The Return to an Era of Income Investing (Lee)

Wednesday, November 30th, 2011

The Return to an Era of Income Investing

by Alfred Lee, CFA, DMS, Vice Pres­i­dent & Invest­ment Strate­gist,
BMO ETFs & Global Struc­tured Invest­ments, BMO Asset Man­age­ment
alfred.lee(@)bmo.com

With the ongo­ing Euro­pean sov­er­eign debt saga drag­ging on and crit­i­cal deci­sions being post­poned, its impact con­tin­ues to weigh on global equity mar­kets. The earn­ings story at the com­pany level, par­tic­u­larly in the U.S, that we’ve been bull­ish on through­out the year con­tin­ues to keep stock mar­kets mod­er­ately buoy­ant. Over the last sev­eral months, a tough bat­tle between macro– and micro-economics has com­pounded volatil­ity. The CBOE S&P Implied Volatil­ity Index (VIX) and the S&P/ TSX 60 Implied Volatil­ity Index (VIXC) cur­rently sit at 33.98 and 28.89, respec­tively, well above their nor­mal­ized ranges, indi­cat­ing con­tin­ued fear in the mar­ket place. From a global macro per­spec­tive, credit default swaps (CDS) or the cost of insur­ing a default on the sov­er­eign debt of Greece and Italy recently hit new records. The pos­i­tive devel­op­ments over the month have been the step­ping down of prime min­is­ters from both Greece and Italy. With Mario Monti now the prime min­is­ter of Italy and Lucas Papademos the new prime min­is­ter of Greece, this chang­ing of the guard as well as their deep eco­nomic expe­ri­ence may help restore some con­fi­dence with investors. As a result, the per­for­mance of global equi­ties for the remain­der of the year depends on whether this dead­weight on investor opti­mism from Europe can be lifted. If so, the focus of the mar­ket can quickly shift to the earn­ings of com­pa­nies, which con­tinue to come in bet­ter than expected. If con­fi­dence is not restored how­ever, mar­kets may poten­tially fall below their Octo­ber lows, leav­ing the pos­si­bil­ity of the much desired year-end Santa Claus rally extremely binary.

Despite the uncer­tainty, which we feel will unfor­tu­nately con­tinue to weigh on the mar­kets, one of the few things that remains quite cer­tain for the next two years is that we will con­tinue to see a low inter­est rate envi­ron­ment. As U.S. Fed­eral Reserve Board (Fed) chair­man Ben Bernanke pledged to keep inter­est rates near or at his­toric lows until at least 2013, other cen­tral banks around the world will likely be forced to fol­low suit. Oth­er­wise they risk caus­ing their cur­rency to rise with a higher rel­a­tive inter­est rate, thus neg­a­tively impact­ing the country’s export­ing indus­try. Div­i­dend pay­ing or income pro­duc­ing strate­gies are one of the themes we have rec­om­mended through­out the year, and one that we con­tinue to rec­om­mend. As we pointed out last year, a 10-year Bank of Canada note now yields less than the div­i­dend yield of the S&P/TSX Com­pos­ite Index. Sim­i­larly, the yield on a 10-year U.S. Trea­sury note is less than that of the div­i­dend yield of the S&P 500 Com­pos­ite Index. Although this con­di­tion will likely not hold as the appetite for risk returns, the spread between the yield of gov­ern­ment bonds and equi­ties will likely remain well below his­tor­i­cal aver­ages. This is a recent key devel­op­ment which should lead investors to con­tinue chas­ing yield ori­ented invest­ments, caus­ing these areas to likely outperform.

Back to the Old: Div­i­dend Investing

The returns from a stock are derived from two com­po­nents: cap­i­tal gains and div­i­dends (or dis­tri­b­u­tions). Since the 1990’s chas­ing cap­i­tal gains has been an effec­tive strat­egy for investors – and for good rea­son. A per­fect storm of rapidly evolv­ing tech­nol­ogy, baby-boomers enter­ing their peak earn­ings age and dereg­u­la­tion were just a few of the fac­tors which led a num­ber of equity mar­ket indices around the world to see their most unprece­dented ral­lies on record. Between 1980 and 2001, the Dow Jones Indus­trial Aver­age Index and the S&P/TSX Com­pos­ite Index gained 1186% and 393% respec­tively. Prior to this era, invest­ing in solid com­pa­nies that pro­vided sus­tain­able div­i­dends was the key to a suc­cess­ful invest­ment strat­egy, a key fac­tor to the invest­ment approach of invest­ing leg­ends such as War­ren Buf­fet. In the cur­rent mar­ket envi­ron­ment where volatil­ity has become (and will likely remain) more of a norm than an excep­tion, the cap­i­tal gains por­tion of a stock will become more unpre­dictable. The div­i­dend por­tion of an equity invest­ment, on the other hand, is more reliable.

Tags: Alfred Lee, Credit Default Swaps, Critical Decisions, Deadweight, Economic Experience, Global Equities, Global Equity Markets, Global Macro, Investment Strategist, Investor Optimism, Macro Perspective, Mario Monti, Micro Economics, New Prime Minister, Prime Minister Of Greece, Prime Minister Of Italy, Sovereign Debt, Structured Investments, TSX 60, Volatility Index Vix
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Déjà Vu? Eurozone Crisis Today vs. 2008 Subprime Crisis (Sonders)

Wednesday, November 30th, 2011

by Liz Ann Son­ders, Charles Schwab and Company

Key Points

• News flow on the euro­zone debt cri­sis is speedy, and the lat­est news of a fis­cal pact brings cheers by stock investors… for now.
• There are many sim­i­lar­i­ties between the 2011 and 2008 crises—but even more differences.
• The end of the "Debt Super­cy­cle" has ush­ered in a period of height­ened risk and short­ened economic/market cycles.

Before we get to a compare-and-contrast between the euro­zone debt cri­sis of today ver­sus the sub­prime cri­sis of 2008, let's first sum­ma­rize (no easy feat) where we are today with the former.

Sin­gle cur­rency exper­i­ment goes awry

At its most basic, the prob­lems in the euro­zone are noth­ing new: too much debt, from euro­zone mem­ber coun­tries to over-leveraged Euro­pean finan­cial insti­tu­tions. Adding to the woes is the lack of global com­pet­i­tive­ness among many of the zone's mem­bers, thanks to the tying of 17 vastly dif­fer­ent economies and poli­cies to one (too-strong) cur­rency. The lack of a sin­gle fis­cal author­ity within the euro­zone that's capa­ble of enforce­ment or super­vi­sion has allowed the prob­lems to fes­ter and the can to be con­tin­u­ally kicked down the road.

Exac­er­bat­ing the cri­sis recently has been spik­ing yields on sov­er­eign debt of the most heav­ily indebted coun­ties (Por­tu­gal, Ire­land, Italy, Greece and Spain, com­monly referred to as PIIGS). The fis­cal aus­ter­ity now being demanded is adding to eco­nomic woes, mak­ing a euro­zone reces­sion all but inevitable. Greece remains the most belea­guered of the euro­zone nations, but Italy and Spain have come into the crosshairs more recently.

Tur­moil in the Euro­pean bank­ing sec­tor is rais­ing fears of bank runs and/or fail­ures. Thanks to the "hair­cuts" placed on Greek debts that didn't trig­ger credit default swaps (CDS), con­cerns have ele­vated about fur­ther con­ta­gion among global banks. If sim­i­lar hair­cuts are applied to other coun­tries in the zone, the prob­lem grows. All of this has greatly raised fears of rating-agency down­grades and fur­ther spikes in yields, sug­gest­ing a vicious cycle of debt, insta­bil­ity and uncertainty.

Ger­many plays chicken

This is unsus­tain­able longer-term, and pol­icy mak­ers know this. Many believe (as we do) that Ger­many is presently play­ing a game of brinkman­ship: say­ing pub­licly it's against Euro­pean Cen­tral Bank (ECB) ini­ti­at­ing quan­ti­ta­tive eas­ing (QE) and balk­ing at the issuance of com­mon euro­zone bonds. Both are seen as the only viable solu­tions to stem the cri­sis longer-term.

Germany's reluc­tance is under­stand­able: If it res­cues its most prof­li­gate euro­zone neigh­bors, its own credit stand­ing gets hit. If Ger­many does not come to the res­cue, a euro­zone col­lapse becomes likely. But a ground­break­ing fis­cal pact may be in the works, whick helps to explain today's mar­ket rally.

As reported in the Novem­ber 28 Wall Street Jour­nal, the fis­cal pact aims to pre­vent the euro cur­rency block from frac­tur­ing by teth­er­ing its mem­bers more closely together. Although not yet agreed to, the pact would make bud­get dis­ci­pline legally bind­ing and enforce­able by Euro­pean author­i­ties, and would "mark a sem­i­nal shift in the gov­er­nance of the 17-nation euro­zone," accord­ing to the WSJ.

One of Germany's biggest con­cerns regard­ing QE by the ECB was that it didn't have the abil­ity to con­trol the finances of any coun­try. This pact may be the "out" Ger­many needs to even­tu­ally sup­port QE or eurobonds. QE and/or eurobonds would likely rep­re­sent the "bazooka" needed to stem the cri­sis, akin to what the Trou­bled Asset Relief Pro­gram (TARP) was to the US cri­sis in 2008.

2011 ver­sus 2008

This brings me to the com­par­isons between today's cri­sis and 2008's. I enlisted the aid of sev­eral col­leagues on Schwab's Invest­ment Strat­egy Coun­cil for this sec­tion, so thanks go to Kathy Jones, Brad Sorensen, Michelle Gib­ley, Rob Williams, David Kast­ner and Tat­jana Michel. In fact, many of our dis­cus­sion occurred on Thanks­giv­ing Day (though it didn't spoil my appetite!)

The euro­zone debt cri­sis is not dis­tinct from 2008's, because what we're really deal­ing with is the finale of the global "Debt Super­cy­cle" that took decades to brew. A break­ing point was reached in the United States in 2008, and more recently in Europe.

The top five list of sim­i­lar­i­ties between the two phases:

1. Per­cep­tion: When Greece's trou­bles erupted, pol­i­cy­mak­ers and investors down­played it because of its size—similar to the ini­tial per­spec­tive about Lehman Broth­ers' problems.
2. Liq­uid­ity: Euro­zone pol­i­cy­mak­ers ini­tially assumed Greece's prob­lems were about liq­uid­ity, not sol­vency, and blamed them on "spec­u­la­tors." This was sim­i­lar to the ini­tial reac­tion to the sub­prime cri­sis in late 2007; ulti­mately investors demanded a more com­pre­hen­sive solution.
3. Real­ity: Investors are now faced with the real­ity that assets pre­vi­ously con­sid­ered risk-free now carry much more credit risk. Finan­cial engi­neer­ing then and now had mag­i­cally and falsely trans­formed the most-dodgy loans and bonds into highly rated secu­ri­ties. Banks hold­ing euro­zone sov­er­eign debt can no longer be sure that the CDS con­tracts they used to hedge against defaults will be hon­ored, so they've been sell­ing bonds, caus­ing yields to spike.
4. Con­ta­gion: Con­sis­tent over the period is a com­plex web of inter­con­nec­tions among global banks and lim­ited trans­parency on credit-derivative expo­sure. Short-term fund­ing risks today also mir­ror those in 2008, though so far to a lesser degree. The struc­ture of the euro­zone sys­tem has encour­aged its finan­cial insti­tu­tions to become heav­ily reliant on short-term fund­ing. The 90 banks cov­ered by the recent Euro­pean Bank­ing Author­ity stress tests need to refi­nance debt in the next two years equiv­a­lent to 45% of EU gross domes­tic product.
5. Moral haz­ard: If there are pol­icy options avail­able, how far do you take them to ensure that the par­ties involved solve their fun­da­men­tal prob­lems? Bond mar­kets and the cost of short-term bor­row­ing, and/or the evap­o­ra­tion of short-term liq­uid­ity in both cases, were fac­tors that exac­er­bated the crises.

A top-10 list of dif­fer­ences between the two phases:

1. Ori­gins: The crises had dif­fer­ent ori­gins, with the 2008 US cri­sis spread­ing from the bot­tom up: start­ing with home buy­ers, through Wall Street's mort­gage secu­ri­ti­za­tion and asleep-at-the wheel credit rat­ing agen­cies, to the global econ­omy. The global reces­sion was trig­gered by the break­down of the finan­cial sector.Europe's cri­sis today started from the top: fis­cally prof­li­gate gov­ern­ments and weak eco­nomic growth led to a loss of faith by the finan­cial and busi­ness com­mu­ni­ties, which crushed private-sector spend­ing and invest­ment. In this case, one could argue that mar­kets and finan­cial insti­tu­tions were not the crim­i­nals, but the victims.
2. Direc­tion: The US pri­vate and finan­cial sec­tors gorged on debt prior to 2008, and the sub­se­quent (and forced) delever­ag­ing caused a mas­sive eco­nomic shock. Europe's cri­sis began with weak euro­zone periph­eral economies, prompt­ing the pri­vate sec­tor to hoard cash.
3. Solu­tions: The solution(s) to the 2008 cri­sis required gov­ern­ment and central-bank inter­ven­tions to pro­vide liq­uid­ity via record-low inter­est rates and bank bailouts. The response was swift and coör­di­nated, with the really big gun com­ing via TARP, which essen­tially took a mas­sive chunk of pri­vate debt and made it public.Today, that response is hoped for in Europe, but it's been slow in com­ing (if it ever does). The pri­mary prob­lem today is a vir­tual absence of con­fi­dence among finan­cial play­ers of every vari­ety in euro­zone gov­ern­ments' and policy-makers' abil­ity to stem the tide and stim­u­late growth. In addi­tion, the bad debt at the heart of the euro­zone cri­sis is already public.
4. Geog­ra­phy: In 2008, the epi­cen­ter of the cri­sis was the United States, a sin­gle nation. Today's the cri­sis is spread among 17 coun­tries, with sur­plus economies pit­ted against deficit economies.
5. Speed: The cri­sis in 2008 hit quickly and fiercely with the col­lapse of Lehman Broth­ers, even though there had been pre­vi­ous warn­ing signs. The euro­zone cri­sis is mov­ing much more slowly. Although kick-the-can effects are in play, they do give lead­ers and finan­cial insti­tu­tions time to make adjustments.
6. Bul­lets: Global cen­tral banks had more bul­lets in their guns in 2008 than they do today. Mon­e­tary pol­icy in the United States is as close to loose as it can get. Both the Fed­eral Reserve and the ECB have injected mas­sive liq­uid­ity into their finan­cial sys­tems, but there are lim­its to these strate­gies' effec­tive­ness. This means stim­u­lus is more likely to come from politi­cians today as com­pared to cen­tral bankers in 2008.
7. Stress tests: Unlike in the United States, where reg­u­la­tors built a credit stress test for the sys­tem­i­cally impor­tant finan­cial insti­tu­tions, Euro­pean reg­u­la­tors used much less rigor. No write-downs were taken on sov­er­eign debt in held-to-maturity accounts and fund­ing pres­sure has become more acute. With no cred­i­ble plan, Euro­pean banks are forced to sell non-core assets, which will exac­er­bate the global delever­ag­ing cycle.
8. Health and liq­uid­ity: US Banks are far bet­ter cap­i­tal­ized, with much lower lever­age than in 2008. Reg­u­la­tion is likely to keep lever­age ratios lower going for­ward, which, although bad for earn­ings, is good for bond­hold­ers and the sta­bil­ity of the finan­cial sys­tem. You can see this below in key charts of the Tier 1 Cap­i­tal Ratio of US banks, US banks' earn­ings, the Bloomberg Finan­cial Con­di­tions Index and the TED Spread.
9. Infla­tion: Com­mod­ity infla­tion was on a tear in 2008, putting sig­nif­i­cant pres­sure on emerging-economy cen­tral banks to adopt tight mon­e­tary poli­cies, which fed into the neg­a­tive global growth loop. Today, infla­tion pres­sures have eased and many global cen­tral banks (includ­ing the ECB) have moved toward looser policies.
10. The US econ­omy: Unlike in 2008, when the econ­omy and jobs were implod­ing, the US econ­omy is much health­ier today (if not healthy in an absolute sense). Cor­po­rate earn­ings are on a tear whereas they were pum­meled in 2008. Pent-up demand among the house­hold and busi­ness sec­tors should sup­port growth over the next few years.

Tier 1 Cap­i­tal (as Per­cent of Risk-Weighted Assets) Much Improved Since 2008

Source: Fact­Set, Fed­eral Deposit Insur­ance Cor­po­ra­tion, as of Sep­tem­ber 30, 2011. Tier 1 Cap­i­tal is pri­mar­ily com­mon equity and cer­tain per­pet­ual pre­ferred stock for FDIC-insured insti­tu­tions. Chart rep­re­sents ratio of cap­i­tal to risk-weighted assets.

Banks' Oper­at­ing Income Has Surged Since 2008

Source: Fact­Set, FDIC, as of Sep­tem­ber 30, 2011.

Key Mea­sure of Finan­cial Con­di­tions Much Health­ier Than 2008

Source: Bloomberg, Fact­Set, as of Novem­ber 25, 2011. The Bloomberg Finan­cial Con­di­tions Index com­bines yield spreads and indices from the short-term debt mar­kets, stock mar­kets and bond mar­kets into a sin­gle nor­mal­ized index.

Key Mea­sure of Bank­ing Sys­tem Stress Well Off 2008's Cri­sis Level

Source: Fact­Set, as of Novem­ber 25, 2011. The TED spread is the dif­fer­ence in yields between three-month Lon­don Inter­Bank Offered Rate loans and three-month US Trea­sury bills.

Con­clu­sion … if there is any to glean

There's no short­age of wor­ries for investors, and when it seems like the neg­a­tives begin pil­ing up, the mar­ket takes a hit and moves into risk-off mode. But, as we're see­ing today, with any sign of good news, the mar­ket can shift to risk-on and stage an impres­sive rally. It's frus­trat­ing for investors, but is illus­tra­tive of why tak­ing an all-or-nothing approach to being invested in stocks can be dangerous.

These are dif­fi­cult and some­what dan­ger­ous times. Rolling crises are likely inevitable, lead­ing to short­ened eco­nomic and mar­ket cycles. We're in a period of his­tory with chal­lenges that are new and more pow­er­ful than what have been dealt with in the past. But it's also help­ful to remem­ber what War­ren Buf­fet once wrote in a share­holder let­ter: "…we have usu­ally made our best pur­chases when appre­hen­sions about some macro event were at a peak."

Copy­right © Charles Schwab and Com­pany, Inc.

Tags: Charles Schwab, Charles Schwab And Company, Credit Default Swaps, Debt Crisis, Economic Market, Economic Woes, European Banking, Financial Institutions, Fiscal Austerity, Fiscal Authority, Global Banks, Global Competitiveness, Ireland Italy, Italy Greece, Liz Ann Sonders, Market Cycles, Single Currency, Sovereign Debt, Stock Investors, Supercycle
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Futures Pop on Global Bailout, Sovereigns Disappoint

Wednesday, November 30th, 2011

Risk mar­kets are tear­ing higher glob­ally with equi­ties, com­modi­ties, and credit all con­sid­er­ably higher. Equi­ties and CONTEXT are back in line as this is a very sys­temic shift up as the dol­lar tanks and TSY yield surge. US equi­ties are back to 11/18 lev­els but are stalling out a lit­tle here as the ini­tial spike wears off — whether this liq­uid­ity surge fixes the insol­vency cri­sis is the ques­tion it seems mar­kets are con­sid­er­ing now that they have had some time to think (and squeeze). We do note that while sov­er­eign spreads in Europe are nar­rower, the moves are not dra­matic and in some cases are actu­ally dete­ri­o­rat­ing still.

Broad risk assets and ES (e-mini S&P futures) are back in sync after CONTEXT pulled back to equity's slow drip weaker overnight. Now the cen­tral banks have dumped liq­uid­ity, risk-on was evi­dent but the move is per­haps notably small if this really is a solu­tion — albeit extremely painful for shorts. The ini­tial jump ear­lier on China's RRR shift was then taken on as the rest of the cen­tral banks joined in the party.

The dol­lar imme­di­ately dropped like a stone –1.5% on the week with AUD (carry and China dri­ven) smash­ing over 5% higher against the USD. The EUR is (as usual) track­ing with DXY as its main dri­ver and we note that JPY did strengthen against the USD but is only mar­gin­ally bet­ter on the week now.

Of course, the dol­lar shift and risk-on sen­ti­ment has surged com­modi­ties with Cop­per the major out­per­former. Sil­ver and Gold also jumped notably (with the for­mer much more than the lat­ter as is its higher beta case) and Oil now over $101 which has to help spend­ing and demand in the real econ­omy right?

Equity and credit have come back together as it seems equity had the sniff of this ear­lier in the week while credit remained less san­guine until now. The move admit­tedly is only back to lev­els from 10 trad­ing days back and credit spreads remain hugely wider rel­a­tive to any sense of nor­mal­ity.

Sov­er­eign spreads over the last cou­ple of days are not exactly respond­ing in a hugely pos­i­tive man­ner. Por­tu­gal still leak­ing wider and Italy not really much bet­ter at all.

And while TSY yields spiked higher, they are pulling back now off those spike highs and 2s10s30s also dragged higher — help­ing to drive the broad risk asset basket.

All-in-all, it is too early to judge this as any­thing other than a knee-jerk reac­tion. The reac­tion of bank spreads is pos­i­tive but only mod­estly — not a solu­tion. The reac­tion in sov­er­eign spreads is min­i­mal — not a solu­tion. Of course equi­ties are tear­ing as they only know one thing. Gold and Sil­ver are up on fiat wor­ries as liq­uid­ity surges, but Copper's surge seems a lit­tle over­done given the demand drag of Oil and the uncer­tainty of liq­uid­ity trans­mis­sion to any real econ­omy growth that AUD and Cop­per seem to be implying.

Charts: Bloomberg

Tags: Stocks
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Some Wall Streeters' Thoughts on Global Bailout

Wednesday, November 30th, 2011

From Reuters:

MARK CLIFFE, CHIEF ECONOMIST, ING GROUP

"It feeds into the idea that pol­i­cy­mak­ers are at least begin­ning to address the prob­lem. There was a very dark mood devel­op­ing at the back end of last week. With the dire sce­nar­ios doing the rounds the last few days, it's all the more impor­tant they step in with aggres­sive mea­sures to sup­port the bank­ing sys­tem and show they're begin­ning to con­front the financ­ing prob­lems of the sov­er­eigns as well."

TONY NYMAN, ANALYST AT INFORMA GLOBAL MARKETS

"From a cur­rency per­spec­tive the move has given risk cur­ren­cies real lift. The liq­uid­ity injec­tion means the world's most liq­uid cur­rency the Dol­lar is less required near-term and is cur­rently being broadly sold.

"Such an oper­a­tion usu­ally gives pairs such as Eur/Usd, Aud/usd a fairly last­ing lift. It is an emer­gency mea­sure and of course will do very lit­tle to aid Greek and other EMU nations debt woes fur­ther out."

MARK THOMAS, HEAD OF ENERGY EUROPE, MAREX SPECTRON IN LONDON

"Ini­tial reac­tion was bull­ish. The announce­ment caught mar­kets by sur­prise and prompted short cov­er­ing in dollar-euro and a firm­ing in oil price. It is sup­port­ive. Dif­fi­cult to pre­dict for how long."

SILVIO PERUZZO, RBS ECONOMIST, LONDON

"This is some­thing that is very wel­come. This will not solve all deep-based fund­ing prob­lems which are due to the sov­er­eign debt cri­sis. But there is an issue with dol­lar liq­uid­ity, espe­cially with for­eign cur­rency and this mea­sure addresses that. This helps the mar­gin and also shows that cen­tral banks remain at unease with what cer­tainly is very sig­nif­i­cant distress.

"We were expect­ing the ECB to deliver these mea­sures next week ... the ECB has more scope to go, and we expect the ECB to announce more mea­sures in next pol­icy meet­ing (on Dec. 8). Now that is has done the swapline, there is scope to reduce the cost of liq­uid­ity banks get from the ECB regard­less of the cur­rency, and that goes via inter­est rates.

"Doing more on the col­lat­eral side is prob­a­bly the sec­ond step. The ECB is help­ing the bank­ing sys­tem while sov­er­eigns do their homework."

WAYNE KAUFMAN, CHIEF MARKET ANALYST AT JOHN THOMAS FINANCIAL IN NEW YORK

"All ter­rific news for short-term traders. You can't fight the Fed, and now that we're in a global econ­omy, you can't fight the global cen­tral banks. They are push­ing liq­uid­ity. The upside is big­ger than the down­side. There is tremen­dous stress out there, so doing some­thing in a con­certed effort to relieve some of the stress is a good thing.

"ADP news is very good news. The pri­vate sec­tor is adding jobs. China reduc­ing reserve ratios is also very good. Gov­ern­ments around the world are act­ing in con­certed to relieve the strains on the sys­tem. Stocks are very under­val­ued based on com­par­ing equity yields ver­sus bond yields, which shows the stress of the finan­cial sys­tem. Under nor­mal cir­cum­stances, stocks would be a lot higher."

CHRISTIAN SCHULZ, BERENBERG BANK

"This shows that cen­tral banks across the world con­tinue to coöper­ate and that the ECB, and its part­ners, are very aware of the fund­ing stress that Euro­pean banks are under at the moment.

"This decreases the cost of fund­ing in U.S. dol­lars or other cur­ren­cies so — it's small — but it's a boost to banks' prof­itabil­ity and gives them a bet­ter chance to shore up their cap­i­tal ratios."

SAL CATRINI, A MANAGING DIRECTOR FOR EQUITIES AT CANTOR FITZGERALD & CO IN NEW YORK

"Not a com­plete sur­prise. Peo­ple were expect­ing China to do some­thing before the end of the year, and given the stresses in the mar­ket there has been talk about the Fed back­stop­ping what's going on in Europe. Des­per­ate times and all.

"The move in (U.S. stock) futures is jus­ti­fied. Whether this solves our long-term prob­lems remains to be seen, but when you flood the mar­ket with liq­uid­ity, risk assets go much higher."

Tags: Aggressive Measures, Aud Usd, Central Banks, Chief Economist, Dark Mood, Debt Crisis, Debt Woes, Doing The Rounds, Emergency Measure, Foreign Currency, Informa Global Markets, Ing Group, Marex, Measure Addresses, Peruzzo, Spectron, Swapline, Thomas Head, Usd Aud, Wall Streeters
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Here Comes The Global, US-Funded Liquidity Bail Out

Wednesday, November 30th, 2011

As expected, the Fed has just bailed out the world once again:

• FED, ECB, BOJ, BOE, SNB, BANK OF CANADA LOWER SWAP RATES — BBG
• ECB, FED other major cen­tral bank to lower the pric­ing of exist­ing USD liq­uid­ity swaps by 50BPS

And as we have been writ­ing every sin­gle day, the world­wide dol­lar crunch is now confirmed:

• At present, there is no need to offer liq­uid­ity in non-domestic cur­ren­cies other than the U.S. dollar

And finally, a promise to bailout Bank of Amer­ica when it hits $4.00 again:

• U.S. finan­cial insti­tu­tions cur­rently do not face dif­fi­culty obtain­ing liq­uid­ity in short-term fund­ing mar­kets.  How­ever, were con­di­tions to dete­ri­o­rate, the Fed­eral Reserve has a range of tools avail­able to pro­vide an effec­tive liq­uid­ity back­stop for such insti­tu­tions and is pre­pared to use these tools as needed to sup­port finan­cial sta­bil­ity and to pro­mote the exten­sion of credit to U.S. house­holds and businesses.

This means that the global sit­u­a­tion is far, far more dire than the talk­ing heads have said. Luck­ily, when this step fails, which it will, Mars can always come and bail us out.

For release at 8:00 a.m. EDT

The Bank of Canada, the Bank of Eng­land, the Bank of Japan, the Euro­pean Cen­tral Bank, the Fed­eral Reserve, and the Swiss National Bank are today announc­ing coör­di­nated actions to enhance their capac­ity to pro­vide liq­uid­ity sup­port to the global finan­cial system. The pur­pose of these actions is to ease strains in finan­cial mar­kets and thereby mit­i­gate the effects of such strains on the sup­ply of credit to house­holds and busi­nesses and so help fos­ter eco­nomic activity.

These cen­tral banks have agreed to lower the pric­ing on the exist­ing tem­po­rary U.S. dol­lar liq­uid­ity swap arrange­ments by 50 basis points so that the new rate will be the U.S. dol­lar overnight index swap (OIS) rate plus 50 basis points.  This pric­ing will be applied to all oper­a­tions con­ducted from Decem­ber 5, 2011.  The autho­riza­tion of these swap arrange­ments has been extended to Feb­ru­ary 1, 2013.  In addi­tion, the Bank of Eng­land, the Bank of Japan, the Euro­pean Cen­tral Bank, and the Swiss National Bank will con­tinue to offer three-month ten­ders until fur­ther notice.

As a con­tin­gency mea­sure, these cen­tral banks have also agreed to estab­lish tem­po­rary bilat­eral liq­uid­ity swap arrange­ments so that liq­uid­ity can be pro­vided in each juris­dic­tion in any of their cur­ren­cies should mar­ket con­di­tions so war­rant.  At present, there is no need to offer liq­uid­ity in non-domestic cur­ren­cies other than the U.S. dol­lar, but the cen­tral banks judge it pru­dent to make the nec­es­sary arrange­ments so that liq­uid­ity sup­port oper­a­tions could be put into place quickly should the need arise.  These swap lines are autho­rized through Feb­ru­ary 1, 2013.

Fed­eral Reserve Actions
The Fed­eral Open Mar­ket Com­mit­tee has autho­rized an exten­sion of the exist­ing tem­po­rary U.S. dol­lar liq­uid­ity swap arrange­ments with the Bank of Canada, the Bank of Eng­land, the Bank of Japan, the Euro­pean Cen­tral Bank, and the Swiss National Bank through Feb­ru­ary 1, 2013.  The rate on these swap arrange­ments has been reduced from the U.S. dol­lar OIS rate plus 100 basis points to the OIS rate plus 50 basis points.  In addi­tion, as a con­tin­gency mea­sure, the Fed­eral Open Mar­ket Com­mit­tee has agreed to estab­lish sim­i­lar tem­po­rary swap arrange­ments with these five cen­tral banks to pro­vide liq­uid­ity in any of their cur­ren­cies if nec­es­sary.  Fur­ther details on the revised arrange­ments will be avail­able shortly.

U.S. finan­cial insti­tu­tions cur­rently do not face dif­fi­culty obtain­ing liq­uid­ity in short-term fund­ing mar­kets.  How­ever, were con­di­tions to dete­ri­o­rate, the Fed­eral Reserve has a range of tools avail­able to pro­vide an effec­tive liq­uid­ity back­stop for such insti­tu­tions and is pre­pared to use these tools as needed to sup­port finan­cial sta­bil­ity and to pro­mote the exten­sion of credit to U.S. house­holds and businesses.

Infor­ma­tion on Related Actions Being Taken by Other Cen­tral Banks
Infor­ma­tion on the actions to be taken by other cen­tral banks is avail­able on the fol­low­ing websites:

Bank of Canada

Bank of England

Bank of Japan

Euro­pean Cen­tral Bank

Swiss National Bank

Fre­quently Asked Ques­tions: For­eign Cur­rency Liq­uid­ity Swaps

Tags: Backstop, Bailout, Bank Of America, Bank Of Canada, Bank Of England, Bank Of Japan, Basis Points, Boj, Central Banks, Domestic Currencies, ECB, Financial Institutions, Financial Stability, Global Financial System, Global Situation, Liquidity Support, Overnight Index Swap, Snb Bank, Swap Rates, Swiss National Bank
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Albert Edwards On The BRICs As A "Bloody Ridiculous Investment Concept"... And A China Hard Landing

Wednesday, November 30th, 2011

Just in time for the Chi­nese 50 bps RRR cut, we get a note from Albert Edwards remind­ing us just why this des­per­ate and sud­den move from China comes: "We have iden­ti­fied a China hard land­ing as one of the biggest invest­ment shocks next year." Not only that, but the Soc­Gen strate­gist takes a long over­due swipe at the world's most ridicu­lous con­cept, Jim O'Neill's BRIC débâ­cle: "Despite recent poor  per­for­mance investors still seem to favour EM and the BRICs. My good friend and for­mer col­league Peter Tasker came up with an alter­na­tive for the widely (over) used BRIC acronym — Bloody Ridicu­lous Invest­ment Con­cept." It appears that the PBOC was well aware of this re-definition when it decided to announce to the world that it has started eas­ning once again last night.

Why the feud with the BRICS?

Euro­zone equity mar­kets have suf­fered badly this year amid the cri­sis that has engulfed the region. Speak­ing to clients, they still retain a pref­er­ence for the rapidly grow­ing emerg­ing mar­kets (EM) against the highly indebted and strug­gling devel­oped economies. Yet, much to many investors' sur­prise, EM, and espe­cially the so-called BRIC equity mar­kets (Brazil, Rus­sia, India and China), have per­formed even more poorly (see chart below).

Despite recent poor per­for­mance investors still seem to favour EM and the BRICs. My good friend and for­mer col­league Peter Tasker came up with an alter­na­tive for the widely (over) used BRIC acronym — Bloody Ridicu­lous Invest­ment Concept.

As my for­mer col­league James Mon­tier always used to point out, investors are suck­ers for a good story. When you look at the evi­dence, there is absolutely no cor­re­la­tion between invest­ment returns and eco­nomic growth because investors over­pay for growth sto­ries and there is no mar­gin for error (see Dim­son, Marsh and Staunton at the Lon­don Busi­ness School 2005 — link). In addi­tion, The Econ­o­mist mag­a­zine reports that Paul Mar­son of Lom­bard Odier has extended this research to emerg­ing mar­kets. He found no cor­re­la­tion between GDP growth and stock mar­ket returns in devel­op­ing coun­tries over the period 1976–2005. A clas­sic exam­ple is China; aver­age nom­i­nal GDP growth since 1993 has been 15.6%, the com­pound stock mar­ket return over the same period has been minus 3.3%. (link)

Yet investors per­sist in the BRIC supe­rior growth fan­tasy. But it is no dif­fer­ent from many of the other invest­ment fan­tasies I have wit­nessed over the last 25 years — only to see them end in severe dis­ap­point­ment. If growth does mat­ter to investors, they should be wor­ried that things seem to be slow­ing sharply in the BRIC uni­verse, most espe­cially in Brazil and India (see chart below).

As for China...

We have iden­ti­fied a China hard land­ing as one of the biggest invest­ment shocks next year. The cru­cial dri­ver investors are miss­ing is the change in global liq­uid­ity as mea­sured by growth in EM for­eign exchange reserves (see charts below). Con­fi­dence often ebbs as growth slows and EM economies are see­ing a sharp drop in reserves and liq­uid­ity tight­en­ing. In this con­text did any­one spot the Chief Econ­o­mist of the China State Infor­ma­tion Cen­tre call­ing for a yuan deval­u­a­tion now that reserves are falling (link). Shall we call this Invest­ment Shock II?

How con­veneint of the PBOC to con­firm Edwards' the­sis lit­er­ally min­utes after this note's publication.

Tags: Bps, BRIC, BRICs, Debacle, Dimson, Economist Magazine, Emerging Markets, Good Friend, Investment Concept, Investment Returns, Lomba, London Business School, Marson, O Neill, Pboc, Peter Tasker, Poor Performance, Strategist, Sudden Move, Swipe
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Eric Sprott: Investment Outlook (November 29, 2011)

Tuesday, November 29th, 2011

Sil­ver Pro­duc­ers: A Call to Action

by Eric Sprott and David Baker

Novem­ber 29, 2011

As we approach the end of 2011, the sil­ver spot price has admit­tedly endured a tougher road than we would have expected. And let’s be hon­est – what invest­ment firm on earth has pounded the table on sil­ver harder than we have? After the orches­trated sil­ver sell-off in May 2011 (please see June 2011 MAAG arti­cle enti­tled, "Caveat Ven­di­tor"), sil­ver promptly rose back to US$40/oz where it con­sol­i­dated nicely, only to drop back below US$30 within a two week span in late September.1 The Sep­tem­ber sell-off was partly due to the market’s dis­ap­point­ment over Bernanke’s Oper­a­tion Twist, which sounded inter­est­ing but didn’t involve any real money print­ing. Like the May sell-off before it, how­ever, it was also exac­er­bated by a seem­ingly need­less 21% mar­gin rate hike by the CME on Sep­tem­ber 23rd, fol­lowed by a 20% mar­gin hike by the Shang­hai Gold Exchange – the CME’s coun­ter­part in China, three days later.

The paper mar­kets still dic­tate the spot mar­ket for phys­i­cal gold and sil­ver. When we talk about the "paper mar­ket", we’re refer­ring to any paper con­tract that claims to have an under­ly­ing link to the price of gold or sil­ver, and we’re refer­ring to con­tracts that are almost always lev­ered. It’s highly ques­tion­able today whether the paper mar­ket has any true link to the phys­i­cal mar­ket for gold and sil­ver, and the futures mar­ket is the most obvi­ous and influ­en­tial "paper mar­ket" offender. When the futures exchanges like the CME hike mar­gin rates unex­pect­edly, it’s usu­ally under the pre­tense of pro­tect­ing the "integrity of the exchange" by increas­ing the col­lat­eral (money) required to hold a posi­tion, both for the long (future buyer) and the short (future seller). When they unex­pect­edly raise mar­gin require­ments two days after sil­ver has already declined by 22%, how­ever, who do you think that mar­gin increase hurts the most? The long buyer, or the short seller? By rais­ing the mar­gin require­ment at the very moment the long con­tracts have already received an ini­tial mar­gin call (because the price of sil­ver has dropped), they end up dou­bling the longs’ pain – essen­tially forc­ing them to sell their con­tracts. This in turn cre­ates even more down­ward price pres­sure, and ends up exac­er­bat­ing the very risks the mar­gin hikes were allegedly designed to address.

When review­ing the per­for­mance of sil­ver this year, it’s impor­tant to acknowl­edge that noth­ing fun­da­men­tally changed in the phys­i­cal sil­ver mar­ket dur­ing the sell-offs in May or mid-September. In both instances, the sell-offs were inten­si­fied by unex­pected mar­gin rate hikes on the heels of an ini­tial price decline. It should also come as no sur­prise to read­ers that the "shorts" took advan­tage of the Sep­tem­ber sell-off by sig­nif­i­cantly reduc­ing their sil­ver short positions.2 Should phys­i­cal sil­ver be priced off these futures con­tracts? Absolutely not. That they have any rela­tion­ship at all is some­what laugh­able at this point. But futures con­tracts con­tinue to heav­ily influ­ence spot prices all the same, and as long as the "longs" set­tle futures con­tracts in cash, which they almost always do, the futures market-induced whip­saw­ing will likely con­tinue. It also serves to note that the class action law­suits launched against two major banks for sil­ver manip­u­la­tion remain unre­solved today, as does the ongo­ing CFTC inves­ti­ga­tion into sil­ver manip­u­la­tion which has yet to bear any dis­cernible results.3

Mean­while, despite the need­less volatil­ity trig­gered by the paper mar­ket, the phys­i­cal mar­ket for sil­ver has never been stronger. If the Sep­tem­ber sell-off proved any­thing, it’s the sim­ple fact that PHYSICAL buy­ers of sil­ver are not fright­ened by volatil­ity. They view dips as buy­ing oppor­tu­ni­ties, and they buy in size. Dur­ing the month of Sep­tem­ber, the US Mint reported the sec­ond high­est sales of phys­i­cal sil­ver coins in its his­tory, with the major­ity of sales made in the last two weeks of the month.4 Reports from India in early Octo­ber indi­cated that phys­i­cal sil­ver demand had cre­ated short-term sup­ply issues for phys­i­cal deliv­ery due to prob­lems with air­line capacity.5 In China, which report­edly imported 264.69 tons (7.7 mil­lion oz) of sil­ver in Sep­tem­ber alone, the vol­ume of sil­ver for­ward con­tracts on the Shang­hai Gold Exchange was more than six times higher than the same period in 2010.6,7 It was clear to any­one fol­low­ing the sil­ver mar­ket that the phys­i­cal demand for the metal actu­ally increased dur­ing the paper price decline. And why shouldn’t it? Have you been fol­low­ing Europe lately? Do the politi­cians and bureau­crats there give you con­fi­dence? Gold and sil­ver are the most ratio­nal finan­cial assets to own in this type of envi­ron­ment because they are no one’s lia­bil­ity. They are per­fectly designed to pro­tect us dur­ing these peri­ods of extreme finan­cial tur­moil. And wouldn’t you know it, despite the volatil­ity, gold and sil­ver have con­tin­ued to do their job in 2011. As we write this, in Cana­dian dol­lars, gold is up 23.4% on the year and silver’s up 6.8%. Mean­while, the S&P/TSX is down –12.3%, the S&P 500 is down –5.1% and the DJIA is up a mere +0.26%.8

Tags: Caveat Venditor, David Baker, Eric Sprott, Futures Exchanges, Futures Market, Gold And Silver, Gold Exchange, Investment Outlook, Margin Rate, Margin Rates, Margin Requirements, Money Printing, Paper Contract, Paper Markets, physical gold, Price Of Gold, Rate Hike, September 23rd, Silver Spot Price, True Link
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AdvisorAnalyst's Top 15 Stories of November 2011

Tuesday, November 29th, 2011

1. Mark Holowesko: "Right Now the Oppor­tu­ni­ties for Investors are Fantastic"
2. Spe­cial Report on Mer­its of Div­i­dend Invest­ing (Lewenza)
3. Hugh Hendry: Irony and Para­dox Fig­ure Large in 2011–2012 Outlook
4. Bonds Beat Stocks Over Past 30 Years: First Time Since Civil War
5. Exit­ing Chi­nese a Force in Cana­dian Real Estate
6. Don Coxe: Invest­ment Rec­om­men­da­tions (Novem­ber 2011)
7. Den­nis Gart­man: Invest­ment Out­look (Late Novem­ber 2011)
8. Bob Jan­juah: Ger­many Will Walk and the S&P Will Under­shoot to 700 in 2012
9. Sprott: Invest­ment Out­look Novem­ber 2011
10. Jim Rogers: Greek Bailout may be Pre­lude to EU Zone Col­lapse, plus News and Views
11. Lead­ing Eco­nomic Indi­ca­tors: Full Steam Ahead
12. Bill Gross: Invest­ment Out­look (Novem­ber 2011)
13. David Rosen­berg (In Depth): Are We in a Recession?
14. Bar­clays Says Italy is Fin­ished, Math­e­mat­i­cally Beyond Point of No Return
15. To Save the Euro, We Must Destroy Germany

Tags: Bailout, Barclays, Bill Gross, Collapse, David Rosenberg, Dennis Gartman, Don Coxe, Exiting, Gross Investment, Hugh Hendry, Investment Outlook, Investment Recommendations, Jim Rogers, Late November, Leading Economic Indicators, News And Views, Point Of No Return, Prelude, Recession, Sprott
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Stocks Buffeted by Euro Fears and Super Committee Failure (Doll)

Tuesday, November 29th, 2011

by Bob Doll, Chief Equity Strate­gist, Black­rock, Inc.

Novem­ber 28, 2011

A Sharp Drop for Stocks

Equity mar­kets sank sharply last week as the Euro­pean debt cri­sis wors­ened and the US super com­mit­tee failed to come to an agree­ment. For the week, the Dow Jones Indus­trial Aver­age fell 4.8% to 11,231, the S&P 500 Index dropped 4.7% to 1,158 and the Nas­daq Com­pos­ite sank 5.1% to 2,441. Because the polit­i­cal prob­lems in the United States and the cri­sis in Europe could result in a nearly end­less array of out­comes, investors are faced with a high degree of uncer­tainty. As a result, unless and until more clar­ity emerges, mar­kets are likely to remain some­what trend­less in the near term.

Out­look Uncer­tain for the Euro­pean Debt Crisis

While much of the focus on the euro cri­sis has been on Greece and its risk of default­ing, in recent weeks, that focus has shifted to a gen­eral lack of liq­uid­ity within the Euro­pean debt mar­kets as banks strug­gle to main­tain credit rat­ings. Many large global banks are attempt­ing to sell or reduce their expo­sures to trou­bled Euro­pean sov­er­eign debt, and the sell­ing pres­sures are trig­ger­ing a new surge in gov­ern­ment bond inter­est rates. This, in turn, has been forc­ing more coun­tries into higher debt bur­dens and big­ger deficits.

At this point, it has become clear that the mea­sures taken so far to stem the cri­sis have not been suf­fi­cient. In our view, it will prob­a­bly require the cre­ation of some­thing like a com­monly issued euro bond to con­tain the debt cri­sis. Although Ger­many has so far resisted that pos­si­bil­ity, there are grow­ing indi­ca­tions that such a solu­tion may well be forthcoming.

Regard­less of what hap­pens in the debt cri­sis itself, a reces­sion in Europe now seems a fore­gone con­clu­sion. Should pol­i­cy­mak­ers be able to come to an effec­tive res­o­lu­tion soon, the reces­sion is likely to be shal­low, but risks are grow­ing that the reces­sion could be deeper. It is an open ques­tion as to how much a Euro­pean reces­sion would impact the United States and other global mar­kets. The main risk comes in the form of the inter­twined nature of the global credit mar­kets since severe Euro­pean bank delever­ag­ing could neg­a­tively impact US credit avail­abil­ity as well.

Super Com­mit­tee Fail­ure Cre­ates a Murky Debt Future

The fail­ure of the super com­mit­tee to pro­vide a plan to reduce the deficit was cer­tainly dis­ap­point­ing, but it would be a mis­take to put too much stock in that spe­cific inci­dent. The dead­line imposed by Con­gress was an arbi­trary one and the auto­matic cuts set to take place as a result of the non-decision will not occur until Jan­u­ary 2013. As a result, Con­gress still has an oppor­tu­nity to address deficit reduc­tion, but of course the fact that all of this is occur­ring with the back­drop of the 2012 elec­tions means that uncer­tainty lev­els are elevated.

In our view, the more impor­tant ques­tion is whether or not Con­gress will be able to extend the pay­roll tax cuts and unem­ploy­ment ben­e­fits set to expire at the end of this year. Should they be unsuc­cess­ful in doing so, it would likely cre­ate a sig­nif­i­cant fis­cal head­wind in 2012.

Stocks Likely to Remain Range-Bound

Some­what lost amid all of the euro debt and US polit­i­cal head­lines has been the fact that US eco­nomic data has con­tin­ued a grad­ual improve­ment. The Novem­ber pay­rolls report is set to be released this Fri­day and indi­ca­tions are that it will be decent. True, last week it was reported that third-quarter gross domes­tic prod­uct (GDP) growth was revised lower, but the inven­tory reduc­tion that occurred may help set the stage for a stronger fourth quar­ter. At this point, fourth-quarter GDP looks to come in at 3% or pos­si­bly higher based on improved prof­its, a bet­ter labor mar­ket, increased cap­i­tal expen­di­tures and a low cycli­cal start­ing point for inventories.

Eco­nomic accel­er­a­tion should cre­ate firmer foot­ing for stocks, but for the time being, we believe mar­kets will remain focused on the short-term head­lines. Of all of the fac­tors affect­ing the mar­kets (US pol­i­tics, the eco­nomic slow­down in China, etc.) the most crit­i­cal remains the Euro­pean debt cri­sis. Stocks are likely to remain range bound (trad­ing between the 1,100 and 1,250 level for the S&P 500) for now, but should pol­i­cy­mak­ers be suc­cess­ful in gain­ing some trac­tion, mar­kets could see some bet­ter results.

About Bob Doll

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

Sources: Black­Rock, Bank Credit Ana­lyst. This mate­r­ial is not intended to be relied upon as a fore­cast, research or invest­ment advice, and is not a rec­om­men­da­tion, offer or solic­i­ta­tion to buy or sell any secu­ri­ties or to adopt any invest­ment strat­egy. The opin­ions expressed are as of Novem­ber 28, 2011, and may change as sub­se­quent con­di­tions vary. The infor­ma­tion and opin­ions con­tained in this mate­r­ial are derived from pro­pri­etary and non­pro­pri­etary sources deemed by Black­Rock to be reli­able, are not nec­es­sar­ily all-inclusive and are not guar­an­teed as to accu­racy. Past per­for­mance is no guar­an­tee of future results. There is no guar­an­tee that any fore­casts made will come to pass. Reliance upon infor­ma­tion in this mate­r­ial is at the sole dis­cre­tion of the reader. Invest­ment involves risks. Inter­na­tional invest­ing involves addi­tional risks, includ­ing risks related to for­eign cur­rency, lim­ited liq­uid­ity, less gov­ern­ment reg­u­la­tion and the pos­si­bil­ity of sub­stan­tial volatil­ity due to adverse polit­i­cal, eco­nomic or other devel­op­ments. The two main risks related to fixed income invest­ing are inter­est rate risk and credit risk. Typ­i­cally, when inter­est rates rise, there is a cor­re­spond­ing decline in the mar­ket value of bonds. Credit risk refers to the pos­si­bil­ity that the issuer of the bond will not be able to make prin­ci­pal and inter­est pay­ments. Index per­for­mance is shown for illus­tra­tive pur­poses only. You can­not invest directly in an index.

Black­Rock is a reg­is­tered trade­mark of Black­Rock, Inc. All other trade­marks are the prop­erty of their respec­tive owners.

Pre­pared by Black­Rock Invest­ments, LLC, mem­ber FINRA.

Copy­right © Black­rock, Inc.

Tags: Blackrock Inc, Bob Doll, Bond Interest, Debt Burdens, Debt Crisis, Debt Markets, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Endless Array, Foregone Conclusion, Global Banks, Government Bond, liquidity, Nasdaq Composite, Open Question, Recession, Sovereign Debt, Strategist, Term Outlook
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"The Oath" (Saut)

Tuesday, November 29th, 2011

“The Oath”

by Jef­frey Saut, Chief Invest­ment Strate­gist, Ray­mond James

Novem­ber 28, 2011

Here is the oath that House and Sen­ate Mem­bers take:

I do solemnly swear (or affirm) that I will sup­port and defend the Con­sti­tu­tion of the United States against all ene­mies, for­eign and domes­tic; that I will bear true faith and alle­giance to the same; that I take this oblig­a­tion freely, with­out any men­tal reser­va­tion or pur­pose of eva­sion; and that I will well and faith­fully dis­charge the duties of the office on which I am about to enter: So help me God.

Dere­lic­tion of duty is a spe­cific offense under United States Code Title 10 § 892, Arti­cle 92, which applies to all branches of the U.S. mil­i­tary. A ser­vice mem­ber who is derelict has will­fully refused to per­form his duties (or fol­low a given order) or has inca­pac­i­tated him­self in such a way that he can­not per­form his duties.

Last week, cer­tain mem­bers of Con­gress were guilty of dere­lic­tion of duty when they “will­fully refused to per­form their duties” by fail­ing to cut gov­ern­ment spend­ing. While the focal point was the “dirty dozen” (aka the Super Com­mit­tee), by our count there are some 68 mem­bers of Con­gress that also qual­ify for dere­lic­tion of duty. No won­der a recent New York Times poll found that more Amer­i­cans approve of polygamy than they do of Con­gress. Indeed, with a 9% approval rat­ing Con­gress has the low­est rat­ing ever! And, while we can’t vote them out quite yet, the D-J Indus­trial Aver­age (INDU/11231.65) has cer­tainly voted with the worst Thanks­giv­ing week decline (-4.78%) since 1932. Last week’s wilt brought the “sell­ing stam­pede” to ses­sion 19, and punc­tu­ated the now ~8.2% decline by the senior index since the Indus­tri­als’ clos­ing reac­tion high of Octo­ber 28, 2011 (12231.11). Recall that such stam­pedes typ­i­cally last 17–25 ses­sions with only one– to three-session pauses, or rally attempts, before they exhaust them­selves. In addi­tion, the S&P 500 (SPX/1158.67) has expe­ri­enced seven con­sec­u­tive ses­sions on the down­side, and mar­kets rarely go that many days in a row in one direc­tion. More­over, as of last Fri­day the sell­ing skein left the McClel­lan Oscil­la­tor as over­sold as it was at the August 8–9, 2011 “lows.” There­fore, the stage was set for some sort of trad­able bot­tom; last week cer­tainly felt like capit­u­la­tion to me.

Quite frankly, when I wrote the strat­egy report titled “Crescendo” on Octo­ber 31, 2011 where I sug­gested a trad­ing top was “in,” I really didn’t think the ensu­ing decline would vio­late my long-standing pivot point of 1217 on the SPX, nor did I think some of our core invest­ment posi­tions such as EV Energy Part­ners (EVEP/$63.22/Strong Buy) and LINE Energy (LINE/$35.19/Strong Buy) would decline by the amount they have. Still, we like the MLPs and think 2012 will have some inter­est­ing twists for the group. As our energy ana­lyst Kevin Smith writes:

“Recently there have been sev­eral high-profile take­outs of C-corps with pipeline assets by mas­ter lim­ited part­ner­ships (MLPs), with at least one trans­ac­tion spark­ing a bid­ding war. You are prob­a­bly think­ing: E&P com­pa­nies don’t have pipeline assets – this won’t affect our E&P invest­ments. Don’t be so sure. The gates have been opened and the sharks have been let loose in your pool too. While Upstream MLP acqui­si­tion activ­ity has picked up, the part­ner­ships have gen­er­ally lacked the need, the finan­cial fire­power, or desire to sig­nif­i­cantly ramp up C-corp acqui­si­tions. That is chang­ing. We believe the ques­tion should not be if, but when will the flood of C-corp acqui­si­tions by MLPs man­i­fest itself?”

Inter­est­ingly, most MLPs trade at 8-9x EBITDA, while E&P C-corps trade at 4-5x EBITDA. The impli­ca­tion is that an MLP could acquire a C-corp and the acqui­si­tion would be earn­ings accre­tive. Though nei­ther the com­pany nor our cov­er­ing ana­lyst have given any indi­ca­tion that a tie-up is in the pic­ture, if this line of rea­son­ing proves cor­rect, one poten­tial acqui­si­tion can­di­date would be Berry Petro­leum (BRY/$36.93/Outperform) given its val­u­a­tion met­rics and our analyst’s pos­i­tive view of the company’s fun­da­men­tal outlook.

Another theme applic­a­ble for this time of year is the cor­re­la­tion between a decent stock mar­ket and good Christ­mas sales. Up until the past few ses­sions we have expe­ri­enced a pretty good stock mar­ket. Said cor­re­la­tion is about 89%, so our sense is that this Christ­mas sell­ing sea­son is going to be good. Speak­ing to this, our soft­line retail ana­lyst, Saman­tha Panella, said that Black Fri­day looks like it is going to be bet­ter than last year but that it is extremely pro­mo­tional with heavy price dis­count­ing. Sam’s obser­va­tions at the Roo­sevelt Field Mall on Fri­day caused her to sug­gest the clear “win­ner” is Express Inc. (EXPR/$20.14/Outperform), while the clear loser is Gap Stores (GPS/$17.62/Market Per­form). Yet, there is another player that has come to the fore over the past 15 years.

Indeed, accord­ing to www.ftportfolios.com:

“A sur­vey from Shop.org found that over 50% of all work­ers plan to do some of their hol­i­day shop­ping online on Cyber Mon­day (Novem­ber 28), accord­ing to CNNMoney.com. Eight out of 10 online retail­ers plan to offer spe­cial pro­mo­tions on that day. Some 75.9 mil­lion work­ers in the U.S. have access to the Inter­net. Sales are expected to set a record at $1.2 bil­lion, accord­ing to com­Score. Inter­net stocks have per­formed quite well since the mar­ket bot­tomed on March 9, 2009. From 3/9/09–11/21/11, the Dow Jones Inter­net Com­pos­ite Index posted a cumu­la­tive total return of 149.8%, com­pared to gains of 106.0% for the S&P Infor­ma­tion Tech­nol­ogy Index and 86.5% for the S&P 500.”

As our Inter­net ana­lyst Aaron Kessler writes, “Through the first three weeks of the 2011 hol­i­day sea­son, e-commerce sales remained robust as indi­cated by Chan­nelAd­vi­sor (same-store sales up 28% y/y) and the Chase Hol­i­day Pulse Index (31% y/y). While still early in the hol­i­day period (first three weeks rep­re­sented 22% of the 2010 hol­i­day sea­son), the strong ini­tial data increases our con­fi­dence in the 2011 e-commerce hol­i­day sea­son out­look.” In addi­tion, while I think it is a stretch to call it an e-commerce com­pany, Shut­ter­fly (SFLY/$31.28/Outperform) is one of Aaron’s favorites.

The call for this week: The week before Thanks­giv­ing has been “up” eight of the past nine years ... that is up until last week. While many pun­dits cited the failed Ger­man Bund auc­tion, China’s slow­ing PMI Index, another bank “stress test,” a down­wardly revised GDP report, Euro­quake, etc.; my hunch is the real rea­son for the recent swoon is our own dys­func­tional gov­ern­ment. To be sure, the break­down of the Super Com­mit­tee has clar­i­fied the dif­fer­ences between the two par­ties. Hence, it is pretty clear that Amer­i­cans must now decide to accept either seri­ous reduc­tions in their health­care and pen­sion pro­grams, or sub­stan­tially higher taxes, and prob­a­bly both. What­ever the rea­son, my sense is that the Novem­ber weak­ness has burned itself out and con­se­quently I look for a con­tin­u­a­tion of the tra­di­tional year-end rally that began on our “buy ‘em” call of Octo­ber 4th. That belief is based on the fact that trad­ing vol­ume has con­tracted so sharply it reveals the pub­lic is g-o-n-e from the invest­ing scene (read: bull­ishly), the econ­omy is NOT slip­ping into reces­sion (our reces­sion indi­ca­tor has the odds down to 11% from 35% in Sep­tem­ber), Euro­quake will be resolved, earn­ings will con­tinue to sur­prise on the upside (like they did in the 3Q10), that last week’s reduc­tion in real GDP was because of inven­tory adjust­ments that should actu­ally boost growth in 4Q11, that Domes­tic Final Sales accel­er­ated to 3.1% in the third quar­ter (ver­sus 1.4% and 0.4% in the pre­vi­ous two quar­ters), and the “bull list” goes on despite all of the neg­a­tive nabobs rants. And this morn­ing Ger­many and France are rumored to be explor­ing “rad­i­cal” meth­ods to solve Euro­quake, which has the pre­open­ing futures up more than 30 points.

P.S. I am in New York City all week; these will be the only strat­egy com­ments of the week.

Tags: Approval Rating, Chief Investment Strategist, Constitution Of The United States, Derelict, Dereliction Of Duty, Dirty Dozen, government spending, Indu, jeffrey saut, Members Of Congress, Mental Reservation, New York Times, New York Times Poll, Polygamy, Purpose Of Evasion, Raymond James, Senate Members, Service Member, True Faith, United States Code
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Ride the Mieders Alpine 'Coaster, With No Brakes

Tuesday, November 29th, 2011

Time for a diver­sion break? While roller coaster walk­ways might rep­re­sent the calm side of amuse­ment rides, this video by David Ellis shows off the extreme need for speed. In this 4 minute video, you can watch David rocket down a single-pipe alpine coaster found in Mieders, Aus­tria. You ride a cable car to get to the top of the moun­tain and then shoot down in a one-person car. You can choose to hit the brakes if you'd like, but this was David's sec­ond time on the ride. He didn't slow down an iota.

Tags: Alpine Coaster, Austria, Brakes, Break, Cable Car, David Ellis, Diversion, Extreme Need, Iota, Need For Speed, Roller Coaster, Second Time, Walkways
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U.S. Equities – Downtrend Arrested?

Tuesday, November 29th, 2011

My notes below are some­what cryp­tic as I am about to leave for abroad. How­ever, the graphs should pro­vide some food for thought regard­ing the short-term out­look for U.S. stocks.

Yesterday’s rally in the S&P 500 was mainly as a result of the PE10 clos­ing the dis­count that opened the VIX last week.

The rally took the PE10 to 19.95 from 19.39 last Friday.

The PE10 remains under the 40-day mov­ing aver­age, with the lat­ter top­ping out. I will not be sur­prised to see the 40-day mov­ing aver­age tested at 20.40 soon.

The PE10 is over­sold but the RSI is still trend­ing down. An unchanged to higher clos­ing of the S&P 500 over the next three days is likely to break the RSI downtrend.

Both the 12-day and 26-day expo­nen­tial mov­ing aver­ages of the PE10 are bottoming.

The MACD (26;12) of the PE10 is show­ing signs of bot­tom­ing. The nine-day mov­ing aver­age of the MACD is still trend­ing down while the gap between it and the MACD indi­cates that a longer-term buy­ing sig­nal is still some way off.

The VIX is test­ing sup­port lev­els around 32.

The RSI of the VIX has retreated some­what from mildly over­bought con­di­tions but remains above the down­trend estab­lished in August.

The VIX is cur­rently test­ing the 12-day and 26-day expo­nen­tial mov­ing averages.

The MACD (26;12) is slowly rolling over and the gap to its nine-day mov­ing average(VIX Sig­nal) is clos­ing slightly.

The VIX MACD and the sig­nal are a bet­ter indi­ca­tor of PE trend changes than those of the PE10. The clos­ing of  theVIX’s MACD and the sig­nal indi­cates that a buy sig­nal could be imminent.

The RSI of the PE10 and the VIX (inverse) com­bined has tested the range of pre­vi­ous over­sold lev­els. Although the RSI is still trend­ing down­wards, unchanged S&P 500 and VIX lev­els over the next three days will break the downtrend.

A break in the down­trend of the com­bined RSI is likely to lead to a sig­nif­i­cant rally in the S&P 500.

Tags: Amp, Break, Exponential Moving Averages, Food For Thought, Gap, Graphs, Last Friday, Macd, Moving Average, Rally, Rsi, Signs, Stocks, Term Outlook, Trend Changes
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Hugh Hendry and Steven Drobny on Markets and More

Tuesday, November 29th, 2011

Hugh Hendry, Co-Founder and CIO of Eclec­tica Asset Man­age­ment, and Steven Drobny, Drobny Global Advi­sors, dis­cuss var­i­ous top­i­cal mat­ters at the LSE’s Alter­na­tive Invest­ment Con­fer­ence about a month ago.

Hugh Hendry, Eclec­tica Asset Man­age­ment and Steven Drobny, Drobny Global Advi­sors from LSE SU AIC on Vimeo.

Source: Vimeo, Octo­ber 18, 2011.

Tags: Aic, Alternative Investment, Cio, Co Founder, Drobny Global Advisors, Eclectica Asset Management, Hugh Hendry, Investment Conference, Lse, Topical Matters
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Eric Sprott on Precious Metals and More

Tuesday, November 29th, 2011

Eric King of King World News recently con­ducted an excel­lent inter­view with Eric Sprott, Chair­man of Sprott Asset Man­age­ment. Sprott has more than 35 years’ expe­ri­ence in the invest­ment indus­try and man­ages $5 bil­lion, includ­ing a gold and sil­ver trust. He has been very accu­rate in his writ­ings for over a decade and pre-crisis cor­rectly chron­i­cled the dan­gers of exces­sive lever­age and the bub­bles the Fed was creating.

Click play to listen:

http://kingworldnews.com/kingworldnews/Broadcast/Entries/2011/11/27_Eric_Sprott_files/Eric%20Sprott%2011%3A27%3A2011.mp3

Source: King World News, Novem­ber 28, 2011.

Tags: 35 Years, Asset Management, Broadcast Entries, Bubbles, Decade, Eric King, Eric Sprott, Gold And Silver, Gold Silver, Investment Industry, Leverage, Mp3, precious metals
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Jeremy Grantham v Bob Doll — Can Record Profit Margins be Maintained?

Tuesday, November 29th, 2011

Any­one observ­ing the finan­cial blo­gos­phere the past few years will surely have read that cor­po­rate profit mar­gins have exploded as global labor and tax haven arbi­trage have been exploited by the multi­na­tional class.  Within the U.S. the share of prof­its between cap­i­tal and labor have swung to extreme lev­els his­tor­i­cally in favor of cap­i­tal.  Labor has paid the price.  The ques­tion is.... is this a new nor­mal, or is this sim­ply unsus­tain­able.  Invest­ment guru Jeremy Grantham leans to sim­ply unsus­tain­able (which he out­lined in his August let­ter Dan­ger Chil­dren at Play) whereas Blackrock's Bob Doll says this is the new nor­mal.  I am afraid I have to side with Doll on this one, if I am going to be con­sis­tent with my long held the­ory that the global labor class is going to fall towards a median across bor­ders.  When pres­sured with ris­ing wages (or taxes) in one coun­try, the multi­na­tion­als march to the next colony coun­try.  There­fore the Amer­i­can, or west­ern Euro­pean worker demand­ing a return to the 'good olé days' will be smirked at.  I hope I am incor­rect on this one, but thus far — not so much.  Also don't for­get the role of automa­tion — you want health ben­e­fits? For­get it, we're going to get some robots....

Wild­card?  Some sort of global energy shock where 'pro­duc­ing local' is a requirement.

Via Bloomberg:

• U.S. com­pa­nies are the most prof­itable in more than 40 years, and some of the best-known stock pick­ers are divided over how long that will last.  Bob Doll, chief equity strate­gist at Black­Rock Inc. (BLK), said low labor costs and cost-saving tech­nol­ogy will allow com­pa­nies to keep up their prof­itabil­ity. Jeremy Grantham, chief invest­ment strate­gist of Boston-based Grantham, Mayo, Van Otter­loo & Co., said mar­gins will send stock mar­kets tum­bling when they even­tu­ally revert to their mean.
• “The impli­ca­tion for the stock mar­ket is ugly, because it means earn­ings are unsus­tain­ably high,” Grantham’s col­league Ben Inker, GMO’s direc­tor of asset allo­ca­tion, said in a tele­phone inter­view. GMO, an invest­ment man­ager that over­sees $93 bil­lion, puts the fair value of the Stan­dard & Poor’s 500 Index at between 950 and 1,000, com­pared with the 1,158.67 level at which it closed last week.
• U.S. com­pa­nies’ abil­ity to squeeze more profit from each dol­lar of sales is push­ing earn­ings higher, even as the econ­omy has grown at a below-average clip since the reces­sion ended in June 2009. Grantham, who called cor­po­rate prof­its “freak­ishly high” in an August com­men­tary, sees wide mar­gins as an aber­ra­tion.
• Grantham also believes in mean rever­sion, the notion that most mea­sures drop back to their his­tor­i­cal norms over time.  “Lower mar­gins are the great threat to mar­ket per­for­mance,” he wrote in the August newslet­ter. Grantham is known for his bear­ish invest­ment out­look and for his suc­cess­ful record in iden­ti­fy­ing stock-market bubbles.
• Mar­gins have been propped up by a “great surge” in gov­ern­ment spend­ing that fueled con­sump­tion, Grantham said. As polit­i­cal pres­sures force the U.S. to cut its bud­get deficit, the econ­omy will suf­fer and mar­gins will drop, Grantham pre­dicted with­out lay­ing out a timetable.  (this is true — the gov­ern­ment has stepped in with its 10% annual deficit spend­ing the past 3 years to prop up cus­tomers, let­ting the gov­ern­ment bub­ble replace the hous­ing bub­ble as a dri­ver of incomes.  If gov­ern­ment ever became seri­ous about cut­ting the deficit it would be a threat to the cur­rent sys­tem — but since our polit­i­cal body can't help them­selves, there will not be any seri­ous cuts.  After all "no one wants to raise taxes in this envi­ron­ment" in 1 party com­bined with every­one is a Key­ne­sian in the other party leads to no seri­ous changes ex account­ing gim­micks.  Hence Grantham has his behind cov­ered by say­ing there is no timetable.)  [Jun 6, 2009: 1 in 6 Dol­lars of Income Now Via Gov­ern­ment, High­est Since 1929]
• Grantham said of profit mar­gins, “They do not seem to be con­nected to eco­nomic realty.”
• Some of his com­peti­tors say changes in the econ­omy and the way firms oper­ate could keep them near peak lev­els for another year or two.  “We don’t think they have to fall,” Doll, whose New York– based firm is the world’s largest asset man­ager, said in a phone inter­view. Black­Rock over­sees $3.35 trillion.
• Two forces that have lifted mar­gins, a weak job mar­ket and invest­ment in labor-saving tech­nol­ogy, show no sign of revers­ing, Doll said. “We lean towards the opti­mistic side,” he wrote in a Nov. 21 note on the stock market’s prospects.
• The mar­gins of non-financial com­pa­nies in the U.S., a widely used mea­sure of prof­itabil­ity, reached 15 per­cent in the third quar­ter, accord­ing to data from Moody’s Ana­lyt­ics . That was the high­est level since 1969. When the reces­sion ended in the sec­ond quar­ter of 2009, the com­pa­ra­ble num­ber was 8.7 percent.
• Those on both sides of the debate agree on two things: mar­gins are unusu­ally high and the dri­ving force behind their rise is com­pa­nies’ abil­ity to keep a lid on expenses.
• “Busi­nesses have done a mar­velous job of reduc­ing costs,” Zandi said in a tele­phone interview.
• The glob­al­iza­tion of the work­force and a U.S. job­less rate of 9 per­cent last month have given man­age­ment the upper hand in deal­ing with labor, Zandi said. (hmmm, sounds like some­thing writ­ten on these pages 4 years ago)  Wages and salaries as a share of national income fell to 49.4 per­cent in the third quar­ter, the low­est since the gov­ern­ment began col­lect­ing the num­bers in 1948, Moody’s data show.
• Com­pa­nies, while slow to hire, have been upgrad­ing tech­nol­ogy.  Busi­nesses invested in equip­ment and soft­ware at an annual pace of $1.15 tril­lion in the third quar­ter, up 26 per­cent since the fourth quar­ter of 2009, data from IHS Global Insight in Lex­ing­ton, Mass­a­chu­setts, show.
• Den­nis Bryan is skep­ti­cal that the trends that have sup­ported mar­gins can con­tinue. Bryan is co-portfolio man­ager of the $1.2 bil­lion FPA Cap­i­tal Fund (FPPTX).  Firms may be reach­ing their limit in wring­ing out costs, after two years of ris­ing mar­gins.  “Will com­pa­nies be able to keep tight­en­ing their belts by cut­ting mil­lions more Amer­i­cans out of the work­force?” he said.  (uhhh yes Dennis)
• Profit mar­gins have been trend­ing higher since the mid-1980s, (and what trend started in earnest in the 1980s?) said Chris Christo­pher (awe­some name by the way), an econ­o­mist at IHS (IHS) Global Insight, who has writ­ten on the sub­ject. Quar­terly mar­gins peaked at 11.9 per­cent in the 1980s, 13.6 per­cent in the 1990s and 14.5 per­cent in the most recent decade.
• High mar­gins are here to stay, said Allen Sinai, chief econ­o­mist at Deci­sion Eco­nom­ics Inc Cloud com­put­ing, which pro­vides access to soft­ware and com­put­ing tasks remotely over the Inter­net, rather than through a company’s own sys­tem, is just the lat­est tool cor­po­ra­tions can use to keep costs in check, Sinai said.  “This is the way of the world now,” he said in a tele­phone inter­view. “CEOs are paid to max­i­mize profits.”

Tags: Arbitrage, Blackrock Inc, Blogosphere, Bloomberg, Bob Doll, Chief Investment Strategist, Children At Play, Corporate Profit, Extreme Levels, Global Energy, Good Ole Days, Grantham Mayo Van Otterloo, Health Benefits, Investment Guru, Jeremy Grantham, Multinationals, Profit Margins, Stock Markets, Stock Pickers, Tax Haven
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Investor Sentiment: Looking ahead (Lerner)

Monday, November 28th, 2011

The arti­cle below is a guest con­tri­bu­tion by Guy Lerner, writer of the Tech­ni­cal Take blog.

The best way to get more investors to turn more bear­ish in their out­look is to have lower prices. The sen­ti­ment indi­ca­tors are nowhere near the kinds of extremes seen at mar­ket bot­toms, so it would be my expec­ta­tion that we will see lower prices as mar­ket bot­toms tend to coin­cide with bear­ish extremes in the sen­ti­ment indi­ca­tors. If I were to guess, those extremes in bear­ish sen­ti­ment (i.e., bull sig­nal) will likely be seen as prices approach the August, 2011 lows. Let’s call that level SP500 ~ 1100. Look­ing ahead, this area of sup­port (i.e., prior buy­ing area) will be our battleground.

The “Dumb Money” indi­ca­tor (see fig­ure 1) looks for extremes in the data from 4 dif­fer­ent groups of investors who his­tor­i­cally have been wrong on the mar­ket: 1) Investors Intel­li­gence; 2) Mar­ket­Vane; 3) Amer­i­can Asso­ci­a­tion of Indi­vid­ual Investors; and 4) the put call ratio. This indi­ca­tor shows neu­tral sentiment.

Fig­ure 1. “Dumb Money”/ weekly

Fig­ure 2 is a weekly chart of the SP500 with the Insid­er­Score “entire mar­ket” value in the lower panel. From the Insid­er­Score weekly report: “Market-wide sen­ti­ment improved, push­ing fur­ther into neu­tral ter­ri­tory and away from bear­ish ter­ri­tory, as the num­ber of buy­ers increased 72% week-over-week and the num­ber of sell­ers fell –10% over the same period. Sen­ti­ment is very mixed over­all, with a high num­ber of pos­i­tive and neg­a­tive Unusual Events.”

Fig­ure 2. Insid­er­Score “Entire Mar­ket” value/ weekly

Fig­ure 3 is a weekly chart of the SP500. The indi­ca­tor in the lower panel mea­sures all the assets in the Rydex bull­ish ori­ented equity funds divided by the sum of assets in the bull­ish ori­ented equity funds plus the assets in the bear­ish ori­ented equity funds. When the indi­ca­tor is green, the value is low and there is fear in the mar­ket; this is where mar­ket bot­toms are forged. When the indi­ca­tor is red, there is com­pla­cency in the mar­ket. There are too many bulls and this is when mar­ket advances stall. Cur­rently, the value of the indi­ca­tor is 58.93%. Val­ues less than 50% are asso­ci­ated with mar­ket bot­toms. Val­ues greater than 58% are asso­ci­ated with mar­ket tops.

Fig­ure 3. Rydex Total Bull v. Total Bear/ weekly

Let me also remind read­ers that we are offer­ing a one-month free trial to our Daily Sen­ti­ment Report, which focuses on daily mar­ket sen­ti­ment and the Rydex asset data. This is excel­lent data based upon real assets and not opinions.

Source: Guy Lerner, Tech­ni­cal Take, Novem­ber 27, 2011.

Tags: American Association Of Individual Investors, Battleground, Bearish Sentiment, Dumb Money, Equity Funds, Extremes, Figure 1, Figure 3, Guy Lerner, Investor Sentiment, Lows, Market 1, Market Bottoms, Market Sentiment, Marketvane, Neutral Territory, Panel Measures, Put Call Ratio, S&P500, Sentiment Indicators
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David Rosenberg says Europe May Pull U.S. Into Recession

Monday, November 28th, 2011

David Rosen­berg, chief econ­o­mist and strate­gist at Gluskin Sheff and Asso­ciates, talks about Europe’s sovereign-debt cri­sis and the pos­si­ble impact on the U.S. econ­omy. He also dis­cusses the out­look for U.S. stocks and his invest­ment strategy.

Source: Bloomberg, Novem­ber 24, 2011.

Tags: Chief Economist, David Rosenberg, Debt Crisis, Economy, Europe, Gluskin Sheff, Investment Strategy, Outlook, Recession, Sovereign Debt, Stocks, Strategist
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Seth Klarman: Rare Interview with Charlie Rose

Monday, November 28th, 2011

Hedge fund maven Seth Klar­man of Bau­post Group, is con­sid­ered a super­star among the 'value investor' set, but is not very well known in retail cir­cles, as he is not very self promotional.

He is rarely seen in the press — in fact I only have one piece on him in nearly 4.5 years. [May 19, 2010: Seth Klar­man Calls for Another Lost Decade].

You wouldn't know that he is one of the 10 largest hedge fund shops in the coun­try as his name rarely comes off the tip of the tongue.   His out of print book 'Mar­gin of Safety' goes for around $1000 on the sec­ondary market.

That said, we have a rare oppor­tu­nity to lis­ten in to his thoughts in extended for­mat as he has a 45 minute inter­view with Char­lie Rose.  The first 18 min­utes or so is focused on the char­ity, so if you want the invest­ing focus skip along to minute 19.

h/t My Invest­ing Notebook

Tags: Book Margin, Charity, Charlie Rose, Circles, Decade, Hedge Fund, Margin Of Safety, Minute Interview, Notebook, Out Of Print Book, Rare Interview, Rare Opportunity, Seth Klarman, Superstar, Tip Of The Tongue, Value Investor
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Are Corporate Balance Sheets Really the Strongest in History? (Hussman)

Monday, November 28th, 2011

Are Cor­po­rate Bal­ance Sheets Really the Strongest in His­tory?

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

Let's begin with a few notes on con­tin­u­ing credit strains in Europe and elsewhere.

The Greek 1 year yield shot to 270% last week, with Greek debt of every matu­rity trad­ing at 35% of face value or less. The prospect of lim­it­ing write­downs to 50% is increas­ingly unlikely, which I sus­pect will put much greater strain on Euro­pean bank cap­i­tal than any­one is will­ing to admit. As expected, we're begin­ning to see nego­ti­a­tions push­ing for deeper restruc­tur­ing than 50%. On Fri­day, Reuters reported:

"Greece is demand­ing harsh con­di­tions from its cred­i­tors as it starts talks with lenders about a pro­posed bond swap, a key part of Europe's plan to reduce its debt pile and save the euro... The Greeks are demand­ing that the new bonds' Net Present Value — a mea­sure of the cur­rent worth of their future cash flows — be cut to 25 per­cent... a far harsher mea­sure than a num­ber in the high 40s the banks have in mind... It is increas­ingly likely that Greece will force bond­hold­ers who do not vol­un­tar­ily take part in the bond swap to accept the same terms and con­di­tions, some­thing that is pos­si­ble because most of the bonds are writ­ten under Greek law."

Should we care? Given the extremely high lever­age ratios of Euro­pean banks, it appears doubt­ful that it will be pos­si­ble to obtain ade­quate cap­i­tal through new share issuance, as they would essen­tially have to dupli­cate the exist­ing float. For that rea­son, I sus­pect that before this is all over, much of the Euro­pean bank­ing sys­tem will be nation­al­ized, much of the exist­ing debt of the Euro­pean bank­ing sys­tem will be restruc­tured, and those banks will grad­u­ally be recap­i­tal­ized, post-restructuring and at much smaller lever­age ratios, through new IPOs to the mar­ket. That's how to prop­erly man­age a restruc­tur­ing — you keep what is essen­tial to the econ­omy, but you don't reward the exist­ing stock and bond­hold­ers — it's essen­tially what we did with Gen­eral Motors. That out­come is not some­thing to be feared (unless you're a bank stock­holder or bond­holder), but is actu­ally some­thing that we should hope for if the global econ­omy is to be unchained from the bad debts that were enabled by finan­cial insti­tu­tions that took on impon­der­ably high lev­els of leverage.

Notably, credit default swaps are blow­ing out even in the U.S., despite lever­age ratios that are sub­stan­tially lower (in the 10–12 range, ver­sus 30–40 in Europe). As of last week, CDS spreads on U.S. finan­cials were approach­ing and in some cases exceed­ing 2009 lev­els. Bank stocks are also plumb­ing their 2009 depths, but with a strik­ing degree of calm about it, and a def­i­nite ten­dency for scorch­ing ral­lies on short-covering and "buy-the-dip" sen­ti­ment. There is a strong mood on Wall Street that we should take these devel­op­ments in stride. I'm not con­vinced. Our own mea­sures remain defen­sive about the prospec­tive return/risk trade­off in the stock market.

As for expec­ta­tions of using the ECB to back­stop the euro, as I noted last week ( Why the ECB Won't, and Shouldn't, Just Print ), we will not just all wake up one day to some sur­prise announce­ment that the ECB has started buy­ing dis­tressed Euro­pean debt. If there is any poten­tial at all to engage the ECB, the first thing to look for will be a con­certed but unpop­u­lar change in EU treaties to sub­or­di­nate the fis­cal poli­cies of each Euro­pean coun­try to one cen­tral­ized fis­cal body for all of Europe. In effect, the next step in the process will be an attempt to trade greater ECB flex­i­bil­ity in return for cen­tral­ized fis­cal con­trol. We'll prob­a­bly see the phrases "cede sov­er­eignty" and "fis­cal union" quite a bit in the com­ing weeks.

Late last week, after a meet­ing between Merkel (Ger­many), Sarkozy (France) and Monti (Italy), the three lead­ers squashed mar­ket expec­ta­tions that they would ask the ECB to inter­vene. Instead, they announced "propo­si­tions for the mod­i­fi­ca­tion of treaties" that would have noth­ing to do with the ECB. The best chance to resolve the cri­sis, in Merkel's words, is to "make clear that we must take steps toward a fis­cal union; to express the con­vic­tion that we know poli­cies must be more closely coör­di­nated if you have a com­mon, sta­ble currency."

Exactly. So now the main ques­tions are whether the attempt at mod­i­fy­ing the EU treaties will gar­ner unan­i­mous sup­port from all the Euro­pean mem­ber coun­tries, and whether a greater fis­cal union will ease the euro cri­sis. The answers, I think, are yes, and partially.

What I mean by "par­tially" is that pro­vided an accept­able agree­ment for greater fis­cal union, Ger­many is more likely to dis­tin­guish short-term fis­cal insta­bil­i­ties from long-term ones, which may increase its will­ing­ness to pro­vide direct back­stops and allow greater flex­i­bil­ity for the ECB to (mod­er­ately) inter­vene in the mar­kets. But there is one key issue remain­ing. The euro will not sur­vive, in my view, unless the indi­vid­ual coun­tries cre­ate an "out" over a period of per­haps 5–7 years by grad­u­ally rolling over their debt into new bonds that are con­vert­ible into their legacy cur­ren­cies. If they solve their prob­lems, no con­ver­sion would be nec­es­sary. But if greater fis­cal coör­di­na­tion fails and var­i­ous mem­ber coun­tries con­tinue to have intractable bud­get imbal­ances, they could exit the euro with­out caus­ing a col­lapse in the entire system.

As I noted last week, the aver­age matu­rity of Euro-area debt is only about 6–7 years, so intro­duc­ing con­vert­ibil­ity fea­tures could pro­vide Europe a sig­nif­i­cant release-valve over a fairly short period of time. Intro­duc­ing a con­vert­ibil­ity option to Euro-area debt would cer­tainly intro­duce addi­tional "con­ver­sion pre­mi­ums" for var­i­ous coun­tries, but those would largely sub­sti­tute for the ris­ing default pre­mi­ums that are cur­rently being tacked onto yields. Bet­ter for mar­ket con­cerns to affect indi­vid­ual Euro­pean states than to threaten one-third of the devel­oped world, and by exten­sion, the entire global economy.

Are cor­po­rate bal­ance sheets really the strongest in history?

It is freely accepted by investors as fact that U.S. cor­po­rate bal­ance sheets are the stronger than ever before in his­tory. This view is largely dri­ven by the sig­nif­i­cant amount of cash (check­ing deposits, sav­ings deposits, money mar­ket funds, com­mer­cial paper hold­ings) on cor­po­rate bal­ance sheets. Our dif­fi­culty with this view is that no sin­gle line item on a bal­ance sheet is a suf­fi­cient indi­ca­tion of "strength." Most use­ful mea­sures are derived from ratios at the very least, and ide­ally cal­cu­la­tions across a vari­ety of dimensions.

The best line item on cor­po­rate bal­ance sheets today is typ­i­cally "Cash and Equiv­a­lents." But while the amount of cash and cash-equivalents on U.S. (non­fi­nan­cial) cor­po­rate bal­ance sheets has increased sig­nif­i­cantly, par­tic­u­larly rel­a­tive to the cash-strapped lows of 2009, cor­po­rate cash is cer­tainly nowhere near his­tor­i­cal highs rel­a­tive to debt. As a side note, prob­a­bly the dumb­est use of bal­ance sheet data that we hear from time-to-time is when ana­lysts talk about the P/E mul­ti­ple of a stock "after you back out the cash," as if the cash line item can mean­ing­fully be sub­tracted from the mar­ket cap of the equity. Really? If a com­pany issues a bil­lion dol­lars of debt, and then holds the pro­ceeds in cash, does that sud­denly make the stock "cheaper" because we can now back out that cash from the company's mar­ket cap? Um, no.

While cash hold­ings are rel­a­tively high com­pared with total assets and net worth, even those fig­ures are in the range of 5–10%, only about 3 per­cent­age points above his­tor­i­cal norms. Cash lev­els are "high" in the sense of being a larger per­cent­age of total assets than nor­mal, but the "excess" cash amounts to roughly $700 bil­lion, ver­sus total assets of non-financial cor­po­ra­tions of about $28.6 tril­lion. The excess is fairly second-order from the stand­point of over­all bal­ance sheet "health."

The best that can be said is that cor­po­ra­tions are fairly liq­uid here, but this is a much dif­fer­ent state­ment than say­ing that cor­po­rate bal­ance sheets have "never been health­ier in his­tory." In eval­u­at­ing over­all balance-sheet health, it is impor­tant to con­sider the over­all debt bur­den of corporations.

As the fol­low­ing chart shows (based on Fed­eral Reserve Flow of Funds data), the debt bur­den of U.S. cor­po­ra­tions is near all-time highs, hav­ing retreated only mod­estly since 2009. Debt bur­dens are ele­vated regard­less of whether they are mea­sured against total assets or net worth. Cer­tainly, cor­po­ra­tions are presently ben­e­fit­ing from very low inter­est rates on cor­po­rate debt, which sub­stan­tially reduces the ser­vic­ing bur­den of these oblig­a­tions. But the com­bi­na­tion of high debt lev­els and low ser­vic­ing bur­dens does cre­ate a poten­tial risk to cor­po­rate health in the event that yields rise in future years. Over­all, the pic­ture is fairly sta­ble at present thanks to low yields and high lev­els of cash-equivalents, but it is impor­tant for investors to keep in mind that cash can burn fairly quickly dur­ing eco­nomic down­turns, and debt is not spread evenly across corporations.

The bot­tom line is that at an aggre­gate level, cor­po­rate bal­ance sheets look rea­son­able, but are cer­tainly not "stronger than they have ever been in his­tory." Cash lev­els are ele­vated, but this is at best a second-order fac­tor (with excess cash rep­re­sent­ing only a few per­cent of total assets), while debt remains near record lev­els rel­a­tive to total assets and net worth. In any event, bal­ance sheet risks should be eval­u­ated on a business-by-business level, rather than accept­ing the blan­ket notion that cash lev­els are so high that nobody needs to worry about cor­po­rate credit risk.

In going through the Flow of Funds data this week, I thought a few other fea­tures of the data were inter­est­ing. First, was the pro­found decline in tan­gi­ble assets as a per­cent­age of total cor­po­rate assets since 1980. This decline goes hand-in-hand with an increase in finan­cial assets held by non-financial com­pa­nies. At present, more than half of the total assets held by non-financial com­pa­nies in the U.S. rep­re­sent finan­cial assets such as debt secu­ri­ties and equi­ties. This is strik­ing, in that we presently have a menu of prospec­tive returns on finan­cial assets that is among the most dis­mal in his­tory. While the move toward zero inter­est rates has cer­tainly been excel­lent for bonds when we look in the rear-view mir­ror, the fact that prospec­tive rates of return are now so low sug­gests that a large por­tion of cor­po­rate assets are unlikely to achieve very much in the way of future returns, bar­ring a decline in those asset prices. Some­thing to think about.

Finally, the Flow of Funds data include two handy series, one rep­re­sent­ing the total net worth of non­fi­nan­cial com­pa­nies, and the sec­ond rep­re­sent­ing the mar­ket value of the equi­ties (stocks) of those com­pa­nies. Intu­itively, if those cal­cu­la­tions are any good, one would expect the ratio of equity mar­ket value to total net worth to be a rea­son­able val­u­a­tion indicator.

In fact, that's just what we see. Though the Flow of Funds data isn't as use­ful as one would like in prac­tice (since it is only reported quar­terly with a lag), it turns out that a low ratio of equity mar­ket value to total net worth is a very good indi­ca­tor of high sub­se­quent total returns for the S&P 500 over the fol­low­ing 10-year period. In con­trast, a high ratio of equity mar­ket value to total net worth is pre­dictably fol­lowed by weak 10-year total returns for the S&P 500.

Let's call this the price-to-net-worth ratio. As of the lat­est data, the mar­ket value of the equi­ties ($15.21 tril­lion) for non-financial com­pa­nies was nearly equal to the total net worth of those com­pa­nies ($15.05 tril­lion) for a price-to-net-worth ratio of about 1.01. Note that this is NOT fair value — rather, the his­tor­i­cal median and aver­age of the price-to-net-worth ratio is just 0.75. The present level of about 1.0 has his­tor­i­cally cor­re­sponded to a sub­se­quent 10-year S&P 500 total return aver­ag­ing only about 5% annu­ally, which is fairly close to the esti­mate we get from a vari­ety of other his­tor­i­cally reli­able meth­ods, though the recent decline has improved our expec­ta­tions a bit. Note that the right scale on the fol­low­ing chart is inverted, so higher lev­els of val­u­a­tion on the left scale (blue line) cor­re­spond to weaker lev­els of sub­se­quent return on the right scale (red line).

Mar­ket Climate

As of last week, the Mar­ket Cli­mate in stocks was char­ac­ter­ized by a com­bi­na­tion of rich val­u­a­tions, unfa­vor­able mar­ket action, con­tin­ued neg­a­tive eco­nomic pres­sures on forward-looking indi­ca­tors, and addi­tional indi­ca­tors (sen­ti­ment, credit spreads, etc) asso­ci­ated with a poor aver­age return/risk pro­file in stocks. Recent mar­ket weak­ness has mod­estly improved val­u­a­tions (our 10-year pro­jec­tion for S&P 500 total returns has improved to 5.6% annu­ally). From our stand­point, the over­all con­di­tion of the mar­ket has improved from hard-negative to mod­estly neg­a­tive. That still holds us to a defen­sive posi­tion, but allows us to make mod­est changes in our hedges (shift­ing index put option strikes, for exam­ple) in a way that main­tains a strong defense but reduces our vul­ner­a­bil­ity to blaz­ing short-squeezes and other bursts of "risk-on" enthusiasm.

It's worth not­ing that finan­cial stocks rep­re­sent a por­tion of the indices we use to hedge (par­tic­u­larly the S&P 500), but not much of the port­fo­lio of Strate­gic Growth. As the finan­cials got crushed last week, we slightly reduced that under-weighting in finan­cials, though our weight­ing remains far below market-weight. We would hold no expo­sure to the bank­ing sec­tor at all if not for the fact that banks rep­re­sent a por­tion of our most effi­cient hedges, but as the mar­ket val­ues come down, it is more rea­son­able to "anti-hedge" a bit, in order to reduce our dis­com­fort dur­ing peri­odic bursts of short-covering.

So the recent decline has given us a chance to "soften" our "hard-defensive" posi­tion some­what, but we remain broadly defen­sive in both Strate­gic Growth and Strate­gic Inter­na­tional. I expect that we'll still expe­ri­ence a bit of dis­com­fort on days when investors take a lop­sided "risk-on" stance (chas­ing finan­cials and mate­ri­als while aban­don­ing less volatile sec­tors), but I don't expect as much sen­si­tiv­ity to spec­u­la­tive ram­pages as we've seen on some of the more exu­ber­ant days in recent memory.

In Strate­gic Total Return, we con­tinue to carry a mod­er­ate dura­tion of about 3 years in Trea­sury notes, and about 20% of assets in pre­cious met­als, and small single-digit expo­sures in (non-euro) for­eign cur­ren­cies and util­i­ties, which we have increased slightly in response to recent weak­ness. The best char­ac­ter­i­za­tion of our recent invest­ment activ­ity is that we have made very mod­est port­fo­lio shifts in response to what we view as a very mod­est improve­ment in mar­ket con­di­tions (par­tic­u­larly val­u­a­tions) from what were, and remain, neg­a­tive lev­els. I expect that major changes in our invest­ment stance will accom­pany major changes in mar­ket con­di­tions, and we don't see that yet. I con­tinue to be very con­cerned about global reces­sion risks, and fur­ther dete­ri­o­ra­tion in credit conditions.

That said, we con­stantly attempt to align our invest­ment posi­tions in response to shifts in pre­vail­ing con­di­tions as new data emerges. We remain defen­sive here (with the excep­tion of pre­cious met­als shares where the expected return/risk pro­file remains favor­able on our mea­sures), but are open to accept­ing much more con­struc­tive invest­ment posi­tions as the evi­dence changes.

Tags: 40s, Adequate Capital, Bond Swap, Bondholders, Cash Flows, Corporate Balance Sheets, Creditors, European Banking System, European Banks, Face Value, Greek Law, Greeks, Harsh Conditions, Hussman Funds, Issuance, Leverage Ratios, New Ipos, Present Value, Reuters, Strains
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Mark Holowesko, in depth: "Right Now, the Opportunities for Investors are Fantastic"

Sunday, November 27th, 2011

This week, on Wealth­Track, Con­suelo Mack inter­views Sir John Templeton’s suc­ces­sor. At only age 27, Mark Holowesko took over the leg­endary Tem­ple­ton funds in 1987, and ran them suc­cess­fully for over 13 years before strik­ing out on his own at Holowesko Partners.

Holowesko, a Bahamian native, explains how he still applies "the Tem­ple­ton way" and why he sees fan­tas­tic oppor­tu­ni­ties in today’s markets.

Source: Wealth­track, Novem­ber 25, 2011.

Here is the full transcript:

Con­suelo Mack Wealth­Track — Novem­ber 25, 2011

CONSUELO MACK: This week on Wealth­Track, the legacy of leg­endary global invest­ment pio­neer Sir John Tem­ple­ton is alive and thriv­ing thanks to the tal­ent of his pro­tégé, Great Investor Mark Holowesko. Olympic sailor, triath­lete and suc­cess­ful money man­ager, Holowesko is find­ing excep­tional value all over the world. A Wealth­Track exclu­sive with Mark Holowesko is next on Con­suelo Mack Wealth­Track.
Hello and wel­come to this edi­tion of Wealth­Track. I’m Con­suelo Mack. We have a unique treat for you this week– a tele­vi­sion exclu­sive with a Great Investor, Mark Holowesko. Does the name sound famil­iar? It might, because way back in 1987, before the famous mar­ket crash, leg­endary global value investor Sir John Tem­ple­ton picked the then 27 year old Holowesko to run the Tem­ple­ton Funds for him, a job he per­formed suc­cess­fully for 13 years. In 1992, he was the youngest per­son on For­tune magazine’s list of the best money man­agers of his gen­er­a­tion. In 2000, he got off the non-stop travel tread­mill required to run the Tem­ple­ton Funds and launched Tem­ple­ton Cap­i­tal Advi­sors to serve insti­tu­tional and high net worth clients. That firm has been renamed Holowesko Part­ners, which Mark con­tin­ues to run out of his native Bahamas. The super com­pet­i­tive Holowesko is an avid ath­lete: cyclist, swim­mer and Olympic sailor who was cited by Busi­ness­Week mag­a­zine as one of the “World’s Fittest CEOs.”
As you will see in a moment, Holowesko has absorbed many of the atti­tudes, dis­ci­plines and lessons of his famous men­tor with a few tweaks. One les­son he has embraced com­pletely is to keep an open mind and con­stantly look at the oppor­tu­ni­ties the mar­ket is offer­ing– right now, Holowesko believes the oppor­tu­ni­ties for investors are fan­tas­tic. You heard me cor­rectly. He is find­ing val­ues he hasn’t seen since the depths of the mar­ket lows in 2008 and 2009. We’ll find out where in just a moment.
I began the inter­view by ask­ing Mark about the major invest­ment lessons he learned work­ing with Sir John.

MARK HOLOWESKO: It was a very sim­plis­tic thing. He walked into my office. He put the funds on my desk and he said, “Look, from now on I want you to man­age these funds, but write the buy and sell tick­ets and leave them on my desk so I can see what you’re doing and I’ll sign them and leave them at the trad­ing floor.” And that was at about 11:00 in the morn­ing and at about 11:15 I left to go for an early lunch and a very long run because it was a bit of a shock and a huge respon­si­bil­ity, but a lot of fun.

CONSUELO MACK: So how did you feel at 27 run­ning, it was Tem­ple­ton Growth, World, and For­eign Funds, right?

MARK HOLOWESKO: And the Tem­ple­ton Smaller Com­pa­nies Fund. So actu­ally all the mutual funds that Tem­ple­ton had at that point at time were all man­aged in the Bahamas by Sir John until May of ’87 and then I man­aged all the funds. I had a lot of help in Fort Laud­erdale. We had a great staff of ana­lysts in Fort Laud­erdale. I was prob­a­bly a lit­tle too young at 27 to truly to under­stand what was hap­pen­ing and to appre­ci­ate the fact that I was tak­ing over the man­age­ment from such a leg­end, but there was so much to do and there was so much going on in the world. You know, we had the crash a cou­ple of months later. He was there dur­ing the crash which was a big help and a big com­fort, and it was also the most excited I’d ever seen him, which was really interesting.

CONSUELO MACK: So tell me about that. Is that one of the points of max­i­mum pes­simism that he just loved?

MARK HOLOWESKO: Most def­i­nitely. He went on a num­ber of pro­grams right after that crash basi­cally com­ing out and say­ing this is a great oppor­tu­nity. There was a very tech­ni­cal decline and I think that was shown by some of the stud­ies later on. And you know, stock prices were 30% cheaper than they were sev­eral days before that or two days before that. So from his per­spec­tive it was just a great oppor­tu­nity to take advan­tage of the fear in the mar­ket and looks for ideas. And we had cash in the fund so we were lucky enough at that point in time– I don’t remem­ber the exact amount of cash in the fund, but we had cash we could put to work so that was very helpful.

CONSUELO MACK: So you just said you had to put for what period of time, every – of course, that was in the days when you wrote out order tickets.

MARK HOLOWESKO: That’s right.

CONSUELO MACK: So you had to put, what, the stack on Sir John’s desk and he would go through them?

MARK HOLOWESKO: Well, there wasn’t really a stack because we only had about a 20% turnover in our port­fo­lios. You know, one of the things that was just a big shock and a sur­prise when I came to Sir John was he had these posi­tions that had 100% returns or 1,000% returns in the case of tele­phones in Mex­ico because they’d been there for so long and, obvi­ously he was right as well. So it wasn’t daily trad­ing activ­ity in the funds because that wasn’t really our style. But the first six months that I put the ideas on his desk he never changed a trade ticket, and then I think about eight or nine months later he said, “Just pass them on to the trad­ing room.” And he could see the trades going through because we had some automa­tion by that time, not a lot. So he over­saw it and he was there. He was help­ful in terms of ideas and bounc­ing things off of. When I saw his enthu­si­asm in ’87 dur­ing the crash, that helped give me some con­fi­dence to do things and that was a big help.

CONSUELO MACK: So what are the major invest­ment lessons that you learned work­ing for and with Sir John?

MARK HOLOWESKO: I think the first les­son I learned was to try to under­stand and really put into math­e­mat­i­cal terms what prob­lems were. So one of my first jobs was try­ing to deter­mine the finan­cial impact of the Bhopal dis­as­ter on Union Car­bide. And what he wanted me to do was to basi­cally quan­tify it, you know, which is a very dif­fi­cult thing to do. It’s sort of like try­ing to quan­tify the BP dis­as­ter in the Gulf. So I would say try­ing to under­stand prob­lems and try­ing to see whether or not those prob­lems were prop­erly reflected in stock prices. In order to be a con­trar­ian, you have to do what other peo­ple aren’t doing. But he wasn’t a con­trar­ian for contrarian’s sake, he tried to under­stand the issue and why peo­ple weren’t doing cer­tain things and whether or not he felt the mar­kets took that into con­sid­er­a­tion in terms of the valuation.

CONSUELO MACK: So if for instance, a lot of it then was an event dri­ven type of analy­sis? If there was an event that impacted the price of a stock, then you and Tem­ple­ton would be acti­vated to look into whether or not this was an opportunity?

MARK HOLOWESKO: Right. A lot of our ideas, I would say a third to a half of all of our ideas came that way. So for exam­ple, in ’98 dur­ing the Asian cri­sis, you know, that was an oppor­tu­nity. That was an event that occurred that pushed stock prices down quite sub­stan­tially. You know, back then you could buy cash at a dis­count. And there wasn’t nec­es­sar­ily a cat­a­lyst to turn around the prob­lem or the stock price rel­a­tive to the prob­lem, but the prob­lem drove stock prices down and we tried to react to that as much as we could.

CONSUELO MACK: So aside from events, what are the other things that would make you look at com­pa­nies to decide whether or not you were inter­ested in them?

MARK HOLOWESKO: Well, a num­ber of things. One of the things that we always tried to do is try to under­stand what we are pay­ing per unit of what­ever the com­pany did. So if it was a tim­ber com­pany, what was the value in the mar­ket­place or the enter­prise value, which is the mar­ket cap plus the debt of the com­pany, net debt, per acre of tim­ber­land? You know, that’s a lot more inter­est­ing to us than to look at the book value of a com­pany or the earn­ing stream of a com­pany. So try­ing to fig­ure out what are you pay­ing for this com­pany per unit of what­ever it does and then it gives you a much bet­ter sense of is that rea­son­able. If it’s an asset man­age­ment com­pany, what are you pay­ing per dol­lar of asset man­age­ment? If it’s a soda man­u­fac­turer, what are you pay­ing per can of soda they sell? And he had me do a lot of that work when I first came on board just to basi­cally under­stand, first of all, what it means to buy a com­pany. Not just the mar­ket value of the com­pany, but what you’re assum­ing in terms of lia­bil­i­ties on the bal­ance sheet.

CONSUELO MACK: So let me take you one step back from that, and that is how do you decide to look at a par­tic­u­lar com­pany to begin with aside from a dis­as­ter? With Sir John and for you now at Holowesko Part­ners, do you just have a list of com­pa­nies that you mon­i­tor on a reg­u­lar basis?

MARK HOLOWESKO: No, not really. We do a num­ber of screens. It’s easy to find prob­lems. Prob­lems are very preva­lent all over the world so they’re push­ing stocks around dra­mat­i­cally. So stocks that come up into our screen­ing because of prob­lems are plen­ti­ful. But we do a num­ber of screens on val­u­a­tion cri­te­ria that we’ve used his­tor­i­cally whether it’s pri­vate mar­ket val­ues. And they’re nor­mally asso­ci­ated with a theme. So for exam­ple, we think merger and acqui­si­tion activ­ity will pick up quite sub­stan­tially right now or over the next six to twelve months and as a result of that we’ll do a lot of screen­ing for com­pa­nies that we think might be attrac­tive can­di­dates in that regard.

CONSUELO MACK: And the rea­son you think that M&A activ­i­ties are going to pick up in the next sev­eral months is why?

MARK HOLOWESKO: Sim­ply because there is too much capac­ity in the sys­tem today, too much phys­i­cal capac­ity. Capac­ity uti­liza­tion is lower than nor­mal, so com­pa­nies don’t need to build capac­ity and the cost of bor­row­ing money rel­a­tive to the return on assets that you can get if you actu­ally go out and buy a com­pany, that spread is very wide. So math­e­mat­i­cally it makes a lot of sense for com­pa­nies to go out and buy assets rather than to build assets.

CONSUELO MACK: So it’s inter­est­ing because there has been a great deal of talk about the fact that com­pa­nies are sit­ting on these hoards of cash, and the fact that they aren’t putting this cash to use. So is there going to be some sort of a global cat­a­lyst that is going to make com­pa­nies sud­denly start to spend the cash and actu­ally make acquisitions?

MARK HOLOWESKO: There are a num­ber of cat­a­lysts that I think will occur. First of all, the cash is build­ing up to such an extent that at some point the firms will become tar­gets them­selves. You know, most phar­ma­ceu­ti­cal com­pa­nies that we look at today, over the next five years will gen­er­ate any­where between 80 to 100% of their mar­ket value in cash.

CONSUELO MACK: Wow.

MARK HOLOWESKO: And so obvi­ously five years from now you’re not going to be able to buy Merck or Pfizer or Sanofi at net cash. You know, get cash and then a busi­ness for free, in fact. And that won’t stay like that. And I think it’s either going to be acqui­si­tions. They’ll make acqui­si­tions. They’ll make huge stock repur­chases. They’ll increase div­i­dends. That’s cash build on a bal­ance sheet. There are only so many things you can do with it. You can let it build and already for a lot of firms it’s 15 or 25% of their mar­ket cap. You can buy back stock and that’s very sup­port­ive for stock prices. You can increase the div­i­dend. You can get involved in merg­ers and acqui­si­tions or you can increase your cap­i­tal expen­di­tures. Because there’s too much capac­ity basi­cally in the world, the cap­i­tal expen­di­ture part of that equa­tion is not going to really happen.

CONSUELO MACK: So in your expe­ri­ence is this a very unusual sit­u­a­tion where you have cor­po­rate bal­ance sheets in such great shape, that are so liquid?

MARK HOLOWESKO: I think there are a cou­ple of things that are very unique about this period. Not only are stocks extremely cheap rel­a­tive to his­tory and rel­a­tive to other assets, but the best qual­ity com­pa­nies are at a dis­count to the mar­ket as well. So typ­i­cally you have to pay up for qual­ity and today you don’t.

I mean, qual­ity is being given away in many respects. So I think peo­ple really under­es­ti­mate how cheap secu­ri­ties are today. I think they’re as cheap as stocks were back in the early 1980s. And I think in addi­tion to that, the finan­cial posi­tion of these com­pa­nies is fan­tas­tic. You know, most of our hold­ings in the United States, for exam­ple, can pay off all of their net debt with 20% of one year’s cash flow.

Those that don’t have, you know, a lot of them already have net cash flow on the bal­ance sheet. The United States is gen­er­at­ing about six or seven per­cent in free cash flow every year rel­a­tive to the mar­ket value stocks, which is a huge amount as well. So there is an enor­mous amount of free cash flow being built up on these bal­ance sheets. So the com­pa­nies are as cheap as they were in the ‘80s, but much bet­ter qual­ity bal­ance sheets.

CONSUELO MACK: So when I looked at a recent report from Holowesko Part­ners I think you had 19 stocks that were 46% of your port­fo­lio hold­ings. Is that a con­cen­tra­tion that is some­thing that you learned from Sir John? Is that a con­cen­tra­tion that is typ­i­cal of the way that you run money as well?

MARK HOLOWESKO: We were some­what mind­ful of War­ren Buffett’s famous phrase that “diver­si­fi­ca­tion is pro­tec­tion against igno­rance.” At some point you can be too diver­si­fied in terms of what you’re doing. We don’t turn over our port­fo­lios a lot. You know, if we like a posi­tion we tend to build two to three per­cent, you know, posi­tion it. So we tend to own about 70 names in the portfolio.

CONSUELO MACK: And the aver­age hold­ing period? I mean, what kind of turnover do you have and has it changed since Sir John’s time?

MARK HOLOWESKO: Not really. It hasn’t changed that much. The first name we bought in our fund 11 years ago we still own today.

CONSUELO MACK: Which is what?

MARK HOLOWESKO: Yu Yuen, which is a shoe man­u­fac­turer in Hong Kong. And we have about a 20 to 30% turnover in our port­fo­lio gen­er­ally in the course of a year.

CONSUELO MACK: Some other lessons that you learned from Sir John that you’re apply­ing at Holowesko Part­ners as well? Are there any other major ones that come to mind?

MARK HOLOWESKO: Well, I think one of the things that most peo­ple don’t real­ize is that Sir John was a big fan of basi­cally chang­ing your invest­ment approach all the time. You know, we main­tained a list of stock selec­tion meth­ods at Tem­ple­ton. As the Direc­tor of Research, I was sort of respon­si­ble for mon­i­tor­ing that, and he always wanted to have 12 new ways of look­ing at stocks. Most peo­ple think there’s a Tem­ple­ton formula.

CONSUELO MACK: For­mula. There have been books writ­ten about it.

MARK HOLOWESKO: And to a cer­tain extent there is a bit of a for­mula and when you’re sell­ing an insti­tu­tional prod­uct, you have to have some con­sis­tency in your prod­ucts all over the world. We used to do a lot of work rel­a­tive to future earn­ings and try­ing to dis­count future earn­ings to today’s stock price and look­ing at div­i­dend streams over that time period. But basi­cally Sir John said if you’re doing the same thing you did ten years ago, it’s not going to work.

So I would say we’re con­stantly try­ing to improve on what we do and I also would say that the mar­ket is always offer­ing me some­thing. I think this is some­thing that Sir John was very good at. Sir John’s genius was in his sim­plic­ity, really. He was always very good at iden­ti­fy­ing what was cheap in the mar­ket. So at some point in time growth stocks might be cheap, other times value stocks might be cheap.

Today what’s cheap in the mar­ket is free cash flow. Free cash flow is abnor­mally high. And what he tried to teach us is find what’s cheap in the mar­ket, what is the mar­ket offer­ing you, and then try to under­stand, well, why is it cheap, what is the ratio­nale behind those prices being so low? So flex­i­bil­ity in the invest­ment approach was very impor­tant and chang­ing your invest­ment approach to sort of accom­mo­date with what the mar­ket is offer­ing you was very impor­tant as well. So I think those sound very sim­plis­tic, but once again, that was part of his great genius.

CONSUELO MACK: Are there any gen­eral rules of invest­ing that are kind of the Tem­ple­ton way or have become the Holowesko way?

MARK HOLOWESKO: Well for a long time, Tem­ple­ton liked to try to find a nor­mal­ized earn­ings num­ber over a full busi­ness cycle. So many peo­ple con­cen­trate on the next quar­ter or what the com­pany will do this year, but he felt that the more effi­cient part of the mar­ket was far­ther out. Because peo­ple weren’t will­ing to look that far out or they weren’t com­fort­able hold­ing secu­ri­ties for that long.

So he felt that the shorter term was much more effi­cient than the longer terms. So there­fore, we should con­cen­trate on a longer term. And for him he felt that a nor­mal busi­ness cycle was five years. And so we could fig­ure out what a com­pany could earn on a nor­mal basis, assum­ing a reces­sion and a con­trac­tion over that five year time period and dis­count that back to today’s stock price. I think that is a pop­u­lar for­mula that a lot of peo­ple hear about in terms of what we used to do at Templeton.

Look, we used to do things, Con­suelo, that were– I used to go home some­times and tell my wife, “You wouldn’t believe what we did today. It was so sim­ple.” And stocks that were ranked 1–1 by Mer­rill Lynch or 1–1 by Value Line with the the­ory that Mer­rill Lynch was the biggest retail bro­ker in the world back in the ‘80s and Value Line was the biggest insti­tu­tional seller of ideas and if stocks were most highly ranked on both sys­tems they were going to get a lot of atten­tion. We’d nar­row the list down on that basis and then we’d go out and work on those stocks. And it was incred­i­bly sim­plis­tic and it was a lot of fun. Some­times, you know, you’d scratch your head and go home and think, boy, you know, I just can’t believe I got a master’s degree in finance and this is what I’m doing here.” But it was great fun and it worked.

CONSUELO MACK: I know that one of the things you told me is that you expect to be wrong a third of the time.

MARK HOLOWESKO: I hope to be wrong a third of the time, yeah.

CONSUELO MACK: You hope to be wrong only a third of the time. I seem to remem­ber Sir John had a higher num­ber that he expected to be wrong. But at any rate, so there­fore, your job, your num­ber one job is man­age risk?

MARK HOLOWESKO: By far. That’s true. I mean, I want to know how much money I can lose with every sin­gle stock I’m invested in all over the world, as much or more so par­tic­u­larly in this sort of envi­ron­ment, than how much money I can make. So I main­tain in my port­fo­lio not a tar­get on the buy names in terms of the upside, but a risk num­ber. You know, if we’re wrong, and a third of the time we’re wrong, how much money can I lose? We chal­lenge our ana­lysts all the time about those num­bers. And about a third of the time we’re wrong on those num­bers as well. If we think the stock price bot­tom might be ten and we’re wrong and it goes to eight then we have to sit around the table and talk about why we were wrong. Is this very tem­po­rary in terms of where the stock price is?

CONSUELO MACK: So that’s not an auto­matic sell decision?

MARK HOLOWESKO: Absolutely not. No. I think the most impor­tant thing when you’re wrong is to try to under­stand why you’re wrong and then to try to deter­mine whether or not you’re okay with that. You know, that the longer term the­sis for own­ing the stock is still in place. If a stock goes down and you don’t under­stand why it’s gone down and don’t under­stand why you’ve been wrong, then I think it’s really silly to main­tain that position.

CONSUELO MACK: Is the mar­ket offer­ing you up oppor­tu­ni­ties that Sir John would be say­ing “look at this”?

MARK HOLOWESKO: Well, we are 104 % invested and we don’t often become 104% invested on the long side than our typ­i­cal prod­uct. We have more ideas than cash at the moment.

CONSUELO MACK: And when was the last time that happened?

MARK HOLOWESKO: Five or six years ago, I would say.

CONSUELO MACK: And again, when I looked at the port­fo­lio, the most recent one that I was able to see, there were a lot of global names there. You know, like John­son & John­son and Kim­berly Clarke, as I men­tioned, HSBC, U.S. Bank Corp. I mean, there were a num­ber of com­pa­nies. So what do they all have in com­mon? I mean, what is it that they represent?

MARK HOLOWESKO: Well, you men­tioned that stock list of 19 names that you saw. And I’ll give you an idea of what they have in com­mon. First of all, they have phe­nom­e­nal bal­ance sheets. Most of those com­pa­nies, once again, have net cash on the bal­ance sheets and those 19 names on aver­age can get rid of their debt with 20% of one year’s cash flow. They yield 3.6% on aver­age which is 160 basis points higher than the ten year trea­sury. And to give you a sense of how cheap that– that is, if you just assume that those 19 names grew their div­i­dends by the same rate over the next ten years as they did over the last ten years, and then you said, okay, well, how much would those stocks have to fall in order for me to get the same return on those 19 stocks as the ten year treasury?

Those stocks would have to fall 40% because the ten year trea­sury yields two per­cent and these stocks yield 3.6 per­cent. Some of them, like John­son & John­son that you men­tioned, have been grow­ing their div­i­dends for the last 20 years at almost 14%.

So as a col­lec­tion, these stocks offer much bet­ter yield than you’re going to find any­where else in the world. These busi­nesses are doing much bet­ter than most peo­ple antic­i­pated because a large por­tion of their busi­ness is actu­ally out­side of the United States. So although the U.S. econ­omy is only grow­ing two to three per­cent at the most, these busi­nesses are grow­ing at rev­enues six and seven per­cent and their grow­ing their earn­ings higher than that. They’re doing that because a good bulk of their busi­ness is over­seas and the over­seas mar­kets are grow­ing much faster.

You know, I’d say that it’s very easy to find com­pa­nies that have grown their div­i­dends con­sis­tently for 20 years, that are sell­ing at nine or ten times earn­ings with seven or eight per­cent free cash flow yields with net cash on their bal­ance sheets that have the abil­ity to grow their busi­ness the same way they’ve done.

And in many cases, even if you looked at the past ten years, which was a very dif­fi­cult period– we’ve had two of the worst reces­sions in his­tory– and a lot of these firms have done incred­i­bly well over that time period, so it’s not inap­pro­pri­ate to think that they’ll do equally as well over the next ten years. So I just think peo­ple are spend­ing so much time think­ing about over­all risk, about sov­er­eign risk as opposed to com­pany spe­cific risk, and they’re mak­ing these asset allo­ca­tion deci­sions that’s a risk on, risk off trade that totally ignores com­pany spe­cific val­u­a­tions and it’s pro­vid­ing oppor­tu­ni­ties, in my view, that are con­sis­tent with the early 1980s.

CONSUELO MACK: We ask each of our guests if there is one invest­ment that we all should own some of in a long term diver­si­fied port­fo­lio what would it be, so what would it be?

MARK HOLOWESKO: Well, I’ll say gen­er­ally com­mon stocks, most peo­ple are afraid of com­mon stocks. And I would say specif­i­cally here in Amer­ica, I really think peo­ple are going to be sur­prised at the amount of income that com­pa­nies pro­duce. There are only four com­pa­nies in Amer­ica that have a AAA rat­ing. I think they’re Exxon, John­son & John­son, Microsoft, and ADP. And of those four names– there are only four of them– and of those four names, three of them are on what’s called the Div­i­dend Aris­to­crat List. Com­pa­nies that have grown their div­i­dends for 20 years.

CONSUELO MACK: So Exxon, John­son & John­son, and ADP?

MARK HOLOWESKO: ADP. Those com­pa­nies, not only do they have AAA rat­ings, but they’ve also grown their div­i­dends for 20 years con­sis­tently every year.
And of those names two of them we own, John­son & John­son and Exxon. So I would say peo­ple should look at stocks, peo­ple should look at income, and I think peo­ple should look at secu­rity of income with a AAA rat­ing and from my per­spec­tive I think those are two of the bet­ter names that are in the stock market.

CONSUELO MACK: And Mark, final ques­tion, is there any­thing that you are doing dif­fer­ently than Sir John would have done?

MARK HOLOWESKO: Yes, but I think that’s part of his approach. His approach was to always do things differently.

CONSUELO MACK: Improvise.

MARK HOLOWESKO: So I would say one of the main dif­fer­ences is that– Sir John used to take big cur­rency bets. Obvi­ously, when you invest in stocks all over the world you have a bas­ket of cur­ren­cies all over the world. He never hedged those cur­ren­cies back to the dol­lar, but he would also take a strong view on a cur­rency. I hedge a lot of cur­ren­cies. I think cur­rency risk today is very strong. I don’t want to assume a lot of that risk.

CONSUELO MACK: And on that note we will end this con­ver­sa­tion.
Mark Holowesko, thank you so much. It was such a treat to have you on Wealth Track.

MARK HOLOWESKO: Well, it’s good to see you again.

CONSUELO MACK: And to share Sir John’s wis­dom and also your own, which is con­sid­er­able as well.
So thanks for being here.

MARK HOLOWESKO: Thank you.

CONSUELO MACK: I know Sir John is look­ing down at Mark Holowesko smil­ing and say­ing keep up the good work! At the con­clu­sion of every Wealth­Track, we try to give you one sug­ges­tion to help you build and pro­tect your wealth over the long term. This week’s Action Point picks up on one of Mark and Sir John’s major themes: keep an open mind. The mar­ket is con­stantly chang­ing. No one approach works all of the time. Sir John and Mark Holowesko are always look­ing at what the mar­ket is offer­ing you. Mark’s com­ment that Sir John’s genius was the sim­plic­ity of his approach, always look­ing for what was cheap­est in the mar­kets. On a per­sonal note, Sir John was one of my heroes, not for his finan­cial skills which were phe­nom­e­nal, but for his rich­ness of spirit and end­less capac­ity to learn and love. A truly remark­able man.
And that con­cludes this edi­tion of Wealth­Track. Next week is a national pledge week on pub­lic tele­vi­sion, so many sta­tions will not carry Wealth­Track dur­ing their fund dri­ves, but some will– includ­ing our pre­sent­ing sta­tion WLIW-New York. We will revisit a fas­ci­nat­ing dis­cus­sion with Finan­cial Thought Leader Michael Mauboussin, chief invest­ment strate­gist of Legg Mason Cap­i­tal Man­age­ment who will explain why doing less in the mar­kets can actu­ally make you more!
For those of you who want to see our Wealth­Track inter­views ahead of the pack, includ­ing this week’s exclu­sive inter­view with Great Investor Mark Holowesko, sub­scribers can see our pro­gram 48 hours in advance as well as timely inter­views exclu­sive to Wealth­Track web sub­scribers. To sign up, go to our web­site, wealthtrack.com. Thank you for watch­ing and make the week ahead a prof­itable and a pro­duc­tive one.

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