Posts Tagged ‘Inverse Relationship’

Lacy Hunt: Unintended Consequences of Well-Intended Policies

Friday, August 3rd, 2012

 

Submitted by Hoisington’s Lacy Hunt on behalf of Casey Research

Unintended Consequences of Well-Intended Policies

In the early 1960s, when JFK was in the White House and William McChesney Martin was Fed chairman, Keynesian economics was in full bloom. One of its major tenets is the Phillips Curve, which posits a stable inverse relationship between the rate of inflation and the unemployment rate. Yale professor James Tobin and others argued that the social outcome could be improved by a more activist monetary and fiscal policy. Specifically, they contended that the unemployment rate could be lowered while only resulting in slightly higher inflation.

The argument posited the notion that economic policymakers had sufficient knowledge to intervene or fine-tune the economy with tools like those of a surgeon. Presidents Johnson, Nixon, and Carter (two Democrats and one Republican) followed this policy. At one point, President Nixon made the famous statement that “We are all Keynesians now.” Moreover, as the White House led, the Fed chairmen of the era – Martin, Burns, and Miller – generally acquiesced.

To judge the effectiveness of this policy, an objective standard is needed. Arthur M. Okun, Yale colleague of Tobin, developed such a standard, which he called the Misery Index – the sum of the inflation and unemployment rates.

Under the activist, Phillips Curve-based policy, some reduction in unemployment was temporarily achieved. However, inflation accelerated much more than was anticipated, and the net result was higher unemployment and faster inflation, an outcome not at all contemplated by the Phillips Curve. The Misery Index surged from an average of 6.7% in the 1950s, to 7.3% in the 1960s, to 13.6% in the 1970s, with peak rates above 20% in the early 1980s.

Many US households suffered. Wages of lower-paying positions failed to keep up with inflation, and when higher unemployment resulted, many of those people lost their jobs. Those on the high end had far more resources that enabled them to protect their investments and earned income, so the income/wealth divide worsened. A half-century later, the United States has never regained the prosperity of the 1950s.

Working independently in the late 1960s, economists Milton Friedman and Edmund Phelps, who would both eventually be awarded the Nobel Prize in economics, had determined that while the Phillips Curve was observable over the short run, this was not the case over the long run. While the economics profession debated the Friedman/Phelps research, the US had to learn its findings the hard way.

Growing Evidence of the Long-term Depressants from Activist Policies
In addition to the compelling evidence that more active monetary and fiscal policy involvement did not produce beneficial results over the short run, three recent academic studies, though they differ in purpose and scope, all reach the conclusion that extremely high levels of governmental indebtedness diminish economic growth. In other words, deficit spending should not be called “stimulus” as is the overwhelming tendency by the media and many economic writers.

Whereas government spending may have been linked to the concept of economic stimulus in distant periods, these studies demonstrate that such an assertion is unwarranted, and blatantly wrong in present circumstances. While officials argue that governmental action is required for political reasons and public anxiety, governments would be better off to admit that traditional tools only serve to compound existing problems.

These three highly compelling studies are:

  • Debt Overhangs: Past and Present, by Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff, National Bureau of Economic Research, Working Paper 18015, April 2012;
  • Government Size and Growth: A Survey and Interpretation of the Evidence, by Andreas Bergh and Magnus Henrekson, IFN Working Paper No. 858, April 2011;
  • The Impact of High and Growing Government Debt on Economic Growth – An Empirical Investigation for the Euro Area, by Cristina Checherita and Philipp Rother, European Central Bank, Working Paper Series 1237, August 2010.

These papers reflect serious research by world-class economists from the US, Europe, and Sweden – and they all confirm the detrimental consequences of extreme governmental indebtedness.

Misery on the Rise Again
In the past year, Okun’s impartial arbiter averaged 10.5%, the highest on record for the third year of an officially recognized economic recovery and almost double the average of the 1950s. The latest readings have occurred despite US gross public debt in excess of 103% of GDP and with the Federal Reserve’s unprecedentedly large balance sheet that approaches nearly $3 trillion.

Other measures of well-being confirm the Misery Index. The Poverty Index in 2011 appears to have reached 15.7%, the highest reading in five decades. Not surprisingly, two unenviable records have been set: 46 million, or 14.6% of the population, are now in the food stamp program, up from 7.9% in 1970 and a record-high 41% pay zero national income tax.

In the eleven quarters of this expansion, the growth of real per-capita GDP was the lowest for all of the comparable post-WWII business cycle expansions. Real per-capita disposable personal income has risen by a scant 0.1% annual rate, remarkably weak when compared with the 2.9% post-war average. It is often said that economic conditions would have been much worse if the government had not run massive budget deficits and the Fed had not implemented extraordinary policies. This whole premise is wrong.

In all likelihood the governmental measures made conditions worse, and the poor results reflect the counterproductive nature of fiscal and monetary policies. None of these numerous actions produced anything more than transitory improvement in economic conditions, followed by a quick retreat to a faltering pattern while leaving the economy saddled with even greater indebtedness. The diminutive gain in this expansion is clearly consistent with the view that government actions have hurt, rather than helped, economic performance. Sadly, many of those whom the government programs were supposedly designed to help the most have suffered the worst.

The Way Out
The original theoretical argument in favor of deficit spending originated in J.M. Keynes’ The General Theory of Employment, Interest and Money. A search of Keynes’ work reveals no recognition of the “bang point,” or the condition where a government engages in deficit spending for such a prolonged period of time that a massive buildup of debt leads to denial of additional credit to the government because of fear that the existing debt will not be repaid. Nor did Keynes address the situation where a large number of countries are all simultaneously getting deeper and deeper in debt and there are gradations of debt among these countries – serious shortfalls in the basic Keynesian theory.

Keynes, as opposed to some of his interpreters and predecessors, may have implicitly recognized that a bang point could occur, because he did not recommend constant budget deficits. Instead, he advocated cyclical deficits, counterbalanced by cyclical budget surpluses. Under such a system, government debt in bad times would be retired in good times. However, Keynes’ original proposition was bastardized in support of perpetual deficits, something Keynes himself never advocated.

Milton Friedman, whom many consider to have been the polar opposite of Keynes, also never addressed the concept of a bang point, but he may also have understood implicitly that such a situation could occur. The reason is that Friedman advocated balanced budgets, which if followed or required constitutionally as Friedman argued, would prevent a buildup of debt. This view was largely rejected as being inhumane since in a recession, government policy would not be responsive to unemployment and other miseries of such a condition. What should have been discussed is whether some short-term misery is a better option than putting the entire country and economic system in jeopardy, as numerous examples in Europe currently illustrate.

The most sensible recognition of budget policy came not from Keynes nor Friedman, but from David Hume, one of the greatest minds of mankind, whom Adam Smith called the greatest intellect that he ever met. In his 1752 paper Of Public Finance, Hume advocated running budget surpluses in good times so that they could be used in time of war or other emergencies. Such a recommendation would, of course, prevent policies that would send countries barreling toward the bang point. Countries would have to live inside their means most of the time, but in emergency situations would have the resources to respond.

In the context of today’s world, this approach would be viewed as unacceptable because it would limit the ability of politicians to continue their excessive spending, thereby saddling future generations with obligations and promises that cannot be honored. But isn’t Hume’s recommendation exactly what we teach our children in preparing them to manage their own personal finances?

 

Lacy Hunt is the executive vice president of Hoisington Investment Management, a firm with over $5.8 billion under management, and one of the nation’s top-performing bond managers. Lacy’s work has been published in Barron’s, Wall Street Journal, New York Times, Journal of Finance, the Financial Analysts Journal, and the Journal of Portfolio Management. Previously he was the chief economist for the HSBC Group, one of the world’s largest banks, and the senior economist for the Dallas Fed.

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“Hot Potato” (John Hussman)

Monday, February 13th, 2012

Hot Potato

February 12, 2012

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

Portfolio Notes – Particularly over the past few quarters, the Strategic Growth Fund has enjoyed muted volatility and positive returns during market declines, but also a moderately inverse relationship versus the S&P 500 during market advances. This behavior isn’t a general feature of our hedging approach, but rather the reflection of two factors that are currently in place. One is our significant “underweight” in financials, materials, cyclicals and other “risk on” sectors that we view as speculative, and where we find few candidates that satisfy the discounted cash flow criteria that we rely on for stock selection. While our stock selection has significantly outperformed the S&P 500 over time, our continued avoidance of financials does introduce some inverse behavior in our hedged investment position during runs of “risk on” speculation.

The other related factor is that the past several quarters have been a constant game of “hot potato” between recession risk and what we identify as an “overvalued, overbought, overbullish” syndrome. The result is that one or the other has generally kept us in a tightly hedged investment position. In our most defensive stance (conditions we identify as “hard negative”), we typically endure some decay in option value during market advances, because we raise the strike prices of our put options in order to defend against indiscriminate selling that often follows, as we saw during sharp market declines in 2010 and 2011. The overall result is that the Fund has typically enjoyed positive returns when the market plunges, but has experienced some erosion during periods of “risk on” speculation.

In order to eliminate this somewhat inverse pattern, we could take a new position in financial stocks and other “risk on” sectors here, and lower the strike prices on our defensive put options. My impression is that both of those would be hostile to our prospective returns, and of course, would also depart from our stock selection discipline in the process. One do-it-yourself method of closing down that pattern would be to take a position in financials, materials, and cyclicals, write call options on them in order to take in time premium, but accept all of the downside risk in those holdings. That would do it. For most of our shareholders, my guess is that that doesn’t sound like a brilliant idea here. This may offer some appreciation for why we continue to pursue our discipline, despite the occasional pressure we experience – I expect temporarily. Even if we ignore economic risks entirely, we presently observe overvalued, overbought, overbullish conditions that have repeatedly been resolved by steep declines, even in the past few years.

Ensembles

We often receive questions relating to the ensemble method that guides our hedging strategy. Along with last week’s comment (Notes on Risk Management ), the following section is intended to provide a broad overview.

One of the main approaches we use to estimate return and risk prospects is to group current market conditions among historical instances that are most similar. Each point in history is defined by various “features” based on a broad range of key factors, including valuations, trend-following indicators, market breadth, sentiment, credit spreads, economic factors, overbought/oversold measures, and so forth. In order to make the analysis less dependent on any particular historical period (e.g. postwar data, bubble-era data, Depression-era data), or any single set of indicators, we extend this analysis to a very large number of randomly selected sub-samples across history.

This sort of analysis is an example of an “ensemble method,” which has several benefits, the two most important being on measures of “accuracy” and “robustness.” It’s easy to fit a model to past data, but those models often break down quickly in new data. So to evaluate accuracy, we estimate return and risk on data that the model has not “seen” previously, and find that the ensemble approach generally performs better than alternative methods. Equally important, the ensemble is robust to very large changes in the underlying economic environment, because randomizing over numerous sub-samples of history reduces the likelihood that the model is “over-fitted” to a particular economic environment.

I wish I could say that we anticipated the depth of the 2008-2009 credit crisis so completely that I developed these ensemble methods in advance, already confident in how they would have performed even in Depression-era data. Unfortunately, that’s not the case, and shareholders are well aware of the challenges we went through in stress-testing our approach against other periods of credit crisis.

Though these weekly comments forewarned much of what actually occurred during the credit crisis, I certainly didn’t anticipate what I still consider to be terrible policy mistakes – particularly the absolute unwillingness to restructure bad debt, in preference for kicking the can down the road with public funds. It was a far cry from how U.S. regulators had responded to the S&L crisis, and how other international banking crises had been successfully addressed (for example, in the early 1990′s, the Swedish banking crisis was durably resolved by the government taking receivership of a large portion of the banking industry, wiping out existing shareholders, writing down bad assets, and then taking the banks public to recapitalize them under new owners).

For anyone who was responsible for investing the funds of others, the proper response to the 2008 crisis was to stress-test every method, though I’m not convinced that much of Wall Street has stress-tested anything at all. For us, stress-testing meant taking our models to Depression-era data, because it was clear that events of the time were largely “out of sample” from the standpoint of post-war data. At the time, we were basing our estimates of market risk and return on data since about 1950, which I had – incorrectly – believed was sufficient to capture “modern” market behavior.

While our existing hedging approach performed well in that Depression-era data overall, the occasional losses were far deeper than I was willing to risk for our shareholders. The result was what I called a “two-data sets” problem, which demanded that our hedging methods perform well, out-of-sample, and with tolerable drawdowns in data drawn from both post-war and Depression-era periods. We reached a satisfactory solution in 2010 with the introduction of our ensemble approach. For the full period, we avoided a significant portion of the market’s 2007-2009 downturn, but in hindsight, my decision to fully stress-test our methods led us to miss a rebound in 2009 that we should not have missed, had our present approach been already in hand.

In real-time, our hedging approach has repeatedly demonstrated value over complete bull-bear market cycles, both adding returns and defending against severe market losses (exceeding 50% downturns twice in the last decade). We’ll certainly have periods where we appear remarkably out-of-step with the prevailing trend of the market, particularly in overvalued, overbought, overbullish periods of speculation. But defending against losses in these periods is essential to risk management, despite the tendency of bulls to declare victory at halftime.

Hot Potato

The period since 2010 has been largely characterized by a fragile underlying global economy coupled with a persistently overvalued stock market (though to varying degrees). We’ve seen little during this period but the effect of a hot potato being repeatedly passed from speculatively overvalued, overbought, overbullish market conditions driven by massive central bank interventions, to credit strains and emerging economic weakness nearly the instant those interventions are even temporarily suspended. As a result, by turns we’ve seen the repeated emergence of the same speculative “Aunt Minnies” that have historically accompanied major and intermediate market peaks, followed by the emergence of credit strains, economic pressures, and a flight to safe-havens.

The alternation is certainly not typical of market history. Nor is it typical of a complete market cycle or business cycle. As unsatisfactory as it may be, the market is presently in an extended game of hot potato which will be resolved by the eventual removal of both conditions.

When I was in college, I bought a stick-shift hatchback wagon that I used for years to haul equipment as the guitarist and lead singer for a rock band (the gig earnings went to buy time on the mainframe at Northwestern’s Vogelback computing center so I could run investment research). If you’ve ever been a beginner driving a stick, you know that if you don’t release the clutch just right, the car goes nowhere and then suddenly jolts forward once the gear engages. My impression is that this is largely what we’re seeing in the economy. Each time underlying credit strains emerge, demand backs off as consumers and businesses become averse to spending. Then, each time central banks launch some massive new intervention, there is a jolt of pent-up demand that is interpreted as sustainable growth. This was the result when the Fed launched QE2, and we’re seeing a replay as the ECB provides enormous loans to banks in return for “collateral” in the form of newly-created, unlisted bonds that European banks have simply issued to themselves.

But what if we are not, in fact, facing further economic weakness, and are instead on course for recovery? What indicators should we monitor, and how would our investment position change?

On the indicator front, as I noted last week, we use dozens of economic indicators and discriminators in practice, but a good, simple rule of thumb to gauge recession risk is to use the combination of the OECD leading indices for the US and total world, combined with the ECRI weekly leading index (WLI). The latest readings from the OECD come out this week. Given that the WLI is still negative, an upturn in both OECD measures – to about +2 on each – would help to relieve our economic concerns.

[Geek's Note: We use standardized values of the growth rates for all of these measures: WLI mean 2.2, std 7.6, OECD_US mean 2.8, std 5.1, OECD_W mean 2.8, std 4.3. Standardized values below -0.5 on all three of these are nearly always associated with recessions. A subsequent move above a standardized value of about -0.2 in at least two of these three has quickly marked new expansions in the past. The corresponding level to monitor on each of the unstandardized indices, of course, is mean - 0.2*std, which translates to levels of about 0.7 on the WLI, 1.8 on the OECD US leading indicator, and 1.9 on the OECD total world index. Again, this is a rule of thumb, but it has a good record for a three-indicator model. The index symbols for Bloomberg users are: ECRWGROW, OLE3US, and OLE3TOTA, which can be examined alongside USRINDEX, which is a binary recession flag].

However, it bears repeating that even if we zero out our economic concerns (and the associated warning indicators in our ensembles) we still obtain very unfavorable expected return and risk estimates for the stock market here. This is because we presently observe a number of historically hostile syndromes that are almost uniquely associated with losses – not always immediately, but almost always large enough to make any intervening gains purely temporary. The stock market may very well enjoy a further advance from here. The likelihood of those gains being durable, however, is quite small.

We’ve heard a few objections that our concerns about market risk are inconsistent with the continued downtrend that we observe in new claims for unemployment. On that note, it’s true that there are a few useful indicators that can be derived from new claims data. For example, the stock market often suffers when new claims rise above their 5-year average, from being previously below that level. But even in those cases, the stock market has usually been falling already, because stocks are short-leading and new claims are at best coincident with the economy. So rising unemployment claims are a “bearish continuation” signal, but should not be expected to provide early warning. More generally, the trend of new claims actually has very little to do with oncoming market action.

A particularly instructive instance is 1987. The chart below shows the 4-week average of new claims for unemployment that year. Notably, the persistent downtrend in new unemployment claims provided no barrier at all to the October 1987 crash. I’ve chosen this particular counterexample because we presently observe the same unusually overextended market conditions that characterized the 1987 peak. These include an overvalued, overbought, overbullish syndrome, which has become increasingly familiar near both major and intermediate market highs in recent years, including the peaks we saw in 2007, 2010 and 2011. The 1987 peak also featured the same “exhaustion syndrome” I discussed a few weeks ago in Goat Rodeo (basically a recent “whipsaw trap” syndrome coupled with falling earnings yields).

If you spend any time at all with historical data, you’ll find a multitude of nearly equivalent ways to define an exhausted advance, and the average outcomes are almost always uncomfortable. When these conditions are coupled with any upward interest rate pressure at all, whether from corporate, Treasury bond, or T-bill yields, the outcomes are almost uniformly hostile.

As one of many ways to define “overvalued, overbought, overbullish, rising yield” conditions, consider the points in history when the S&P 500 was at a “Shiller” multiple of over 19 times 10-year inflation-adjusted earnings, the index was at least 8% over its 89-week moving average, within 2% of a 3-year high, with Investors Intelligence sentiment over 45% bulls, less than 30% bears, or both, and with at least one yield measure above its level of 26-weeks earlier (corporate, Treasury bond, or T-bill). This set of conditions produces a cluster restricted to about 8% of market history, and also self-selects for many of the worst times an investor could have chosen to buy stocks, based on the depth of the market’s decline within the following 18 months.

While the criteria above are loose enough to include several false signals, the periods also include late-1961 (-25%), early-1966 (-20%), late-1968 (-30%), late-1972 (-30%, and a nearly -50% loss extending beyond that 18 month window), mid-1987 (-33%), mid-1998 (-12% over the next 13 weeks), mid-2000 (-35%, and a loss of more than 50% beyond that 18 month window), and mid-2007 (-55%).

We’d never recommend this as an actual investment strategy, but it’s informative that even if an investor had simply avoided the market for a full 18-month period after every emergence of the foregoing set of conditions (including every false signal, and entirely regardless of what else happened over the next 18 months), that strategy would still have captured cumulative returns about 70% higher than a buy-and-hold since 1963, with periodic losses only about half as deep as a buy-and-hold approach. Again, we’d never recommend this in practice, but it underscores that although the market may move even higher over the near term, investors have achieved nothing durable from investing in overextended conditions like those we presently observe. On average, very weak market outcomes have followed for an extended period of time.

There are tighter ways to define conditions that exclude false signals but also miss some major declines (see A Who’s Who of Awful Times to Invest and Extreme Conditions and Typical Outcomes ), and looser ways to define conditions that capture even more historical plunges, but also invite more false signals. Regardless, the benefit of avoiding the major plunges nearly always swamps the cost of the occasional false signals.

The S&P 500 has lost more than half of its value on two separate occasions since 2000, and the value of avoiding major losses in a decline generally offsets missed gains very quickly (a 20% loss wipes out a 25% gain, a 30% loss wipes out a 43% gain, a 40% loss wipes out a 67% gain, and a 50% loss wipes out a 100% gain). My argument is certainly not that stocks will decline immediately, nor that they cannot advance further from present levels. Rather, the point is that even if such an advance emerges, the likelihood of those gains being retained by investors over the course of the full market cycle is exceedingly small.

This cycle of hot potato will end, and we will have opportunities to accept moderate or even significant amounts of risk, with proportionately high expected returns. As recession uncertainties resolve, and we observe a normal ebb-and-flow of investor sentiment and short-term price movement, I expect that we’ll observe at least some of these opportunities in the months ahead. A major positive shift in our investment stance would most probably accompany a significant improvement in valuations, confirmed by improving market internals (a sequence that is characteristic of early bull market advances). With the market presently at (normalized) valuations that are associated with poor long-term prospective returns, with short-term conditions overbought and overbullish, and with intermediate-term conditions characterized by an exhaustion syndrome that has historically produced disproportionately weak returns over the next few quarters, I do not believe that we are faced with such an opportunity here. This will change, and we will respond accordingly.

Meanwhile, it’s worth repeating that most bear markets wipe out more than half of the gains achieved during the prior bull market. There is very little chance, in my view, that gains from present levels will be retained by investors over the completion of the current cycle. There is equally little chance that investors who are willing to accept significant risk now will be prompted to reduce their risk later, until they encounter a market decline that is – by then – nearly impossible to act upon. Have we not seen this movie before?

Market Climate

As of last week, the stock market remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome, coupled with an “exhaustion” syndrome that has historically been followed by declines on the order of -25% over the ensuing 6-month period. Our return/risk estimates remain “hard negative” here. We’ve been relatively slow in raising our put option strike prices toward the prevailing level of the market, but I continue to expect some modest “inverse” behavior of Strategic Growth relative to the major indices, largely owing to our lighter holdings of financial stocks, cyclicals, and high-beta stocks here. Though day-to-day movements in individual holdings can affect day-to-day Fund values (as one of our largest and most profitable holdings did last week on a pullback), our stock selections have performed well relative to the indices in recent years, and also since inception. Most of the “basis risk” from weighting our holdings differently from the major indices has tended to be short-lived. Strategic Growth and Strategic International are tightly hedged here.

In Strategic Total Return, we reduced our precious metals holdings further early last week. Despite longer-term inflation risks, precious metals shares clearly dislike upward pressure on long-term interest rates, particularly when that pressure does not reflect simultaneous pressure on observed inflation rates. While gold stocks tend to decouple from the broad stock market during economic downturns and inflationary periods, that doesn’t always happen during significant selloffs, particularly when there is any upward pressure on interest rates. I expect that we will significantly expand our holdings in precious metals shares (currently less than 2% of assets) in the event of price weakness in this sector, particularly if observable economic pressures and renewed downward pressure on interest rates reappear. Presently, given the volatility of this sector, we’ve taken some profits and remain on watch. The Fund continues to hold a duration of about 4.5 years in Treasury securities.

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Overweight U.S. High Yield Bonds (BCA)

Friday, July 8th, 2011

U.S. high yield bonds represent an opportunity for investors to benefit from a resurgence in the “risk on” trade, while getting some downside protection against the current economic softness, says BCA Research, this week.

Relative to equities, junk bonds are expensive, however it is representative of a lasting trend of raised equity risk premium that BCA says is not likely to fade away anytime soon. In absolute terms, corporate bond valuations remain attractive, as well as in relation to Treasurys, in the context of minimal default risk, and considering the recent backup in spreads.

The health of corporate balance sheets is also sustaining improvement, and the Fed’s low interest rate environment has investors seeking yield for the foreseeable future, and could most likely result in yield spreads being pushed well into overbought territory, before this rally comes to an end.

Junk bonds have performed superbly since the beginning of the rally in March 2009, and BCA believes the favourable conditions enabling junk bond investors to profit still have some way to go.

The inverse relationship between junk spreads and Treasury yields is one of the important reasons high yield has outperformed during the most recent “risk off” period. That is, the Treasury curve shifted lower while spreads widened, and this had offset effects on on junk yield levels.

Should the opposite conditions occur, in the event the economy has a stronger second half, Treasury yields should increase, however, spreads should narrow even more, according to BCA.

Given the uncertain economic outlook, this makes the junk bond index’s running yield attractive; BCA’s bottom line call – Upgrade high-yield back to overweight.

Source: BCA Research – Daily Insights

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Investors Bet on Prospect of ‘Greek Accident’; 2-yr Greek Bond Yield at 28.15%

Thursday, June 16th, 2011

by Michael ‘Mish’ Shedlock, Global Economic Trends Analysis

Greek, Irish, and Portuguese yields are at or flirting with new all-time highs.

Moreover, things are not looking pretty for Spanish and Italian bonds. Both trade at the upper end of their respective ranges yet German bond yields have fallen since the second week in April.

The prospect of a messy default in Greece is rising, even though it appears the IMF will hold its nose and give Greece another trance of money.

Credit default swaps price in a 75% chance of default in 5 years. However, Investors Now Bet On a ‘Greek Accident’ Within a Year.

A new bet has been placed on the Greek debt crisis. It backs a growing view among investors that Athens may be about to suffer a messy default that could spark a run on the country’s banks and a deeper euro zone crisis.

One senior investor said: “There is a meaningful chance of a Greek accident this summer. That involves a hard default and big losses for investors, which could have very worrying repercussions for the euro zone.”

These fears have prompted bets on the so-called “accident scenario”, which involves buying one-year credit default swaps that would pay out big profits in the event of a hard default, typically a non-payment of loans, in the next 12 months.

Although these funds have placed only a small amount of money on these bets, the mere fact that they are using them highlights the growing risks for the euro zone.

Greek two-year bond yields, which have an inverse relationship with prices, lurched 160 basis points higher, one of the biggest daily moves of the year, to a euro-era record of 28.02 percent.

Greek five-year CDS leapt to a high of 1,700 basis points, or a cost of $1.7 million to insure $10 million of debt annually over five years. Greek CDS is also pricing a 75 percent chance of a default by the country over the next five years – it was about 45 percent at the start of the year.

Irish and Portuguese two-year yields and five-year CDS also jumped to record highs. More worryingly, Spanish and Italian bond markets were hit too, with Spanish bond yields closing in on highs last seen in 2000.

Inquiring minds may wish to consider some charts of 2-year sovereign debt yields.

2-Year Yield Germany – 1.47%

2-Year Yield France – 1.75%

2-Year Yield Italy – 3.05%

2-Year Yield Spain – 3.52%

2-Year Yield Ireland – 12.28%

2-Year Yield Portugal – 12.44%

2-Year Yield Greece – 28.15%

If there was no risk of default as ECB president Jean-Claude Trichet insists, there would be no investor preference for German bonds over Greek bonds, Portuguese bonds, or Irish bonds.

Instead there is a significant difference between German and French bonds and the bonds of every other country.

Spain is too big to bail and Italy is much bigger still. All hell is going to break loose when yields in Spain or Italy rapidly rise, and it’s only a matter of time before they do.

Spanish 10-Year bonds are flirting with disaster right now.

10-Year Yield Spain – 5.62%

German 10-year bonds are 2.95%.

A sustained move above this level spells serious trouble for Spain.

Greek Recap

Copyright © Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

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I’m Hedging my Stocks by Going Long Volatility

Friday, January 21st, 2011

by Prieur du Plessis, Plexus Asset Management

I have often in the past referred to the CBOE Volatility (VIX) Index, also known as Wall Street’s “fear index”. This is a measure of the implied volatility of S&P 500 index options – a high value corresponds to a more volatile market and therefore more costly options.

The VIX Index is an excellent contrary indicator, moving in the opposite direction to stocks, and worth keeping an eye on. The Index peaked at 80.9 in November 2008 and has since declined to a low of 15.5 December 22 and January 14 before climbing by 15.0% to 18.0 over the past three days. To add some longer-term perspective, the relatively calm four-year period prior to the start of the credit crisis was characterized by a range between 10 and 20.

The graph below shows the neat historical inverse relationship between the S&P 500 Index (black line) and the VIX (red).

Source: StockCharts.com

I am of the opinion that the nascent bull market is looking tired, on top of the fact that stocks over over-loved, overbought and overvalued. (Also see my post of yesterday, entitled “Stock markets – two canaries calling for caution”.) But let’s also get a second opinion on the matter and who better than from David Fuller (Fullermoney) from across the pond. He said: “On seeing some downside key day reversals in European indices yesterday and with a number of leading Western stock market indices looking temporarily overextended following their uptrend extensions over the last seven weeks, plus every financial TV commentator saying “buy Wall Street”, I opened shorts in the Nasdaq 100 Index and the S&P 500 Index … I am not looking for more than a short-term reaction and some mean reversion towards the medium-term uptrend represented by the 200-day moving average.”

Back to the VIX: One way of hedging an equity portfolio is to bet on increased volatility that is bound to happen with any stock market correction. One can do this by buying either the iPath S&P 500 VIX Short-term Futures ETN (VXX) or iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). VXX invests in VIX futures contracts ending within the next two months, whereas VXZ is made up of VIX futures contracts running for four to seven months. A word of warning, though: these products generally represent an excellent way of hedging against stock market declines, but may not always fully track the VIX as a result of investing in futures that are also affected by other risk factors. As I am pre-empting an upside break of the VIX, I have protected my position with a fairly tight stop.

The graph below shows the VIX Index (red line) together with both VXX (green) and VXZ (blue).

Source: StockCharts.com

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Curious Move in United States Oil Fund (USO)

Sunday, June 27th, 2010

By Dian L. Chu, Economic Forecasts & Opinions

United States Oil Fund (USO) was a big mover on Friday jumping 3.69% to $35.65, outperforming other ETFs. The fund was trading in the negative territory for the most part in the morning, but spiked up around 11:45 EST, and kept the momentum through closing. (Chart 1)

Curious Move On a Friday

Some of the sharp move could be attributed to crude oil and the Dollar.

Crude oil moved higher as well on Friday, up 3.07% to $78.86, partly on concerns over a possible tropical storm hitting the Gulf of Mexico.

Meanwhile, dollar was moving lower on weaker U.S. GDP release, coupled with the recent slew of softer data on jobs and housing.

Typically, a declining dollar would prompt a flight to gold as the ultimate dollar hedge. But USO managed to outperform the SPDR Gold Trust (GLD), which was up 1.2%, as well as the United Natural Gas Fund (UNG), up 2.97%. (Chart 1)

Friday is usually a light trading day as traders take profits off the table unwilling to risk long positions into the weekend. So, this move on crude, the dollar and USO caught some traders off guard.

Dollar Unwind

Of course, one could very well argue that one day does not make it a trend. Nevertheless, it seems to suggest some dollar unwinding, as markets are beginning to reassess the dollar risk ahead of the G8 and G20 meetings — the still loose deficit spending of the U.S. vs. austerity measures in Europe and the monetary tightening in China.

This trend is evident in the dollar chart.  For the week, the dollar index has slipped for a third week, particularly against the euro, while commodities and equities seem to have reacquainted the historical inverse relationship with the dollar.  (Chart 2)

Better Prospect in Crude

Another suggestion is that since gold has had a nice run-up, while natural gas has relatively poor medium-term fundamentals, certain players could view crude oil, along with USO fund, as better investments, relative to gold and natural gas, at the moment.

Sovereign Funds Diversification

Market movements aside, two recent events also signal longer-term bullish for commodity and commodity-related ETFs in general.

Back in February, Bloomberg reported that China’s sovereign wealth fund–China Investment Corp.–invested for the first time in the U.S. Oil Fund (USO) and became the fourth-largest holder with a value of $78.6 million.

Chesapeake Energy (CHK) also announced this week it has sold US$900 million in preferred stock to sovereign wealth funds from China, Singapore, South Korea, Abu Dhabi, as well as two private-equity firms, as reported by The Wall Street Journal.

The BP Gulf disaster most likely will increase investor interest in onshore energy and natural gas. So, conceivably, sovereign funds would continue to look at commodity investment vehicles such as UNG and USO for diversification, as well as a hedge against their massive dollar holdings.

USO – A Technical Look

While I don’t typically recommend futures-based ETFs due to the rolling effect, for investors who are still interested, the following is a technical take on U.S. Oil Fund (USO). (Chart 3)

USO shares were trading in the bearish territory for quite a while. The next few trading sessions should decide if the momentum from Friday would hold to a definitive breakout.

Meanwhile, the shares should find the next resistance at the 50-day moving average of around $36, support at $33- $34. If it breaks above the $36, the next resistance level should be around $38.

Near Term Indicator – The U.S. Dollar

In the near term, markets—commodity and equity—most likely will look to the dollar and macro indicators for direction, which is something investors should also keep a close watch on.

Economic Forecasts & Opinions

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Long-Term Bond Yields: Where Are You Going?

Thursday, June 3rd, 2010

The yield on the 10-year US government bond dropped from a high of 3.96% to a recent low of 3.13%. The key question for investors is: Will US long bond yields continue down or consolidate and move higher? In order to cast some light on this issue, I have analyzed a few key graphs and historical relationships, as reported below.

Sources: I-Net Bridge, Plexus Asset Management.

The first question to be answered is whether the sudden drop in the yield on the 10-year Note was a flight to security due to the current debt crisis in the European Union that began in Greece and subsequently spread to Portugal and Spain. The GDP-weighted spread between the so-called PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) has had an inverse relationship with the yield on the US 10-year Note since the liquidity crisis unfolded in 2008, with the US yield rising when the GDP-weighted PIIGS’ bond yield spread falls and vice versa.

Sources: I-Net Bridge, Plexus Asset Management.

The yield spread between PIIGS bonds and US bonds has a close relationship with the yield spread between emerging-market bonds and US Treasuries. It can therefore be argued that bonds in the PIIGS countries are essentially emerging-market bonds with similar risk attributes.

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The Fear Premium of Gold

Friday, May 14th, 2010

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Gold prices were hitting record highs as gold’s appeal as a safe haven asset exploded. June gold was down 1.1% to settle at $1,229.20 an ounce on Thursday after hitting a record high of $1,250 in previous session.

The metal’s surge was driven primarily by concern that an almost $1 trillion loan package in Europe will slow the region’s growth and debase its currency. Adjusted for inflation, gold is near its highest since April 1981, based on data at Bloomberg.

Record Investment Boosted by ETFs

Global investors, led by the US, last year bought a record 228.5 tons of gold in the form of bullion coins, up from 77.4 tons in 2000, according to GFMS, the London-based precious metals consultancy.

Exchange-traded funds (ETFs) also have made it convenient for retail investors to get in on gold. Holdings in physically backed gold exchange traded funds are at record highs after some ETFs last week experienced their biggest inflows in over a year.

The largest gold ETF–the SPDR Gold Trust (GLD)–recorded its highest daily inflow since early 2009 last week with total holdings hitting a record 1,185.78 tons.

Pattern Change – Gold & Stocks

Gold tends to rise when investors are uneasy about risky investments, so gold often gains as stocks fall. However, stocks continued to recover from last week’s big drop, while gold also broke new highs.  (Chart 1)

Meanwhile, the euro broke through the 14-month low reached against the dollar last week touching $1.2516. Some analysts say a test of the euro’s 2008 low of $1.2330 looks likely in coming sessions. These are clear signals that investors’ anxiety is with the euro.

Pattern Change – Gold, Dollar & Euro

Furthermore, gold prices usually go down when the dollar strengthens. But that inverse relationship gold previously has with the dollar has now been switched to the euro since late last year due to the sovereign debt crisis in Greece and Europe (Chart 1).

The lack of faith in the sustainability of the euro has been driving investors to flee the euro and go into gold, stocks and the U.S. dollar. Nevertheless, this is not indicative of any fundamental strength in the U.S. currency. Rather, it’s “relatively stronger” against the embattled euro.

Similar to Crude – Gold Has a High “P/E Ratio”

Now, many analysts expect gold prices to fall back near $800 an ounce over the next ten or twelve months, according to Jon Nadler at Kitco Bullion Dealers. Nadler thinks the economic fundamentals for gold are “completely upside down.” Demand from jewelry has been weak, and that much of gold’s recent strength has been speculative in nature.

However, similar to crude oil, gold also has become an asset class in itself and trades beyond market fundamentals. Gold has long been a safe haven when world markets are gripped by fear. Those fear factors—outlined below–if prolonged, will most likely drive investors to gold and send gold’s P/E ratio soaring far beyond the demand/supply fundamentals.

Fear Factor #1 – Inflation

Analysts say there’s a lot of fear on the part of the Europeans that moves to mitigate debt crisis will only lead to more problems. FT.com reported that traders and coin dealers said buying was exceptionally strong from German and Swiss investors.

The spike appears to reflect concerns in Germany about the potential inflationary impact of the European Central Bank’s decision to buy up euro zone government bonds in the wake of the Greek debt crisis. Outside the euro zone, dealers said that demand was also strong in North America.

Fear Factor #2 – Fiat Currencies Debase

The potential for other countries to be overwhelmed by debt also has investors rethinking paper currencies in general. Gold is vastly appealing as it has become the only reserve currency not backed by debt.

It is this fear that has fueled the price of gold rising against every major currency, not just the thrashed euro. (Chart 2)

Fear Factor #3 – Mountainous Sovereign Debt

The European Monetary Union (EMU) collectively is facing €965 billion of debt redemption this year.  Among them, three of the most heavily indebted PIIGS countries, Spain has to redeem €81 billion of debt this year, Italy at €267 billion, and Portugal with €19 billion. (Chart 3)

The Greek contagion may seem to be partially contained at the moment, but investors are still concerned widespread fiscal tightening could derail the already weak European economic recovery. Continued fears over the stability of the euro zone should further depress the euro and buoy gold prices.

The sheer scale of fiscal deficits facing numerous countries, including the United States, will likely prompt further diversification from fiat currencies and could ultimately propel gold to fresh highs.

Dissimilar to Crude – Not a Real Commodity

As noted earlier, gold is similar to crude oil with a built-in premium due to psychological factors. However, unlike crude oil, which is an essential energy source that the world cannot function without, gold has no real fundamental demand except for the use in jewelry.

Indeed, much of gold’s recent run-up has been driven by speculators, which means the correction(s) could be just as ferocious as the climb-up once investors’ fear subsides.

Short to Medium Term – Hinges on The Euro

Gold has risen 40% since the beginning of 2009, which suggests the market could be due for a correction. A dip in gold prices within the next 10 to 20 months is certainly possible as European and U.S. markets stabilize.

For now, the general trend over short term basis is still to the upside. But at this juncture, gold looks over-priced from a risk/reward standpoint. Retail/individual investors looking to invest in gold are best to stay on the sideline until a significant pullback, possibly at round $1,130. (Chart 4)

In the mean time, the 1,000-point drop in the Dow on May 6, although still under investigation, is a grim reminder that markets will likely be volatile going forward. Volatility breeds chaos and fear, and gold certainly has a proven record of thriving on both.

Economic Forecasts & Opinions

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On Hedging Equities By Being Long Volatility

Friday, April 23rd, 2010

By Prieur du Plessis, Investment Postcards from Capetown, Plexus Asset Management.

I have often in the past referred to the CBOE Volatility (VIX) Index, also known as Wall Street’s “fear index”. This is a measure of the implied volatility of S&P 500 index options – a high value corresponds to a more volatile market and therefore more costly options.

The VIX Index is an excellent contrary indicator, moving in the opposite direction to stocks, and worth keeping an eye on. The Index peaked at 80.9 in November 2008 and has since declined to a low of 15.6 beginning March before edging up a bit to 16.4. To add some longer-term perspective, the relatively calm four-year period prior to the start of the credit crisis was characterized by a range between 10 and 20.

The graph below shows the neat historical inverse relationship between the S&P 500 Index (black line) and the VIX (red).

Source: StockCharts.com

I am of the opinion that the nascent cyclical bull market is looking tired, on top of the fact that stocks over over-loved, overbought and overvalued. But let’s also get a second opinion on the matter and who better than from David Fuller (Fullermoney) from across the pond. He said: “Over the last fortnight I have repeatedly mentioned that the excellent stock market rally over the previous nine to ten weeks was becoming increasingly overextended relative to the mean for numerous trends. Last Friday and also this Monday, we saw a number of downward dynamics for many important stock market indices, such as the Dow Jones Industrial Index, the Shanghai Composite Index, the Switzerland SMI Index and the Australia AS&P ASX200 Index. Where they occurred, they interrupted short-term upward trends, indicating that a reaction and consolidation had commenced. I have also mentioned that this could turn into a mean reversion correction for some stock markets.

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“I do not think we are witnessing the onset of new or renewed bear markets. However, there have been some blows to investor confidence recently – mainly deteriorating sovereign debt problems, China’s monetary tightening to check property speculation, and the SEC’s case against Goldman Sachs. These events have checked upward momentum for most stock markets at a time when they were technically overstretched in the short term. Lastly, debt concerns prevented southern European stock markets from participating in the February to mid-April uptrend extension rallies seen elsewhere and laggards such as Greece, Portugal and Spain are trading below their moving averages.”

Back to the VIX: One way of hedging an equity portfolio is to bet on increased volatility that is bound to happen with any stock market correction. One can do this by buying either the iPath S&P 500 VIX Short-term Futures ETN (VXX) or iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). VXX invests in VIX futures contracts ending within the next two months, whereas VXZ is made up of VIX futures contracts running for four to seven months. A word of warning, though: these products generally represent an excellent way of hedging against stock market declines, but may not always fully track the VIX as a result of investing in futures that are also affected by other risk factors.

The graph below shows the VIX Index (red line) together with both VXX (green) and VXZ (blue).

Source: StockCharts.com

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Japan’s Misfortune Good News for Canadian Market

Sunday, January 10th, 2010

Commodities and the Canadian dollar have continued to strengthen despite the rally in the U.S. dollar. That’s odd, because for nine months, the U.S. dollar was involved in an inverse relationship with commodities, the Canadian dollar, equities, and emerging markets.

That relationship ended in late November as the dollar began its now, six-week old recovery.

It was often reported, from March to November 2009, that commodities prices were rising as a by-product of the falling U.S. dollar. That, indeed was doubly so. Speculative interest in commodities was driving prices higher, while rising short interest in the U.S. dollar, and record deployments of institutional cash were sending the currency lower, against the yen, and euro…

Find out why its possible Canadian stocks, bonds, the loonie, the commodity complex could remain relatively stable, and possibly go higher, though modestly.

Read the whole article here…

Pierre Daillie (AdvisorAnalyst.com), GlobeAdvisor.com, January 11, 2009

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