJ) pay­ing less than 3% for new 10-year debt.

But these his­tor­i­cally low bond yields have a darker side: Accord­ing to a new report from Fitch Rat­ings, ultra-low inter­est rates will exac­er­bate the under­fund­ing of many U.S. cor­po­ra­tions' pen­sion plans.

Just as with Amer­i­can work­ers who have failed to save enough for retire­ment and have seen their assets lose value, com­pa­nies also will have no choice but set aside more of their earn­ings. And just as that means belt-tightening for con­sumers, it means cor­po­ra­tions have less to dis­trib­ute to their shareholders.

The bur­den of fund­ing tra­di­tional pen­sion plans—known as defined-benefit plans—is why they have waned in Cor­po­rate Amer­ica. More com­mon are defined-contribution plans—such as the ubiq­ui­tous 401(k)s—that have sup­planted DB plans in the pri­vate sec­tor. As has been reported widely, DB plans remain the stan­dard in the pub­lic sec­tor, which are dec­i­mat­ing bud­gets of many states and municipalities.

But, accord­ing to Fitch, the low-yield, defla­tion­ary envi­ron­ment is adding to the prob­lems of under­funded cor­po­rate pen­sion plans. Again, the prob­lem is two-fold: The decline in the val­ues of invest­ments, such as tra­di­tional stocks and com­mer­cial real estate, has hurt the asset side. The rush into so-called alter­na­tive invest­ments such as hedge funds right at their peaks didn't help. The flip side is that low inter­est rates increase the present value of future liabilities.

(Time out for those who aren't finance geeks. If you put $1 in a sav­ings account at 7%, in 10 years you would have $2. Trust me on that. That means the future value of $1 in 10 years, com­pounded at 7%, is $2. Con­versely, the present value of that $2 invested for 10 years is $1.

But what if inter­est rates are just half as high, or 3.5%, a far more real­is­tic yield for a 10-year, high-grade cor­po­rate bond? The present value of that $2 in 10 years is $1.42. Trust me again on that, or get a finan­cial cal­cu­la­tor or find one on the Web. In other words, where it took only $1 for you to wind up with $2 in 10 years if you invest at 7%, it takes an invest­ment of $1.42 to end up with that same $2 in 10 years at 3.5%. That means you have to set aside 42% more today to meet your sav­ings goal a decade hence.)

Thus, a decline in bond yields can be as dev­as­tat­ing to a sav­ings plan as a drop in the stock mar­ket. Accord­ing to Ken­neth S. Hackel, pres­i­dent of CT Cap­i­tal, a finan­cial advi­sory firm, 1% cut in a retire­ment plan's assumed rate of return is roughly equal to a 15% decline in stock prices.

Fitch's ana­lysts find the mean assumed return for cor­po­rate pen­sion plans in 2008 and 2009 was 8%. That's with an allo­ca­tion to fixed-income assets of 34% of the total. Trea­suries and investment-grade cor­po­rate bonds yield far less than 8%, which is closer to the very long-term return from equi­ties, which means they haven't locked in much of yesterday's higher yields. And, in case you need to be reminded, over the past decade or so, the return from stocks has been prac­ti­cally nil.

In line with Hackel's rough cal­cu­la­tion, Fitch reck­ons a 1% cut in the assumed dis­count rate for com­pa­nies' DB plan can result in a 10%-20% increase in the present value of future lia­bil­i­ties. How to bridge that gap?

"The fact is that there are no shortcuts—prudent man­age­ment will likely require con­tri­bu­tions well in excess of the min­i­mum required given low yields and low equity returns," Fitch ana­lysts write. Sim­ply hop­ing for higher equity returns or bond yields sim­ply isn't pru­dent, they add.

So, what's the answer? You know those hefty cash hold­ings on cor­po­rate bal­ance sheets on which the bulls keep harp­ing? Fitch thinks pen­sion fund­ing require­ments will have dibs on cor­po­rate cash flows, and then the stock of cash on com­pa­nies' bal­ance sheets.

That's the thing about defla­tion; it's like a neu­tron bomb for cor­po­rate, public-sector and con­sumer bal­ance sheets. Asset val­ues and returns get dec­i­mated while lia­bil­i­ties remain stand­ing. Except that falling inter­est rates make those future lia­bil­i­ties more oner­ous, requir­ing more belt-tightening, which only exac­er­bates the deflation.

As I've repeat­edly stated, defla­tion is the arch neme­sis of the finan­cial sec­tor and the Fed will do what­ever it takes to avert it. More­over, in order to address pen­sion deficits, you need a rise in bond yields (low­ers present value of future lia­bil­i­ties) and a rise in asset prices. In other words, you need a lot more days like Fri­day where stocks took off and bond yields backed up.

The Fed's pol­icy has been geared towards the big banks and their big hedge fund clients. Reflate and inflate is the offi­cial pol­icy. By bor­row­ing at zero and invest­ing in higher yield­ing Trea­suries, banks lock in the spread, mak­ing instant prof­its which they then use to trade risk assets all around the world.

Is this pol­icy suc­ceed­ing? Yes and no. It's help­ing banks shore up their bal­ance sheets and some élite hedge funds who thrive on volatil­ity, but doing lit­tle to help the real econ­omy which remains weak at this stage of the cycle.

How­ever, that all may be chang­ing. Over the week­end, I will go over some encour­ag­ing signs that receive lit­tle or no atten­tion in main­stream media. Below, lis­ten to an inter­view with Nigel Gault, chief U.S. econ­o­mist at IHS Global Insight as he dis­cusses his views on the US econ­omy and his take on Ben Bernanke's speech at the Fed's annual Jack­son Hole confab.

Tags: Alternative Investments, Benefit Plans, Bond Yields, Chip Corporations, Commercial Real Estate, Corporate Pension, Darker Side, Defused, Dow Jones, Fitch Ratings, Flip Side, Friesen, Global Investment, Interests Rates, International Business Machines, Investment Solutions, Low Interest Rates, Neutron Bomb, Present Value, S Corporations, Traditional Pension
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A Bad Case of Economic Hypochondria? (Kolivakis)

Tuesday, August 31st, 2010

Via Pen­sion Pulse.

Fol­low­ing my lat­est post on whether the Fed has defused the neu­tron bomb, a senior pen­sion fund man­ager sent me a link to AXA Invest­ment Man­agers' lat­est weekly com­ment by Eric Chaney, Defla­tion may have won a bat­tle, but not the war.

It is an excel­lent read and demon­strates why any dis­cus­sion on the inflation/deflation debate which doesn't take into account what's going on out­side the US is miss­ing the big­ger pic­ture. I quote the following:

Although con­tem­po­ra­ne­ous esti­mates of out­put gaps are some­what elu­sive, the broad pic­ture is clear: a grow­ing por­tion of the global econ­omy is fac­ing infla­tion risks and the bulk of devel­oped economies is no longer in the defla­tion dan­ger zone. This uneven dynamic dis­tri­b­u­tion mat­ters a lot for investors, who need to make up their mind about infla­tion. One key les­son from the past cycle is that price move­ments have a larger com­mon com­po­nent than in pre­vi­ous times; call it the glob­al­i­sa­tion fac­tor. Mat­teo Cic­carelli and Benoît Mojon esti­mated that “(infla­tion rates of) OECD coun­tries have a com­mon fac­tor that alone accounts for nearly 70% of their vari­ance” (ECB work­ing paper, Octo­ber 2005), a find­ing that is con­sis­tent with later research by Haroon Mum­taz and Paolo Surico (Bank of Eng­land work­ing paper, Feb­ru­ary 2008). In such a world, the fact that China, India and Brazil have entered into the infla­tion risk zone mat­ters more than Spain, Ire­land and Greece being on the brink of deflation.

Mr. Chaney con­cludes by stating:

In sum, there is no evi­dence that defla­tion has gained much ground dur­ing the sum­mer. For sure, a dou­ble dip of the US econ­omy would tick a few boxes in the defla­tion camp. Yet the most likely sce­nario in our view is that the US has embarked on a slow growth cycle, the mir­ror image of the arti­fi­cially debt-fuelled pre­vi­ous decade, rather than on a stop-and-go cycle. Once the mar­kets get a clearer pic­ture of busi­ness cycle devel­op­ments, which may unfor­tu­nately take sev­eral months, there are good rea­sons to believe that the cur­rent defla­tion buzz will be quickly replaced by its oppo­site. In the mean­time, enjoy the bond rally!

There are other encour­ag­ing signs sug­gest­ing that the global recov­ery is back on track. This past week, the CPB Nether­lands Bureau for Eco­nomic Pol­icy Analy­sis released its World Trade Mon­i­tor for June 2010, show­ing that world trade was up 0.7% month on month after an upwardly revised 2.3% increase in May.

Why is this sig­nif­i­cant? Because, as Yan­ick Desnoy­ers, Assis­tant Chief Econ­o­mist at the National Bank of Canada dis­cusses below, Global trade vol­ume finally back to its pre­vi­ous peak:

Accord­ing to CPB Nether­lands Bureau for Eco­nomic Pol­icy Analy­sis, the vol­ume of world trade grew 0.7% in June after an upwardly revised 2.3% gain in May. This rep­re­sents the ninth increase in ten months. Global trade vol­ume is now expand­ing at a 21.2% growth on twelve month basis, just shy of the 23% peak reg­is­tered in May. In the sec­ond quar­ter as a whole, global vol­ume trade was up a sig­nif­i­cant 15.3%. As today’s hot chart shows (click on char above), it took only about a year for world trade vol­ume to vir­tu­ally get back to its pre­vi­ous peak.

On the global indus­trial out­put side, the index is already in an expan­sion mode with a 0.7% gain above its pre­vi­ous peak, despite the fact that IP is still down 10% in advanced economies. After all, it seems that fears of sov­er­eign debt con­ta­gion from the Euro zone ear­lier in the spring did not have a mate­r­ial impact on global trade vol­ume. Despite an upcom­ing slow­down in the U.S., we are still fore­cast­ing an above 4% global GDP growth in 2010.

What this tells you is that this cycle is dif­fer­ent than pre­vi­ous cycles because the Emerg­ing economies are the source of growth. Too many ana­lysts are focused solely on what is going on in the US and other devel­oped economies. I too had writ­ten about Galton's fal­lacy and the myth of decou­pling, but maybe this view needs to be revisited.

Tags: Axa Investment Managers, Bad Case, Bank Of England, Brazil, Canadian Market, China, Ciccarelli, Danger Zone, Double Dip, Eric Chaney, Global Economy, Haroon, India, Inflation Deflation, Inflation Rates, Inflation Risk, Inflation Risks, Later Research, Mirror Image, Mumtaz, Neutron Bomb, Oecd Countries, Output Gaps, Pension Fund Manager
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Hugh Hendry — The Battle Over Potash

Tuesday, August 31st, 2010

Hugh Hendry appeared on BBC this week head­lin­ing an inter­est­ing dis­cus­sion about West­ern vs. East­ern Agri­cul­ture and Potash and shared these thoughts:

"The Chi­nese and the Cana­di­ans hate each other, here. There's been a pro­found game of roulette. Chi­nese con­sump­tion of Potash is 35% less than we use in West­ern agri­cul­ture. The Chi­nese were very aggrieved when they saw the chart with potash at $1000 per ton.They stopped; they haven't been con­sum­ing in the man­ner they should and they risk an absolute col­lapse in their yields."

"Again, we made this point, that for thirty years, the price of agri­cul­ture has col­lapsed, its fallen 90% in real terms, so we haven't invested in the sector."

"As a world soci­ety, we're now acutely vul­ner­a­ble in the busi­ness of feed­ing our­selves. We haven't spent enough, and we haven't orga­nized the pro­duc­tion of agri­cul­ture in a man­ner which is appropriate."

By the way, Con­grat­u­la­tions to Hugh Hendry on being awarded Global Macro-Hedge Fund Man­ager YTD, accord­ing to Bloomberg.

Tags: Absolute, Agriculture, Bbc, Canadian Market, Canadians, Collapse, Consumption, Game, Game Roulette, Global Macro, Hedge Fund Manager, Hugh Hendry, Potash, risk, Roulette, Thirty Years, Western Agriculture
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Doug Kass: “I just can’t be that negative now”

Monday, August 30th, 2010

Despite the the stock mar­ket aver­ages tak­ing a nose­dive over the past few, strate­gist Doug Kass said on Tues­day he “just can’t be that neg­a­tive now”.

That’s largely because Kass thinks the doom-sayers – such as econ­o­mist David Rosen­berg of Gluskin Sheff, who said the econ­omy is in a depres­sion, not a reces­sion – are miss­ing key points. Click on the image for the skinny.

Source: CNBC, August 24, 2010.

Tags: Cnbc, David Rosenberg, Depression, Doom Sayers, Doug Kass, Economist, Economy, Gluskin Sheff, Nosedive, Recession, Scheff, Stock Market Averages, Strategist
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US stock market returns – what is in store?

Monday, August 30th, 2010

Stock mar­ket move­ments since the start of the credit cri­sis have been char­ac­terised by rel­a­tively high volatil­ity as uncer­tainty became para­mount. And as new pieces of the eco­nom­ics puz­zle are added every day, investors are increas­ingly strug­gling to make sense of the most likely direc­tion of stock prices.

It seems to be a case of so many pun­dits, so many views. Has the mar­ket started top­ping out and is a pri­mary bear mar­ket about to resume, or is a new sec­u­lar bull mar­ket merely cor­rect­ing the strong rally that com­menced in March 2009, before mov­ing higher? Or is a “muddle-through” trad­ing range in store?

It is one thing to trade the market’s ral­lies and cor­rec­tions, but this is eas­ier said than done, with not many peo­ple actu­ally get­ting it right with any degree of con­sis­tency. Oth­ers are of the opin­ion that the recipe for cre­at­ing wealth is sim­ply to fol­low the patient approach, say­ing that “it’s time in the mar­ket, not tim­ing the mar­ket” that counts.

This gives rise to the all-important ques­tion: does one’s entry level into the mar­ket, i.e. the val­u­a­tion of the mar­ket at the time of invest­ing, make a sig­nif­i­cant dif­fer­ence to sub­se­quent invest­ment returns?

In an attempt to cast light on this issue, my col­leagues at Plexus Asset Man­age­ment have updated a pre­vi­ous multi-year com­par­i­son of the price-earnings (PE) ratios of the S&P 500 Index (as a mea­sure of stock val­u­a­tions) and the for­ward real returns, as done by Jeremy Grantham’s GMO. Our study cov­ered the period from 1871 to August 2010 and used the S&P 500 (and its pre­de­ces­sors prior to 1957). In essence, PEs based on rolling aver­age ten-year earn­ings were cal­cu­lated and used together with ten-year for­ward real returns.

In the first analy­sis the PEs and the cor­re­spond­ing ten-year for­ward real returns were grouped in five quin­tiles (i.e. 20% inter­vals) (Dia­gram A.1).

The cheap­est quin­tile had an aver­age PE of 8.6 with an aver­age ten-year for­ward real return of 10.9% per annum, whereas the most expen­sive quin­tile had an aver­age PE of 24.2 with an aver­age ten-year for­ward real return of only 2.4% per annum.

This analy­sis clearly shows the strong long-term rela­tion­ship between real returns and the level of val­u­a­tion at which the invest­ment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% inter­vals (see dia­grams A.2 and A.3).

This analy­sis strongly con­firms the down­ward trend of the aver­age ten-year for­ward real returns from the cheap­est group­ing (PEs of less than six) to the most expen­sive group­ing (PEs of more than 21). The sec­ond study also shows that any invest­ment at PEs of less than 12 always had pos­i­tive ten-year real returns, while invest­ments at PE ratios of 12 and higher expe­ri­enced neg­a­tive real returns at some stage.

A third obser­va­tion from this analy­sis is that the ten-year for­ward real returns on invest­ments made at PEs between 12 and 17 had the biggest spread between min­i­mum and max­i­mum returns and were there­fore more volatile and less predictable.

As a fur­ther refine­ment, hold­ing peri­ods of one, three, five and 20 years were also analysed. The research results (not reported in this arti­cle) for the one-year period showed a poor rela­tion­ship with expected returns, but the find­ings for all the other peri­ods were con­sis­tent with the find­ings for the ten-year periods.

Although the above analy­sis rep­re­sents an update to and exten­sion of an ear­lier study by GMO, it was also con­sid­ered appro­pri­ate to repli­cate the study using div­i­dend yields rather than PEs as val­u­a­tion yard­stick. The results are reported in dia­grams B.1, B.2 and B.3 and, as can be expected, are very sim­i­lar to those based on PEs.

Based on the above research find­ings, with the S&P 500 Index’s cur­rent ten-year nor­malised PE of 19.3% and div­i­dend yield of 2.1%, investors should be aware of the fact that the mar­ket is by his­tor­i­cal stan­dards above “aver­age value” ter­ri­tory. As far as the mar­ket in gen­eral is con­cerned, this argues for unex­cit­ing long-term returns, and pos­si­bly a “muddle-through” trad­ing range for quite a num­ber of years to come.

Although the research results offer no guid­ance as to call­ing mar­ket tops and bot­toms, they do indi­cate that it would not be con­sis­tent with the find­ings to bank on above-average returns based on the cur­rent val­u­a­tion lev­els. As a mat­ter of fact, there is a dis­tinct pos­si­bil­ity of below-average returns.

Tags: Asset Management, Bear Market, Creating Wealth, Credit Crisis, Investment Returns, Jeremy Grantham, Muddle, Patient Approach, Pe Ratios, Predecessors, Price Earnings, Pundits, Quintile, Rallies, Secular Bull Market, Stock Market Returns, Stock Prices, Stock Valuations, Store Stock, Volatility
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Close Those Longs in the Bond Market!

Monday, August 30th, 2010

The yield on the US 10-year Trea­sury Note sank from a high of 3.97% in April to touch 2.49% recently.

Source: StockCharts.com

But just what is the bond mar­ket try­ing to tell us? My analy­sis indi­cates that more than 75% of the yield on the 10-year note can be explained by MZM veloc­ity, cal­cu­lated as the ratio between GDP (cur­rent terms) and MZM (money zero matu­rity). When the his­tor­i­cal rela­tion­ship is applied to the cur­rent yield on the 10-year note of 2.54% it indi­cates that the bond mar­ket is expect­ing MZM veloc­ity to fall from 1.55 to 1.47. Given the most recently released num­bers for MZM a fall in MZM veloc­ity will de facto imply that the US econ­omy has shrunk by 5.2% in cur­rent money terms in the third quar­ter on a quarter-ago basis (22.5% annu­alised). You have to ask your­self whether this is real­is­tic or not. What it means is that the bond mar­ket is say­ing that the US is already in a deep reces­sion – there­fore the dou­ble dip is already here!

The mar­ket has been wrong before. It tends to over­shoot the under­ly­ing eco­nomic fun­da­men­tals sig­nif­i­cantly. In the final quar­ter of 2008 the mar­ket antic­i­pated a much worse under­ly­ing econ­omy than that which has even­tu­ated. Since the sec­ond quar­ter of 2009 through the first quar­ter of this year the mar­ket was overly bear­ish on bonds by forc­ing up yields in antic­i­pa­tion of a much stronger econ­omy. Is the mar­ket now overly bull­ish on bonds and bear­ish on the econ­omy by forc­ing the yield on the 10-year note to lev­els sim­i­lar to those that pre­vailed in the midst of the liq­uid­ity crisis?

Tags: 10 Year Treasury, Analysis Indicates That, Anticipation, Bond Market, Consumer Confidence Index, Cue, Current Yield, Double Dip, Economic Fundamentals, First Quarter, GDP, Liquidity Crisis, Midst, Money Terms, Mzm, Recession, Second Quarter, Velocity, Year Treasury Note, Zero Maturity
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Opportunities in the Bad News?

Monday, August 30th, 2010

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

There’s been plenty of bleak news com­ing out of the equity mar­kets and the U.S. econ­omy as a whole. Are there oppor­tu­ni­ties hid­den within that bad news? Are we now in one of those “blood in the streets” sce­nar­ios that Roth­schild (and many investors after him) found so appealing?

If you believe in the cycli­cal nature of mar­kets, the chart below from Stifel Nico­laus may be of inter­est. This chart shows the 10-year rolling return of the S&P Stock Mar­ket Com­pos­ite going back nearly two centuries—current per­for­mance (inside the cir­cled area) is at low lev­els only seen dur­ing the Great Depression.

The neg­a­tive news flow keeps many investors on the side­lines wait­ing for sun­nier days, while those who believe that what goes down even­tu­ally comes back up may see an oppor­tu­nity to snap up equi­ties at bar­gain prices.

A sim­i­lar story line may be cre­ated for the next chart, which was pro­duced by Old Mutual insur­ance com­pany. The MSCI World Index is a mea­sure of stock mar­ket per­for­mance across the world (includ­ing the U.S.).

The chart shows how the growth rate can swing wildly based on global events, but what’s clear is that the neg­a­tive rolling 10-year growth since 2008 is unmatched in the past four decades. Mar­kets have always bounced back, and as you can see on both charts, the best gains tend to be posted early in the turnaround.

One more data point—over the past decade, Trea­sury bonds have out­per­formed U.S. equi­ties by nearly 90 per­cent. This is the widest mar­gin of such out­per­for­mance over a rolling 10-year period in more than a century.

J.P. Mor­gan points out that his­tory shows equi­ties even­tu­ally revers­ing that trend, and when they do, they on aver­age climb more than 250 per­cent over 10 years—a com­pounded annual growth rate of 13.6 percent.

The per­sis­tent bad macro­eco­nomic news makes another round of “quan­ti­ta­tive eas­ing” (i.e., money injec­tion) by the Fed­eral Reserve increas­ingly likely. This could be good for equi­ties by low­er­ing long-term inter­est rates, stim­u­lat­ing the econ­omy and boost­ing valuations.

It’s often said that hope is not an invest­ment strat­egy, and that’s cer­tainly true. It’s also true that hope­less­ness is also not an invest­ment strat­egy. His­tory and cycles are not per­fect pre­dic­tors, but it’s worth­while to pay atten­tion to these indicators.

I would also invite you to take our G-20 flag quiz—not only is it fun, it also teaches you a lit­tle about one of the most impor­tant global eco­nomic groups. If you have already done the quiz, try it again—you can always increase your speed and accuracy.

Copy­right © U.S. Global Investors

Tags: Bad News, Bargain Prices, Chief Investment Officer, Cyclical Nature, Federal Reserve, Frank Holmes, Global Events, Great Depression, J P Morgan, Macroeconomic News, Msci World Index, Mutual Insurance Company, Negative News, Outperformance, Rothschild, Scenarios, Sidelines, Stock Market Performance, Treasury Bonds, U S Global Investors
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Faber and Shiff: Bond Bubble Trouble?

Saturday, August 28th, 2010

This post is a guest con­tri­bu­tion by Dian Chu, mar­ket ana­lyst, trader and author of the Eco­nomic Fore­casts and Opin­ions blog.

As I’ve been say­ing for some time that the bond mar­ket is scream­ing for an immi­nent burst,  Dr. Marc Faber and Mr. Peter Schiff also spoke with CNBC on August 23 warn­ing of a bond bub­ble trouble.

Faber – Stay away from a 19-year rally
Faber advises investors to “stay away from Trea­suries as they’ve been ral­ly­ing since 1981–equivalent to a 19-year bull run”–when the 10-year bot­tomed out on Sep. 21, 1981. Faber says Dec. 18, 2008 was the peak of the bond bub­ble with yields of 2.08% and 2.53% on the 10-year and 30-year respec­tively. (See 10-year chart)

“I think  there isn’t much upside poten­tial in Trea­suries unless it’s for the short term. Even the short term is uncer­tain. But if I look 10 years ahead, where do I want to have my money? Cer­tainly not in U.S. Treasuries.”

Faber’s biggest con­cern is that because of a weak econ­omy, the U.S. bud­get deficit will likely remain high, and con­tinue to go up under the Obama admin­is­tra­tion, which could make inter­est pay­ments on gov­ern­ment debt unbearable.

He also warned against the mis­guided con­fi­dence aris­ing from still strong for­eign demand for U.S. Treasuries:

“In 1999 and 2000, for­eign­ers (bought) the NASDAQ and what hap­pened after­wards was a major col­lapse. I would not look at for­eign buy­ing as a very intel­li­gent lead­ing indicator.”

Faber says a bet­ter place for investor’s money now is farm land and, agri­cul­tural com­modi­ties, and gold should also be a part of an investor’s portfolio.

Schiff – The mother of all bub­bles
Schiff basi­cally declares the bond mar­ket the mother of all bub­bles, and notes that when the bub­ble bursts, the loss will dwarf the com­bined losses of the bub­bles of the stock mar­ket and  real estate. Even­tu­ally, the gov­ern­ment will either inflate or default. Either way will ulti­mately make bond investors go bust.

For risk-averse investors, Schiff believes gold and for­eign bonds such as Switzer­land where gov­ern­ment debt level is not as high, would be bet­ter options than U.S. treasuries.

My thoughts
Dis­mal eco­nomic data have spooked investors flock­ing to Trea­suries, dri­ving down yields. Tra­di­tion­ally, bonds are con­sid­ered to be safer and less volatile than equi­ties and com­modi­ties. How­ever, the finan­cial mar­kets have evolved in such a way that the same play­ers are active in all sec­tors, employ­ing the same trad­ing tech­nique. This, in part, has made bonds behave almost like stocks with sim­i­lar volatil­ity. (See com­par­i­son chart.)

So, investors should start look­ing at bonds the same way as equi­ties and com­modi­ties, and now is the time to move out of bonds and into either equi­ties (dividend-paying blue chips as noted in my pre­vi­ous post), or com­modi­ties such as gold.

And for the highly risk averse, park­ing in cash for the short term would still be bet­ter  than stay­ing in “the mother of all bubbles”.

(Rec­om­mended Read­ing: Self-fulfilling Prophecy: The Bond Trade, Yield: Dow 30 vs. 10-year U.S. Trea­sury, and Bonds & Equi­ties: Expect a Major Shift)

Video Source: CNBC

Source: Dian Chu, Eco­nomic Fore­casts & Opin­ions, August 25, 2010.

Tags: Agricultural commodities, Bond Investors, Bond Market, Bubble Trouble, Bubbles, Budget Deficit, Bull Run, Cnbc, Commodities, Dian, Dr Marc Faber, Economic Forecasts, Gold, Government Debt, Interest Payments, Leading Indicator, Market Analyst, Nasdaq, Peter Schiff, Shiff, Stock Market, Treasuries
Posted in Gold, Markets | 1 Comment »

U.S. Equity Market Diary (August 30, 2010)

Saturday, August 28th, 2010

U.S. Equity Mar­ket Diary (August 30, 2010)

The fig­ure below shows the per­for­mance of each sec­tor in the S&P 500 Index for the week. Three sec­tors gained and seven declined. The best-performing sec­tor was util­i­ties, up 2 per­cent. Other better-performing sec­tors included tele­com ser­vices & energy. The three worst-performing sec­tors were tech­nol­ogy, indus­tri­als and con­sumer discretion.

Within the util­i­ties sec­tor the best-performing stock was NiSource Inc., up 6 per­cent. Other top per­form­ers in the sec­tor were CMS Energy Corp., Ameren Corp., TECO Energy Inc. and PG&E Corp

Strengths

• The indus­trial real estate invest­ment trust (REIT) group was the top-performing group, up 8 per­cent on the strength of its sin­gle mem­ber, Pro­L­o­gis. A research report by the owner/developer of indus­trial ware­house facil­i­ties stated that the nation’s dis­tri­b­u­tion prop­erty leas­ing mar­kets were show­ing signs of recov­ery at midyear 2010.
• The con­sumer elec­tron­ics group out­per­formed, ris­ing 5 per­cent, led by its sin­gle mem­ber, Har­man Inter­na­tional Indus­tries Inc. The maker of high-quality con­sumer elec­tron­ics gear was men­tioned favor­ably in an invest­ment blog.
• The edu­ca­tion ser­vices group out­per­formed, advanc­ing 4 per­cent, led by mem­ber Apollo Group Inc. The for-profit edu­ca­tion firm pub­lished a white paper that pro­vided some incre­men­tal data points on its stu­dents’ loan default rates.

Weak­nesses

• The spe­cialty stores group was the worst per­former, down 5 per­cent, led by its largest mem­ber, Tiffany & Co. The retail jew­eler reported second-quarter earn­ings above con­sen­sus and raised earn­ings guid­ance for the fis­cal year, but second-quarter rev­enue was below consensus.
• The invest­ment bank & bro­ker­age group under­per­formed, falling 5 per­cent. All four mem­bers of the group were down, with Charles Schwab Corp. hav­ing the largest per­cent­age decline after a major bro­ker­age firm low­ered its rat­ing and tar­get price.
• The coal & con­sum­able fuel group under­per­formed, los­ing 5 per­cent. The price of nat­ural gas, a rival fuel for coal in power plants, declined this week, mak­ing it some­what eas­ier for power com­pa­nies to switch from coal to nat­ural gas for fuel.

Oppor­tu­ni­ties

• There may be an oppor­tu­nity for gain in merger & acqui­si­tion trans­ac­tions in 2010. Cor­po­rate liq­uid­ity is high, thereby pro­vid­ing the means to pur­sue acquisitions.

Threats

• Should investors’ expec­ta­tions for an improv­ing econ­omy not come to fruition on a rea­son­able time frame, it could be a threat to stock prices.
• As gov­ern­ments around the world begin to wind-down the mon­e­tary and fis­cal stim­u­lus pro­grams put in place dur­ing the eco­nomic cri­sis, it will likely present a head­wind for stocks.

Tags: Ameren Corp, Apollo Group Inc, Brokerage Group, Charles Schwab, Charles Schwab Corp, Cms Energy Corp, Consumer Electronics Gear, Consumer Electronics Group, Education Services Group, Estate Investment Trust, Harman International Industries, Harman International Industries Inc, Loan Default Rates, Natural Gas, Nisource Inc, Percentage Decline, Quality Consumer Electronics, Retail Jeweler, Target Price, Teco Energy, Teco Energy Inc
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The Economy and Bond Market Diary (August 30, 2010)

Saturday, August 28th, 2010

The Econ­omy and Bond Mar­ket Diary (August 30, 2010)

Trea­sury bonds sold off sharply on Fri­day, send­ing yields higher as the mar­ket was dis­ap­pointed by Fed­eral Reserve Chair­man Bernanke’s com­ments regard­ing the prospect for addi­tional uncon­ven­tional mon­e­tary pol­icy. The mar­ket wanted a more defin­i­tive com­mit­ment and appar­ently was priced accordingly.

The chart below shows the 10-year Trea­sury bond, which expe­ri­enced the sharpest one-day sell off since May. For the week, how­ever, yields were only mod­estly higher.

Strengths

• Mort­gage rates hit a fresh new low of 4.36 per­cent, the low­est level since records began 39 years ago.
• Credit-card debt fell to the low­est lev­els in eight years as con­sumers con­tinue to pare down debt and repair per­sonal bal­ance sheets. While this is neg­a­tive for near-term spend­ing, it is ulti­mately what must be done and the process is mov­ing for­ward rel­a­tively rapidly.
• The Fed reit­er­ated its com­mit­ment to do what it takes to pre­vent defla­tion through addi­tional mon­e­tary policy.

Weak­nesses

• Second-quarter GDP was revised lower to 1.6 per­cent from the orig­i­nally reported 2.4 per­cent. This was in line with expec­ta­tions, but does high­light the ten­ta­tive nature of the eco­nomic recovery.
• Hous­ing remains very weak, new home sales fell 12.4 per­cent and reached a new record low while exist­ing home sales fell by more than 27 percent.
• Ireland’s long-term debt was down­graded this week and credit default swap spreads for the sovereign-debt-burdened “PIIGS” coun­tries (Por­tu­gal, Ire­land, Italy, Greece and Spain) have reached lev­els at or near all-time highs. After a lull, investors appear to have refo­cused on the long-term neg­a­tive prospects for many of these countries.

Oppor­tu­ni­ties

• Infla­tion is unlikely to be a prob­lem for some time and this gives cen­tral bankers and other pol­i­cy­mak­ers around the world room for expan­sive policies.

Threats

• Next week’s eco­nomic cal­en­dar is full of poten­tial market-moving reports. The most impor­tant of these will be next Friday’s job report and Wednesday’s ISM Man­u­fac­tur­ing Index.

Tags: 10 Year Treasury, 10 Year Treasury Bond, All Time Highs, Credit Card Debt, Credit Default Swap, Economic Calendar, Existing Home Sales, Federal Reserve Chairman, Federal Reserve Chairman Bernanke, Ireland Italy, Italy Greece, Market Diary, Mortgage Rates, Personal Balance, Policy Weaknesses, Potential Market, Quarter Gdp, Sovereign Debt, Tentative Nature, Treasury Bonds
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Gold Market Diary (August 30, 2010)

Saturday, August 28th, 2010

Gold Mar­ket

For the week, spot gold closed at $1,238.01 per ounce, up $10.13, or 8.3 per­cent, for the week. Gold equi­ties, as mea­sured by the Philadel­phia Gold & Sil­ver Index, rose 3.4 per­cent. The U.S. Trade-Weighted Dol­lar Index was essen­tially flat.

Strengths

• The World Gold Coun­cil released it Gold Demand Trends pub­li­ca­tion for the sec­ond quar­ter of 2010 and high­lighted the mas­sive growth in invest­ment demand, includ­ing a 414 per­cent jump in gold ETFs com­pared to the same period last year. Gold demand also rose 36 per­cent higher than the same period as last year.
• The gold price was pro­pelled to a seven-week high due to a U.S. gov­ern­ment report that showed weaker-than-expected data in orders for durable goods and a record low pace sales of new homes.
• India’s con­sump­tion of gold rose 94 per­cent in the first half of 2010 com­pared to the same period last year. The total demand for gold jew­elry in the coun­try in the first half of 2010 increased 67 per­cent com­pared to the same period last year.

Weak­nesses

• “The world may well have lost its opti­mism over the global eco­nomic out­look, but the two key dri­vers for the price of gold—anticipation of higher infla­tion and lack of risk appetite—are lit­tle more than shift­ing sands,” accord­ing to Renais­sance Asset Management.
• Investors with­drew $33 bil­lion from domes­tic stock mar­ket mutual funds in the first seven months of this year, accord­ing to the Invest­ment Com­pany Insti­tute. If that pace con­tin­ues, more money will be pulled out of mutual funds in 2010 than any year since the 1980s, with the excep­tion of 2008, when the global cri­sis peaked.
• It was hoped the numer­ous fes­ti­vals in India at the end of August would revive gold buy­ing in India, but the high price appears to have trimmed vol­umes and caused con­sumers to opt for cheaper imi­ta­tion gold.

Oppor­tu­ni­ties

• Van Eck Asso­ciates fore­casts a new record gold price as of $1,400 as we move through the fall of 2010 and into 2011.
• Amid the like­li­hood of a hung Par­lia­ment, Australia’s Asso­ci­a­tion of Min­ing and Explo­ration Com­pa­nies is push­ing for the gov­ern­ment to remove all uncer­tainty and scrap a planned min­ing tax. The AMEC points out that Australia’s rep­u­ta­tion has been dam­aged, and that drop­ping the tax would “announce to the world that Australia’s doors are open for busi­ness again.”
• An ana­lyst at the Gold Fore­caster stated that “gold will not enter a bear mar­ket by falling as equity mar­kets are to do today. It is not an item whose demand will fall away.”

Threats

• U.S. Rep­re­sen­ta­tive Ron Paul plans to intro­duce a new bill next year that would allow for an audit of U.S. gold reserves.
• Many real estate experts now believe that home own­er­ship will never again yield rewards like those enjoyed in the sec­ond half of the 20th century.
• Dean Baker, co-director of the Cen­ter for Eco­nomic and Pol­icy Research, esti­mates that it will take two decades to recover the $6 tril­lion of the hous­ing wealth lost since 2005.

Tags: Dollar Index, Domestic Stock Market, ETF, ETFs, Festivals In India, Global Crisis, Global Economic Outlook, Gold, Gold Demand Trends, Gold Equities, Gold Jewelry, Gold Market, Gold Price, Imitation Gold, India, Investment Company Institute, Investment Demand, Market Diary, Philadelphia Gold, Risk Appetite, Silver, Silver Index, Spot Gold, Van Eck Associates, World Gold Council
Posted in ETFs, Gold, India, Markets, Outlook, Silver | Comments Off

Energy and Natural Resources Market Diary (August 30, 2010)

Saturday, August 28th, 2010

Energy and Nat­ural Resources Mar­ket Diary (August 30, 2010)

Strengths

• Despite con­cerns over global growth, the price of cop­per gained 1.7 per­cent on the week and has con­sis­tently traded above the key $3 per pound level dur­ing the month.
• The 4-week mov­ing aver­age of chem­i­cal rail­car load­ings increased 5.1 per­cent in the week ended August 21 fol­low­ing a 5.8 per­cent increase the prior week.
• Chicago corn futures con­tin­ued to rise late in the week, extend­ing the pre­vi­ous session’s biggest one-day rally in nearly a month as strong global demand and con­cerns over the size of the U.S. crop sup­ported the market.
• Fer­rous scrap prices into Rot­ter­dam rose 3.4 per­cent to $365 per met­ric ton, accord­ing to Platts.

Weak­nesses

• The price of nat­ural gas fell nearly 10 per­cent this week, below $4 per mil­lion BTU, on amply sup­ply and wan­ing con­sump­tion enter­ing the shoul­der months for demand.
• Power rationing in China’s Zhe­jiang province is expected to cut demand from cop­per fab­ri­ca­tors for at least sev­eral months, with some fab­ri­ca­tors indi­cat­ing pro­duc­tion lev­els down 30 per­cent. Zhe­jiang province accounts for approx­i­mately 20 per­cent of China’s total pro­duc­tion of copper-fabricated products.
• China’s cok­ing coal imports fell in July to 3.1 met­ric tons from 4.9 met­ric tons in July 2009 and 3.6 met­ric tons in June this year.

Oppor­tu­ni­ties

• The Wall Street Jour­nal reported that China's sec­ond largest util­ity is aim­ing to increase coal self-sufficiency. The exec­u­tive direc­tor of Datang Inter­na­tional Power Gen­er­a­tion said that the com­pany aims to boost its coal self-sufficiency ratio to 40 per­cent by 2015 from 20 per­cent now by seek­ing to buy mine projects in Inner Mon­go­lia to secure supplies.
• China called for fur­ther merg­ers and con­sol­i­da­tion in its mas­sive coal indus­try to elim­i­nate out­dated capac­ity and improve effi­ciency, the State Coun­cil said on its website.
• Accord­ing to media reports, state-owned Oil India has $2.5 bil­lion avail­able in cash and is look­ing to pur­chase shale-gas assets in the U.S. and Aus­tralia. The gov­ern­ment has asked Oil India and Oil & Nat­ural Gas Corp. to each make at least one acqui­si­tion this year to meet demand in Asia’s second-fastest grow­ing major economy.

Threats

• The com­bi­na­tion of slow­ing Chi­nese eco­nomic growth and expand­ing refiner­ies means this year’s 51 per­cent decline in profit mar­gins from turn­ing crude into gaso­line, diesel and kerosene is poised to worsen.

Tags: BRIC, BRICs, Btu, China, Coal Imports, Coal Industry, Coking Coal, Commodities, Copper Fabricators, Corn Futures, energy, Global Demand, Global Growth, India, Inner Mongolia, Market Diary, Metric Ton, Metric Tons, Moving Average, Natural Gas, Natural Resources, oil, Oil India, Price Of Copper, Price Of Natural Gas, Railcar, Self Sufficiency, Wall Street Journal, Zhejiang Province
Posted in Emerging Markets, Energy & Natural Resources, India, Markets, Oil and Gas | Comments Off

Emerging Markets Diary (August 30, 2010)

Friday, August 27th, 2010

Emerg­ing Mar­kets Diary (August 30, 2010)

Strengths

• Thailand’s GDP expanded by a higher-than-expected 9.1 per­cent in the sec­ond quar­ter from a year ear­lier, as surg­ing exports helped off­set the impact of polit­i­cal turmoil.
• Second-quarter GDP rose 7.9 per­cent year over year in The Philip­pines, exceed­ing con­sen­sus esti­mates. Growth was dri­ven by higher fixed-asset invest­ment, espe­cially in con­struc­tion, and gov­ern­ment spending.
• GDP and con­sump­tion lev­els in dol­lar terms place Rus­sia on par with Brazil and India, accord­ing to Troika Dia­log research. Data from the Brook­ings Insti­tu­tion imply that Rus­sia actu­ally has the largest middle-class con­sump­tion among the BRIC nations, which sup­ports the con­sumer sec­tor invest­ment theme.
• The Brazil­ian cor­po­rate and retail investors still con­tinue to borrow—the data from July show 18 per­cent growth of out­stand­ing loans year over year.
• •The unem­ploy­ment rate in Brazil in July declined to 6.9 per­cent from 7 per­cent in June. With the lat­est infla­tion data at 4.4 per­cent, below the offi­cial tar­get of 4.5 per­cent, the mar­ket expec­ta­tions are that the cur­rent inter­est rates of 10.75 per­cent are unlikely to change by year-end
• Investors con­tinue to be attracted by the prospects of Brazil. Shell and Cosan set up a joint ven­ture to pro­duce sugar and ethanol and to con­sol­i­date the fuel dis­tri­b­u­tion in the coun­try. The com­bined entity will have an 18 per­cent mar­ket share in the fuel dis­tri­b­u­tion, behind Petro­bras (34 per­cent) and Ultra­par (21 percent)
• Retail sales in the greater San­ti­ago area in July increased by 25 per­cent year over year. The Cen­tral Bank of Chile updated a pre­vi­ously fore­cast GDP growth of 4 per­cent to 5 per­cent, say­ing it is more likely to reach 6.5 percent

Weak­nesses

• Hong Kong’s July exports increased by a slower-than-expected 23.3 per­cent year over year, while imports grew a less-than-estimated 24.9 per­cent year over year, reflect­ing a slow­down in China.
• Accord­ing to WINDS data­base, out of 90 Chi­nese prop­erty devel­op­ers listed in Shang­hai and Shen­zhen that have reported first-half results, close to two-thirds show neg­a­tive oper­at­ing cash flows. A sim­i­lar ratio was last seen in the mid­dle of 2008.
• Russia’s min­istry of econ­omy esti­mated that the drought will shave off at least 0.4 per­cent to 0.5 per­cent from GDP growth this year. Accord­ing to Reuters, poten­tial total effect on the econ­omy could be 0.7 per­cent to 0.8 per­cent being slashed from GDP growth.
• An appre­ci­at­ing Chilean peso (up 3.3 per­cent against the U.S. dol­lar last month) is caus­ing strain for many Chilean exporters. The Cen­tral Bank rejected an inter­ven­tion call at this stage, say­ing the cur­rency strength is a reflec­tion of the strength of the Chilean economy

Oppor­tu­ni­ties

• The 60-mile traf­fic jam in North­ern China since August 14 is attrib­ut­able to coal trans­porta­tion to meet higher demand for power gen­er­a­tion because of unusu­ally hot weather. The provinces of Inner Mon­go­lia, Shanxi and Shaanxi account for half of China’s coal pro­duc­tion. Truck trans­porta­tion to coastal regions has added tremen­dous pres­sure on high­way infra­struc­ture. These bot­tle­necks high­light the longer-term need for more infra­struc­ture con­struc­tion in the hin­ter­lands and shorter-term oppor­tu­nity for higher coal prices.

• Russ­ian car deliv­er­ies increased 9 per­cent in the first seven months of the year and jumped 48 per­cent in July, com­pared to first-half year sales growth of 0.6 per­cent in the rest of Europe.
• The Venezue­lan gov­ern­ment will can­cel $200 mil­lion in out­stand­ing debt of Colom­bian exporters. Although the two coun­tries rep­re­sent very diver­gent polit­i­cal sys­tems, their trade rela­tions remain strong
• HSBC is reported to be bid­ding for a con­trol­ling stake in Ned­bank, the fourth-largest bank in South Africa. It remains to be seen whether the South African author­i­ties will autho­rize such a trans­ac­tion after hold­ing ICBC (of China) to a 20-percent stake in Stan­dard Bank
• Time Warner bought a stake in Chile­vi­sion, the local free-to-air TV net­work, for around $150 mil­lion. It remains to be seen how Time Warner, which already oper­ates in Chile through CNN, will repo­si­tion its strat­egy in the country

Threats

• Dete­ri­o­rat­ing U.S. eco­nomic data, includ­ing hous­ing sales and unem­ploy­ment, might weigh on investor sen­ti­ment toward Asian coun­tries that have largely relied on exports for the cur­rent recovery.
• The con­sti­tu­tional ref­er­en­dum on Sep­tem­ber 12 could limit poten­tial upside in Turk­ish equi­ties until the out­come is known. His­tor­i­cally, mar­ket per­for­mance was hin­dered by the prospect of a coali­tion government.
• Mex­ico con­tin­ues to bat­tle to restore sta­bil­ity while con­duct­ing its war on drugs.

Tags: Asset Investment, Bank Of Chile, Brazil, BRIC, BRICs, Brookings Institution, Central Bank Of Chile, China, Consensus Estimates, Consumer Sector, Consumption Levels, Cosan, Current Interest Rates, Dialog Research, Dollar Terms, Emerging Markets, Fuel Distribution, GDP Growth, India, Inflation Data, Market Expectations, oil, Political Turmoil, Quarter Gdp, Retail Investors, Russia, Target, Unemployment Rate
Posted in Brazil, Emerging Markets, Energy & Natural Resources, India, Infrastructure, Markets, Oil and Gas | Comments Off

Tech Sector Watch: Is Mega Merger the Inevitable Solution?

Friday, August 27th, 2010

By Dian L. Chu, Eco­nomic Fore­casts & Opin­ions

The most active mar­ket sec­tor in terms of con­sol­i­da­tion is def­i­nitely Tech­nol­ogy and there is a rea­son for this wave of M&As. At the fore­front of any analy­sis it is always impor­tant to fol­low the money. This is the real dri­ver of this trend that has been going on for the past year, and will only inten­sify over the next four months.

Who has all the money in the world to spend on major tech­nol­ogy pur­chases? The answer would be large cor­po­ra­tions and big gov­ern­ments with both the money and need to cut costs to be more effi­cient and pro­duc­tive through more advanced tech­nol­ogy infrastructure.

Law of Dimin­ish­ing Returns & Survival

Tech sec­tor is not immune to the Law of Dimin­ish­ing Returns, which means mar­gins will inevitably con­tin­u­ally come down as tech­no­log­i­cal prod­ucts and ser­vices become com­modi­tized. The high mar­gins are always in the new growth areas of tech­nol­ogy that have yet to become com­modi­tized. Thus enter all the hoopla over cloud com­put­ing. This is an area that will pro­duce the high mar­gin growth oppor­tu­ni­ties in tech­nol­ogy for at least the next five years.

All the big play­ers want to make sure they get in a bet­ter posi­tion to fully cap­i­tal­ize and com­pete in this new area of high mar­gins. It is the death of a tech­nol­ogy com­pany to be left in the realm of com­modi­tized prod­uct offer­ings. The bat­tle over 3PAR between HP (HPQ) and Dell is really about the future sur­vival in the tech­nol­ogy arena.

Dell – Too Late in the Diver­si­fi­ca­tion Game

Dell should have been think­ing along these terms five years ago the way HP has diver­si­fied itself along the higher mar­gin spec­trum to off­set the com­modi­tized por­tion of their busi­ness port­fo­lio. Instead, Dell has failed at becom­ing com­pet­i­tive pur­su­ing its strat­egy of the past three years of try­ing to come up with “cool” prod­ucts to drive higher mar­gins—-à la Apple (AAPL).

Now, Dell is try­ing to play catch-up in an attempt to dupli­cate HP’s suc­cess­ful tran­si­tion from strictly a com­mod­ity provider to that of a value added busi­ness enter­prise based rev­enue model. Well, Dell is prob­a­bly too far behind and don`t have enough resources at this point to go this route, in my opinion.

And this lit­tle 3PAR dog­fight is just a micro­cosm of what is tak­ing place in strat­egy ses­sions all over Sil­i­con Val­ley, and board­rooms across the world as tech­nol­ogy com­pa­nies con­stantly have to fight to stay relevant.

Not Enough Mar­gins to Go Around

The prob­lem is that there are not enough resources to go around in the high growth areas. There are too many big play­ers fight­ing for the same ter­ri­tory, whereas it was much eas­ier in the past to divide up the space and say Dell and HP do hard­ware, Cisco does routers and Net­work­ing, IBM does large main­frame and con­sult­ing, etc. All that has changed as the sec­tor has become intensely com­pet­i­tive, with every player increas­ingly encroach­ing onto each other’s turf, par­tic­u­lar in the higher mar­gin categories.

But here is the rub–there can only be high mar­gins with few com­peti­tors. As more com­peti­tors fight for the same space in the cat­e­gory, inevitably mar­gins for the cat­e­gory start shrink­ing.  As such, there will con­tinue to be these smaller deals in tech as com­pa­nies try to posi­tion them­selves to bet­ter com­pete in these high mar­gin growth areas. How­ever, this is really just miss­ing the for­est for the trees.

The big­ger pic­ture is that the tech sec­tor is still rel­a­tively frag­mented with too many big play­ers com­pet­ing for the same high mar­gin growth cat­e­gories, and not all of them are going to sur­vive. Some of the big play­ers will need to con­sol­i­date with some of the other big play­ers in the sec­tor in order to pre­serve any kind of pric­ing power. Oth­er­wise, ulti­mately they will all be reduced to low-margin com­mod­ity providers, even in the cur­rently attrac­tive high mar­gin category.

A Short List Fit­ting the M&A Prerequisites

The list of big tech­nol­ogy play­ers includes Microsoft, IBM, Ora­cle, Cisco, Apple, HP, Intel and Google. Some firm on this list most likely will need to be sub­sumed under the umbrella of one of the other in the group.

One pre­req­ui­site of acquir­ing another big player is a healthy stock price and mar­ket cap. Since these deals will be so big to be all cash, a firm`s mar­ket cap and stock price will become cru­cial in stock swap con­ver­sion ratio, which will be a major com­po­nent of any deal. For exam­ple, HP`s cur­rent mar­ket cap–just under $89 Billion—is the small­est on the list, and thus pre­cludes them from being a major player.

The sec­ond ele­ment will be a per­ceived strate­gic fit between both firms. A third require­ment will be a bold leader who is ahead of the curve, and fight­ing the bat­tle of next five years, instead of just this year. Another com­po­nent may include a lack of attrac­tive organic growth prospects in the acquir­ing firm. But in gen­eral, the stronger com­pany will acquire the weaker company.

Remem­ber, in these deals it is not where the two firms are today, they may seem like alliances with no true syn­er­gies, but it is where both com­pa­nies are head­ing three years down the line as future competitors.

On a side note, a smaller firm can actu­ally acquire a much larger firm and be quite suc­cess­ful. Sev­eral come to mind, but it is more risky, and given the cur­rent eco­nomic envi­ron­ment, will be a con­cern for boards in con­sid­er­ing this type of bold move.

Poten­tial Deal Scenarios

Microsoft, IBM, and Apple are the strongest com­pa­nies on this list. I would have included HP on this list a cou­ple of months ago, but as noted ear­lier, their cur­rent low stock price pre­cludes them from being active as a major acquirer.

Apple is sit­ting on tons of cash, but acqui­si­tion actu­ally goes against their fun­da­men­tal strat­egy of seek­ing growth organ­i­cally. Fur­ther­more, Apple is so dis­tinct in devel­op­ing prod­ucts that fit in with the Apple Cul­ture that the only firm on this list that I could envi­sion Apple acquir­ing would be Cisco, as the other possibility—Intel–would prob­a­bly have anti-trust issues that would be insurmountable.

IBM could acquire HP much eas­ier from an anti-trust per­spec­tive than, say, Oracle, but both acqui­si­tions would make for strate­gic sense along dif­fer­ent lines. Mean­while, the most likely deals for Microsoft would be them buy­ing Cisco or HP, as these are the only two with a strate­gic fit and with­out as much anti-Trust concerns.

An Ora­cle – HP alliance would be intrigu­ing, but again I think Ora­cle is too small to acquire HP, but from a busi­ness enter­prise soft­ware and hard­ware stand­point maybe three years down the line there would be some excel­lent sales syn­er­gies to be gained from this combination.

A Cisco –HP alliance would make con­sid­er­able strate­gic sense, but nei­ther of them is in a posi­tion to acquire the other–Cisco is not quite large enough to acquire HP, and HP stock is still in cri­sis mode to be the acquirer either.

Intel and Google are sort of stuck in the mid­dle as both want to branch out into other areas and diver­sify their rev­enue streams, as both have not suc­ceeded so well with their organic growth ini­tia­tives out­side of their core com­pe­tency over the last five years.

How­ever, both Intel and Google either lack enough syn­er­gies for the oth­ers to acquire, or are prob­lem­atic from an anti-trust per­spec­tive. Fur­ther­more, I don`t fore­see either firms real­iz­ing they need to make a bold acqui­si­tion to gen­uinely diver­sify their rev­enue streams until it is too late, and they have both become com­modi­tized play­ers in technology.

Anti-trust Not As Problematic

Let me men­tion here that anti-trust issues are not as prob­lem­atic for these types of Mega Merg­ers as peo­ple might think. The tech sec­tor has become very crowded with at least six to eight major play­ers in a given cat­e­gory instead of two or three major com­peti­tors in the old days. This fact reduces anti-trust con­cerns to a deal being done in many poten­tial scenarios.

Fight for the Greener Grass

So yes, in tech­nol­ogy, the grass is greener on the other side. And every­body has their hands in every­body else`s kitchen so to speak. Apple wants to start mak­ing video game play­ers, Microsoft wants to cre­ate a great smart phone, Ama­zon wants to make all encom­pass­ing Tablets, HP wants into stor­age, Dell wants to be like HP, they tried being like Apple, etc. But in the end all these com­pa­nies are going to merge into the same high growth areas, and fight it out with dis­tinct win­ners and losers.

And the advance of cloud com­put­ing is only high­light­ing the fact that there are too many big play­ers, and not enough avail­able high mar­gin growth areas for all to flour­ish. Even­tu­ally, some will have to team up with others, some will be rel­e­gated to low mar­gin com­mod­ity play­ers, and only a hand­ful of the strong-and-fit-to-survive will emerge at the fin­ish line as Mega Tech Giants that dom­i­nate the high-end of the tech­nol­ogy land­scape in the future.

Dis­clo­sure: No Posi­tions
Dian L. Chu, Aug. 27

Tags: 3par, Aapl, Active Market, All The Hoopla, Business Portfolio, Cool Products, Economic Forecasts, Growth Areas, Hp Hpq, Inevitable Solution, Large Corporations, Law Of Diminishing Returns, Major Technology, Market Sector, Product Offerings, Sector Watch, Technological Products, Technology Arena, Technology Infrastructure, Technology Purchases
Posted in Infrastructure, Markets | Comments Off

Increasing Risks (Boeckh)

Friday, August 27th, 2010

The arti­fi­cial nature of the U.S. eco­nomic recov­ery from the reces­sion lows has always been obvi­ous. In recent months, judg­ing from media cov­er­age, it is now main­stream. While there are a few lin­ger­ing signs that sup­port some mod­est opti­mism, it is get­ting dif­fi­cult to find much to cheer about. In our let­ter Vol. 2.10, The Arti­fi­cial Eco­nomic Recov­ery, dated July 23, 2010 we pointed out that the U.S. growth tra­jec­tory was con­verg­ing on 1% p.a. With revi­sions to sec­ond quar­ter GDP that seems to be fact now. A double-dip U.S. reces­sion is still not a done deal but forces are all on the side of eco­nomic weak­ness and defla­tion, and a double-dip reces­sion next year car­ries a sig­nif­i­cant possibility.(note 1)

Charts 1–3 show how the weak recov­ery in employ­ment and pro­duc­tion prospects and the sta­bil­ity in hous­ing have all gone into reverse in spite of zero inter­est rates. This is highly unusual, to say the least, after only five quar­ters of eco­nomic recov­ery. The mes­sage is clear: the pol­icy stim­u­lus pro­vided only a short-term boost.

It is clear that there is one global mar­ket place for goods, ser­vices and money. And the world has become, once again, struc­turally very unbal­anced and hence, frag­ile, as pointed out in our Let­ter dated August 2, 2010, Vol­ume 2.11, Roller Coaster Eco­nom­ics: Pre­pare for the Next Down­turn, and dis­cussed at length in The Great Refla­tion.(note 2)

For many years prior to 2008, there was a pre­car­i­ous dis­e­qui­lib­rium requir­ing a del­i­cate bal­anc­ing act to keep things afloat. The crash demol­ished this arti­fi­cial world and cre­ated another one via the great­est peace­time global refla­tion in his­tory. In the ver­nac­u­lar, we describe this as try­ing to pump air back into the burst balloon.

Many would argue that the struc­tural dis­e­qui­lib­rium, directly and indi­rectly, was a prin­ci­ple cause of the crash. We are now head­ing back in that same direction—growing sur­pluses in China, Ger­many and Japan (Charts 4–6) and the coun­ter­part, grow­ing deficits in the U.S. and other weak debtor and deficit nations. This is a recipe for dis­as­ter because the deficit coun­tries do not have the inter­nal and exter­nal bal­ance sheets to absorb the excess sav­ings in the rest of the world. Rather than lever­ag­ing up their bal­ance sheets, as they once did to con­sume, they are delever­ag­ing under the pres­sure of mar­kets to get liq­uid. When every­one tries to get liq­uid, either by sav­ing more and spend­ing less, or by try­ing to get oth­ers to buy their goods (in order to get their liq­uid­ity), the result inevitably is that liq­uid­ity shrinks in the key areas where it is most needed.

In the U.S., delever­ag­ing in the house­hold sec­tor (Chart 7) has barely begun in spite of a surge in the sav­ings rate, yet the U.S. trade deficit has widened dra­mat­i­cally (Chart 8). The coun­ter­part is an explo­sive growth in exports of sur­plus coun­tries like China, Ger­many and Japan. Chart 9 shows China’s surg­ing trade balance.

The most egre­gious offender is mer­can­tilist China Inc., with its enor­mously under­val­ued exchange rate, loan sub­si­dies to exporters and a vari­ety of other import restrict­ing / export sub­si­diz­ing poli­cies. Its dra­matic for­eign exchange reserve growth in recent years reflects these poli­cies. The result­ing addi­tion to Chi­nese liq­uid­ity feeds real estate bub­bles (but not yet the stock mar­ket in this cycle). China does try to ster­il­ize the mon­e­tary effects of reserve accu­mu­la­tion but it is not easy to do on a sus­tain­able basis.

Effec­tively, the sur­plus coun­tries are steal­ing growth from the deficit coun­tries and not allow­ing them to adjust to exter­nal and inter­nal dis­e­qui­lib­rium. In the U.S., this can be seen most clearly by the simul­ta­ne­ous rise in the sav­ings rate, the trade deficit and the dete­ri­o­ra­tion in labor mar­ket data. When the nat­ural forces of the adjust­ment process to eco­nomic dis­e­qui­lib­rium are blocked, polit­i­cal ten­sion must nec­es­sar­ily increase. In an elec­tion year, you can expect vul­ner­a­ble politi­cians to act.

The options in this sit­u­a­tion for a coun­try like the U.S. are lim­ited and not very good. Apart from fur­ther push­ing on the mon­e­tary string (alias quan­ti­ta­tive eas­ing, for­merly known as money print­ing), there is the pos­si­bil­ity of more fis­cal stim­u­lus. With the U.S. gov­ern­ment debt:GDP ratio already head­ing toward 100 by the end of the decade, this is a dan­ger­ous option and unlikely to buy much growth, nor for very long. How­ever, politi­cians in the U.S. have never been known to worry too much about the longer run.

The third option is for the U.S. to opt for non-market solutions—tit-for-tat mercantilism—to boost domes­tic demand and employ­ment at the expense of for­eign­ers. Trade pro­tec­tion can be employed via com­pet­i­tive deval­u­a­tion, tar­iffs, non-tariff trade restric­tions, etc. It was last tried in the 1930s when sur­plus coun­tries didn’t allow deficit coun­tries to adjust. It would be a far more dan­ger­ous option now because the U.S. is a large for­eign debtor. The U.S. has net lia­bil­i­ties of over $3.5 tril­lion, most of which are held in short-term instru­ments by cen­tral banks who could try to dump them in retal­i­a­tion. The inter­na­tional mon­e­tary sys­tem is seri­ously flawed as it was in the 1930s, although there is the impor­tant dif­fer­ence that domes­tic money sup­plies are not rigidly linked to cen­tral bank hold­ings of gold or for­eign exchange assets. Nonethe­less, great insta­bil­ity with the major reserve asset of the world—dollars—would be catastrophic.

The options for other debtor coun­tries are far more lim­ited than for the U.S. Deficit coun­tries in the euro area are cur­rently being forced into fis­cal aus­ter­ity. More gov­ern­ment spend­ing and tax cuts are not going to hap­pen. Nor do these coun­tries have a monetary/competitive deval­u­a­tion weapon in their tool box. By default, that leaves defla­tion, declin­ing incomes and high unem­ploy­ment (20% in Spain with Greece head­ing there) as the log­i­cal out­come. When social ten­sions reach the break­ing point, trade pro­tec­tion will be seen as an alter­na­tive. In more extreme cir­cum­stances, some coun­tries might depart from the euro, cre­ate their own cur­rency and mas­sively devalue. The result would be high infla­tion and chaos.

Apart from the U.S. and coun­tries in the euro area, there are a vari­ety of oth­ers with finances and economies in var­i­ous states of dis­ar­ray. The U.K., one of the larger ones, has gam­bled on major fis­cal defla­tion. Even with major cut­backs, some fore­cast­ers such as Moody’s see U.K. debt spi­ral­ing up to 90% of GDP in three years.  Japan, after 20 years of stag­na­tion, has a gov­ern­ment debt:GDP ratio over 200%. How Japan has man­aged to avoid a sov­er­eign debt cri­sis for so long is a mys­tery, only partly explained by its for­merly high per­sonal sav­ings rate. This has been falling in recent years, although a surge in cor­po­rate sav­ings has kept total sav­ings at the national level very high. With dis­mal growth prospects and rapidly dete­ri­o­rat­ing demo­graph­ics, the over­val­ued yen is an acci­dent wait­ing to hap­pen (Chart 10). Most of East­ern Europe is also in dire straits, propped up with IMF cred­its. The few bright spots tend to be com­mod­ity pro­duc­ers such as Canada, Aus­tralia, Nor­way and Rus­sia. Nev­er­the­less, they will have trou­ble hid­ing if the world goes pro­tec­tion­ist, anti-market and growth suffers.

These prospects should not be seen as a fore­cast yet. But the grow­ing ten­sions from the dete­ri­o­rat­ing world econ­omy, the need for sus­tained, large pub­lic and pri­vate delever­ag­ing and the imper­a­tive of resolv­ing global dis­e­qui­lib­rium must be cred­i­bly addressed with­out delay. Time is of the essence. The global slow­down is accel­er­at­ing and the U.S. faces a key elec­tion in 10 weeks. Fail­ure to deal with these issues will inevitably push the U.S. and other debtor coun­tries into tak­ing action against the sur­plus coun­tries to steal back growth. Every­one knows that would be a dis­as­ter, but it doesn’t mean it won’t hap­pen. When options run out, you do what you have to, and that includes politi­cians fac­ing vot­ers who are look­ing for quick and easy solutions.

The key for investors is to under­stand that adjust­ments will hap­pen. The process of try­ing to get a pos­i­tive res­o­lu­tion will be messy, fraught with bel­liger­ent threats on all sides and, as always, it will be a nail bit­ing, bluff­man­ship, go to the matt set of nego­ti­a­tions. Fail­ure is not an insignif­i­cant probability.

Invest­ment Conclusions

The uncer­tainty described above nec­es­sar­ily cre­ates a very ner­vous envi­ron­ment for investors. Money does not like such uncer­tainty. Investors, more than ever, will have to grap­ple with these issues, hav­ing no clear idea how it will play out.

In the case of the U.S., politi­cians are return­ing from sum­mer hol­i­days to face a surly elec­torate. They must deal with dete­ri­o­rat­ing employ­ment, pro­duc­tion and hous­ing con­di­tions and a wob­bly stock mar­ket. Pol­icy change is inevitable within the con­straints of a Republican/Democrat partisanship.

Fed­eral Reserve resump­tion of quan­ti­ta­tive eas­ing, (i.e., buy­ing bonds and mort­gages) to inflate its bal­ance sheet fur­ther is inevitable (Chart11). As the Fed’s bal­ance sheet increases, banks will get more reserves, but con­tin­u­ing finan­cial con­sti­pa­tion means not much money growth will come out the other end. How­ever, the action could boost finan­cial mar­kets and con­fi­dence for awhile. Vot­ers might also feel bet­ter temporarily.

Fur­ther fis­cal stim­u­lus ini­tia­tives by the Admin­is­tra­tion will be exploited by Repub­li­cans on deficit bash­ing grounds. There­fore, Democ­rats will have to be cre­ative to seduce enough Repub­li­cans to get the votes they need. Small busi­ness sub­si­dies and hous­ing would seem to be the eas­i­est tar­gets to get quick and pop­u­lar action. Pro­tec­tion­ist mea­sures are prob­a­bly inevitable, but in the short term, there will be a lot more talk than action.

Debt for­give­ness on under-water mort­gages has been mooted. Another mora­to­rium on mort­gage fore­clo­sures is pos­si­ble. There are lots of things that could get con­gres­sional sup­port and have a quick impact (i.e., Novem­ber use-by date) but, like pre­vi­ous mea­sures, would only buy a lit­tle time. After all, 14% of mort­gages are in fore­clo­sure or delin­quent. The esti­mate is that there will be one mil­lion fore­closed homes this year. With­out some sup­port, the brief sta­bi­liza­tion of hous­ing prices will end.

As our read­ers well know, we have empha­sized the crit­i­cal impor­tance of cap­i­tal preser­va­tion in this volatile, highly uncer­tain world. Within that con­ser­v­a­tive con­text, we have been rel­a­tively bull­ish on risk assets. We think the time has come to add another layer of cau­tion to port­fo­lios. The S&P 500 may well remain in an extended trad­ing range but we may be much closer to the upper bound­ary than the lower. Sea­son­ally, we are head­ing into a period when mar­kets tend to be weak, and some impor­tant declines have occurred.

At this point, an extended bear mar­ket is unlikely, though pos­si­ble. Cor­po­rate liq­uid­ity and prof­its have been, and still are, a good source of strength. But that is yesterday’s news. Ana­lysts always lag behind when prof­its are peak­ing and that could well be the case now with the rapid slow­ing of the econ­omy. How­ever, the mar­ket is not expen­sive on a long-term basis.

The explo­sive rally in Trea­sury bonds has cre­ated an inter­est­ing sit­u­a­tion in sev­eral ways. The 10-year yield is down about 100 basis points to 2¾% and the 10-year TIPS (real, infla­tion adjusted) yield has fallen from 1.7% to 1% over the last few months (Chart 12). It is at a record low and com­pares with the 2.1% div­i­dend yield in the S&P. While most peo­ple com­pare nom­i­nal bond yields with div­i­dend yields, the con­cep­tu­ally cor­rect com­par­i­son is with real bond yields because div­i­dend yields are “infla­tion adjusted” over time. The com­par­i­son shows that, if real bond yields remain low, stocks are cheap on this basis. The obser­vant reader will note, how­ever, that the last time real rates were this low was in early 2008, just before the stock mar­ket tanked. But that coin­cided with a move to over 3% in TIPS yields. A repeat any­time soon is unlikely.

It should also be remem­bered that low and falling real inter­est rates are bull­ish for gold. The recent decline in the real rate of inter­est has cer­tainly sup­ported gold prices. But it is use­ful to note that gold has essen­tially gone side­ways in recent months (Chart 13) in spite of this tail­wind of falling rates and the pub­lic­ity sur­round­ing huge pur­chases of gold by sev­eral very high pro­file hedge funds and mas­sive pur­chases by retail investors.

Clearly, a sharp rise in real inter­est rates would be a major neg­a­tive for both asset classes. At some point, real inter­est rates will rise, either because defla­tion sets in(note 3) or because the Trea­sury will have trou­ble sell­ing its bonds as fears heighten over ris­ing debt lev­els. It is unlikely to hap­pen for some time.

Putting all this together, it is clear that there are cross-currents that will con­tinue to affect the equity mar­ket and we pre­fer to shift toward more cau­tion. Uncer­tainty will con­tinue to grow and plenty can go wrong on short notice. On the other hand, it is hard to see where the pos­i­tives might come from, other than another polit­i­cally moti­vated reck­less refla­tion effort from the U.S. author­i­ties. We use the term reck­less in a long-term sense. The U.S. sim­ply does not have good options. There­fore, it will use the tools it has, trad­ing off short-term ben­e­fits for long-term risks. There is noth­ing new in that!

Gold remains an enigma. It is still in a bull mar­ket, but one that seems to be los­ing momen­tum. It is a highly pop­u­lar, well-advertised asset and has become very expen­sive rel­a­tive to almost all other assets. It is, how­ever, a demon­strated hedge against finan­cial melt­down and, as such, deserves an insur­ance role of 5–10% in port­fo­lios. But it is very expen­sive insur­ance; it will be volatile and could be a very poor per­former if insta­bil­ity fears abate.

Mis­cel­la­neous Thoughts:

• The sharp move up in bond prices in recent months in reac­tion to the well-publicized eco­nomic slow­down makes bonds vul­ner­a­ble on a short-term basis. How­ever, long-term investors should con­tinue to hold posi­tions because bonds are doing what they are sup­posed to—provide safe income and a hedge against defla­tion. As a result they are a very good port­fo­lio diver­si­fier in this envi­ron­ment. Five and ten-year TIPS are poor value at near zero and 1% yields respec­tively. Twenty-year TIPS are much bet­ter at 1.7% yield but they are at the low end of their range and hence vulnerable.

• Credit spreads have nar­rowed and do not pro­vide much value unless skill­fully cho­sen. Junk bonds will expe­ri­ence increased risk as the econ­omy deteriorates.

• The U.S. dol­lar should con­tinue to weaken as fur­ther Fed bal­ance sheet expan­sion occurs.

• Com­modi­ties (includ­ing oil) have more down­side than upside poten­tial as the econ­omy slows fur­ther. How­ever, the China slow­down is now a fact (Chart 14). Price infla­tion has eased sharply (Chart 15), the hous­ing bub­ble has been pricked and exports are surg­ing. Look for China to reverse mon­e­tary tight­en­ing, the stock mar­ket to increase and demand for com­modi­ties to start ris­ing again.

• The con­tro­ver­sial Aus­tralian min­ing tax is worth pay­ing atten­tion to by global investors who favor the resource sec­tor as a long-term bull­ish play on world com­pe­ti­tion for these assets. While the rul­ing party in Aus­tralia lost seats in the recent elec­tion, the tax is not dead and has many sup­port­ers. In a world of des­per­ate gov­ern­ments hun­gry for tax rev­enues, fat prof­its of resource com­pa­nies are a tempt­ing tar­get. The old argu­ment that such prof­its are a wind­fall on a deplet­ing asset would play well to a large part of any electorate.

• Canada went through preda­tory gov­ern­ment action against resource com­pa­nies in the 1970s and again in Alberta a few years ago with an ill-fated increased roy­alty tax on energy. A left-leaning gov­ern­ment in the future may well be tempted again.

• While Canada has deservedly had a good ride in recent years par­tic­u­larly through the global reces­sion, due to strong Fed­eral Gov­ern­ment finances and a strong bal­ance sheet, all is not quite as rosy as meets the eye. Chart 16 shows that, while the U.S. sav­ings rate has gone from 2% to 6.5% since 2007, the Cana­dian sav­ings rate, after a brief rally, has col­lapsed to about 2 1/2% Cana­dian house­holds have con­tin­ued to add to their debt, obliv­i­ous to the changed world envi­ron­ment. House prices rose to new highs dur­ing the recov­ery, while U.S. house prices are down over 30% from their peak. More­over, while fed­eral debt lev­els and trends are good by world stan­dards, provin­cial debts are dis­as­trous. There is even some talk of Ontario going the way of Cal­i­for­nia. Its per capita pub­lic debt is ten times that of Cal­i­for­nia whose bonds are rated slightly less risky than Croatia’s.(note 4)

In sum­mary, con­tinue to focus on wealth preser­va­tion. Increased cau­tion is warranted.

Tony Boeckh / Rob Boeckh

Date: August 27, 2010

Boeckh Invest­ment Letter

Tags: Balancing Act, Canadian Market, China, Commodities, Deflation, Disequilibrium, Double Dip Recession, Downturn, Economic Recession, Economic Recovery, Economic Weakness, Global Market Place, Gold, Growth Trajectory, Letter Dated August, Letter Vol, oil, Peacetime, Principle Cause, Quarter Gdp, Reflation, Roller Coaster, Russia, Stimulus, Surpluses, Vernacular, Zero Interest
Posted in Canadian Market, Energy & Natural Resources, Gold, Markets, Oil and Gas | Comments Off

Debt Be Not Proud (Arnott)

Friday, August 27th, 2010

We live in a world pro­foundly addicted to debt-financed con­sump­tion. Today, many peo­ple, com­pa­nies, and coun­tries bor­row with no evi­dent inten­tion to repay. When the debt comes due, they will replace it with new (and often larger) debt. Kick the can down the road, again and again. But inevitably the road ends abruptly with a wall, much like the ones at the end of a crash test­ing site.

Debt crash test dum­mies abound—take, for exam­ple, the home buy­ers dur­ing the late U.S. hous­ing bub­ble or the Ice­land banks that bor­rowed seven times the country’s GDP. These dum­mies hit their walls a cou­ple of years ago. Soon, many governments—who have thrown money they don’t have, osten­si­bly bor­row­ing from future gen­er­a­tions, into the breach—will approach their walls. Greece recently hit a wall and had to break a lot of promises to its cit­i­zens, notably the retirees and prospec­tive retirees from gov­ern­ment employ­ment. Greece cer­tainly won’t be the last. The loom­ing sov­er­eign debt cri­sis will be one of—if not the—defin­ing influ­ences on cap­i­tal mar­ket returns over the next 10 years.

In this issue we explore the rela­tion­ship between sov­er­eign debt lev­els and the eco­nomic might of the debtor nations. This sim­ple exer­cise paints a scary pic­ture, par­tic­u­larly for those who rely on cap weight­ing their gov­ern­ment bond mar­ket expo­sure. Bond investors are lenders. Why should we delib­er­ately choose to lend more to those who are most deeply in debt?

Mea­sur­ing Sov­er­eign Capac­ity to Ser­vice Debt

Mea­sur­ing a sovereign’s abil­ity to ser­vice debt is not easy. There is no direct mea­sure, so we esti­mate the capac­ity to ser­vice debt by com­par­ing a sovereign’s out­stand­ing debt to its eco­nomic size. We mea­sure a country’s eco­nomic size using four met­rics that proxy the key fac­tors of pro­duc­tion in a cap­i­tal­ist econ­omy. Eco­nom­ics lit­er­a­ture typ­i­cally iden­ti­fies two or three fac­tors of pro­duc­tion: cap­i­tal, labor, and resources (a sub­sec­tor of cap­i­tal). Our fourth fac­tor is energy, the most impor­tant sub­sec­tor of resources, which we treat as a sep­a­rate fac­tor of pro­duc­tion, given its impor­tance. We mea­sure these fac­tors as follows:

Cap­i­tal: GDP is the most widely-used gauge of the size of an economy.

Labor: A nation’s pop­u­la­tion is the sim­plest gauge of labor.2

Resources: A nation’s land­mass is a very crude gauge of access to resources.3

Energy: The aggre­gate energy con­sump­tion of a nation is a mea­sure of the energy that goes into pro­duc­tion of goods and ser­vices. One caveat is that this may be sourced exter­nally through petro­leum imports.

Build­ing on our Fun­da­men­tal Index® work in equi­ties, we cal­cu­late coun­try weights for each met­ric sep­a­rately, then equally weight each country’s weight in these met­rics to arrive at a Research Affil­i­ates Fun­da­men­tal Index (RAFI®) weight. The fun­da­men­tal mea­sures of size for var­i­ous economies are pre­sented in Table 1, color-coded to high­light the rel­a­tive debt bur­dens with green sig­ni­fy­ing the finan­cially sound coun­tries and red sig­ni­fy­ing the debtor nations.

We believe a country’s abil­ity to ser­vice their debt is a func­tion of the debt-level-to-economic-size ratio. Thus, we cat­e­go­rize coun­tries into five cat­e­gories, from light to heavy debt bur­den, as follows:

Dark Green Fun­da­men­tal Weight > Cap Weight by more than 100%

Light Green Fun­da­men­tal Weight > Cap Weight by more than 25%

No Color Fun­da­men­tal Weight approx­i­mately equal to Cap Weight

Light Red       Cap Weight > Fun­da­men­tal Weight by more than 25%

Dark Red Cap Weight > Fun­da­men­tal Weight by more than 100%

There’s a lot of red ink in the devel­oped economies of the world, and a lot of green in the emerg­ing mar­kets. Many devel­oped coun­tries carry debt—not even count­ing often vast off-balance-sheet debt—which is out of pro­por­tion with their scale in the world economy.

There are pock­ets of dis­ci­pline. Aus­tralia, Poland, and Slo­va­kia show no “red” at all, mean­ing that the national debt isn’t 25% above their eco­nomic fac­tors of pro­duc­tion on any of the four met­rics. Canada, Fin­land, New Zealand, Nor­way, Slove­nia, and Swe­den are “out of bounds” on only one of the four measures.4 Col­lec­tively these “Pru­dent Nine” com­prise less than 4% of world sov­er­eign bond debt, and yet they encom­pass 6% of world GDP, 18% of world land mass, and 8% of world RAFI weight.5 Fur­ther­more, sev­eral of the “Pru­dent Nine” have less hid­den debt than the G–5. For instance, Aus­tralia, New Zealand, Nor­way, and Swe­den largely pre­fund their future pen­sion obligations.

One might argue that Por­tu­gal, Ire­land, Italy, Greece, and Spain (derisively—and unfairly—characterized as the PIIGS) are bank­rupt states seek­ing shel­ter from larger bank­rupt states. The col­lec­tive bond debt of the PIIGS is 2.6 times their col­lec­tive RAFI weight in the world econ­omy, which arguably relates to their abil­ity to ser­vice debt. That’s an acknowl­edged prob­lem. Isn’t it a sad irony to note that the G–5 economies have a near iden­ti­cal ratio of debt to our abil­ity to ser­vice our debts as the so-called PIIGS. And yet we have the temer­ity to label the Mediter­ranean rim coun­tries “the PIIGS”?!

The Emerg­ing Mar­kets Debt Conundrum

How pre­car­i­ous are the debt bur­dens in the emerg­ing economies, economies typ­i­cally viewed as the most risky in the world? Sur­pris­ingly benign! Con­sider the so-called BRICs.6 As we can see in Table 1, they col­lec­tively com­prise 22% of world GDP, and yet have only 5% of world bond debt. The G–5 col­lec­tively has bond debt six times as large, rel­a­tive to GDP, as the BRICs.

Even this over­states the debt pic­ture from a global investor’s per­spec­tive. The ele­phant that’s not in the room also bears men­tion: there are some coun­tries with no net debt. China and Rus­sia have for­eign reserves larger than their respec­tive bond debt. Saudi Ara­bia, Kuwait, Qatar, the Emi­rates, as well as tax havens like Cay­man Islands, Monaco, and Liecht­en­stein all have no net debt. Most such coun­tries, as with China and India, have no bond debt that any for­eign investor would be per­mit­ted to buy. These “net cred­i­tors” would have a sig­nif­i­cant col­lec­tive “fun­da­men­tal weight” if only there were bonds to buy!

If the BRICs can com­fort­ably sup­port more debt than they carry (based on their GDP, their pop­u­la­tion, their resources, or their energy con­sump­tion), then surely there must be trou­ble spots in the emerg­ing mar­kets. Indeed, there are some pock­ets of trou­ble: Sin­ga­pore and Tai­wan each have a share of world bond mar­kets rival­ing their fun­da­men­tal eco­nomic foot­print in the world economy.7 Accord­ing to the United Nations, Sin­ga­pore and Tai­wan are emerg­ing mar­kets, though many experts and some index cal­cu­la­tors con­sider them to be part of the devel­oped world.

Let’s con­sider the rest of the emerg­ing mar­kets list. Not one of the other 43 emerg­ing mar­kets, which spans all coun­tries that are included in any of the EM debt indexes, has as much debt as any of the G–5 coun­tries, whether mea­sured rel­a­tive to GDP or rel­a­tive to the RAFI fun­da­men­tal eco­nomic foot­print of these coun­tries. In almost all cases, emerg­ing mar­kets debt is mod­est rel­a­tive to their respec­tive abil­ity to carry debt based on the four fac­tors of eco­nomic production.

Devel­oped mar­kets account for 62% of the world’s GDP and owe 90% of the world’s sov­er­eign bond debt. The emerg­ing mar­kets col­lec­tively pro­duce 38% of the world’s GDP and owe just 10% of world sov­er­eign bond debt. Does hid­den debt and off-balance-sheet debt change this pic­ture? Yes. In the wrong direc­tion!8 The emerg­ing mar­kets have, for the most part, lit­tle off-balance-sheet debt. The devel­oped economies have, in many instances, vast off-balance-sheet debt.

One might rea­son­ably argue that—absent polit­i­cal risk—emerging mar­kets are col­lec­tively more cred­it­wor­thy than U.S. Trea­suries. Which invites a provoca­tive ques­tion: when will U.S. Trea­suries be priced to offer a “risk pre­mium” (higher yield) than the most sta­ble and sol­vent sov­er­eign debt that money can buy: Emerg­ing Markets?9

The Ad Coun­cil in 1985 released a series of pub­lic ser­vice announce­ments with two crash test dum­mies, Vince and Larry, pro­mot­ing safety belt usage in auto­mo­biles. The tagline of the suc­cess­ful cam­paign was “You can learn a lot from a dummy… Buckle your safety belt.”10 But have we learned the proper restraints in our invest­ment port­fo­lios from our two most recent debt crash dummies—Greece and the U.S. home­owner? Doubt­ful. Let’s take a close look at our bond allo­ca­tions and the index funds that com­prise them. The wall is com­ing. Are we buck­led up?

End­notes

1.       With apolo­gies to John Donne: “Debt be not proud, though some have called thee / Mighty and dread­ful, for thou art not so / For those, whom thou think’st, thou dost over­throw / Die not, poor debt, for yet canst thou kill me.” This issue is an excerpt from a research paper we expect to pub­lish, likely under the same title.

2.       The work­ing age pop­u­la­tion might be a bet­ter gauge. We chose total pop­u­la­tion because it’s uni­ver­sally avail­able for all countries.

3.       We choose to use the square root of land mass in order to avoid grossly reward­ing big, sparsely pop­u­lated coun­tries like Rus­sia, Aus­tralia, and Canada, or penal­iz­ing small, crowded coun­tries like Hong Kong and Sin­ga­pore. For mid­size coun­tries like Argentina or Ger­many, this adjust­ment makes lit­tle difference.

4.       Inter­est­ingly, in each case, the pop­u­la­tion is the sole out­lier; it would appear that their debt is well within bounds on three fac­tors of pro­duc­tion: cap­i­tal, resources, and energy.

5.       It’s inter­est­ing to note that these coun­tries also largely skated through the “Global Finan­cial Cri­sis” bet­ter than the coun­tries with more debt. They enjoyed aver­age real GDP growth of 1.7% in 2009, dou­ble the lev­els of the G–5 and of the Eurozone.

6.       We’ve long found this label puz­zling: four coun­tries with almost noth­ing in com­mon but a shared acronym! Even though China shares bor­ders with Rus­sia and India, the three coun­tries have less in common—culturally, eco­nom­i­cally, or legally—than essen­tially any coun­tries on the devel­oped economies list.

7.       Sin­ga­pore has a sov­er­eign wealth fund and Tai­wan has gold and for­eign cur­rency reserves, in both cases larger than their aggre­gate debt. So, as with Rus­sia and China, their net debt is nonexistent.

8.       See “The 3-D Hur­ri­cane: Deficit, Debt, and Demo­graph­ics,” Fun­da­men­tals, Novem­ber 2009 (http://researchaffiliates.com/ideas/pdf/Fundamentals_200911.pdf). In the United States, the com­bi­na­tion of GSE debt, state and local debt, unfunded pen­sions and enti­tle­ments, all add up to just under $60 tril­lion, roughly 10 times the offi­cial U.S. pub­lic debt.

9.       On June 30, 2010, the Mer­rill Lynch USD Emerg­ing Mar­kets Sov­er­eign Plus Index, which spans the dollar-denominated debt of the emerg­ing mar­kets, was priced to yield 6.0%. This was 3% higher than U.S. 10-year Treasuries.

10.         Since the ad cam­paign began in 1985, usage of seat­belts increased from 14% to 79%, sav­ing an esti­mated 85,000 lives. http://www.adcouncil.org/default

Copy­right © 2010 Research Affil­i­ates

Tags: Arnott, Bond Investors, BRIC, BRICs, Canadian Market, Capitalist Economy Economics, China, Crash Dummies, Crash Test Dummies, Debt Crisis, Debt Levels, Debtor Nations, Economic Size, Factors Of Production, Future Generations, Gold, Government Bond Market, Government Employment, Housing Bubble, India, Market Exposure, Metrics, Russia, Seven Times, Simple Exercise, Sovereign Debt, Today Many People
Posted in Emerging Markets, Gold, India, Markets | Comments Off

Why Another Fiscal Stimulus Won't Do (PIMCO)

Friday, August 27th, 2010

· What is crit­i­cal to keep in mind is that this sit­u­a­tion is part of a broad, mul­ti­year process dri­ven by national and global realign­ments. It's a sec­u­lar phe­nom­e­non that needs to be bet­ter under­stood and nav­i­gated — by rec­og­niz­ing its struc­tural dimen­sions and by urgently broad­en­ing the exces­sively cycli­cal pol­icy mind­sets that abound.

·  Spe­cific pol­icy mea­sures would include pro-growth tax reform, hous­ing finance reform, increased infra­struc­ture invest­ments, greater sup­port for edu­ca­tion and research, job retrain­ing pro­grams, removal of out­dated inter­state com­pe­ti­tion bar­ri­ers and stronger social safety nets.

·  This wor­ri­some trio of increas­ingly inef­fec­tive national and global pol­icy stances, intense polit­i­cal polar­iza­tion and grow­ing social pres­sures speaks to the risk that the economy's recent soft patch will evolve into some­thing even more trou­ble­some and sinister.

This arti­cle was orig­i­nally pub­lished on washingtonpost.com on August 27, 2010.

The great hope a few months ago was for a "recov­ery sum­mer," with the econ­omy respond­ing favor­ably to var­i­ous pol­icy ini­tia­tives. Yet the recov­ery has lost momen­tum, and while the end of the year will not be as gut-wrenching as the final 3 1/2 months of 2008, when the global econ­omy suf­fered a car­diac arrest, it will be as con­se­quen­tial in affect­ing the wel­fare of mil­lions of people.

Through­out the sum­mer, data sig­nals have become more alarm­ing. Despite all the rhetoric about job cre­ation, unem­ploy­ment remains stub­bornly high and the prob­lem is becom­ing struc­tural in nature (and, there­fore, harder to solve). Con­sumer credit con­tin­ues to con­tract while small com­pa­nies find it dif­fi­cult to access new bank lines of credit. Hous­ing activ­ity is falling, and home val­ues are poised for fur­ther declines as fore­clo­sures increase. The trade bal­ance has taken an omi­nous turn, with exports stag­nat­ing and imports surg­ing. More Amer­i­cans are falling through the large holes in the country's safety net.

The equity mar­kets are again under pres­sure while yields on Trea­sury bonds have col­lapsed, reflect­ing that market's grow­ing con­cerns about the weak eco­nomic out­look. With such fragility, house­holds and com­pa­nies have become even more cau­tious, under­min­ing the "ani­mal spir­its" needed for eco­nomic expansion.

Mean­while, the United States has received lit­tle help from the rest of the world. Yes, Ger­man growth is up, but a sig­nif­i­cant part reflects its well-functioning export machine. The ben­e­fi­cial spillover effects have been imma­te­r­ial. And despite the polit­i­cal nar­ra­tive to the con­trary, mar­ket con­cerns with debt sol­vency in some euro­zone coun­tries (Greece, Ire­land, Por­tu­gal and Spain) remain high.

Even a steadily grow­ing China is prov­ing to be of lim­ited help. While Bei­jing is imple­ment­ing addi­tional struc­tural changes to reori­ent its econ­omy toward domes­tic con­sump­tion, the pace remains mea­sured; what is under­stand­able from a Chi­nese national per­spec­tive does lit­tle to help sus­tain­ably rebal­ance the global economy.

In sum, the cur­rent pol­icy approaches here and abroad are unlikely to deliver a durable and robust U.S. recov­ery and, crit­i­cally, cre­ate suf­fi­cient growth in jobs. Yet the main debate in Wash­ing­ton is whether to do more of the same — namely, another fis­cal stim­u­lus and another round of quan­ti­ta­tive eas­ing by the Fed­eral Reserve. This clearly con­flicts with evi­dence that a broader and more holis­tic response is needed.

These real­i­ties will fuel debate among econ­o­mists, who already hold unusu­ally diver­gent views, and reignite the dis­com­fort­ing notion that eco­nomic unthink­ables and improb­a­bles — such as a double-dip reces­sion and a defla­tion trap — are more of a possibility.

What is crit­i­cal to keep in mind is that this sit­u­a­tion is part of a broad, mul­ti­year process dri­ven by national and global realign­ments. It's a sec­u­lar phe­nom­e­non that needs to be bet­ter under­stood and nav­i­gated — by rec­og­niz­ing its struc­tural dimen­sions and by urgently broad­en­ing the exces­sively cycli­cal pol­icy mind­sets that abound. Unfor­tu­nately, the approach in too many indus­trial coun­tries has been to kick the can down the road, seem­ingly hop­ing for a series of immac­u­late eco­nomic recoveries.

Pol­i­cy­mak­ers must break this active iner­tia by imple­ment­ing a struc­tural vision to accom­pany their cur­rent cycli­cal focus. Mea­sures are needed to address key issues, which include the change in dri­vers of growth and employ­ment cre­ation; the high risk of skill ero­sion and lost labor pro­duc­tiv­ity; finan­cial delever­ag­ing in the pri­vate sec­tor; debt over­hangs; the uncer­tain reg­u­la­tory envi­ron­ment; and the unac­cept­ably high risks fac­ing the most vul­ner­a­ble seg­ments of society.

Spe­cific mea­sures would include pro-growth tax reform, hous­ing finance reform, increased infra­struc­ture invest­ments, greater sup­port for edu­ca­tion and research, job retrain­ing pro­grams, removal of out­dated inter­state com­pe­ti­tion bar­ri­ers and stronger social safety nets.

That, of course, is what is desir­able; how about what is likely?

With the recovery's vis­i­ble loss in momen­tum, more peo­ple are com­ing to appre­ci­ate the impor­tance of struc­tural issues. Indeed, some ele­ments of the pack­age are vis­i­ble. Yet, to my dis­may, the prospects for a suf­fi­ciently bold pol­icy reac­tion are doubt­ful. Post-financial cri­sis, it is no longer just about the "unusu­ally uncer­tain" eco­nomic out­look and related chal­lenges for a pol­icy approach that remains too reac­tive and ad hoc. The pol­i­tics of struc­tural change are now a mate­r­ial impediment.

An already polar­ized polit­i­cal envi­ron­ment is becom­ing even more frac­tured by real and far less sub­stan­tive issues. There is vir­tu­ally no polit­i­cal cen­ter that can anchor con­sen­sus and enable sus­tained imple­men­ta­tion of pol­icy. Mean­while, as anti-Washington sen­ti­ments rise, inter­est in a national agenda is increas­ingly giv­ing way to the elec­tion cycle. Inter­na­tion­ally, the impres­sive degree of cross-border coör­di­na­tion seen dur­ing the global finan­cial cri­sis has been reduced to incon­sis­tent — and at times con­tra­dic­tory — national responses.

This wor­ri­some trio of increas­ingly inef­fec­tive national and global pol­icy stances, intense polit­i­cal polar­iza­tion and grow­ing social pres­sures speaks to the risk that the economy's recent soft patch will evolve into some­thing even more trou­ble­some and sinister.

I hope that sober pol­icy responses will accom­pany the com­ing cooler tem­per­a­tures. Given the prox­im­ity of the Novem­ber elec­tions, how­ever, I worry they may not.

This mate­r­ial con­tains the opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial has been dis­trib­uted for infor­ma­tional pur­poses only and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. This mate­r­ial was reprinted with per­mis­sion of the Wash­ing­ton Post.

Date of orig­i­nal pub­li­ca­tion August 27, 2010.

Copy­right © PIMCO

Tags: Cardiac Arrest, China, Final 3, Finance Reform, Fiscal Stimulus, Global Economy, Global Policy, Home Values, Infrastructure Investments, Interstate Competition, Job Creation, Job Retraining, Mindsets, Policy Initiatives, Policy Measures, Political Polarization, Research Job, Safety Net, Social Pressures, Social Safety, Trade Balance
Posted in Infrastructure, Markets, Outlook | Comments Off

S&P 500: Weekly Charts Work! (Hewison)

Friday, August 27th, 2010

Many traders get so involved with the mar­ket on a daily or even an intra­day basis, that they some­how lose out on the big­ger pic­ture. Weekly charts are enor­mously help­ful in giv­ing clues to the future direc­tion of the market.

In today's video we exam­ine one of the biggest mar­kets in the world, the S&P 500, using a weekly chart. The video runs about two min­utes in length and I think you will find it both edu­ca­tional and informative.

Tags: Free Lessons, Two Minutes
Posted in Markets | Comments Off