Month of May: Sell and Go Away, or Hang in There? (Sonders)

Tuesday, May 15th, 2012

May 14, 2012

by Liz Ann Son­ders, Senior Vice Pres­i­dent, Chief Invest­ment Strate­gist, Charles Schwab & Co., Inc.

Key Points

• We believe the stock market's cor­rec­tion is likely to be less severe this year rel­a­tive to 2010 or 2011.
• Be aware of the pos­si­ble per­ils of fol­low­ing a "sell in May" trad­ing strategy.
• For now, macro concerns—including Europe and the loom­ing "fis­cal cliff"—are trump­ing bet­ter micro news.

The stock mar­ket is in cor­rec­tion mode and investors are on edge. There are likely sev­eral rea­sons for the weak­ness, includ­ing what we pointed out in our early-April report on ele­vated opti­mistic sen­ti­ment. Since sen­ti­ment tends to work a con­trar­ian magic on the mar­ket, we were antic­i­pat­ing a period of con­sol­i­da­tion after the stel­lar six-month, 30% run off the early Octo­ber 2011 low—and we're get­ting it.

Of course, we're also yet again deal­ing with the euro­zone debt cri­sis, but also chop­pier eco­nomic indi­ca­tors in the United States recently, a volatile elec­tion sea­son and con­cerns about the so-called "fis­cal cliff" head­ing into the end of this year. But one of the ques­tions I've got­ten most often recently has been about the sea­sonal phe­nom­e­non called "sell in May and go away," and whether the market's in store for another sum­mer swoon like we've had the past two years.

Macro trump­ing micro

I'll start with "sell in May," but before I do, I want to address an impor­tant gen­eral obser­va­tion. As we've noted many times recently in reports and media appear­ances; and as detailed in a ter­rific recent report by Wall Street research firm Wolfe Tra­han, macro is trump­ing micro. One of the rea­sons for this is the decline in guid­ance investors are receiv­ing from com­pany managements.

In the past, guid­ance was often an anchor of rea­son in volatile times. Events like Euro­pean elec­tions or spik­ing euro­zone sov­er­eign bond yields might not have been such big market-moving events when we could rest on US com­pa­nies' guid­ance as to the future. Add to that rapid-fire trad­ing, short­ened time hori­zons, greatly increased access to infor­ma­tion, greatly increased speed of news' dis­sem­i­na­tion, and much more glob­al­ized eco­nomic and finan­cial sys­tems, and you have a recipe for increased volatil­ity around macro events.

Sell in May?

Much is made every year of the "sell in May" phe­nom­e­non. Its basis is rooted in the fact that the best per­for­mance for the mar­ket has gen­er­ally come in the Novem­ber through April period, while the worst has come between May and October.

There is some truth to the adage. Accord­ing to data com­piled by Ned Davis Research (NDR), through the begin­ning of May this year the aver­age per­for­mance for the period from May 1 through Octo­ber 31 each year since 1950 was 1.2%. The aver­age per­for­mance for the period from Novem­ber 1 through April 30 each year since 1950 was 7.0%.

As com­pelling as those num­bers may seem, there are many things to con­sider, espe­cially if it's your incli­na­tion to develop a trad­ing strat­egy around those sea­sonal pat­terns. First, the cal­en­dar months indi­vid­u­ally tend to fall into either the "hot" or "cold" columns for per­for­mance, as you can see in the table below. Three of the six months that fall into the "all out" period span­ning from May through Octo­ber are actu­ally his­tor­i­cally strong months, while three of the six months that fall into the "all in" period span­ning from Novem­ber through April are actu­ally his­tor­i­cally weak months.

Source: NDR, Inc. (Fur­ther dis­tri­b­u­tion pro­hib­ited with­out prior per­mis­sion. Copy­right 2012 © Ned Davis Research, Inc. All rights reserved.), as of 1928-April 30, 2012.

As you can see, all of the sea­sons seem to be ade­quately rep­re­sented in both columns. And what we know for a fact is that time hori­zons have become much shorter over the recent years, and the reac­tion func­tion gets trig­gered more often. It's likely that many investors may find their patience tested when expe­ri­enc­ing either a great month (or two) dur­ing the May-October "all out" period and/or a poor month (or two) dur­ing the November-April "all in" period. Of course, the sea­sonal trad­ing strat­egy must con­sider trans­ac­tion costs and tax impli­ca­tions.

Sec­tor per­for­mance May-October

For investors who like to take a tac­ti­cal approach to the sea­sonal ten­den­cies, a sec­tor bias strat­egy may be worth con­sid­er­ing. Before I get to the details, let me remind our clients that we moved toward a more sector-neutral strat­egy back in early April when we became more cau­tious about the mar­ket in the short term. Presently the only out­per­form rat­ing we have is on the infor­ma­tion tech­nol­ogy sec­tor, while the only under­per­form rat­ing we have is on the util­i­ties sector.

As you can see in the table below, cour­tesy of The Leuthold Group, cycli­cal groups have tended to out­per­form dur­ing the market's tra­di­tion­ally strong November-April period, while defen­sive sec­tors have been the rel­a­tive win­ners dur­ing the cus­tom­ar­ily weaker May-October period. In fact, the size and per­sis­tence of these effects have been impres­sive (at least since 1989, the span of the analy­sis).

S&P 500 Sec­tor Seasonality

Source: The Leuthold Group, Octo­ber, 1989-April, 2012. Defen­sive sec­tors: con­sumer sta­ples, health care and util­i­ties. Cycli­cal sec­tors: con­sumer dis­cre­tionary, indus­tri­als and mate­ri­als.

Buy in May in elec­tion years?

There's also the rub of this being an elec­tion year, dur­ing which sit­ting out the May through Octo­ber period has his­tor­i­cally not worked well. Using the Dow Jones Indus­trial Aver­age because of its longer his­tory, the mar­ket has been up 4.5% dur­ing elec­tion years in the May-October span ver­sus 2.6% for all years (includ­ing elec­tion years). And for what it's worth, accord­ing to NDR, the mar­ket has bucked sea­sonal weak­ness even more when the incum­bent pres­i­dent has won, with a median gain of 7.6% ver­sus 0.5% when the incum­bent pres­i­dent has lost.

NDR pro­vides a clue as to why this is the case: A cor­rec­tion has occurred dur­ing the sec­ond quar­ter of elec­tion years, on aver­age (sound famil­iar?). But the cor­rec­tion has tended to be con­cen­trated in the sec­ond quar­ter, set­ting the stage for a sum­mer rally.

2012's pos­i­tive off­sets to present weakness

I actu­ally think the sce­nario noted above is more likely than not this year. Mus­cle mem­ory has many investors fret­ting a repeat of 2011 and 2010, when eco­nomic weak­ness in the spring led to bru­tal cor­rec­tions each year, to the tune of –19% and –16%, respec­tively. But there's a long list of pos­i­tive off­sets this year rel­a­tive to the past two years:

• Infla­tion is com­ing down, espe­cially among com­mod­ity prices.
• Credit growth is quite strong, espe­cially for consumers.
• Hous­ing has improved markedly.
• The US man­u­fac­tur­ing sec­tor is humming.
• NFIB's small busi­ness sur­vey made recent upside breakout.
• Job growth is much better.
• Con­sumer con­fi­dence is improving.
• Private-sector lever­age ratios are much improved (debt ser­vic­ing costs are extremely low).
• Recov­ery in state/local gov­ern­ment spending.
• The US econ­omy some­what decou­pling from rest of world; at least Europe.
• US bank capital/health is much bet­ter than Europe's.
• The Euro­pean Cen­tral Bank's Long-Term Refi­nanc­ing Oper­a­tions have reduced like­li­hood of global finan­cial contagion.
• Ger­many appears more will­ing to accept higher infla­tion, open­ing the door to eas­ier mon­e­tary pol­icy for the eurozone.
• Val­u­a­tions are quite cheap, espe­cially on for­ward earnings.
• Investor sen­ti­ment has improved sharply with the cor­rec­tion to-date (mean­ing pes­simism has kicked back in).

I don't think the present cor­rec­tion is over, but do believe it could be kept to within the nor­mal 5–10% range. Since the cur­rent bull mar­ket began in March 2009, the S&P 500 has had 15 cor­rec­tions of more than 5% that were pre­ceded by at least a 5% rally (con­sis­tent with this year's pat­tern). The table below high­lights their dura­tion and ulti­mate per­cent­age drop.

S&P 500 5% Cor­rec­tions

Source: NDR, Inc. (Fur­ther dis­tri­b­u­tion pro­hib­ited with­out prior per­mis­sion. Copy­right 2012 © Ned Davis Research, Inc. All rights reserved.), as of May 11, 2012.

Wall of worry being rebuilt

Tem­per­ing my short-term con­cern has been the afore­men­tioned improve­ment in sen­ti­ment con­di­tions. That said, I think there's likely a bit more pes­simism needed to estab­lish a short-term bot­tom for the mar­ket. As you can see, the well-watched NDR Crowd Sen­ti­ment Poll (CSP) has moved deci­sively lower, but not yet to the extreme pes­simism zone:

Bye-Bye Opti­mism

Source: NDR, Inc. (Fur­ther dis­tri­b­u­tion pro­hib­ited with­out prior per­mis­sion. Copy­right 2012 © Ned Davis Research, Inc. All rights reserved.), as May 8, 2012.

NDR noted in a recent report sev­eral key rea­sons to expect the cor­rec­tion to be within the nor­mal 5–10% range:

• Ini­tial rever­sals in CSP extremes are con­sis­tent with median declines of about 8% within six months.
• The first half of elec­tion years have shown median declines of just less than 10%.
• Once "pre-waterfall" highs have been exceeded, as occurred in Feb­ru­ary of this year, median mar­ket declines have ranged between –3% and –7% within six months.

Sav­ing the worst for last

I think investors and the media may be under­es­ti­mat­ing the impact the com­ing "fis­cal cliff" is hav­ing on mar­ket and busi­ness psy­chol­ogy. The fis­cal cliff refers to the near-simultaneous Jan­u­ary 2013 expi­ra­tion of the Bush tax cuts, the pay­roll tax cuts, emer­gency unem­ploy­ment ben­e­fits and the sequester (auto­matic spend­ing cuts) estab­lished in last summer's debt-limit agreement.

The range of esti­mates for its ulti­mate impact are, unfor­tu­nately, quite wide. The low­est esti­mate I've seen comes from NDR, using Con­gres­sional Bud­get Office assump­tions, with the impact at a rel­a­tively "low" 2.4% of US gross domes­tic prod­uct (GDP). Most esti­mates tend to clus­ter around 3.5% of GDP.

It's impos­si­ble to know what's right because dif­fer­ent assump­tions are being used. But the con­sen­sus is clos­ing in on a worst-case sce­nario of about 4% of GDP. ISI recently put the num­bers into three dis­tinct buck­ets, each with about $200 bil­lion of impact:

1. Pro­vi­sions likely to cre­ate a fis­cal drag (approx­i­mately (≈) $221 bil­lion or 1.4% of GDP):
   • Cuts to dis­cre­tionary spend­ing (≈$84 billion)
   • Tax increases on upper-income Amer­i­cans included in the Afford­able Care Act (≈$21 billion)
   • Pay­roll tax cut (≈$116 billion)
2. Bush tax cuts (≈$200 bil­lion or 1.3% of GDP, although likely impact would be spread over sev­eral years)
3. Items unlikely to be allowed to take affect and thus aren't likely to cre­ate a fis­cal drag (≈$179 bil­lion or 1.1% of GDP):
   • Huge increase in num­ber of Amer­i­cans pay­ing the alter­na­tive min­i­mum tax (≈$94 billion)
   • Sequester cuts (~$85 billion)

There are three addi­tional items that don't fall neatly into ISI's three buck­ets, includ­ing tax exten­ders, extended unem­ploy­ment insur­ance ben­e­fits and the "doc fix," which would together total about $75 bil­lion. These items are not expected to cre­ate a sig­nif­i­cant fis­cal drag.

I actu­ally think this is hav­ing a larger impact on psy­chol­ogy than many believe, espe­cially on the con­fi­dence of cor­po­rate lead­ers and their abil­ity to plan (and guide Wall Street's ana­lysts) for the future.

Mus­cle mem­ory may fail us this year

In sum, there's much to fret about, and volatil­ity is likely to remain ele­vated until this cor­rec­tion has run its course. But a lot has changed in the past two years—much for the better—particularly for domes­ti­cally ori­ented US com­pa­nies. There's at least a lit­tle bit of decou­pling under­way, cer­tainly between the United States and Europe, and that's likely to assist in keep­ing the cor­rec­tion from mir­ror­ing the ones in 2010 and 2011.

Impor­tant Disclosures

The infor­ma­tion pro­vided here is for gen­eral infor­ma­tional pur­poses only and should not be con­sid­ered an indi­vid­u­al­ized rec­om­men­da­tion or per­son­al­ized invest­ment advice. The invest­ment strate­gies men­tioned here may not be suit­able for every­one. Each investor needs to review an invest­ment strat­egy for his or her own par­tic­u­lar sit­u­a­tion before mak­ing any invest­ment decision.All expres­sions of opin­ion are sub­ject to change with­out notice in reac­tion to shift­ing mar­ket con­di­tions. Data con­tained herein from third party providers is obtained from what are con­sid­ered reli­able sources. How­ever, its accu­racy, com­plete­ness or reli­a­bil­ity can­not be guaranteed.Examples pro­vided are for illus­tra­tive pur­poses only and not intended to be reflec­tive of results you can expect to achieve.

Tags: Anchor, Bond Yields, Charles Schwab, Chief Investment Strategist, Debt Crisis, Economic Indicators, Election Season, European Elections, Liz Ann, Media Appearances, Micro News, Perils, Seasonal Phenomenon, Senior Vice President, Sentiment, Stock Market, Swoon, Trading Strategy, Trahan, Volatile Times
Posted in Markets | Comments Off

David Rosenberg's Take on Europe

Monday, May 7th, 2012

From David Rosen­berg of Gluskin Sheff

MY TAKE ON EUROPE

Europe is a mess, polit­i­cally, eco­nom­i­cally, and fis­cally. LTRO gave a short life­line and at the same time bound the ties even more tightly between bank bal­ance sheets and gov­ern­ment bond per­for­mance. For all the back­slap­ping, LTRO was a fail­ure, pure and sim­ple. Just as QE — for if QE had been a suc­cess, nobody would be look­ing for a third round (more like the fourth).

I fail to see how any coun­try is going to be able to "grow" their way out of their deficits, bar­ring ECB debt mon­e­ti­za­tion or via Ger­man accep­tance of a com­mon fis­cal pol­icy, which would then allow prof­li­gate sov­er­eigns to ride off of Germany's strong bal­ance sheet. The prob­lem is that the Ger­man econ­omy is start­ing to soften, and along with that I expect polls to start show­ing lesser sup­port for pro­vid­ing back­stops to the periph­ery. And from a geopo­lit­i­cal stand­point, an ever-isolated Ger­many spells even more insta­bil­ity. Gold and the gold min­ing stocks should be a beneficiary.

In less than two years, we are now up to a total of seven Euro­pean lead­ers or rul­ing par­ties that have been forced out of office, cour­tesy of the spread­ing gov­ern­ment debt cri­sis — tack on France now to Ire­land, Por­tu­gal, Greece, Italy, Spain and the Nether­lands. Even Germany's coali­tion is look­ing shaky in the after­math of the fal­ter­ing state elec­tion results for the CDU's (Chris­t­ian Demo­c­ra­tic Union) Free Demo­c­rat coali­tion partner.

This is quite a potent brew — finan­cial insol­vency, eco­nomic fragility and polit­i­cal instability.

Now we have gov­ern­ments, led by Mr. Hol­lande, who want to adopt "growth agen­das" at a time when erod­ing credit qual­ity is increas­ingly imped­ing fis­cal bor­row­ing capac­ity. The French vote comes quickly on the heels of the Dutch gov­ern­ment col­lapse and is joined by a frac­tious elec­tion result in Greece. Ger­many and other pro-austerity/structural reform enti­ties are the big losers. Then again, how cash-strapped sov­er­eigns who need Germany's com­par­a­tively strong finan­cial posi­tion embark on this new anti-fiscal-probity drive is an inter­est­ing ques­tion.
More uncer­tainty, more volatil­ity, more risk-aversion likely lies ahead — and along with it, a fur­ther dete­ri­o­ra­tion in gov­ern­ment finan­cial strength.
As it stands, glob­ally, since the time the Great Reces­sion took hold in 2008, we have seen the total value of gov­ern­ment debt backed with AAA-ratings decline from over a 50% share of total out­stand­ing sov­er­eign credit to less than 10%. Qual­ity is scarce, and as such should be owned.

In sum, this is not the back­drop for sus­tained risk-on invest­ment behav­iour. Both Bob Far­rell and Wal­ter Mur­phy see the cur­rent cor­rec­tive phase in the mar­ket being extended over the near and inter­me­di­ate term. I'm not sure I'd want to bet against them, even if Mike San­toli in Barron's and Paul Lim in the Sun­day NYT are advo­cat­ing a "buy the dips" strategy.

In terms of scour­ing the globe for coun­tries that are cur­rently being rated AAA by all three agen­cies, here they are:

- Aus­tralia
– Canada
– Den­mark
– Fin­land
– Ger­many
– Lux­em­bourg
– Nether­lands
– Nor­way
– Sin­ga­pore
– Swe­den
– Switzer­land
– U.K.

If we did a fur­ther over­lay with respect to the most attrac­tive "real yield" char­ac­ter­is­tics — low infla­tion and attrac­tive coupons along with strong national bal­ance sheets — we would find Nor­way, Aus­tralia and Switzer­land lead­ing the pack.

Tags: Backstops, Big Losers, Borrowing Capacity, Christian Democratic Union, Coalition Partner, David Rosenberg, Debt Crisis, Democrat Coalition, Europe Europe, Financial Insolvency, French Vote, German Economy, Gold Mining Stocks, Government Bond, Government Collapse, Greece Italy, Monetization, Potent Brew, Ruling Parties, State Election Results
Posted in Markets | Comments Off

The High Yield Trade: Crowded, or Crowd Pleaser? (Tucker)

Monday, May 7th, 2012

by Matt Tucker, iShares

A fre­quent ques­tion that I’ve been get­ting from our clients is around the out­look for high yield bonds.  With record low rates cre­at­ing an income chal­lenge for investors, many are now will­ing to take on the extra risk involved in a high yield invest­ment in order to poten­tially add yield to their port­fo­lios – as evi­denced by the $29.0 bil­lion in flows into HY mutual funds and ETFs so far this year.  Com­pa­nies have responded to all this demand by issu­ing $115.1 bil­lion in new high yield bonds YTD, with most of the pro­ceeds going to refi­nanc­ing exist­ing debt or to fund gen­eral oper­a­tions.  But all this high yield hub­bub begs the ques­tion:  Is the high yield trade too crowded?

First, let’s review how much more room exists for pos­i­tive returns.  Almost half of high yield’s 4.55% year-to-date return can be attrib­uted to coupon pay­ments, while the remain­der was due to cap­i­tal appre­ci­a­tion from tight­en­ing HY credit spreads (cur­rently hov­er­ing around 5.5% over US Trea­suries, com­pared to their aver­age level of 6% over the past 10 years).  Today’s spreads are lower in part because the level of cor­po­rate bond default has been low, at around 2%.  In fact, spreads have typ­i­cally been 4–5% in sim­i­lar favor­able credit envi­ron­ments, so spreads are actu­ally wide rel­a­tive to the level of cor­po­rate defaults (see chart below).

So why are spreads higher than default rates would seem to sug­gest?  The answer is volatil­ity and uncer­tainty.  The for­ward path of the US econ­omy is still some­what murky.  Our view is that we will remain in a period of low but steady growth for a while, but there are risks that we could see another down­turn.  The Euro­pean debt cri­sis is the other major mar­ket dynamic weigh­ing on investors.  As the cri­sis con­tin­ues with­out a clear long term solu­tion, investors are nat­u­rally more skit­tish.  This skit­tish­ness, along with the con­cerns about the US eco­nomic out­look, results in investors demand­ing a higher level of yield for tak­ing on high yield cor­po­rate bond risk.  The extra risk pre­mium is what is keep­ing credit spreads higher than the default out­look would suggest.

Over­all, high yield spreads appear to be at a rea­son­able level, since investors are being paid both for the level of defaults as well as the level of global invest­ment uncer­tainty.  If you are an investor with a long-term time hori­zon and can han­dle some volatil­ity, then high yield could still be an attrac­tive place to invest.  If high yield spreads reach lev­els seen in 2004–2006, the bonds could have addi­tional cap­i­tal appre­ci­a­tion.  How­ever, investors have to be aware that neg­a­tive eco­nomic sur­prises, espe­cially in the US or Europe, could impact prices along the way.

With all this dis­cus­sion of high yield bonds, it’s impor­tant to think about the suit­abil­ity of these invest­ments in your port­fo­lio.  While HY expe­ri­ences about half the volatil­ity of equi­ties, the bonds are still more volatile than invest­ment grade bonds.  How­ever, with yield lev­els around 7%, yield-hungry investors may find them worth the risk.

Sources: Bar­clays Cap­i­tal, Moody’s, Morn­ingstar and Bloomberg as of 3/30/2012

Bonds and bond funds will decrease in value as inter­est rates rise. High yield secu­ri­ties may be more volatile, be sub­ject to greater lev­els of credit or default risk, and may be less liq­uid and more dif­fi­cult to sell at an advan­ta­geous time or price to value than higher-rated secu­ri­ties of sim­i­lar maturity.

Tags: Bond Default, Capital Appreciation, Corporate Bond, Corporate Defaults, Coupon Payments, Crowd Pleaser, Debt Crisis, Default Rates, Downturn, Economic Outlook, ETFs, Favorable Credit, Frequent Question, High Yield Bonds, High Yield Investment, Hubbub, Long Term Solution, Matt Tucker, Outlook Results, Treasuries
Posted in Markets | Comments Off

Can Stocks Avoid Another Bear in Spring?

Thursday, May 3rd, 2012

Can Stocks Avoid Another Bear in Spring?

by Fran­cis Gan­non, Royce Funds

After back-to-back double-digit return quar­ters, the equity mar­kets paused in April. Uncer­tainty and volatil­ity returned on renewed con­cerns about a slow­down in eco­nomic growth in the United States and China, and the never-ending debt cri­sis in Europe. Inter­est­ingly, these are the same issues that unset­tled investors dur­ing the spring of 2010 and 2011, and there remains wide­spread fear that this year could play out the same way. After falling close to 30% in the first quar­ter, the CBOE Volatil­ity Index (VIX) spiked 20% and the Rus­sell 2000 Index fell –1.54% dur­ing April.

Many investors remain spooked by the last two cruel Aprils. They can eas­ily recall how well stocks, espe­cially small-caps, did dur­ing the early months of the past two years, only to peak in 2010 on April 23 before drop­ping 20.3% through July 6, 2010, and then peak­ing on April 29, 2011 before plung­ing 29.1% through Octo­ber 3, 2011.

What­ever the com­bined rea­sons for the change in the market's for­tunes, we have been struck by the con­sis­tently opti­mistic tone we are hear­ing from cor­po­rate man­age­ments fol­low­ing first-quarter earn­ings. From our per­spec­tive, while many are once again ques­tion­ing the sus­tain­abil­ity of earn­ings and fear that peak mar­gins are at hand in the face of renewed eco­nomic con­cerns, we think there is a long way to go.

It's prob­a­bly not sur­pris­ing that, lost among today's uncer­tain macro head­lines and the seem­ingly end­less fear of equi­ties falling (as mea­sured by sus­tained actively man­aged equity mutual fund out­flows), is the real­ity that high-quality smaller com­pa­nies not only have strong bal­ance sheets, but also con­tinue to expand in what can only be described as an ane­mic eco­nomic growth environment.

While pop­u­lar opin­ion seems to be call­ing for mar­gins to reverse, we have been hear­ing about con­tin­ued pro­duc­tiv­ity gains, expand­ing profit mar­gins, and sound cap­i­tal allo­ca­tion in many of our recent con­ver­sa­tions with cor­po­rate man­age­ment teams. In fact, for many com­pa­nies, the spread between the cost of cap­i­tal and return on cap­i­tal has never been wider, which should con­tinue to drive cap­i­tal for­ma­tion and there­fore growth and mar­gin expansion.

Remark­ably, small-cap oper­at­ing mar­gins remain sig­nif­i­cantly below prior peaks, and there is ample room for con­tin­ued expan­sion. Accord­ing to Chip Miller of UBS, "S&P Small­Cap 600 oper­at­ing mar­gins are roughly 180 basis points—or 20%—below last cycle's high." To be sure, smaller-company mar­gins in gen­eral have been solid, but we think they have room to improve.

The imme­di­ate issue, then, is whether or not the mar­ket can avoid a third con­sec­u­tive bear­ish spring. Will the third time be the charm? For the moment, the mar­ket is caught in a tug of war between bet­ter first-quarter cor­po­rate earn­ings and a string of dis­ap­point­ing eco­nomic news. Could this be the begin­ning of another eco­nomic growth scare and equity cor­rec­tion? We are not sure. We do know, how­ever, that cor­rec­tions hap­pen. From our per­spec­tive, they are part of the small-cap land­scape and occur on a reg­u­lar basis. They are nei­ther unusual nor unprecedented.

"Price cor­rec­tions serve an impor­tant func­tion
in our invest­ment process, allow­ing for the accu­mu­la­tion
of well-run com­pa­nies at attrac­tive prices.
After all, total return is a func­tion of entry price."

Using the Rus­sell 2000 as an exam­ple, the small-cap index has expe­ri­enced 18 down­turns of 10% or more since its 1979 incep­tion, includ­ing the most recent one in 2011. While calendar-year declines have occurred about every third or fourth year, down­turns of 10% or more have hap­pened about every other year. With­out a doubt they are unpleas­ant, but in our view they remain a key com­po­nent in build­ing higher long-term returns.

Price cor­rec­tions serve an impor­tant func­tion in our invest­ment process, allow­ing for the accu­mu­la­tion of well-run com­pa­nies at attrac­tive prices. After all, total return is a func­tion of entry price.

We have always believed in the old adage that "great com­pa­nies cre­ate their own suc­cess," which is espe­cially true today as many smaller com­pa­nies posi­tion and pre­pare for bet­ter eco­nomic times in the not too dis­tant future. It is also true, from our per­spec­tive, that there is an abun­dance of high-quality small-caps trad­ing at a dis­count not only to their fel­low small-caps but to their larger-cap sib­lings as well.

Stay tuned…
FDG

Impor­tant Dis­clo­sure Information

Fran­cis Gan­non is a Port­fo­lio Man­ager of Royce & Asso­ciates LLC. Mr. Gannon's thoughts in this essay con­cern­ing the stock mar­ket are solely his own and, of course, there can be no assur­ance with regard to future mar­ket move­ments. No assur­ance can be given that the past per­for­mance trends as out­lined above, will con­tinue in the future. The his­tor­i­cal per­for­mance data and trends out­lined are pre­sented for illus­tra­tive pur­poses only and are not nec­es­sar­ily indica­tive of future mar­ket movements.

The CBOE Volatil­ity Index (VIX) mea­sures mar­ket expec­ta­tions of near-term volatil­ity con­veyed by S&P 500 stock index option prices. The S&P 500 is an index of U.S. large-cap stocks selected by Stan­dard & Poor's based on mar­ket size, liq­uid­ity and indus­try group­ing, among other fac­tors. The Rus­sell 2000 is an unman­aged, capitalization-weighted index of domes­tic small-cap stocks. It mea­sures the per­for­mance of the 2,000 small­est pub­licly traded U.S. com­pa­nies in the Rus­sell 3000 index. The S&P 600 is an index that cov­ers roughly the small-cap range of stocks selected by Stan­dard & Poor's based on mar­ket size, liq­uid­ity and indus­try group­ing, among other factors.

Tags: April 29, Balance Sheets, Capital Allocation, Cboe Volatility Index, Debt Crisis, Economic Concerns, Endless Fear, Fortunes, Francis Gannon, Growth Environment, Optimistic Tone, Popular Opinion, Productivity Gains, Profit Margins, Quarter Earnings, Royce Funds, Russell 2000 Index, Slowdown, Small Caps, Smaller Companies
Posted in Markets | Comments Off

Roller Coaster Returns (Sonders)

Wednesday, May 2nd, 2012

April 27, 2012

After an extended, and almost unprece­dented period of rel­a­tive calm, result­ing in robust stock mar­ket gains from Octo­ber 2011 through March 2012, we have seen some volatil­ity return. Con­cerns over global growth have reemerged as Chi­nese eco­nomic data has dis­ap­pointed, the Euro­pean debt cri­sis again is gain­ing head­lines as the mer­its of aus­ter­ity are being ques­tioned, and US eco­nomic data has been less impressive.

Volatil­ity has picked up

Source: Fact­Set, Chicago Board of Trade. As of Apr. 24, 2012.

One poten­tial ben­e­fit of this rise in con­ster­na­tion has been the long-awaited cor­rec­tion in stocks that many had been call­ing for. In fact, we have been com­forted by numer­ous investor sen­ti­ment read­ings now show­ing ele­vated bear­ish­ness (remem­ber that investor sen­ti­ment is a con­trary indi­ca­tor). The Amer­i­can Asso­ci­a­tion of Indi­vid­ual Investors’ (AAII) bull ratio recently moved decid­edly below the 50% mark for the first time in 2012. The per­cent­age of respon­dents say­ing they are bear­ish has moved from just under 28% to nearly 42% between April 4 and April 11; and the per­cent­age of bulls dropped to 28% from over 38% over the same time period. We believe this change in sen­ti­ment was needed in order for the mar­ket to reestab­lish a sus­tain­able uptrend going forward.

The recent mild increase in volatil­ity again reminds us that it's impor­tant to main­tain a long-term focus and to main­tain a diver­si­fied port­fo­lio. It's vital that investors review their port­fo­lio hold­ings on a reg­u­lar basis, while also look­ing at how cor­re­la­tions among asset classes change over time. A well-diversified port­fo­lio in one year may not be nearly so two years later, even if the posi­tions are roughly the same—the inter­ac­tion between asset classes changes over time. One final note on port­fo­lio con­struc­tion: The drum­beat of bear­ish bond com­men­tary has grown over the past month as yields remain near record lows. While we again remind investors that invest­ing in bonds for spec­u­la­tive or cap­i­tal appre­ci­a­tion pur­poses has become more risky; it is also true that for diver­si­fi­ca­tion, income, and cap­i­tal preser­va­tion pur­poses, bonds will still have a valu­able place in many port­fo­lios. Again, bal­ance is the key.

Macro con­cerns again trump­ing micro story

Investors' atten­tion is again focused on the macro rather than the micro over the past cou­ple of weeks—the height of first quar­ter earn­ings sea­son. The report­ing period has been much bet­ter than expected, although admit­tedly from a lower bar—83% of com­pa­nies have beaten expec­ta­tions so far, which is an all-time record high. But mar­ket reac­tions to good reports have been more muted rel­a­tive to the pun­ish­ments doled out to those that dis­ap­pointed. It appears Chi­nese devel­op­ments, Euro­pean debt and growth con­cerns, and some soft­en­ing in US eco­nomic data has led to increased volatility.

In the United States, the eco­nomic expan­sion con­tin­ues, but we may be in yet another soft spot. This isn't sur­pris­ing given the likely pulling for­ward of some eco­nomic activ­ity that was influ­enced by the unusu­ally warm weather dur­ing the win­ter months. We believe this is a rel­a­tively mod­est and tem­po­rary phe­nom­e­non and that activ­ity will again pick up in the com­ing months. Con­cern has grown that 2012 will be a repeat of the pre­vi­ous two years when the mar­ket declined begin­ning in April on soft­en­ing eco­nomic data after decent starts to the year. We believe the story is dif­fer­ent this time as jobs, lend­ing and hous­ing have improved and infla­tion has eased, allow­ing global cen­tral banks to keep pol­icy loose; lead­ing to our view that his­tory won't repeat this year.

Recently, we've seen regional man­u­fac­tur­ing sur­veys dis­ap­point, although remain­ing in ter­ri­tory depict­ing growth. The Empire Man­u­fac­tur­ing Index fell from 20.2 to 6.6 and the Philly Fed Index dropped to 8.5 from 12.5. Encour­ag­ingly, the employ­ment expec­ta­tion com­po­nent of Philly Fed jumped six points to its high­est level in a year, while March retail sales increased 0.8%, above esti­mates, indi­cat­ing that the Amer­i­can con­sumer remains engaged. Com­mod­ity costs have also lev­eled off recently, which should help to bol­ster dis­cre­tionary income.

Lower com­mod­ity prices should help consumers

Source: Fact­Set, Stan­dard & Poor's. As of Apr. 24, 2012.

Despite this still-positive pic­ture, recent job and hous­ing data has weak­ened a touch. The March pay­roll report dis­ap­pointed despite the unem­ploy­ment rate drop­ping and recent ini­tial job­less claims have crept a bit higher. We remain rel­a­tively uncon­cerned given that sea­sonal adjust­ments around the Easter hol­i­day can be dif­fi­cult and the level still remains well below the key 400,000 num­ber. Jobs are a vital cog in the econ­omy and we believe that increas­ing retail demand and a declin­ing abil­ity of com­pa­nies to squeeze addi­tional pro­duc­tiv­ity out of exist­ing work­ers should allow for con­tin­ued improve­ment on the labor front.

Tags: Austerity, Charles Schwab, Chicago Board Of Trade, Chief Investment Strategist, Dangerous Game, Debt Crisis, Earnings Season, Economic Data, Economic Forecasts, Election Season, Fed Meeting, Global Growth, Investor Sentiment, Liz Ann, Relative Calm, Roller Coaster, Sector Analysis, Senior Vice President, Stock Market Gains, Unprecedented Period
Posted in Markets | Comments Off

Is it 2010 and 2011 All Over Again?

Thursday, April 26th, 2012

Fol­low­ing a string of weaker than expected eco­nomic reports over the last few weeks and today's much larger than expected drop in Durable Goods Orders, investors are increas­ingly ask­ing if the mar­ket is set­ting itself up for a repeat of 2010 and 2011.  In the chart below, we high­light the annual per­for­mance of the S&P 500 so far this year, as well as in 2010 and 2011.  As shown in the chart, in both 2010 and 2011 the S&P 500 ral­lied in the first four months of the year.

In 2010, the S&P 500 was up 9.2% when it reached its first half peak on 4/23.  From there, the index dropped sharply and was down as much as 10% YTD before ral­ly­ing when the Fed stepped in with QE2.  In 2011, we saw a sim­i­lar pat­tern.  When the S&P 500 reached its first half peak on April 29th, the index was up 8.4% on the year.  From there, it was a down­ward slide as the index fell roughly 20% through Octo­ber.  Then late in the year, the mar­ket once again ral­lied when the Sum­mer ended and the Fed stepped in with 'Oper­a­tion Twist.'

This year, the mar­ket finds itself in a sim­i­lar posi­tion as the month of April comes to a close.  At its peak on 4/2, the S&P 500 was up 12.8% on the year, but it has since seen a minor pull­back.  This pull­back cou­pled with recent weak­ness in eco­nomic data and the on-going Euro­pean debt cri­sis has investors wor­ried that this could be a long hard Summer.

Will 2012 turn out a lot like last year?  Only time will tell, but while there are some sim­i­lar­i­ties between now and then, there are also some key dif­fer­ences.  For starters, the econ­omy is at a higher level now than it was then.   Addi­tion­ally, while most global Cen­tral Banks had a bias towards tight­en­ing early last year, this year the bias is towards eas­ing.  Finally, last year's peak in the mar­ket and eco­nomic activ­ity came just weeks after the earth­quake in Japan.  As we noted back then, when the world's third largest econ­omy essen­tially grinds to a halt, the global econ­omy will feel an impact.

Tags: Amp, Bias, Central Banks, Debt Crisis, Downward Slide, Durable Goods Orders, Earthquake In Japan, Economic Activity, Economic Data, Economic Reports, Four Months, Global Economy, Half Peak, Investors, Month Of April, Months Of The Year, Pullback, Qe2, Starters, Ytd
Posted in Markets | Comments Off

Market Drawdown Presents Buying Opportunities

Tuesday, April 17th, 2012

Mar­ket Draw­down Presents Buy­ing Opportunities

by Bob Doll, Chief Equity Strate­gist, Fun­da­men­tal Equi­ties, Black­Rock

April 16, 2012

Another Down­turn for Stocks

Once again, risk assets strug­gled last week with most investors blam­ing the down­turn on re-ignition of con­cerns over the Euro­pean debt cri­sis brought about by a dis­ap­point­ing debt auc­tion in Spain. For the week, the Dow Jones Indus­trial Aver­age fell 1.6% to 12,849, the S&P 500 Index declined 2.0% to 1,370 and the Nas­daq Com­pos­ite dropped 2.3% to 3,011.

Does His­tory Repeat? Or Just Rhyme?

Last year around this time, stocks were com­ing off an impres­sive first quar­ter, but were headed for trou­ble. Higher oil prices, the earth­quake in Japan and the brouhaha over the US debt ceil­ing all con­spired to cause a sharp turn­around in risk assets. So far this year, stocks have been fol­low­ing a some­what sim­i­lar pat­tern as early strength for equi­ties appears to be fad­ing some­what. So, it is worth ask­ing the ques­tion: Will 2012 look like 2011?

There are some aspects of the finan­cial and eco­nomic back­drop that do look sim­i­lar between the two years. In addi­tion to the flare ups in Europe regard­ing debt prob­lems, we are cur­rently in the midst of a period of ris­ing energy prices. Gaso­line prices in par­tic­u­lar are get­ting close to last year's peaks. We are also see­ing some renewed weak­ness in the eco­nomic data—the pace of jobs growth slowed in March and con­sumer con­fi­dence lev­els have been look­ing softer. Should gaso­line prices con­tinue to rise, it would be rea­son­able to fear that the spillover effect onto the rest of the econ­omy would worsen.

We believe it would be a mis­take, how­ever, to look too closely to 2011 as a model for what might hap­pen this year. For starters, cur­rent expec­ta­tions for both the econ­omy and the mar­kets are worse than they were at this point last year. In early 2011, investors were pric­ing in a bet­ter eco­nomic envi­ron­ment than what would ulti­mately come to pass. In con­trast, at this point we believe that mar­kets are already priced for rel­a­tively mod­est lev­els of growth, sug­gest­ing that there is less room for down­side dis­ap­point­ments. Addi­tion­ally, the fun­da­men­tal strength of the econ­omy is bet­ter now than it was one year ago. Notwith­stand­ing last month's data, the labor mar­ket is stronger than it was, hous­ing appears to be bot­tom­ing and US credit con­di­tions have been improv­ing. Finally, it is impor­tant to remem­ber that the recov­ery and mar­ket strength last year were, to some extent, derailed by the nat­ural dis­as­ters in Japan and by S&P's credit down­grade of the United States. While exter­nal shocks are always a risk, we can hope that these sorts of fac­tors will not be repeated.

Rea­sons for Optimism

Given the rel­a­tive dif­fer­ences between the econ­omy in 2011 and what it looks like today, we believe the US econ­omy will be more resilient than it was last year, pro­vid­ing some sup­port for US equities.

In addi­tion to the eco­nomic back­drop, we would also look to cor­po­rate earn­ings as a source of strength. Although we are fore­cast­ing that the pace of earn­ings growth will be slower this year than it has been in the recent past, so far the data has shown that cor­po­rate earn­ings have been doing just fine. Expec­ta­tions for the first quar­ter have been set rel­a­tively low, but so far over 80% of the com­pa­nies that have reported have sur­passed expec­ta­tions, which is a good sign. (In com­par­i­son, in the pre­vi­ous sev­eral quar­ters around 60% to 70% of com­pa­nies beat expectations.)

Putting all of this together, we would argue that we are unlikely to see the sort of sharp and severe pull­back in stock prices that we wit­nessed in 2011. We do, how­ever, expect to see higher lev­els of volatil­ity in the months ahead com­pared to what we expe­ri­enced in the first quar­ter and we would not be sur­prised to see the cur­rent pull­back take the mar­kets down to around the 1,350 or 1,300 level for the S&P 500. Such a pull­back would rep­re­sent a nor­mal cor­rec­tion occur­ring in the midst of a bull mar­ket. Fur­ther­more, we also believe that stocks should see a resump­tion of gains after the cur­rent period of weak­ness, which could cre­ate buy­ing oppor­tu­ni­ties for investors.

Tags: Bob Doll, Brouhaha, Confidence Levels, Consumer Confidence, Debt Ceiling, Debt Crisis, Debt Problems, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Drawdown, Earthquake In Japan, Economic Backdrop, Economic Data, Energy Prices, Flare Ups, Gasoline Prices, Nasdaq Composite, Rising Energy, Spillover Effect
Posted in Markets | Comments Off

Presidential Election Year: Good for Stocks?

Wednesday, April 11th, 2012

by Colum­bia Management

With the elec­tion sea­son upon us, have you been won­der­ing what the stock mar­ket will do in a pres­i­den­tial elec­tion year? To be sure, no one has the answer, but look­ing at stock mar­ket per­for­mance dur­ing elec­tion years can pro­vide some help­ful insight.

Elec­tion year mar­ket cycles

His­tor­i­cal data sug­gest that the stock mar­ket and pres­i­den­tial elec­tion years fol­low pre­dictable pat­terns and tra­di­tion­ally result in bet­ter per­for­mance if the incum­bent party wins. A look at the his­tor­i­cal returns of the Dow Jones Indus­trial Aver­age (DJIA), the old­est equity mar­ket index that tracks 30 sig­nif­i­cant stocks, helps illus­trate this point.

Over the past 29 pres­i­den­tial elec­tion years since the Dow was first pub­lished in 1896, the index has deliv­ered an aver­age return of 7.18%, slightly off from the aver­age of 7.35% seen in a non-election year accord­ing to Dow Jones Indexes. Keep in mind that this data rep­re­sents past per­for­mance and there’s no guar­an­tee that pat­terns and results will con­tinue in the future.

The polit­i­cal landscape

Gen­er­ally, investors haven’t suf­fered big losses dur­ing elec­tion years. How­ever, the mar­ket did decline as recently as the last U.S. pres­i­den­tial elec­tion in 2008 dur­ing the finan­cial cri­sis and sub­se­quent bear mar­ket. While his­tor­i­cal analy­sis offers an inter­est­ing snap­shot, it’s impor­tant to remem­ber that each elec­tion year brings its own unique char­ac­ter­is­tics. Cur­rently, the eco­nomic out­look for 2012 holds a tremen­dous amount of uncer­tainty with many fac­tors up in the air rang­ing from cor­po­rate earn­ings to unem­ploy­ment. In addi­tion, the Euro­pean debt cri­sis con­tin­ues to weigh on global mar­kets and the effects will remain unknown while prob­lems go unre­solved. All of these fac­tors can poten­tially have a big­ger impact on the mar­ket and your port­fo­lio than the pres­i­den­tial elec­tion itself.

Pol­i­tics and your portfolio

The polit­i­cal envi­ron­ment and upcom­ing elec­tion can cer­tainly influ­ence the stock mar­ket, as ulti­mately, the pres­i­dent plays a cru­cial role in direct­ing the nation’s eco­nomic pol­icy, tax rates, bud­gets, etc. But mak­ing any finan­cial deci­sions based on elec­tion year mar­ket cycles is not a pru­dent invest­ment strategy.

Stick with your long-term asset allo­ca­tion strat­egy. Don’t let an elec­tion year influ­ence your finan­cial decision-making or your invest­ment goals.

Copy­right © Colum­bia Management

Tags: Bear Market, Columbia Management, Corporate Earnings, Debt Crisis, Dow Jones, Dow Jones Indexes, Dow Jones Industrial, Dow Jones Industrial Average, Economic Outlook, Election Season, Election Year, Historical Returns, Incumbent Party, Market Cycles, Market Index, Political Environment, Political Landscape, Predictable Patterns, Stock Market Performance, Upcoming Election
Posted in Markets | Comments Off

60 Minutes Reviews the European Debt Crisis

Monday, April 9th, 2012

60 Min­utes did a piece on the sit­u­a­tion in Europe, and for a not finan­cial ori­ented TV show, it did a pretty fine job of describ­ing the sit­u­a­tion for a mass audi­ence.   They key line I wish they had expanded upon was along the lines of "in the past, if Greece found its accounts over­drawn the coun­try sim­ply printed more money, or deval­ued its cur­rency…" – which are paths the U.S., U.K. and Japan now fol­low.   Fur­ther they should have explained how these finan­cial injec­tions are back­door bailouts for the finan­cial élite, namely Ger­man and French banks, among others.

How­ever, it was inter­est­ing to see the dynamic between Greece and Ger­many in far greater detail than the num­bers we are numb to – the long and vio­lent his­tory of this con­ti­nent makes for inter­est­ing relationships.

14 minute video, email read­ers will need to come to site to view

Tags: 60 Minutes, Backdoor, Continent, Currency, Debt Crisis, Europe, Financial Elite, French Banks, Germany, Greece, Japan, Job, Key Line, Mass Audience, Money, Relationships, Tv Show, Video Email, Violent History
Posted in Markets | Comments Off

The Hazard of Second Best

Monday, April 2nd, 2012

by Mohamed El-Erian, PIMCO, via Project Syn­di­cate

NEWPORT BEACH – The inter­na­tional com­mu­nity risks set­tling for sec­ond best on two key issues to be dis­cussed this month at global meet­ings in Wash­ing­ton, DC: the lin­ger­ing (if cur­rently some­what dor­mant) Euro­pean debt cri­sis, and the selec­tion of the World Bank’s next pres­i­dent. It is not too late to change course, but doing so will require the United States and gov­ern­ments in Europe to resist harm­ful habits, and emerg­ing coun­tries to fol­low up effec­tively on recent ini­tia­tives. In the last few days, Euro­pean lead­ers, includ­ing French Pres­i­dent Nico­las Sarkozy and Euro­pean Cen­tral Bank Pres­i­dent Mario Draghi, have declared that the worst of the euro­zone cri­sis is over. Oth­ers, like French Finance Min­is­ter Fran­cois Baroin, have gone even fur­ther, claim­ing that Europe “has done its part,” and that it is now up to other coun­tries to do theirs.

These announce­ments should come as no sur­prise. Hav­ing expe­ri­enced pro­longed tur­moil, the euro­zone is cur­rently in a period of rel­a­tive tran­quil­ity. The coura­geous reform mea­sures imple­mented by Mario Monti, Italy’s tech­no­cratic prime min­is­ter, have eased imme­di­ate con­cerns that Greek dis­lo­ca­tions might tip other Euro­pean coun­tries – much big­ger and harder to res­cue – into insol­vency. Europe’s deci­sion last week to bol­ster its inter­nal finan­cial fire­walls has rein­forced the result­ing pos­i­tive impact on mar­ket sen­ti­ment. But, as impor­tant as these steps are, the recent tran­quil­ity has been more bor­rowed than earned. Since Decem­ber, the ECB has twice deployed long-term refi­nanc­ing oper­a­tions, which pro­vide unlim­ited three-year financ­ing to banks at 1% inter­est. This has given the bank­ing sys­tem more time to increase cap­i­tal and improve asset qual­ity. It has also reduced sev­eral gov­ern­ments’ financ­ing costs. What it does not do, and is not meant to do, is resolve Europe’s twin prob­lems of too lit­tle growth and too much debt.

If it is not care­ful, Europe risks falling into the trap of try­ing to shift respon­si­bil­ity for its prob­lems onto oth­ers, rather than build­ing on recent progress. That temp­ta­tion is partly reflected in efforts to press offi­cials from around the world to agree this month to a major increase in the Inter­na­tional Mon­e­tary Fund’s resources, with emerg­ing economies foot­ing a sig­nif­i­cant part of the bill. In piv­ot­ing from inter­nal to externally-financed fire­walls, Europe is push­ing a polit­i­cal agenda that is not yet war­ranted by eco­nomic and finan­cial real­i­ties. Euro­peans are about to embark on another round of elec­tions, in both core and periph­eral EU coun­tries, as well as a ref­er­en­dum in Ire­land. Recent his­tory sug­gests that these votes are unlikely to favor rul­ing par­ties unless they can sig­nal some progress in resolv­ing the crisis.

Read Com­plete Article

Copy­right © Project Syndicate

Illus­tra­tion by Paul Lachine

Tags: Asset Quality, Bank President, Debt Crisis, Europe Risks, European Leaders, French Finance Minister, French President Nicolas, French President Nicolas Sarkozy, Global Meetings, Harmful Habits, Mario Monti, Market Sentiment, Mohamed El Erian, Newport Beach, Nicolas Sarkozy, PIMCO, President Nicolas Sarkozy, Project Syndicate, Reform Measures, Relative Tranquility
Posted in Markets | Comments Off

Austerity – Mais, non. Spending – Nein. PSI – Tal Vez?

Thursday, March 29th, 2012

by Peter Tchir, TF Mar­ket Advisors

Aus­ter­ity hasn’t worked for coun­tries. So far the aus­ter­ity path has made sit­u­a­tions worse, rather than bet­ter.  With­out stim­u­lus, economies have seen their prob­lems com­pound.  So now vir­tu­ally every­one is against the idea that aus­ter­ity is helpful.

That takes us back to spend­ing.   Maybe it’s just me, but spend­ing is what got us into this mess in the first place. If spend­ing worked so well and was so easy we wouldn’t have a sov­er­eign debt cri­sis in the first place.  Vir­tu­ally every coun­try was spend­ing, yet deficits grew and economies shrank.  Why is there any faith that spend­ing now will work?  Are we so good at tar­get­ing spe­cific things that will really, truly, work?  Not a chance.  Spend­ing will ensure debt grows just as fast, make the prob­lem even big­ger in the end, but will make peo­ple slightly hap­pier in the near term.

So if aus­ter­ity doesn’t work, and spend­ing hasn’t worked, what will?

PSI, or Default, or Restructuring.

Debts have grown so big, that the only way to bring them under con­trol is to default on them in one form or another and wipe some out per­ma­nently.  Doing it sooner than later is key.

Now is the time.  Por­tu­gal 75% hair­cut.  Ire­land 50%.  Spain 40% hair­cut (once they put all the Span­ish guar­an­teed debt on bal­ance sheet, they will need 40%).  Italy 25%.  Greece – just make EU and ECB eat the same dish they served to pub­lic sec­tor.  Only IMF money is sacro­sanct.  The ECB, EFSF, and EU can take losses like the rest of us.  The EU talks about “fire­walls”, well, put up or shut up.  The ECB can print away the losses.

Using cur­rent data, here is the amount of debt at the sov­er­eign level for each coun­try (I think if they are going to do the restruc­tur­ing, they should put on bal­ance sheet a lot of the guar­an­teed debt, so they only have to do this once).

Por­tu­gal:  €171 bil­lion * 75% = €128 billion

Ire­land:    €122 bil­lion * 50% = €61 billion

Spain:       €712 bil­lion * 40% = €285 billion

Italy:      €1,631 bil­lion * 25% = €408 billion

Total write-downs would be €882 billion.

A lot of banks have writ­ten down hold­ings in Por­tu­gal already and taken reserves on other coun­tries.  Greece shows that banks had done a semi decent job reserv­ing against it.  Let’s assume €100 bil­lion of losses have been reserved against or already marked.

That leaves €772 bil­lion of losses.

The ECB has about €175 bil­lion of non Greek bonds on its SMP bal­ance sheet (or a num­ber close to that)?  Assume an aver­age loss of 40% on that (it is a mix of debt from the var­i­ous coun­tries).  That is €70 bil­lion accounted for.  The ECB should just print that money. Call it a one-time exer­cise. With all the default/restructuring, infla­tion isn’t likely to be a concern.

So that leaves €702 bil­lion still that needs to be taken out of the system.

Uni­credit has an equity mar­ket cap of €23 bil­lion.  Intesa is about the same.  Ass­gen (an insur­ance com­pany, where the bond ticker is so much more fun than actual equity ticker) has a mar­ket cap of €19 bil­lion.  BBVA is €30 bil­lion.  DB is €35 billion.

The losses will be a mas­sive hit to the bank­ing and insur­ance indus­try.  But to some extent, so what?  The big “money cen­ter” banks will all sur­vive it.  The DB’s, SocGen’s, BNP’s, HSBC’s of the world will take some seri­ous hits.  US banks will take some hits.  But they have plenty of equity cap­i­tal to sup­port it, and they made bad lend­ing decisions.

The BBVA’s of the world will get hit extremely hard, but they should be able to sur­vive it.  I’m less sure about some of the Ital­ian banks as they seem to have big­ger con­cen­tra­tions, but in the end, there are a lot of banks.

So let the restruc­tur­ings begin and fig­ure out what to do with the banks after.

Many will sur­vive with­out assistance.

Some banks may fail.  If the ECB and EU and EFSF pro­tect senior unse­cured cred­i­tors from losses at the expense of equity and sub debt hold­ers, then the risk of a bank­ing death spi­ral goes away. How much needs to be pro­tected and at what level is unclear.  Some banks that were truly over exposed should see losses to  bond­hold­ers too.  Less losses for the pub­lic to bear and more losses for the bad deci­sion mak­ers to bear.

Pro­vide “War­ren Buf­fet” style equity cap­i­tal to banks that want it or need it.  Why shouldn’t the tax­pay­ers make money like War­ren does?  Stop with the easy money for banks, make them pay the coun­try like they would a pri­vate investor.

There has been ZERO evi­dence that bank share prices influ­ence lend­ing. It doesn’t seem to mat­ter what we cur­rently do to banks, they aren’t lend­ing much.  So let’s not worry about their share price.  So long as they have access to money, they will or won’t lend regard­less of whether their share prices are low.

Banks that are pre­pared and pru­dent will thrive in this environment.

Rather than mak­ing it hard to start new banks, the ECB and Fed should encour­age new banks. There has to be 10’s of bil­lions of Pri­vate Equity money that would start good mid-size banks.  Heck, maybe we could get an i-Bank.  But seri­ously, new money has been crowded out of the space by zom­bie banks and kick the can policies.

Take the hit.  Fig­ure out who excels, who fails, and for those in between, what is the cost of sur­viv­ing.   Open the mar­kets to new equity cap­i­tal and new participants.

Maybe this is too harsh and will never work, but it is a bet­ter path than pur­su­ing the same poli­cies that have failed year after year.

Tags: Austerity, Balance Sheet, Debt Crisis, Debts, Dish, ECB, Efsf, Faith, Greece, Haircut, Hasn, Losses, Nbsp, Psi, Public Sector, Restructuring, Sovereign Debt, Stimulus, Tf, Time Portugal
Posted in Markets | Comments Off

Where Are We in the Boom/Bust Liquidity Cycle?

Thursday, March 29th, 2012

Where Are We in the Boom/Bust Liq­uid­ity Cycle?

By Thomas Fahey, Asso­ciate Direc­tor of Macro Strate­gies, Loomis Sayles

March 2012

In an often cyn­i­cal world, stan­dard fi nan­cial and macro­eco­nomic quan­ti­ta­tive mod­els give peo­ple the benefi t of the doubt. Fun­da­men­tal eco­nomic the­ory assumes the best of us, sup­pos­ing that human beings are per­fectly ratio­nal, know all the facts of a given sit­u­a­tion, under­stand the risks, and opti­mize our behav­ior and port­fo­lios accord­ingly. Real­ity, of course, is quite dif­fer­ent. While a sig­nifi cant por­tion of indi­vid­ual and mar­ket behav­ior can be mod­eled rea­son­ably well, the human emo­tions that drive cycles of fear and greed are not pre­dictable and can often defy his­tor­i­cal prece­dent. As a result, quan­ti­ta­tive mod­els some­times fail to antic­i­pate major macro­eco­nomic turn­ing points. The ongo­ing debt cri­sis in Europe is the most recent exam­ple of an extreme event shat­ter­ing his­tor­i­cal norms.

Once an extreme event occurs, stan­dard mod­els offer lim­ited insight as to how the ensu­ing cri­sis could play out and how it should be man­aged, which is why pol­icy responses can seem dis­jointed. The lat­est pol­icy responses to the Euro­pean cri­sis have been no excep­tion. To under­stand and respond to a cri­sis like the one in Europe, per­haps we need to con­sider some new mod­els that include the “human fac­tor.” Eco­nomic his­to­rian Charles Kindle­berger can offer some insight. In his book Manias, Pan­ics, and Crashes, Kindle­berger explores the anatomy of a typ­i­cal fi nan­cial cri­sis and pro­vides a frame­work that con­sid­ers the impact of the pow­er­ful human dynam­ics of fear and greed. Kindleberger’s descrip­tive process of the boom and bust liq­uid­ity cycle can help shed light on the cur­rent Euro­pean sov­er­eign debt saga, and per­haps illu­mi­nate whether we have in fact turned the cor­ner on this fi nan­cial crisis.

KINDLEBERGER AND THE MINSKY MODEL

Kindle­berger ana­lyzed hun­dreds of fi nan­cial crises dat­ing back cen­turies and found them to share a com­mon sequence of events, one that fol­lowed mon­e­tary the­o­rist Hyman Minsky’s model of the insta­bil­ity of a credit sys­tem. Fun­da­men­tally, the more sta­ble and pros­per­ous an eco­nomic struc­ture appears, the more lever­age and spec­u­la­tive fi nanc­ing will build within the sys­tem, even­tu­ally mak­ing it highly vul­ner­a­ble to a sur­pris­ing, extreme col­lapse. Kindle­berger pro­vided the qual­i­ta­tive (as opposed to quan­ti­ta­tive!) descrip­tion of the Min­sky Model, shown below, which is a use­ful snap­shot of the liq­uid­ity cycle. It can be applied to Europe and any poten­tial boom/bust can­di­date, includ­ing Chi­nese real estate, com­mod­ity prices, or investors’ recent love affair with emerg­ing mar­kets. Kindle­berger famously dubbed this sequence a “hardy peren­nial,” prob­a­bly because the gal­va­niz­ing human con­di­tions of fear and greed are more often than not prone to over­shoot fun­da­men­tal val­ues com­pared to the behav­ior of a ratio­nal indi­vid­ual, which exists only in macro­eco­nomic theory.

DISPLACEMENT

The boom typ­i­cally starts with a “dis­place­ment,” a macro­eco­nomic shock (for exam­ple a new tech­nol­ogy, dereg­u­la­tion of an indus­try), that cre­ates new profi t oppor­tu­ni­ties. For Europe, dis­place­ment came in the form of the Eco­nomic and Mon­e­tary Union (EMU) in 1999, which united par­tic­i­pat­ing coun­tries under a sin­gle mon­e­tary pol­icy and cur­rency, the euro. By estab­lish­ing one inter­est rate for EU mem­ber states, EMU enabled all par­tic­i­pat­ing sov­er­eigns to trade as if they pos­sessed Germany’s supe­rior cred­it­wor­thi­ness, regard­less of their fi scal con­di­tion. The oblig­ing mar­ket responded by lend­ing to EU coun­tries indiscriminately.

BANK CREDIT FEEDS THE BOOM

Armed with “AAA credit” bor­rowed from Ger­many, Europe entered the next phase of the cycle: bank credit feeds the boom. As Euro­pean bond yields con­verged to Ger­many under the united cur­rency, it appeared that Europe had entered a new era of exchange rate and inter­est rate sta­bil­ity. How­ever, this con­ver­gence weak­ened mar­ket dis­ci­pline and spurred mount­ing lever­age in Europe’s pub­lic and pri­vate sec­tors. Money was unprece­dent­edly cheap for many sov­er­eign nations and, con­se­quently, the pri­vate sec­tor also saw huge declines in inter­est rates. For exam­ple, neg­a­tive real inter­est rates in Spain and Ire­land fueled real estate booms. Europe ended up with a one-size-fi ts-none mon­e­tary policy.

Impor­tantly, when bank credit feeds the boom, Kindle­berger explains that the fi nan­cial sys­tem often spawns “new” forms of money. This is known as the elas­tic­ity of credit, and it facil­i­tates bor­row­ing and spec­u­la­tion. In Europe, Basel cap­i­tal rules facil­i­tated the elas­tic­ity of credit. Using the assump­tion that devel­oped mar­ket sov­er­eigns would not default, Basel cap­i­tal rules had loop­holes that allowed banks to hold sov­er­eign bonds with­out some off­set­ting charge to risk-based cap­i­tal. As a result, bank appetite for sov­er­eign bonds was endur­ing despite dete­ri­o­rat­ing credit profi les in coun­tries like Greece and Por­tu­gal. With­out any cap­i­tal charge for sov­er­eign bonds, this cre­ated unchecked lever­age on bank bal­ance sheets.

The wave of secu­ri­ti­za­tion and the rise of repur­chase and sale (or “repo”) agree­ments also spawned new forms of money that fed the credit boom. The secu­ri­ti­za­tion and repo mar­kets were the dark cor­ners in which the global fi nan­cial cri­sis man­i­fested itself, because the run on Lehman Broth­ers’ assets occurred in the repo mar­ket, not out­side the broker-dealer’s front door. Sim­i­larly, the Euro­pean bank­ing cri­sis and rush for liq­uid­ity is occur­ring through the inter­bank repo markets.

The repo mar­ket, like bank­ing, is a vehi­cle of liq­uid­ity trans­for­ma­tion. Banks secure fund­ing in short-term liq­uid mar­kets, lend in longer-dated less liq­uid mar­kets and col­lect the inter­est rate spread between the two. Liq­uid­ity trans­for­ma­tion is sus­cep­ti­ble to pan­ics and runs if short-term lenders lose faith and demand imme­di­ate repay­ment. Banks have deposit insur­ance to limit runs, but only up to cer­tain cash lim­its, say €250,0001. In the repo mar­ket, where the sums of money are in the bil­lions, bor­row­ers post col­lat­eral, which serves as insur­ance to let lenders know their money should be safe. This col­lat­eral, usu­ally a pool of loans or bonds, allows banks to secure cru­cial fund­ing liq­uid­ity through short-term loans.

Secu­ri­ti­za­tion and the repo mar­ket expanded the elas­tic­ity of credit that fed the boom. In a cir­cu­lar fash­ion, they also increased the demand for eli­gi­ble col­lat­eral to post as insur­ance in the repo mar­ket. This is where the fi nan­cial engi­neers went to work and helped cre­ate AAA col­lat­eral out of worth­less loans to sub­prime bor­row­ers. By not requir­ing cap­i­tal charges on sov­er­eign bonds, the laissez-faire reg­u­la­tory envi­ron­ment also made sov­er­eign bonds highly val­ued col­lat­eral in repo transactions.

SPECULATION, OVERTRADING & GEARING

As the cycle churned on, the urge to spec­u­late in sov­er­eign bonds, real estate and struc­tured prod­ucts drove prices higher, and the veloc­ity of money (rate at which money changes hands) expanded. This is typ­i­cal of booms—easy credit and the increased wealth that accom­pa­nies soar­ing asset val­u­a­tions feed a sense of eupho­ria and the per­cep­tion that asset val­ues will increase indefi nitely. Greed enters. In Europe, pri­vate and pub­lic investors were rid­ing high. They will­ingly sus­pended their dis­be­lief, seduced into think­ing the music would never stop. Liq­uid­ity trans­for­ma­tion, espe­cially in the repo mar­ket, tends to be very pro-cyclical. As long as prices rise and col­lat­eral val­ues remain sta­ble, there is ample market-based liq­uid­ity to fuel the over­trad­ing and gear­ing (lever­age) of assets. It was cir­cum­stances like these that led Irish banks to lend against ques­tion­able assets six times the size of the nation’s econ­omy with­out being ques­tioned. Accord­ing to Minsky’s fi nan­cial insta­bil­ity hypoth­e­sis, this is the time when the fi nan­cial sys­tem starts becom­ing highly spec­u­la­tive and shaky despite the appear­ance of sta­bil­ity. Just look at how sta­ble Euro­pean bond yields were before the cri­sis, hid­ing deep­rooted credit prob­lems in the periph­eral markets.

INSIDERS TAKE PROFIT AND THE RUSH FOR LIQUIDITY

Finally, the cycle grinds to the point at which insid­ers start to take profi ts, pre­cip­i­tat­ing a rush for liq­uid­ity. Insid­ers are investors who pos­sess an infor­ma­tion advantage—and they rep­re­sent a pow­er­ful real­ity that fl ies in the face of eco­nomic the­ory and mod­el­ing. If insid­ers or lenders begin to worry that the col­lat­eral pool (of sov­er­eign bonds, bank loans, struc­tured prod­ucts) is weak­en­ing, they can demand bet­ter col­lat­eral or a big­ger hair­cut (the dif­fer­ence in value between the actual money lent ver­sus the posted col­lat­eral). These increased require­ments com­pro­mise bor­row­ers’ abil­ity to fund their liq­uid­ity trans­for­ma­tion, fear unseats greed, and the pan­icked rush for liq­uid­ity is on. Bor­row­ers are forced to sell assets and reduce lever­age, caus­ing prices to abruptly reverse.

The fact that trans­ac­tional money (or market-based liq­uid­ity) and credit (like the repo mar­ket) are not fac­tored into tra­di­tional eco­nomic mod­els is a crit­i­cal rea­son why these mod­els failed to iden­tify the sever­ity of the global fi nan­cial cri­sis or its rever­ber­a­tions through­out the inter­con­nected fi nan­cial sys­tem. It was in the repo mar­ket that the insid­ers fi rst began to take profi ts dur­ing the Euro­pean sov­er­eign and bank­ing panic of 2011, just as they had done three years ear­lier when Lehman Broth­ers imploded. As shown in the chart to the right, dur­ing the sum­mer and fall of 2011, the level of repo reported by the Fed­eral Reserve and Euro­pean Cen­tral Bank (ECB) was declin­ing, sig­nal­ing insid­ers’ stress and the rush for liq­uid­ity. Though most tra­di­tional mod­els may have missed the signs of spec­u­la­tive fi nance and grow­ing insta­bil­ity, the Min­sky Model helps high­light these risks, at least fi guratively.

REVULSION, FRAUD, DISCREDIT AND THE LENDER OF LAST RESORT

Once the liq­uid­ity reverses, caus­ing a fi nan­cial crash and cri­sis, the fi nger point­ing begins. Heroes turn to vil­lains as revul­sion, fraud and dis­credit creep in. Banker revul­sion has become an endur­ing issue, the Greek fraud as to the true size of its national debt has been dis­closed, and the notion that a devel­oped mar­ket sov­er­eign could not default was dis­cred­ited. The saga has fol­lowed the typ­i­cal sequenc­ing of a fi nan­cial cri­sis, but a crit­i­cal ques­tion remains: have we moved past revul­sion, fraud, dis­credit and turned the cor­ner toward recovery?

Accord­ing to Kindleberger’s fi gura­tive descrip­tion of Minsky’s liq­uid­ity cycle, we should be turn­ing the cor­ner on the bust phase of the global liq­uid­ity cycle because lenders of last resort have fi nally promised suffi cient liq­uid­ity to restore order—or have they?

In our pre­vi­ous updates on the Euro­pean cri­sis, we were very crit­i­cal of the ECB because it was, in our view, not act­ing like a cred­i­ble lender of last resort. There was a rush for liq­uid­ity when the Euro­pean repo mar­ket plum­meted in the fall of 2011. Widen­ing credit spreads, falling equity prices and tighter bank credit indi­cated the mar­kets were scream­ing for liq­uid­ity. At that time, we believed that the ECB needed to expand its bal­ance sheet much more aggres­sively and meet the ris­ing demand for liq­uid­ity. The ECB has since responded, and its bal­ance sheet is expand­ing rapidly. Most recently, the ECB broke the fever of risk aver­sion with its three-year Long-Term Refi nanc­ing Oper­a­tion (LTRO), which deliv­ered liq­uid­ity to the bank­ing sys­tem and should help avert the devel­op­ment of a severe credit crunch.

While cen­tral bank liq­uid­ity buys time, it does not fi x the fun­da­men­tal sol­vency ques­tion of whether there is enough future income to ser­vice out­stand­ing debts. The say­ing “a rolling loan gath­ers no loss” is a nice thought, but even­tu­ally bad debt has to be rec­og­nized, and some­one has to take a loss. The gear­ing, or lever­age, from the past decade’s credit boom was mas­sive and is tak­ing a long time to resolve. It takes time to reveal which assump­tions on future income, prices and profi tabil­ity lev­els were faulty when lever­age was ris­ing rapidly. Recent infor­ma­tion on some Euro­pean bal­ance sheets, includ­ing the Greek sov­er­eign bal­ance sheet, has revealed such extreme gear­ing that it is unre­al­is­tic to think future incomes and tax rev­enues will be suffi cient to ser­vice the debt. For now, pol­icy mak­ers are try­ing to for­tify bal­ance sheets before rec­og­niz­ing any poten­tial losses to min­i­mize sys­temic risks. In our view, we are not through the process of unwind­ing lever­aged bal­ance sheets; that is why we have had such a hard time reach­ing escape veloc­ity from the fi nan­cial cri­sis despite repeated attempts by cen­tral banks to pro­vide suffi cient liq­uid­ity. The halt­ing eco­nomic recov­ery sug­gests cen­tral banks will have to fi ght any urge to pre­ma­turely reduce their uncon­ven­tional liq­uid­ity provisions.

Nev­er­the­less, the fact that the ECB has laid its cards on the table and is act­ing like a lender of last resort, despite its tough rhetoric, is good news. Other cen­tral banks have also moved to pro­vide more liq­uid­ity: the Fed­eral Reserve, for exam­ple, recently gave guid­ance that inter­est rates will stay very accom­moda­tive until late 2014; the Bank of Japan has imple­mented an infl ation goal of 1.0% and will use quan­ti­ta­tive eas­ing to pur­sue its objec­tive; the People’s Bank of China cut its cap­i­tal reserve require­ments and has been rolling loans to local gov­ern­ments; the Brazil­ians, Aus­tralians, Swedes and Nor­we­gians all cut inter­est rates. Coör­di­nated cen­tral bank actions are help­ing to boost risk appetites glob­ally. These are pos­i­tive signs for reduc­ing major sys­temic tail risks going forward.

So, if cen­tral banks are try­ing to restore order by promis­ing suffi cient liq­uid­ity, should we now focus on iden­ti­fy­ing where bank credit could feed the next boom? Our answer is a resound­ing yes. The next boom always seems to rise from the ashes of the pre­vi­ous bust, just as the global hous­ing bub­ble rose from the easy money poli­cies that fol­lowed the 1990s tech­nol­ogy bust. For now, investors should look around the world and deter­mine which bank­ing sys­tems appear healthy enough to pro­vide that elas­tic­ity of credit. In many devel­oped mar­kets, there are still major head­winds to a tra­di­tional bor­row­ing– and spending-driven recov­ery. The con­sumer and pub­lic sec­tors appear less will­ing or able to lever­age their bal­ance sheets to pro­vide that extra boost to growth. Emerg­ing mar­kets, on the other hand, should still have ample room to grow. How­ever, we sug­gest investors remain vig­i­lant, watch­ing for any sign that boom­ing credit has sown the seeds of Kindleberger’s “hardy perennial.”

Charles P. Kindle­berger (1910–2003) was an Amer­i­can econ­o­mist and eco­nom­ics pro­fes­sor. His noted works include Manias, Pan­ics, and Crashes, A His­tory of Finan­cial Crises, first pub­lished in 1978 (John Wiley & Sons, Inc.).

Hyman P. Min­sky (1919–1996) was an Amer­i­can econ­o­mist and eco­nom­ics pro­fes­sor. His noted works include Sta­bi­liz­ing an Unsta­ble Econ­omy, first pub­lished in 1986 (Yale Uni­ver­sity Press).

Past mar­ket expe­ri­ence is no guar­an­tee of future results.

This arti­cle is pro­vided for infor­ma­tional pur­poses only and should not be con­strued as invest­ment advice. Any opin­ions or fore­casts con­tained herein reflect the sub­jec­tive judg­ments and assump­tions of the authors only and do not nec­es­sar­ily reflect the views of Loomis, Sayles & Com­pany, L.P., or any port­fo­lio man­ager. Invest­ment rec­om­men­da­tions may be incon­sis­tent with these opin­ions. There can be no assur­ance that devel­op­ments will tran­spire as fore­casted and actual results will be dif­fer­ent. Data and analy­sis does not rep­re­sent the actual or expected future per­for­mance of any invest­ment product.

We believe the infor­ma­tion, includ­ing that obtained from out­side sources, to be cor­rect, but we can­not guar­an­tee its accu­racy. The infor­ma­tion is sub­ject to change at  any time with­out notice.

MALR008968 LEGREV122812

Copy­right © Loomis Sayles

Tags: Associate Director, Boom And Bust, Brazil, Charles Kindleberger, Cynical World, Debt Crisis, Economic Historian, Economic Theory, Extreme Event, Greed, Human Dynamics, Human Emotions, liquidity, Loomis Sayles, Market Behavior, Nancial, Panics, Policy Responses, Quantitative Models, Sovereign Debt, Thomas Fahey
Posted in Markets | Comments Off

Alfred Lee: Investment Outlook (March-April 2012)

Sunday, March 25th, 2012

Invest­ment Out­look, March 2012

Silent Waters Run Deep

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

As we artic­u­lated in last month’s report, equity mar­ket volatil­ity remains eerily quiet given the num­ber of macro-economic issues that remain largely unre­solved. With the news of Greece agree­ing to a debt restruc­tur­ing deal, the con­cern of a Euro­pean sov­er­eign debt cri­sis has been put on the back burner and the mar­ket has shifted its focus to U.S. eco­nomic data, which con­tin­ues to come in bet­ter than expected. The deci­sion by the Inter­na­tional Swaps and Deriv­a­tives Asso­ci­a­tion Inc. (ISDA) to deem the Greek bond deal a default, also restores faith in credit default swaps (CDS)1 as a viable insur­ance pol­icy for debt issuances, which will help Euro­pean sov­er­eigns keep their yields lower over the short-term. Although, U.S. eco­nomic data con­tin­ues to impress, con­cerns of the other, and larger, PIIGS2 nations, are being overlooked.

The con­tin­u­a­tion of the cur­rent rally does hinge to a degree on U.S. eco­nomic data and its abil­ity to con­tinue gath­er­ing pos­i­tive momen­tum. Most notably, unem­ploy­ment is down to 8.7% in its Decem­ber read­ing, from 9.1% in Sep­tem­ber. In addi­tion, there is a grow­ing, albeit small, trend of “on-shoring” where man­u­fac­tur­ing jobs are com­ing back state­side, due to ris­ing labour costs in cer­tain emerg­ing mar­kets. Recent opti­mism of the U.S. econ­omy has led the mar­ket to quell their expec­ta­tions for an addi­tional round of quan­ti­ta­tive eas­ing, or fur­ther stim­u­lus from the U.S. Fed­eral Reserve (Fed). As a result, our short-term momen­tum indi­ca­tors show that gold prices have stalled, and is the rea­son we remain neu­tral on pre­cious metals.

Despite the re-pricing of asset mar­kets to reflect improv­ing U.S. eco­nomic fun­da­men­tals and a lower per­cep­tion of tail-risk3, the CBOE/S&P Implied Volatil­ity Index (“VIX”)4 remains abnor­mally sup­pressed. In mid-March, the VIX had an intra­day print of 13.99, which would be con­sid­ered low dur­ing a sec­u­lar bull-market and well below its long-term aver­age of 20. As volatil­ity has a ten­dency to quickly revert to its aver­age, we remain cau­tiously opti­mistic on risk assets. While we have moved over­weight to equi­ties, we remain defen­sively posi­tioned in our equity expo­sure, in order to bet­ter dis­trib­ute risk across our strat­egy. Although we have become more pos­i­tive on equi­ties over the mid-term, we believe there are unre­solved struc­tural issues which will weigh on equi­ties in the long-term.

Notable Changes to the Mix

• Global equi­ties have ral­lied sig­nif­i­cantly over the course of the last five months with the MSCI All Coun­try World Index (ACWI) gain­ing 23.9% from its Octo­ber lows. More encour­ag­ing has been the breadth of the rally, with all sec­tors con­tribut­ing to the strength of its ascent. As the over­hangs on the mar­ket have been more macro-economically related, a ris­ing tide lifts all boats as the mar­kets have re-priced a lower prob­a­bil­ity of an imme­di­ate tail-risk event.

• We have decreased our allo­ca­tion to fixed income and increased our weight in equi­ties and cash. Though attrac­tive from a fun­da­men­tal per­spec­tive, the equity mar­ket con­tin­ues to look over­bought in the short-term based on tech­ni­cal and quantitative-based momen­tum indi­ca­tors. Con­se­quently, we antic­i­pate some short-term con­sol­i­da­tion. By increas­ing our cash posi­tion, it allows us to be more nim­ble and take advan­tage of any upcom­ing oppor­tu­ni­ties and slowly increase our weight towards tac­ti­cal oppor­tu­ni­ties in equi­ties. In addi­tion, the ongo­ing equity rally could put upward pres­sure on inter­est rate expec­ta­tions, which is why we have over-weighted the short-and mid-part of the yield curve to lower our dura­tion risk.

• Com­ing into the new year, we were bear­ish on Cana­dian equi­ties. Though we have raised our posi­tion­ing to neu­tral, we believe that weaker gold prices and con­cerns over China tar­get­ing lower growth expec­ta­tions will weigh on the S&P/TSX Com­pos­ite Index (TSX). We do how­ever remain bull­ish toward cer­tain areas within Cana­dian equi­ties such as lower volatil­ity equi­ties and div­i­dend pay­ing equi­ties, and we are rec­om­mend­ing the BMO Low Volatil­ity Cana­dian Equity ETF (ZLB) and BMO Cana­dian Div­i­dend ETF (ZDV), respec­tively, to access these areas.

New Additions/Deletions to Strategy:

• One of the areas where we have been bull­ish over the last six­teen months has been U.S. equi­ties. More specif­i­cally, we were bull­ish on the large-cap blue chip com­pa­nies, the rea­son why we have been rec­om­mend­ing the BMO Dow Jones Indus­tri­als Aver­age Hedged to CAD Index ETF (ZDJ). Though we still favour the stocks in the Dow Jones Indus­trial Aver­age (Dow), higher oil prices and a buoy­ant U.S. dol­lar, will weigh on the multi­na­tion­als in the Dow. More­over, improv­ing eco­nomic con­di­tions and on-shoring will likely lead to an improv­ing busi­ness envi­ron­ment for some of the smaller, more locally based U.S. com­pa­nies. We are there­fore par­ing back some of our expo­sure to ZDJ in favour of the BMO U.S. Equity Hedged to CAD Index ETF (ZUE) in our strat­egy mix.

• Last week, the Fed released the results of the U.S. bank stress test, which came in over­whelm­ingly pos­i­tive. Of the 19 banks, 15 were given pass­ing grades. Fur­ther­more a num­ber of the banks were given approval by the Fed to raise its div­i­dends. This news added a fur­ther tail­wind to the U.S. bank­ing sec­tor, as it con­tin­ues to show lead­er­ship amongst the U.S. equity sec­tors. Cur­rently, the BMO Equal Weight U.S. Banks Hedged to CAD Index ETF (ZUB), which tracks the Dow Jones U.S. Large-Cap Banks Equal Weight Total Stock Mar­ket Index CAD Hedged Index, trades at a for­ward price-to-earnings (P/E) ratio of 11.9x, a dis­count to the 13.5x for­ward P/E of the S&P 500 Com­pos­ite Index. Our tech­ni­cal indi­ca­tors sug­gests that pos­i­tive momen­tum in ZUB has returned, some­thing we like to see in assets trad­ing at attrac­tive val­u­a­tions as we want to avoid value traps. Given the sec­tor remains vul­ner­a­ble we rec­om­mend investors con­sider uti­liz­ing a trail­ing stop loss order of no more than 10% and limit their allo­ca­tion to mit­i­gate risk.

Things to Keep and Eye On

Last month, we men­tioned that most broad equity mar­ket indices, includ­ing the TSX, were trad­ing at a dis­count to their respec­tive 10-year aver­ages. This month we wanted to take a closer look at the TSX to deter­mine which of the sec­tors look more attrac­tive from a val­u­a­tion stand­point. We used the cur­rent price-to-earnings (P/E) ratios of the sec­tor index rel­a­tive to its own 10-year aver­age using his­tor­i­cal daily data. It should be noted that 10-years may not be a long enough period to demon­strate the sec­u­lar trend in equi­ties; how­ever, the 2008 finan­cial cri­sis should also com­press a 10-year aver­age P/E ratio, mak­ing a more strin­gent bench­mark for deter­min­ing which sec­tors are attrac­tive on a his­tor­i­cal basis. In addi­tion, investors should also note that since the TSX lacks depth in a num­ber of its sec­tors, the val­u­a­tion of those sec­tors can be heav­ily impacted by indi­vid­ual com­pa­nies. Infor­ma­tion tech­nol­ogy and health care are prime exam­ples of sec­tors lack­ing depth.

Rec­om­men­da­tion: A num­ber of the sec­tors trad­ing at a dis­count to their 10-year aver­age in terms of P/E are well rep­re­sented in the BMO Low Volatil­ity Cana­dian Equity ETF (ZLB). Although the mar­ket has rotated into more cycli­cal ori­ented areas, we con­tinue to favour lower volatil­ity areas in the equity mar­ket as a long-term core hold­ing. As men­tioned, in our recent BMO Trade Oppor­tu­nity report, a com­bi­na­tion of ZLB with the BMO S&P/TSX Equal Weight Global Base Met­als Index ETF (ZMT) pro­vides investors with a solid long-term hold­ing com­bined with a more tac­ti­cal ori­ented opportunity.

Since the 2008 finan­cial cri­sis, there has been an increas­ing con­cern of run­away infla­tion due to the stim­u­la­tive mea­sures and accom­moda­tive mon­e­tary poli­cies of cen­tral banks around the world. Although it can be argued that the Con­sumer Price Index (CPI) is not a good rep­re­sen­ta­tion of true infla­tion, espe­cially given the ele­vated prices of hard assets over the decade, CPI for the U.S. remains at 2.9%, well below its long-term aver­age of 3.4%. One of the key rea­sons why an increase in money sup­ply has not trans­lated to infla­tion is due to a slower money velocity7, which has decreased sub­stan­tially since the 2008 finan­cial cri­sis as a result of greater uncer­tainty with the busi­ness envi­ron­ment. Should the recent improve­ment in U.S. eco­nomic data and unem­ploy­ment prove to be a sus­tained trend, the rate at which money changes hands could increase, even­tu­ally mak­ing infla­tion a concern.

Rec­om­men­da­tion: As U.S. mon­e­tary pol­icy indi­rectly affects the actions of other cen­tral banks and par­tic­u­larly the Bank of Canada, investors should keep an eye on the actions of the Fed. Although not an imme­di­ate con­cern, an uptick in money veloc­ity could poten­tially make infla­tion a prob­lem sev­eral years down the road. As a result, we con­tinue to favour short– and mid-term bonds as a means of decreas­ing interest-rate risk (See Cross-Asset Allo­ca­tion Mix Table for our rec­om­mended exposures).

In recent weeks, there has been much dis­cus­sion about the diverg­ing trends between the VIX and the Credit Suisse Fear Barom­e­ter Index (CSFB)5. Both indices are used as a gauge of mar­ket sen­ti­ment with higher read­ings indi­cat­ing increased ner­vous­ness with investors. In recent months, the VIX has dropped sig­nif­i­cantly whereas the CSFB has steadily risen. The VIX is reflec­tive of the market’s cur­rent antic­i­pa­tion of volatil­ity over the next 30-days, annu­al­ized. The CSFB, on the other hand, is cal­cu­lated as a zero-cost collar6, using three-month options. As such, there are a num­ber of dif­fer­ences in the two indices, includ­ing dif­fer­ent matu­rity terms of the under­ly­ing options, mak­ing a diver­gence pos­si­ble depend­ing on the term struc­ture in volatil­ity. Also worth men­tion­ing, is that the VIX cal­cu­lates volatil­ity using options on indi­vid­ual com­pa­nies whereas the CSFB uses index options.

Rec­om­men­da­tion: As we noted at the onset of the year, the term struc­ture in the VIX futures curve is cur­rently upward slop­ing and rel­a­tively steep in the first three con­tracts, which has made a diver­gence between the two “fear indices” pos­si­ble. The term struc­ture for VIX can be inter­preted as the market’s cur­rent expec­ta­tion for volatil­ity in the future. Although the term struc­ture for the VIX futures changes over time, and it is pos­si­ble that the term struc­ture could flat­ten, the VIX is well below its long-term aver­age and can­not get much lower. We con­tinue to advise investors that short– and mid-term bonds should not be neglected as a risk mit­i­ga­tion tool and that investors should con­tinue to main­tain expo­sure to defen­sive ori­ented areas in the equity mar­ket.

Oil prices have seen a steady rise since early Octo­ber reflect­ing an increase in opti­mism of a global eco­nomic recov­ery. Though polit­i­cal tur­moil has had more of a direct impact on the prices of Brent crude (Brent), West Texas Inter­me­di­ate (WTI) which is more reflec­tive of North Amer­i­can oil prices has seen an indi­rect impact due to a chang­ing demand and sup­ply equi­lib­rium. Last year on Sep­tem­ber 26, we rec­om­mended investors invest in energy through our BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO), which has gained 13.7% on a total return basis since. Energy com­pa­nies remain our top invest­ment idea within the com­mod­ity sec­tor based on global macro-economic and polit­i­cal forces. More­over, both Brent and WTI prices tend to strengthen the first seven months of the year, which could pro­vide an addi­tional tail-wind for oil prices.

Rec­om­men­da­tion: Although we would never make an invest­ment rec­om­men­da­tion based on sea­son­al­ity alone, the ten­dency for oil to gain in the first half of the year does pro­vide us with an addi­tional rea­son to be pos­i­tive on energy com­pa­nies. How­ever, as we men­tioned last month, since oil does have a ten­dency to be very reac­tive to macro-economic risk, we con­tinue to rec­om­mend a trail­ing stop-loss order of 10% on BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO). Investors that acted on the trade in Octo­ber may also want to con­sider par­ing back their expo­sure to their orig­i­nal allocation.

Cross-Asset Asset Allo­ca­tion Mix using BMO ETFs (click to enlarge)

Foot­notes

1 Credit Default Swaps (CDS): A swap agree­ment where the seller of the CDS will com­pen­sate the buyer in the event of a loan default or other credit event. The buyer of a credit default swap receives credit pro­tec­tion, whereas the seller of the swap guar­an­tees the credit wor­thi­ness of the debt secu­rity. In doing so, the risk of default is trans­ferred from the holder of the fixed income secu­rity to the seller of the swap. As such, a ris­ing CDS price indi­cates an increas­ing prob­a­bil­ity of a default on a fixed income issue, while a declin­ing price indi­cates a lower prob­a­bil­ity.
2 PIIGS: An acronym used to refer to the five euro­zone nations, which were con­sid­ered weaker eco­nom­i­cally fol­low­ing the finan­cial cri­sis: Por­tu­gal, Italy, Ire­land, Greece and Spain.
3 Tail-risk: The risk of an out­lier or improb­a­ble event occur­ring. Sta­tis­ti­cally, the event is said to be three stan­dard devi­a­tions or more away from the mean, under a nor­mally dis­trib­uted curve.
4 CBOE/S&P 500 Implied Volatil­ity Index (VIX): shows the market’s expec­ta­tion of 30-day volatil­ity. It is con­structed using the implied
volatil­i­ties of a wide range of S&P 500 index options. This volatil­ity is
meant to be for­ward look­ing and is cal­cu­lated from both calls and puts.
The VIX is a widely used mea­sure of mar­ket risk and is often referred to
as the “investor fear gauge”.
5 Credit Suisse Fear Barom­e­ter (CSFB): mea­sures investor sen­ti­ment for 3-month invest­ment hori­zons by pric­ing a zero-cost col­lar. The col­lar is imple­mented by sell­ing of a 10% out-of-the-money call (OTM) option on
the S&P 500 Com­pos­ite (SPX) and using the pro­ceeds to buy an OTM put.
The CSFB level rep­re­sents how far OTM that SPX put is.
6 Zero-cost col­lar: con­sists of the simul­ta­ne­ous sale of one option and using
the pro­ceeds towards the pur­chase of another option at dif­fer­ent strikes.
7 Money veloc­ity: aver­age fre­quency with which a unit of money is spent on new goods and ser­vices pro­duced domes­ti­cally in a spe­cific period of time.

Tags: Alfred Lee, Asset Markets, BMO, Canadian, Canadian Market, Cboe, Cmt, Credit Default Swaps, Debt Crisis, Debt Restructuring, Economic Fundamentals, ETF, ETFs, European Sovereigns, Gold Prices, Investment Outlook, Investment Strategist, Labour Costs, Market Volatility, Mining, Momentum Indicators, precious metals, Silent Waters, Structured Investments, Volatility Index, Volatility Index Vix
Posted in Markets | Comments Off

Understanding the New Price of Oil (Martenson)

Wednesday, March 14th, 2012

by Gre­gor Mac­don­ald via Chris Marten­son

Under­stand­ing The New Price Of Oil

In the Spring of 2011, when Libyan oil pro­duc­tion — over 1 mil­lion bar­rels a day (mpd) — was sud­denly taken offline, the world received its first real-time test of the global pric­ing sys­tem for oil since the crash lows of 2009.

Oil prices, already at the $85 level for WTIC, bolted above $100, and even­tu­ally hit a high near $115 over the fol­low­ing two months.

More impor­tantly, how­ever, is that — save for a brief eight week period in the autumn — oil prices have stub­bornly remained over the $85 pre-Libya level ever since. Even as the debt cri­sis in Europe has flared.

As usual, the main­stream view on the world’s abil­ity to make up for the loss has been wrong. How could the removal of “only” 1.3% of total global pro­duc­tion affect the oil price in any pro­longed way?, was the uni­ver­sal view of “experts.”

Answer­ing that ques­tion requires that we mod­ern­ize, effec­tively, our under­stand­ing of how oil's numer­ous price dis­cov­ery mech­a­nisms now oper­ate. The past decade has seen a num­ber of enor­mous shifts, not only in sup­ply and demand, but in mar­ket per­cep­tions about spare capac­ity. All these were very much at play last year.

And, they are at play right now as oil prices rise once again as the global econ­omy tries to strengthen.

The Sub­or­di­na­tion of Cushing

Through the dom­i­nant force of its own demand, the US econ­omy largely con­trolled the oil price for many decades. For years, it was com­mon prac­tice there­fore to gauge world demand through the weekly updates to oil stor­age at Cush­ing, Okla­homa as well as total oil stor­age in the United States. If the US was demand­ing more oil from the global mar­ket, and thus either not adding to oil inven­to­ries or draw­ing them down, then a sig­nal was given, point­ing to future oil price strength.

But this dynamic began to break down com­ing into 2005–2007. That was the period when US oil demand — because of ris­ing prices — began its cur­rent decline. Now that US oil demand is down over 12% from its mid-decade peak, the fluc­tu­a­tion of oil inven­to­ries in the US no longer drive prices.

The chart below shows that US inven­to­ries have been on an upward trend since 2005, and are now near decadal highs above 300 mil­lion bar­rels even though oil prices are back above $100:

What we're now see­ing is that US inven­to­ries and US demand are now sub­or­di­nate to numer­ous other fac­tors, rang­ing from emerg­ing mar­ket demand, to mar­ket per­cep­tion of spare capacity.

Lessons of Libya

A use­ful fact learned dur­ing last year's Libyan civil war is that Saudi Ara­bia does not nec­es­sar­ily posses the 2–3 mbpd of spare capac­ity which most have assumed for years. More­over, Saudi Ara­bia ceded the posi­tion of top world oil pro­ducer to Rus­sia over 5 years ago in 2006. Indeed, Saudi Ara­bia made no pro­duc­tion response to the loss of Libyan oil last spring. Pro­duc­ing near 9 mbpd, it was only by June that Saudi pro­duc­tion was lifted by 600 thou­sand bar­rels a day (kbpd). That is a hefty pro­duc­tion increase to be sure, but it raised ques­tions as to how quickly spare capac­ity in the world can be brought online.

By the time Saudi Ara­bia had lifted pro­duc­tion, the OECD coun­tries led by the IEA in Paris had already decided to release oil from offi­cial inven­to­ries. But this, too, did lit­tle to calm oil prices — and as I pointed out last June, only cre­ated fur­ther prob­lems. In The Dark Side of the OECD Oil Inven­tory Release, I explained that, by low­er­ing OECD inven­to­ries, the mar­ket would cor­rectly deduce that safety buffers had been reduced fur­ther. Com­bined with the Saudi increase in pro­duc­tion, this only reduced spare capac­ity further.

The result was even stronger prices as WTIC ran back to $100 (until all global mar­kets floun­dered on a flare-up in the EU finan­cial cri­sis). Indeed, it is no longer US inven­to­ries of crude oil but the fluc­tu­a­tions in the emer­gency cush­ion of all inven­to­ries in the OECD (of which the US is part) that is now the more impor­tant fac­tor in oil prices:

The loss of Libyan pro­duc­tion caused a dra­matic draw­down of OECD total oil stocks, which were already in a down­ward trend start­ing the pre­vi­ous sum­mer in 2010. OECD inven­to­ries fell on both an absolute basis and on a com­par­a­tive basis to the trail­ing 5 Year Aver­age as the above chart shows. Tak­ing these inven­to­ries from a high of 2800 mb to 2600 mb only 6 months later, com­bined with unrest across the entire Mid­dle East, was more than enough sup­port to boost WTIC oil prices from $85 to above $100 last spring. Addi­tion­ally, as we can see in the chart, the decline in OECD oil inven­to­ries was main­tained into the end of 2011.

These are impor­tant con­di­tions to con­sider when try­ing to under­stand how oil prices now, in early 2012, are once again on the rise.

The Decline of Spare Pro­duc­tion Capacity

The lat­est global pro­duc­tion data shows that Saudi Ara­bia was pro­duc­ing 9.4 mbpd on aver­age dur­ing 2011, an increase of 500 kbpd over 2010. To accom­plish this, The Saudis had to increase pro­duc­tion from 9 mbpd in 1H 2011 to 9.8 mbpd dur­ing 2H of 2011. But para­dox­i­cally, this pro­duc­tion increase has only made the global oil mar­ket even tighter, as spare capac­ity shrinks further.

Let's recall that nearly 60% of global oil sup­ply comes from out­side of OPEC from coun­tries like the US, Canada, Brazil, Mex­ico, China, Aus­tralia, and the big producer—Russia. There is no spare capac­ity in this non-OPEC group­ing and there hasn’t been for years. Sure, there is oil to be devel­oped in non-OPEC coun­tries; but that is not pro­duc­tion capac­ity (mean­ing it is not sup­ply that can be brought online quickly).

More­over, Rus­sia, the coun­try that single-handedly saved non-OPEC pro­duc­tion from going into steep decline, mas­sively increased its con­tri­bu­tion to world sup­ply in 2002. But in the past two years, it has seen its pro­duc­tion growth taper off and flat­ten, to just shy of 10 mbpd.

That leaves the oil mar­ket, tasked with the job of pric­ing, to fig­ure out the ongo­ing mys­tery that is the "true" spare pro­duc­tion capac­ity in OPEC. That it took 4–5 months for Saudi Ara­bia to increase pro­duc­tion is a con­cern. Such delays should seri­ously give pause to those ana­lysts who’ve regur­gi­tated the belief over years that Saudi has 2–3 mbpd that can be brought on quickly.

Although EIA Wash­ing­ton cur­rently judges OPEC spare capac­ity to be higher than dur­ing the lows of 2003–2008, it's his­toric fig­ures show that spare capac­ity has been declin­ing since a 2009 high.

More­over, the fail­ure of non-OPEC pro­duc­tion to increase within last decade counts as a true sur­prise to the global oil mar­ket. The faith in non-OPEC sup­ply over the last decade helped to keep prices sub­dued, until that faith was shat­tered by 2007's wild spike.

The prob­lem now is that the oil mar­ket has been re-educated. Faith in the non-OPEC coun­tries' abil­ity to increase sup­ply is no more. Mean­while, the great decel­er­a­tion in Russ­ian oil sup­ply growth, has spooked the mar­ket. Com­bined, a mar­ket with 74 mbpd of pro­duc­tion and a the­o­ret­i­cal spare capac­ity of 3 mbpd sim­ply cre­ates too much uncertainty.

And con­sider this: the amount of total spare capac­ity is now equal to the 3 mbpd of demand that’s been taken offline in Europe, Japan, and the United States over the past 7 years, as oil prices have risen from $40 to the $100 level. Thus the oil mar­ket has quite cor­rectly rationed sup­ply, at higher prices. If prices were to fall to $50 or $60, the world’s lost demand could be rebuilt rather quickly.

Killing dis­cre­tionary demand is now the proper func­tion of the oil mar­ket in an age of flat sup­ply growth.

Quan­ti­ta­tive Eas­ing and Granger Causality

We should also remem­ber that the global econ­omy would be mired in a text­book defla­tion­ary depres­sion were it not for the con­tin­ual and gar­gan­tuan US$ tril­lions that have been pro­vided by cen­tral banks since 2008.

Early 2009 saw oil prices slip briefly below $40. But, of course, that's the price level appro­pri­ate to a world dur­ing an indus­trial crash — with reduced ship­ping, halted economies, and dis­lo­cated con­sumer demand. The world can have those prices again, if it chooses. But it must also be will­ing to accept a global reces­sion to achieve such low oil prices.

Thus, there is a mis­con­cep­tion that cur­rency debase­ment is the main dri­ver of oil prices. How­ever, given the new sup­ply real­i­ties, that sim­ply isn't true any longer.

The chart below is help­ful in explain­ing why. There is no ques­tion that com­ing out of 2000, the decline of the US Dol­lar as expressed by the USD Index was a true com­po­nent of the ris­ing oil price. Dur­ing that period, as the USD was falling, global oil sup­ply was still increas­ing. The descent of the US Dol­lar was unques­tion­ably part of the repric­ing process, as the USD Index fell from a high of 120.00 in 2002 to 80.00 in 2005:

But see how the most fero­cious part of oil’s price advance started to unfold after 2005, when, as the USD con­tin­ued falling, the global sup­ply of oil stopped grow­ing.

If we think of this com­pre­hen­sively, we have to con­clude that the debase­ment of cur­ren­cies is no longer the pri­mary fac­tor in the price of oil on a val­u­a­tion basis. Rather, it is that quan­ti­ta­tive eas­ing pre­vents a defla­tion­ary indus­trial col­lapse, thus keep­ing the global econ­omy alive and able to con­sume more energy.

We can there­fore say that in our post-credit bub­ble col­lapse era, and with global oil sup­ply now flat, that quan­ti­ta­tive eas­ing causes higher oil prices (through Granger causal­ity). It keeps economies from col­laps­ing (for now) and thus brings demand up against very tight sup­ply. As we can see from the chart above, the USD Index has for 3 years now been bounc­ing off the bot­tom it first reached in 2008. In a way, this is help­ful because it brings to light the new dom­i­nant fac­tor in global oil prices: supply.

Sup­ply is now Primary

Sup­ply, and the recog­ni­tion of sup­ply, are now the dom­i­nant fac­tor in the oil price. A point so obvi­ous, it hardly seems worth mak­ing. How­ever, the devel­oped world is still largely oper­at­ing on the clas­si­cal eco­nomic view that higher prices will make new oil resources available.

That is true. But, it’s just not true in the way most anticipate.

While higher prices have brought on new sup­ply, these resources have been slow to develop, are more dif­fi­cult to extract, and gen­er­ally flow at lower rates of pro­duc­tion. As the older oil fields of the world decline, the price of oil must reflect the eco­nom­ics of this new tranche of oil resources. There are no vast, new sup­plies of oil that will come online in 2013, 2014, and 2015 at the scale to negate exist­ing global declines.

Dur­ing the entire time that global oil sup­ply has been held at a ceil­ing of 74 mbpd, since 2005, a lot of new pro­duc­tion in the Amer­i­cas and Africa espe­cially has come online. But it has not not enough to increase total world sup­ply. And the price of oil has finally started to price in that new reality.

Here Comes Volatil­ity in Oil Prices

The pric­ing dynamic dis­cussed above is accen­tu­ated by the cri­sis cycle: the repet­i­tive oscil­la­tion between acute and chronic phases of the ongo­ing debt cri­sis, mit­i­gated by cen­tral bank refla­tion­ary policies.

In Part II: Get Ready for Oil Price Volatil­ity to Kill the 'Recov­ery', we fore­cast how today's pro­tractly high recent oil prices are already send­ing a sig­nal that a new hit to global demand is underway.

Gen­er­ally, it appears that the oil price is mak­ing its move too early in the year — which will likely serve as a sucker punch to the frag­ile world econ­omy — thus mak­ing spec­tac­u­larly high prices before year end less likely, and a sharp mar­ket cor­rec­tion and return to eco­nomic reces­sion more so.

Investors will be wise to take pru­dent pre­cau­tions before this nasty wake-up call arrives.

Click here to access Part II of this report (free exec­u­tive sum­mary; enroll­ment required for full access).

Tags: Cushing Oklahoma, Debt Crisis, Dominant Force, Global Economy, Global Production, Gregor Macdonald, Lows, Mainstream View, Market Perceptions, Martenson, Oil Demand, Oil Inventories, Oil Price, Oil Prices, Oil Storage, Price Discovery, Price Of Oil, Price Strength, Russia, Time Test, Universal View, Wtic
Posted in Markets | Comments Off

Is Risk in Emerging Economies Less Than Developed Economies?

Monday, March 12th, 2012

To get an over­all view of the health of emerging-market economies I devel­oped a GDP-weighted man­u­fac­tur­ing PMI as well as a GDP-weighted non-manufacturing/services PMI index using 2010’s GDP con­verted to U.S. dollars.

Fol­low­ing a double-dip in Sep­tem­ber and Novem­ber last year, growth in man­u­fac­tur­ing is steadily increas­ing, with the man­u­fac­tur­ing PMI in Feb­ru­ary ris­ing to 52.0. The PMI is still sig­nif­i­cantly below the recent peak of 54.3 in Jan­u­ary last year.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

In the first half of last year growth in the man­u­fac­tur­ing sec­tor of emerg­ing economies was sig­nif­i­cantly slower than that of the major devel­oped economies. The sov­er­eign debt cri­sis in the Euro­zone lev­eled the score in the sec­ond half, though.

Sources: Markit; HSBC; CFLP; Kag­iso; ISM; Plexus Asset Management.

With a weight of 51.9% China’s man­u­fac­tur­ing sec­tor has a major bear­ing on the emerg­ing economies’ man­u­fac­tur­ing PMI. Nowa­days it is pop­u­lar to say that when China sneezes the other the emerging-market economies catch a cold – yes, the same adage used for the U.S. in the past. My analy­sis indi­cates it is devoid of any truth. It is evi­dent that the trend of my cycli­cally adjusted China CFLP Man­u­fac­tur­ing PMI is out of sync with the GDP-weighted Man­u­fac­tur­ing PMI of the emerg­ing economies exclud­ing China. The grad­ual weak­en­ing of China’s PMI from Octo­ber 2010 to Feb­ru­ary 2011 had no effect on the rest of the emerg­ing economies as the latter’s PMI con­tin­ued to rise until Japan’s ter­ri­ble twin dis­as­ters in March. The Man­u­fac­tur­ing PMI (exclud­ing China) bot­tomed in Sep­tem­ber last year while China’s PMI only bot­tomed in Novem­ber, but the two series are now ris­ing in unison.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

The GDP-weighted PMI (exclud­ing China) is highly cor­re­lated with the GDP-weighted Man­u­fac­tur­ing PMI that I cal­cu­late for the major devel­oped economies.

Sources: Markit; HSBC; CFLP; Kag­iso; ISM; Plexus Asset Management.

Due to lim­ited data, I was forced to focus on the BRIC coun­tries when cal­cu­lat­ing the non-manufacturing/services PMI for emerg­ing economies. Con­trary to the man­u­fac­tur­ing PMI the non-manufacturing/services PMI of the BRICs remained well above 50 at the height of the Euro­zone cri­sis and in Feb­ru­ary regained pre-crisis levels.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

It is note­wor­thy that while the ser­vices sec­tor in the devel­oped economies col­lec­tively was severely affected by Japan’s twin dis­as­ters the ser­vices sec­tor in the BRIC zone was largely unaf­fected. It was only when the Euro­zone cri­sis deep­ened that sig­nif­i­cant weak­ness appeared in the BRIC ser­vices sec­tor. This sec­tor also led the recov­ery as the cri­sis started to dissipate.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

China’s non-manufacturing sec­tor that com­prises 44.7% of the BRIC zone’s non-manufacturing/services PMI ini­tially held up extremely well rel­a­tive to the other BRIC economies when the Euro­zone cri­sis hit the head­lines, but in the end suc­cumbed when the cri­sis deep­ened. The drop in China’s PMI in Feb­ru­ary last year can be ascribed to the later than nor­mal Chi­nese Lunar New Year.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

It is also inter­est­ing to note that growth in the ser­vices sec­tor of the BRIC zone is very steady com­pared to that of the devel­oped economies – even with the stal­wart China excluded.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management

Although the country’s weight is only 3.4%, I included South Africa in the cal­cu­la­tion of a GDP-weighted com­pos­ite PMI (man­u­fac­tur­ing and ser­vices com­bined) for emerg­ing economies as rep­re­sented by the BRICS zone (BRIC plus South Africa).

The BRICS Com­pos­ite PMI recov­ered sharply to 55.5 in Feb­ru­ary after nearly stalling in Novem­ber last year.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

The com­pos­ite PMI of BRICS remained rel­a­tively steady in the after­math of Japan’s twin dis­as­ters but even­tu­ally gave way as the Euro­zone cri­sis deepened.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

Again China’s dom­i­nance in the com­pos­ite PMI had a major impact as it is note­wor­thy that the BRICS Com­pos­ite PMI exclud­ing China bot­tomed in Sep­tem­ber while China’s PMI only bot­tomed two months later.

Sources: Markit; HSBC; CFLP; Kag­iso; Plexus Asset Management.

I asked myself whether rel­a­tive strength in the BRICS com­pos­ite PMI rel­a­tive to devel­oped economies mat­ters in the rel­a­tive per­for­mance of the emerging-market equity indices against mature-market equity indices.

There is clear evi­dence that China’s stock market’s per­for­mance rel­a­tive to the MSCI World Index in terms of U.S. dol­lar is in fact heav­ily influ­enced by the per­for­mance of the under­ly­ing econ­omy rel­a­tive to the global econ­omy as mea­sured by rel­a­tive com­pos­ite PMIs. The der­at­ing of China’s stock mar­ket rel­a­tive to global stock mar­kets in the sec­ond quar­ter of last year stands out. Over the past three months the Chi­nese mar­ket has made up some lost ground but sig­nif­i­cant rel­a­tive upside poten­tial remains.

Sources: Markit; HSBC; CFLP; Kag­iso; I-Net Bridge; Plexus Asset Management.

My research indi­cates that the under­ly­ing econ­omy of India as mea­sured by the com­pos­ite PMI has no bear­ing on the rel­a­tive per­for­mance of the Indian stock mar­ket. The rel­a­tive per­for­mance of China’s econ­omy has a huge impact, though.

Sources: Markit; HSBC; CFLP; Kag­iso; I-Net Bridge; Plexus Asset Management.

As in the case of India the under­ly­ing econ­omy of Brazil as mea­sured by the com­pos­ite PMI has no bear­ing on the rel­a­tive per­for­mance of the Indian stock mar­ket. What I found is that the Brazil­ian stock market’s per­for­mance rel­a­tive to global stock mar­kets is highly cor­re­lated to the GDP-weighted Emerg­ing Economies’ man­u­fac­tur­ing PMI.

Sources: Markit; HSBC; CFLP; Kag­iso; I-Net Bridge; Plexus Asset Management.

In Russia’s case the rel­a­tive per­for­mance of the stock mar­ket is pri­mar­ily influ­enced by oil prices and not the state of the under­ly­ing econ­omy as mea­sured by the com­pos­ite PMI rel­a­tive to the global economy.

Sources: I-Net Bridge; Plexus Asset Management.

The rel­a­tive per­for­mance of the South Africa’s econ­omy also has no bear­ing on the stock market’s per­for­mance. Metal prices are the main determinants.

Sources: I-Net Bridge; Plexus Asset Management.

In con­clu­sion, the emerg­ing economies are not as depen­dent on China as many would like to believe. In light of the steadi­ness of espe­cially the non-manufacturing/services com­pos­ite PMI of BRICs rel­a­tive to that of the JP Mor­gan Global Ser­vices PMI I am of the opin­ion the eco­nomic risk in emerg­ing economies is less than that of devel­oped economies. Do emerg­ing mar­kets then not deserve bet­ter rat­ings and more expo­sure in global diver­si­fied port­fo­lios? It is clear to me that dif­fer­ent fac­tors influ­ence the rel­a­tive per­for­mance of the indi­vid­ual emerg­ing mar­kets and they are there­fore not a homoge­nous group.

Tags: Adage, Asset Management, Bearing, China, Debt Crisis, Disasters, Double Dip, Emerging Economies, Emerging Market Economies, Eurozone, GDP, Ism, Manufacturing Sector, Manufacturing Services, Pmi, Russia, Score, Second Half, Sovereign Debt, Sync, Unison
Posted in Markets | Comments Off

Emerging-Market Stocks Have More Upside, But in Need of Correction

Tuesday, March 6th, 2012

In past arti­cles I referred to the rela­tion­ship between the MSCI Emerg­ing Mar­ket Index expressed in Swiss francs and China’s CFLP Man­u­fac­tur­ing PMI. By using arguably one of the world’s only non-fiat cur­ren­cies the influ­ence of cur­rency move­ments on the MSCI Emerg­ing Mar­ket Index is minimized.

The graph below illus­trates just how out of line and inex­pen­sive emerging-market equi­ties were com­pared to the state of the world’s growth loco­mo­tive in the lat­ter half of 2011 as the Euro­zone debt cri­sis spooked investors. The mar­ket returned to ratio­nal­ity as the cri­sis eased in recent months, with the MSCI Emerg­ing Mar­ket Index in line with February’s PMI of 51.0.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

But where to from here?

After col­laps­ing to 48.3 in Novem­ber last year my sea­son­ally adjusted CFLP Man­u­fac­tur­ing PMI for China increased for the third con­sec­u­tive month to 51.9 in Feb­ru­ary, with the drop in the reserve require­ment rate (RRR) of Chi­nese banks fil­ter­ing through to the econ­omy. As the global econ­omy is not out of the woods yet, the fur­ther cut in the RRR in Feb­ru­ary is likely to lend addi­tional sup­port to the sea­son­ally adjusted PMI and there­fore China’s econ­omy in com­ing months.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

After being held in check by the Golden Week cel­e­bra­tions of China’s lunar New Year from the sec­ond half of Jan­u­ary through mid-February, the unad­justed CFLP Man­u­fac­tur­ing PMI is likely to receive a sig­nif­i­cant sea­sonal boost in March and April.

Sources: CFLP; Li & Fung; Plexus Holdings.

I there­fore argue that the MSCI Emerg­ing Mar­ket Index in terms of Swiss francs is likely to be under­scored by the expected sea­sonal strength in the unad­justed PMI, as well as the accel­er­a­tion in growth as reflected in the sea­son­ally adjusted PMI, on the back of the reduced RRR of Chi­nese banks.

In a pre­vi­ous note I pointed out that changes in the direc­tion of China’s banks’ RRR were soon fol­lowed by direc­tional changes in the Shang­hai Com­pos­ite Index (SSEC 2410.45 ↑0.00%). In the fol­low­ing graph the cumu­la­tive change in the RRR was quan­ti­fied where a 0.5% change in RRR amounts to approx­i­mately US$60 bil­lion. When depicted against the MSCI Emerg­ing Mar­ket Index in Swiss francs it is evi­dent that changes in direc­tion in the RRR are fol­lowed by major changes in direc­tion of the MSCI Emerg­ing Mar­ket Index in CHF. The cuts in the RRR in the last quar­ter of 2008 were fol­lowed by a bot­tom in the MSCI Emerg­ing Mar­ket Index in the first quar­ter of 2009. The hike in the RRR in the first quar­ter of 2010 was ini­tially fol­lowed by the top­ping out of emerging-market equi­ties, while fur­ther increases led to a slump in equity prices. Although equity prices showed an improve­ment at the start of the fourth quar­ter last year the cut in the RRR pulled equity prices out of the doldrums.

Sources: NBSC; I-Net Bridge; Plexus Holdings.

The MSCI Emerg­ing Mar­ket Index has sig­nif­i­cantly out­per­formed the MSCI World Index since Decem­ber last year and is cur­rently in line with China’s unad­justed CFLP Man­u­fac­tur­ing PMI.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

The Shang­hai Com­pos­ite Index in terms of U.S. dol­lars rel­a­tive to the S&P 500 Index (SPX 1350.02 ↓-1.05%) has moved com­pletely out of line with the unad­justed CFLP Man­u­fac­tur­ing PMI, though.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

The appear­ance of another black swan will alter my view but as things are I am of the opin­ion that the rally in emerging-market equi­ties is likely to con­tinue over the next few months. That said, the mar­ket has had a huge run and, being over­bought, it is in des­per­ate need of con­sol­i­da­tion or even a major cor­rec­tion. I con­tinue to favor the Chi­nese stock mar­ket above other emerg­ing mar­kets and devel­oped markets.

Tags: Acceleration, Celebrations, China Economy, China S Economy, Chinese Banks, Currency Movements, Debt Crisis, Emerging Market Stocks, fiat, Fiat Currencies, Global Economy, Locomotive, Lunar New Year, Msci Emerging Market, Msci Emerging Market Index, Nbsc, Pmi, Rationality, Rrr, Swiss Francs
Posted in Markets | Comments Off

China & India PMI Measures Rebound To a Degree

Friday, March 2nd, 2012

Overnight read­ing for Pur­chas­ing Man­agers Indexes in China and India were released.  As always China has two reports, one from the gov­ern­ment which focuses on large and state owned com­pa­nies, and one by pri­vate firm HSBC which has a broader focus – both increased month over month, although the lat­ter still shows a slight con­trac­tionary read­ing.  Mean­while, India's mea­sure rose to an 8 month high.

Via Bloomberg:

• In China, the pur­chas­ing man­agers’ index rose for a third month to 51.0 from 50.5 in Jan­u­ary, the sta­tis­tics bureau and logis­tics fed­er­a­tion said in a state­ment today. In India, a PMI released by HSBC Hold­ings Plc and Markit Eco­nom­ics was close to an eight-month high.
• Today’s data, along with a sur­prise gain in Japan­ese com­pa­nies’ cap­i­tal spend­ing and South Korea’s biggest increase in exports in six months, add to signs that global growth prospects are improv­ing as the U.S. recov­ery strength­ens and Europe works to con­tain its debt crisis.
• In China, the PMI’s level, above the expansion-contraction divid­ing line of 50, was the high­est since Sep­tem­ber and com­pares with the 50.9 median esti­mate in a Bloomberg News sur­vey. Eco­nomic data in the first two months are dis­torted by the week­long Chi­nese New Year holiday.
• A sep­a­rate man­u­fac­tur­ing index released today by HSBC Hold­ings Plc and Markit Eco­nom­ics rose to 49.6 in Feb­ru­ary from 48.8 the prior month, the third straight improve­ment and the high­est since Octo­ber.
• Mean­while, the Indian gauge was at 56.6 in Feb­ru­ary from 57.5 in Jan­u­ary, HSBC and Markit said.
• A fourth-quarter slow­down in exports was prob­a­bly “tran­si­tory” and economic-growth fore­casts for Asia “are too low,” said Con­don, who pre­vi­ously worked at the Inter­na­tional Mon­e­tary Fund.

Of course the num­bers are very noisy in Jan­u­ary and Feb­ru­ary due to sea­sonal effects from the Chi­nese Lunar New Year.

• The subindexes of both PMIs track­ing input costs sug­gested infla­tion­ary threats.  The government-backed sur­vey of input prices rose to 54 in Feb­ru­ary from 50 in the prior month, while HSBC’s sur­vey showed aver­age input costs tick­ing up for the first time in four months.
• Ana­lysts said the surge was a result of higher energy costs and rate hikes by utilities

Keep in mind U.S. ISM Man­u­fac­tur­ing will be released today at 10 AM – it is still one of the few reports that can be mar­ket mov­ing in the haze the cen­tral bankers have over markets.

Tags: Bloomberg News, Chinese New Year, Condon, Contractionary, Debt Crisis, Dividing Line, Economic Data, Economic Growth Forecasts, Global Growth, Growth Prospects, Hsbc Holdings, Hsbc Holdings Plc, International Monetary Fund, Japanese Companies, Markit, Median Estimate, Medium Sized Companies, Private Firm, Purchasing Managers Index, Statistics Bureau
Posted in Markets | Comments Off

Time to Add the VIX to Your Equity Portfolio?

Tuesday, February 28th, 2012

The interim solv­ing of the debt cri­sis in Greece has restored calm in the mar­kets, with the CBOE S&P 500 Volatil­ity Index (VIX) set­tling at 17.3 com­pared to its long-term aver­age of 20.0. The big ques­tion now is whether the VIX will return to the low lev­els of 1991–1996 and 2004–2006.

Sources: CBOE; Plexus Holdings.

But why is it impor­tant? The two peri­ods men­tioned coin­cided with sus­tained strong ris­ing equity mar­kets. Let us take a look at the period 2004 to end 2006. The VIX fell to an aver­age of approx­i­mately 13 over that period, while val­u­a­tion lev­els as mea­sured by Robert Shiller’s PE10 increased sig­nif­i­cantly. Please note that in the graph below I used the inverse of the PE10, which is in fact the earn­ings yield or EY10. The period was marked by strong steady global eco­nomic growth on the back of China’s for­tunes, strong cor­po­rate profit growth and a sig­nif­i­cant increase in risk appetite.

Sources: Robert Shiller; CBOE; Plexus Holdings.

At this stage the market’s rat­ing reflects the VIX, but where to now? While sim­i­lar strong eco­nomic growth etc. may await us fur­ther down the road the same can­not be said for the next two years, let alone this year, as the weak global eco­nomic envi­ron­ment (a much weaker Chi­nese econ­omy, the Eurozone’s con­tin­ued woes and the rel­a­tively weak U.S. econ­omy) is likely to per­sist. I am there­fore of the opin­ion that a VIX of around 20 and a PE10 of 22 can be seen as fair value. These com­pare with the cur­rent VIX of 17.3 and PE10 of 22.6. Yes, opti­mism may drive the VIX down to 15 again and the PE10 to 25 but to me that will indi­cate a sig­nif­i­cant sell­ing oppor­tu­nity. Sim­i­larly, the more reg­u­lar occur­rence of black swans has led to a sig­nif­i­cantly changed invest­ment envi­ron­ment. Yes, it has led to the VIX being more volatile than in the past.

So much for volatil­ity, but what about the under­ly­ing eco­nomic fun­da­men­tals? I have often referred to the rela­tion­ship between con­sumer con­fi­dence and mar­ket val­u­a­tion. Con­sumer spend­ing is the back­bone of the U.S. econ­omy and is there­fore the rea­son why con­sumer con­fi­dence gauges are closely watched by the major mar­ket play­ers. At this stage it is evi­dent that the S&P 500 Index (SPX 1367.59 ↑0.00%) at a PE10 of 22.6 is fully reflect­ing the Con­fer­ence Board Con­sumer Con­fi­dence Index and there­fore the under­ly­ing econ­omy as it stands.

Some may argue that the employ­ment sit­u­a­tion in the U.S. remains dire and is likely to lead to another fall-off in con­sumer con­fi­dence. Well, my research indi­cates that con­sumer con­fi­dence in fact leads the U.S. unem­ploy­ment rate by approx­i­mately nine months. With the Con­fer­ence Board Con­sumer Con­fi­dence Index at 61.1 in Jan­u­ary, it points to an unem­ploy­ment rate of approx­i­mately 8% in the third quar­ter of this year com­pared to 8.3% in Jan­u­ary this year.

Sources: I-Net; FRED; Plexus Holdings.

The val­u­a­tion lev­els of the S&P 500, or PE10, lead the unem­ploy­ment rate by approx­i­mately six months and are cur­rently point­ing to an unem­ploy­ment rate of below 8% in the third quar­ter of this year.

I still hold the view that con­sumer con­fi­dence will improve to approx­i­mately 80 through end 2012 and that the val­u­a­tion of the S&P 500 Index will improve to a PE10 of 25, mean­ing fur­ther upside of approx­i­mately 10% from the cur­rent lev­els. The going will be tough, though, as I think volatil­i­ties will remain high, result­ing in the VIX rang­ing between 15 and 30 and the PE10 between 20 and 25.

Time to add the VIX to your equity port­fo­lio? I think so.

Tags: Black Swans, Cboe, Chinese Economy, Consumer Confidence, Corporate Profit, Debt Crisis, Earnings Yield, Economic Fundamentals, Eurozone, Global Economic Environment, Global Economic Growth, Investment Environment, Plexus, Profit Growth, Risk Appetite, Robert Shiller, Swans, Valuation Levels, Volatility Index Vix, Woes
Posted in Markets | Comments Off

Hedge Fund Managers Thrilled to Death?

Thursday, February 9th, 2012

Mia Lamar of the WSJ reports, Hedge Funds Added Small Gains in Jan­u­ary:

Hedge-fund per­for­mance perked up in Jan­u­ary, although con­tin­ued to lag the major stock indexes, accord­ing to indus­try adviser Hen­nessee Group.

Hennessee's hedge fund index rose 2.5% for the month of Jan­u­ary, less than the Stan­dard & Poor's 500 and Dow Jones Indus­trial Aver­age, which posted gains of 4.4% and 3.4%, respec­tively. The Nas­daq Com­pos­ite Index climbed 8% last month.

Still, the advance­ment in Jan­u­ary comes after a dis­mal 2011 for the hedge indus­try, which has been bat­tered by swiftly chang­ing sen­ti­ment on Europe's sovereign-debt cri­sis and other macro con­cerns around the world. Hennessee's hedge fund Index fell 4.27% in 2011, mark­ing the worst year for hedge funds since 2008.

"It is encour­ag­ing to see a respectable gain even with man­agers con­ser­v­a­tively posi­tioned," said Lee Hen­nessee, man­ag­ing prin­ci­pal of Hen­nessee Group.

Equity long/short strate­gies were among the best-performing strate­gies last month, as the Hen­nessee Long/Short Equity Index advanced 2.47%. Stocks pushed higher in Jan­u­ary, led by tech­nol­ogy and finan­cials, as U.S. eco­nomic data con­tin­ued to show signs of improvement.

It's hardly sur­pris­ing to see Equity long/short funds posted the best returns as stock mar­kets rock­eted up in Jan­u­ary. In other words, once more, it's all about beta stupid!

There is how­ever more good news for hed­gies. Har­riet Agnew of Finan­cial news reports, Long/short hedge funds to gain from cor­re­la­tion decline:

Stock cor­re­la­tion within sec­tors has dropped sig­nif­i­cantly this year as mar­kets have ral­lied, pro­vid­ing a boon for long/short equi­ties man­agers who buy and sell com­pa­nies based on fun­da­men­tal analy­sis of their indi­vid­ual mer­its.

Giles Wor­thing­ton, a port­fo­lio man­ager at River­Crest Cap­i­tal, said: "Cor­re­la­tions are falling with quite a pow­er­ful force and diver­sity in stock returns is ris­ing. This is good news for stock-pickers as once again investors are con­sid­er­ing the dif­fer­ence between a high-quality and a low-quality company.”

The attached chart, pub­lished yes­ter­day on Busi­ness Insider, illus­trates the 21-day stock cor­re­la­tion within the Rus­sell 1000 Index. It shows that cor­re­la­tion has fallen from a peak of about 0.75 in Sep­tem­ber to about 0.2.

Wor­thing­ton said that the key short-term dri­ver of this has been the Euro­pean Bank's three-year pro­vi­sion of liq­uid­ity through its Long Term Refi­nance Oper­a­tion that was announced in December.

He said: "The LTRO has sig­nif­i­cantly reduced the tail risk in the mar­kets. The huge risk of finan­cial implo­sion has gone away for the time being. Last year the mar­kets were dic­tated by macro calls and now they are focus­ing on stocks."

For many man­agers, the drop in cor­re­la­tion is a wel­come respite from the high cor­re­la­tions dri­ven by macro­eco­nomic news­flow that char­ac­terised the mar­kets for much of last year.

Look­ing at val­u­a­tions alone would have cre­ated the wrong idea: defen­sive growth stocks trad­ing at high mul­ti­ples per­formed well, while cheap cycli­cal stocks per­ceived as value invest­ments suf­fered losses.

At times com­pany share prices moved not on indi­vid­ual val­u­a­tions but on the per­ceived coun­try risk or cur­rency risk of the issuer. Late last year, for exam­ple as investors became more con­cerned about France's triple-a rat­ing poten­tially being down­graded, French stocks were sold off indis­crim­i­nately, in line with the market's per­cep­tion of an inher­ent risk of invest­ing in France.

Accord­ing to data provider Hedge Fund Research, the aver­age hedge fund gained 2.63% in Jan­u­ary, with equity strate­gies lead­ing the way, up 3.84%.

Among long/short equity man­agers, many of last year's biggest losers rebounded strongly in Jan­u­ary. Crispin Odey's Odey Euro­pean fund is up dou­ble dig­its this year, while Lans­downe Part­ners' UK fund gained 5.7% in Jan­u­ary, investors said.

Wor­thing­ton said that although stock selec­tion detracted from his fund's per­for­mance in Decem­ber, by Jan­u­ary it accounted for 60% of the returns.

How­ever, he also sounded a note of cau­tion. He said: "The mar­ket always starts the year quite buoy­ant as com­pa­nies invari­ably come out with good expec­ta­tions and they have a full year to disappoint.

"There's been bit of a 'dash for trash' too — in the US, for exam­ple, the top-performing stocks this year under­per­formed by 40% on aver­age in 2011. A lot of the highly-leveraged, high-cyclical com­pa­nies have bounced as port­fo­lio man­agers have rotated out of more defen­sive names."

Accord­ing to Credit Suisse strate­gists, the rota­tion ratio in Jan­u­ary was 76%. This means that around three quar­ters of sec­tors either out­per­formed in Jan­u­ary 2012 after under­per­form­ing in 2011 or vice versa, the high­est level of rota­tion since 2001. Banks are the most strik­ing exam­ple of this, they said.

The chart was first reported by Busi­ness Insider blog.

In other news, Final­ter­na­tives reports that Gold­man Sachs' for­mer spe­cial sit­u­a­tions chief will launch his new firm's maiden hedge fund next quar­ter along with another Gold­man and Tudor vet:

Richard Ruzika, global head of spe­cial sit­u­a­tions at Gold­man between 2007 and last year, founded Dublin Hill Cap­i­tal in Con­necti­cut with Lance Bakrow and Joe How­ley. The Connecticut-based firm will unveil its Global Macro Fund in an effort to take advan­tage of the strategy's cur­rent pop­u­lar­ity, HFMWeek reports.

Ruzika was co-head of global macro trad­ing and global head of com­modi­ties at points dur­ing his 29-year career at Goldman.

Bakrow, another Gold­man Sachs vet­eran, is a founder of Green­wich Energy Part­ners. How­ley, a Tudor Invest­ment Corp. vet­eran, was man­ag­ing direc­tor of nat­ural gas trad­ing at Sem­pra Energy.

When­ever you read vet­er­ans from Gold­man and Tudor are get­ting together to start a global macro fund, it's worth meet­ing them and dis­cussing their new fund. Ask them lots of tough ques­tions but this is the type of new fund I like invest­ing in.

I've been tough on hed­gies lately. Some­one accused me of "wag­ing war against them". Noth­ing can be fur­ther from the truth. While I've seen many "malakies" in the hedge fund indus­try, includ­ing non­sense within pen­sion funds invest­ing in hedge funds, I still believe that excel­lent hedge funds are worth invest­ing with.

Do I believe in pay­ing 2 & 20? A lot less than I used to. Why? Because most hedge funds are mediocre and the large ones are mostly asset gath­er­ers. More­over, insti­tu­tions can repli­cate a lot of hedge funds strate­gies inter­nally and if you're a large pen­sion fund like ATP, you got a large enough bal­ance sheet to beat them at their own game at a frac­tion of the cost. It's stu­pid to get eaten alive by hedge fund fees, mak­ing them rich for gath­er­ing assets.

Tonight I had din­ner with some for­mer col­leagues. We all worked in hedge funds before. We were dis­cussing how stu­pid it is for large pub­lic pen­sion funds to pay mil­lions in fees to hedge funds instead of devel­op­ing alpha inter­nally. These guys are sharp money man­agers and know all about hedge funds. One of the guys can slice and dice any hedge fund strat­egy and reverse engi­neer it. The other is a credit spe­cial­ist who has done his share of due dili­gence on hedge funds and knows all about alpha and man­ag­ing money.

We all feel that too many insti­tu­tions are wast­ing their money on hedge funds. Save your money, develop alpha tal­ent inter­nally and don't waste your time and resources chas­ing hedge funds. And if you are going to ven­ture into hedge funds, seed some alpha man­agers who are per­for­mance dri­ven but don't take an equity stake!!!

All these insti­tu­tions invest­ing in hedge funds, includ­ing the Caisse and Ontario Teach­ers', should pub­licly dis­close how much they've dis­bursed in fees since incep­tion of their hedge fund pro­grams. My guess is hun­dreds of mil­lions. Sure, they've invested in some great funds, made money, but also got clob­bered in oth­ers which you'll never hear about. The point is would they have been bet­ter off tak­ing the ATP approach, invest­ing in inter­nal hedge funds? Results speak for them­selves.

Below, Ann Pet­ti­for, George Kapopou­los and Matina Ste­vis dis­cuss the prospect of a Greek default on Al-Jazeera. Debt dis­cus­sions in Greece have stalled on pen­sion dis­pute. If Greece defaults, you'll see macro news take over again, and cor­re­la­tions rise across all asset classes (except bonds).

If all hell breaks loose, hedge funds will suf­fer. If a deal is struck, watch out, a mas­sive liq­uid­ity rally could mean many hedge funds will under­per­form. Both sce­nar­ios would be bad for hedge funds, espe­cially the for­mer one. At the end of the day, most hedge funds are a lot more like mutual funds and pen­sion funds in that they des­per­ately need the big beta boost to make money.

Tags: Debt Crisis, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Equity Index, Fundamental Analysis, Group Equity, Hedge Fund Index, Hedge Fund Performance, Hedgies, Lee Hennessee, Long Short Equity, Major Stock Indexes, Nasdaq Composite Index, Respectable Gain, Short Hedge, Sovereign Debt, Stock Pickers, Stock Returns, Wsj Reports
Posted in Markets | Comments Off

PIMCO's El Erian: "Too Early to Declare Victory"

Wednesday, February 8th, 2012

PIMCO's Mohamed El-Erian vis­ited with CNBC this morn­ing, and offered his usu­ally inter­est­ing thoughts on the macro econ­omy and invest­ment themes. Inter­est­ingly, he touted pre­cious met­als in this inter­view (rel­a­tive to equi­ties) which is the first time I've really heard him tout them.

8 minute video – email read­ers will need to come to site to view:

• This year's mar­ket gains will need more than an improv­ing eco­nomic pic­ture and investor will­ing­ness to shrug off the Euro­pean debt cri­sis, Pimco's Mohamed El-Erian said. "It's too early to declare vic­tory," the co-CEO for the world's largest bond fund told CNBC in an inter­view Tuesday.
• He out­lined three issues that must be addressed if the 2012 rally is to continue:

1) Geopo­lit­i­cal risk that remains both in Europe and the Mid­dle East.

2) A "hand­off to more sus­tain­able poli­cies" beyond the mon­e­tary eas­ing from the world's cen­tral banks.

3) Get­ting "long-term investors" off the side­lines and putting their money to work in riskier assets than bonds.

• As those head­winds remain, El-Erian advises investors to ded­i­cate a smaller por­tion of their port­fo­lios to stocks and a larger allo­ca­tion toward pre­cious met­als. On bonds, he advo­cates shorter dura­tion, with a tar­get of seven years or less, which is where the Fed­eral Reserve has focused its debt-buying efforts.
• "They're both will­ing and able," El-Erian said of the Fed and other cen­tral banks and aggres­sive mon­e­tary poli­cies. "The issue is the effec­tive­ness. Even the cen­tral bankers are begin­ning to announce that it is not just about the ben­e­fits, it's also about the costs and risks."
• "The cen­tral banks are absolutely com­mit­ted, but we must not extrap­o­late that they will remain highly effec­tive," he con­tin­ued. "They need help. They are a bridge and they have to be a bridge to some­where. So far the other gov­ern­ment agen­cies are on the sidelines."
• "There's more to do," El-Erian said. "It's crit­i­cal that noth­ing be done to inter­rupt this won­der­ful cycli­cal bounce. We want the cycli­cal bounce to trans­late into a sec­u­lar bounce, because that's what the mar­kets need to sus­tain the won­der­ful returns so far this year."
• El-Erian con­trasted the sit­u­a­tion in Europe from the Lehman Broth­ers col­lapse in 2008, and said that while cen­tral banks "have become much more proac­tive" with refi­nanc­ing oper­a­tions, the cur­rent econ­omy may not be as pre­pared for eco­nomic shock. Regard­ing the "Lehman moment," El-Erian said, "If you define it as the econ­omy being able to take the shock, that's in fact a higher risk because we are in a worse place than we were in '08."

Dis­clo­sure Notice

Any secu­ri­ties men­tioned on this page are not held by the author in his per­sonal port­fo­lio. Secu­ri­ties men­tioned may or may not be held by the author in the mutual fund he man­ages, the Pal­adin Long Short Fund (PALFX). For a list of the afore­men­tioned fund's hold­ings at the end of the prior quar­ter, visit the Pal­adin Funds web­site at http://www.paladinfunds.com/holdings/blog

Tags: Bond Fund, Central Banks, Cnbc, Debt Crisis, Handoff, Headwinds, Improving Economic Picture, Investment Themes, Macro Economy, Mohamed El Erian, Monetary Policies, Other Government Agencies, PIMCO, precious metals, S Central, S Market, Sidelines, Sustainable Policies, Target, Term Investors
Posted in Markets | Comments Off