Housing: Good Vibrations (Sonders)

Thursday, August 2nd, 2012

July 30, 2012

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

Key Points

• Household formations are moving higher but housing completions aren’t keeping pace.
• Real mortgage rates plunge into negative territory.
• Key housing market index indicates continued sales (and pricing) recovery.

I’ve penned quite a few reports dedicated to housing over the past six years or so, the most recent being my “Rock Bottom” report in January of this year. I’ve also incorporated many of the charts I track into recent Market Snapshots videos. It’s time for an update.

First, I wear no blinders hiding the truth that the recovery in housing is not yet “healthy” relative to history. The housing market will continue to be hampered by anemic job growth, “underwater” homeowners and the foreclosure pipeline. But the forces of demographics and supply/demand imbalances have begun to register their weight and the data has done a great job of reinforcing our message from earlier this year.
Laws of supply and demand
Current conditions in the economics of housing reflect a considerable imbalance between supply and demand. Many chapters have been written about the supply part of the imbalance (i.e., overbuilding), but less ink has been spilled on the role of weak demand specific to declining household formations in since 2007. The National Association of Home Builders’ (NAHB) HousingEconomics.com division concludes that two-thirds of excess vacant housing units in the existing housing stock can be attributed to a steep decline in demand during the recession.

Household formations (e.g., adult children leaving parents’ households, singles leaving shared housing arrangements, etc.) are the largest component of demand for additions to the housing stock. These new households are accommodated by additions to the housing stock when vacancy rates are low, and are absorbed into the existing stock when vacancy rates are high. There’s a strong trend component to growth in the number of households, but formations are influenced by economic conditions—rising during good times and declining during bad times.

In the history of the data, the biggest declines in household formations occurred around recessions and bear markets. The 2010 drop in formations set a modern-day record, as seen in the chart below.
Boomerang Kids Moving Out of Parents’ Homes

Source: ISI Group, US Census Bureau, as of 2011. Household formations are calculated as the difference in households this year versus the past year.

A large gap is now developing as household formations surge from their recent base, while home completions lag behind. HousingEconomics.com suggests that a considerable portion of the excess housing supply (NY Fed president William Dudley recently estimated three million units) is due to a steep decline in demand related to economic conditions, rather than overbuilding. This has important implications: if excess housing supply was “pure” supply (i.e., assuming no pent-up demand), then recovery would take as long as it would take for demographic forces to catch up with supply. But, given that the excess supply embodies pent-up demand, then the recovery in housing will probably unfold more quickly than many believe.

Whether measured in terms of months’ supply or as a percentage of the working population, inventories of homes for sale have fallen dramatically since their peak. Inventories of single-family homes are down 24% from a year ago—the largest annual drop in at least 30 years, leaving inventories at roughly the historic levels that preceded the housing bubble. The number of homes for sale normalized for potential buyers (working age population) is now at a record low. This helps to explain the recent weaker home sales reports, which brought a few housing bears back out of hibernation. Existing home sales fell more than 5% in June to the lowest level in eight months. But, the prior month was revised up nicely and sales remain up more than 4% from a year ago. Looking deeper, the National Association of Realtors noted the decline in June was due to “tight supplies of affordable homes, limiting first-time buyers.” Another good sign is that despite weaker sales, median existing home prices shot up, reaching their highest level since September 2008. Real median home prices are up over 5% on a year-over-year trend basis, which is the most since March 2006, before the bubble burst.

Mortgage rates … get real!

Home prices are important for the obvious reasons, but also as an input into what I think is one of the most important housing metrics—the real mortgage rate. We’ve seen plenty of good news on the nominal mortgage rate front. The nominal 30-year fixed mortgage rate is now a record low 3.5%, but the “real” mortgage rate is even lower—in fact, it recently went negative.

Many long-time readers know that I pay more attention to the real mortgage rate (RMR) than the nominal mortgage rate. Just like real gross domestic product (GDP) is the difference between nominal GDP and inflation, the RMR is the difference between the nominal mortgage rate and the rate of appreciation (or depreciation) in median home prices. Why should we look at it this way? It’s not only the rate at which we’re borrowing that matters, but what’s happening to the price of the asset we’re borrowing to buy. See the chart below, which tracks the RMR back to the early 1970s.

Real Mortgage Rates Plunging

Source: FactSet, Federal Reserve, National Association of Realtors, National Bureau of Economic Research (NBER), as of June, 2012.

At the peak in the bubble, RMRs were -11% (6% nominal mortgage rate minus 17% appreciation rate). Fast-forward to the trough of the housing bust and RMRs had surged to 22% (5% nominal mortgage rate minus a 17% depreciation rate). No wonder the bubble burst: who would want to borrow at any rate to buy a rapidly depreciating asset? But today, RMRs are back in negative territory. It makes sense again to borrow to buy a house since home prices are now appreciating at a rate higher than the mortgage rate.

Surging housing market index

The NAHB/Wells Fargo Housing Market Index (HMI) is one of the most watched housing metrics and is based on a monthly survey of the National Association of Home Builders’ members. It gauges builder confidence about the single-family housing market and is a weighted average of market conditions for current new home sales, sales expectations for the next six months, and traffic from prospective buyers. As you can see in the chart below, there has historically been a tight relationship between the HMI and total home sales; and the latest jump is “forecasting” more sales to come.

Housing Market Index Suggests Higher Sales

Source: FactSet, National Association of Home Builders (NAHB), National Association of Realtors, US Census Bureau. NAHB Housing Index as of July, 2012. Total Home Sales (existing and new) as of June, 2012.

As an aside, I recently discovered (thanks to Wolfe Trahan) the relationship charted below, which compares the HMI (advanced 21 months) to the fed funds rate (which has effectively been zero since late 2008). Historically the two have been highly correlated. This should not serve as any kind of “warning” that the Fed will be raising rates sooner than it’s telegraphed (late 2014)—the Fed is making decisions on more than just trends in housing—but it will be something I am tracking.

Will Housing’s Recovery Alter Fed Policy?

Source: FactSet, Wolfe Trahan & Co., as of July 30, 2012.
Echo boomers to the rescue
I recently read the “State of the Nation’s Housing” report by the Joint Center for Housing Studies of Harvard University. In it was a discussion of demographics and I’ll conclude with some of their most interesting observations. “Assuming the economic recovery is sustained in the next few years, the growth and aging of the current population alone—including the entrance of the echo boomers into adulthood—should support the addition of about one million new households per year over the next decade.” The report also suggested adding at least another 180,000 to that estimate from immigration. Due to these demographic trends, it’s a decent bet that demand will continue to revive, even if job growth remains weak.

One of the concluding comments from the report was its most compelling: “The good news for housing production is that this new generation already outnumbers that of the baby boomers at the same ages. With even a modest lift from immigration, the echo boom generation will grow even larger as its members move into the prime household formation years.”
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.

Copyright © Charles Schwab & Co., Inc.

Tags: Adult Children, Blinders, Charles Schwab, Chief Investment Strategist, Completions, Good Vibrations, Housing Market, Keeping Pace, Laws Of Supply And Demand, Liz Ann, Market Index, Market Snapshots, Mortgage Rates, Nahb, National Association Of Home Builders, Negative Territory, Rock Bottom, Senior Vice President, Steep Decline, Vacancy Rates
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U.S. Equity Market Radar (July 30, 2012)

Sunday, July 29th, 2012

U.S. Equity Market Radar (July 30, 2012)

The S&P 500 Index rose 1.71 percent this week as the equity market shrugged off weak earnings reports and focused on potential monetary policy easing from both the Federal Reserve and European Central Bank (ECB), which could come as early as next week. The telecom services sector led the way, followed by financials and industrials. The materials sector was the only sector in negative territory for the week.

Strengths

• The telecommunication services sector was the best performer this week rising 4 percent, driven by much-better-than-expected earnings reports from MetroPCS Communications and Sprint Nextel. MetroPCS was the best performer in the S&P 500, rising by more than 40 percent.
• The financial sector was predominately led higher by the investment banks and brokerage stocks, which were among the worst performers last week. JPMorgan Chase, Goldman Sachs, Morgan Stanley and Citigroup all rose by more than six percent.
• The industrial sector also performed well as key stocks outperformed, including Caterpillar and General Electric.

Weaknesses

• The materials sector lagged as Dow Chemical disappointed along with Vulcan Materials. Cliffs Natural Resources was the worst performer in the group on continued weak iron ore prices.
• Other areas that were weak included education services, casino and gaming, construction materials, and coal.
• DeVry, the for-profit education company, was the worst performer, falling 29 percent as the company warned of higher costs and declining enrollment.

Opportunity

• The market shifted its focus from earnings to central bank policy late in the week and that should be the focus next week as we could see action from the Fed, the ECB or both.

Threat

• While policy-makers in Europe have made strides to stabilize the situation, many risks remain and the situation remains very fluid.
• China recently cut interest rates for the second time in a month, which likely indicates that conditions on the ground remain challenging.

Tags: Dow Chemical, Earnings Reports, ECB, Education Company, Education Services, Financial Sector, Goldman Sachs, Industrial Sector, Investment Banks, Iron Ore Prices, Market Radar, Materials Sector, Metropcs, Morgan Stanley, Negative Territory, Profit Education, Sprint Nextel, Telecom Services, Telecommunication Services, Vulcan Materials
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3 reasons Eurozone’s investors love Danish bonds

Sunday, July 15th, 2012

by Sober Look

Would you pay Denmark’s government 0.6% to hold your money for two years? Sounds strange, but that’s exactly what investors are now doing. Denmark’s government paper yields just hit new lows. And it’s not only the short-term bills with the negative yield (short term bills sometimes go negative when investors seek immediate liquidity). The 2 and 3-year notes are now also comfortably in the negative territory as Eurozone’s investors simply can’t get enough.

Denmark’s 2 and 3-year government yields

Why do the Eurozone investors love Demark’s bonds so much that they are willing to lock in negative yields for 2-3 years? Here are 3 key reasons:

1. Eurozone based investors are not taking much FX risk because Denmark keeps EUR-DKK exchange rate tightly pegged.

DKK per 1 euro

2. Investors love Denmark’s economic fundamentals, particularly the relatively low government debt and deficit.

Source: Bloomberg/BW

3. Keeping funds outside the Eurozone may provide a hedge against potential problems associated with the monetary union’s stability.

Bloomberg/BW: – If the euro crisis worsens, foreign capital may keep pouring in, negative rates or no. Says Ian Stannard, chief European currency strategist at Morgan Stanley in London: “For an international investor with euro zone exposure, buying Danish assets can be a hedge against the extreme scenario of the euro breaking up.”

SoberLook.com

Tags: Bloomberg, Bw 3, Currency Strategist, Demark, Dkk Exchange Rate, Economic Fundamentals, Euro Zone, Extreme Scenario, Government Debt, Government Paper, International Investor, Key Reasons, liquidity, Lows, Monetary Union, Morgan Stanley, Negative Territory, Stannard, Term Bills, Zone Exposure
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Gold, Gold Miners Float Higher on Eurozone Concerns and Weakness (June 4, 2012)

Monday, June 4th, 2012

Gold Market Radar (June 4, 2012)

For the week, spot gold closed at $1,624.10 up $51.07 per ounce, or 3.3 percent.  Gold stocks, as measured by the NYSE Arca Gold Miners Index, beat bullion with a 3.6 percent return. The U.S. Trade-Weighted Dollar Index gained 0.6 percent for the week.

Strengths

• Confidence in the gold market got a big boost on Friday as the change in U.S. Nonfarm Payroll jobs number came in at just 69,000, falling far short of the 150,000 expectation, thus increasing the likelihood that the Fed will take steps to stimulate the economy.
• The yield on the U.S. 10-year note plunged to 1.45 percent and two-year German note yields actually drifted into negative territory.  Although inflation is pretty tame, real interest rates are negative and gold historically performs well under such conditions.
• John Embry of Sprott Asset Management was certainly ahead of the curve when interviewed for a story on Mineweb this week and noted he doesn’t see a recovery of any substance whatsoever in the U.S.  Everybody is just so focused on Europe at the moment.  Embry points out that the most shocking statistic that has come out in the last nine months is the fact that last year the U.S. monetized 61 percent of its budget deficit, which is staggering, yet no one seems to care.

Weaknesses

• Silver did not participate in the rally this week but with trading in the new silver contracts on the Shanghai Futures Exchange its prospects could improve.  Some traders speculate the contracts to be bullish for silver prices, similar to the start of trading in gold futures in China, and that the venue could make market manipulation more difficult.  It is believed that this move signals China clearly wants more control over the precious metal’s pricing policy.  Historically China has used silver as a currency.
• While Greece has been at the forefront of most of the European woes, the shift in focus to Spain is a real worry as this problem cannot be effectively addressed. Something like 100 billion euros were withdrawn from the country in the first quarter and, much like Greece, there have been issues with citizens taking their money out of local banks.  Last week trading in shares of Bankia, the fourth largest Spanish bank which was nationalized earlier this month, was suspended as it became apparent that the bank requires more than 15 billion Euros ($19 billion).  Bankia holds around 10 percent of the country’s bank deposits.
• The combined European nations don’t have the wherewithal to bail Spain out from its enormous debt.  Implementing further austerity measures to allay its debt problems when a quarter of its people (and nearly 50 percent of its youth) are already unemployed will prove to be very problematic.

Opportunities

• Robert Cohen, a precious metals portfolio manager at GCIC, was interviewed by the Gold Report and pointed out we are at a unique place in history where the metal prices are robust and yet the stock prices are the cheapest he has ever seen relative to underlying commodity prices.  Investors have turned up their risk dials resulting in lower stock prices with few willing buyers.  Cohen believes it is a good time to accumulate positions before QE3 comes.
• Industrial and Commercial Bank of China Ltd. (ICBC) is the world’s largest bank by market value and is the top player by volume on China’s gold and future exchanges.  It was reported that ICBC is seeking membership of overseas exchanges and aims to become a major global bullion market maker.  This would allow ICBC to grow its financial products to service the supply chain of the bullion market, including loans to miners and smelters, physical gold leasing, hedging and brokering.
• Ian McAvity noted that gold is increasingly trading like a currency and believes most of the speculative money has now largely been chased out of the gold market.  But he states that the attitude of many of the U.S. banks is that what is happening now is very much a European problem. “If a European bank blows up, that problem will cross the Atlantic in a Nano-second because the Federal Reserve was bailing out some of the European banks in 2008-2009 and they’ll be doing it again.”  Ian raises the question, how can you borrow your way out of a debt problem?  With money coming out of the euro and the dollar not really in that much better shape, Ian believes that some of that money will find its way into the gold market, pushing prices higher.

Threats

• Europe is China’s largest export market and it is a very important source of trade finance for its industry.  Much like 2008, trade in commodities nearly came to a halt as shippers could not obtain a Letter of Credit from a financial institution. Problems in Europe will roll over to China.  Economic growth in India showed its weakest quarter in roughly nine years and inflation is still stinging their confidence.
• In Argentina, the mining business just got a little harder. As of this week, mining companies will have to submit quarterly estimates of their purchasing needs which will need approval by a special working group at the Mining Ministry.  It is feared the government review process could delay the deliveries of mining inputs by an additional six months.
• Since February, mining companies have had to obtain approvals from a number of government agencies before they can import goods or buy offshore services.  Mining companies have also had to create a separate purchasing department dedicated to substituting imported goods and services with Argentinean products and services.  Currently it is estimated that as much as 70 percent of inputs used by the mining industry have to be imported.

Tags: Budget Deficit, Dollar Index, Eurozone, Gold Bullion, Gold Futures, Gold Gold, Gold Market, Gold Miners, gold stocks, India, John Embry, Market Manipulation, Market Radar, Negative Territory, Nonfarm Payroll, Nyse Arca, Precious Metal, Shanghai Futures Exchange, Shocking Statistic, Silver Prices, Spot Gold, Sprott
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Investor Question: Gold or Gold Miners? (Koesterich)

Wednesday, April 18th, 2012

by Russ Koesterich, iShares

The Federal Reserve may be the best friend gold investors ever had.

The most important factor for gold is actually not inflation or the dollar, but rather the level of real interest rates. In fact, the relationship between gold and real rates is so critical that since 1990, the level of real rates explains roughly 60% of the annual performance of gold.

Gold generally does best in an environment in which real rates are low to negative as this means no opportunity cost to holding gold. Since 2003 – when gold began its long-term outperformance – we have been in just such an environment. Real long-term yields have averaged 1.3%, half of their long-term average, and over the past year, real rates have fallen into negative territory.

And given that the Fed has made it clear that monetary conditions will remain accommodative for the foreseeable future, the low to negative real rates that have supported gold for most of the last decade will likely stay in place.

So what does this mean for investors? It’s important to keep in mind that despite gold’s expense and the current cheap valuations of gold mining company stocks, gold miners are not a good substitute for physical gold from an asset allocation perspective.

First, while it’s true that miners and gold tend to be highly correlated, these are different asset classes. As a commodity, gold is diversifying to a portfolio. Second, over the long term, gold has been a much better inflation hedge. Third, while many investors believe that miners are due for a spell of outperformance given their recent under performance versus the metal, miners have actually been trailing gold since 2003. Finally, real rates have historically had little to no impact on equity returns.

As such, I wouldn’t advocate selling gold to buy gold miners, and I continue to advocate maintaining a strategic allocation to gold through funds that access the physical metal such as the iShares Gold Trust (NYSEARCA: IAU).

Source: Bloomberg

Copyright © iShares

Tags: Asset Allocation, Asset Classes, Commodity Gold, Company Stocks, Federal Reserve, Foreseeable Future, Gold Gold, Gold Investors, Gold Miners, Gold Mining Company, gold stocks, Investor Question, Last Decade, Monetary Conditions, Negative Territory, Opportunity Cost, Outperformance, physical gold, Term Yields, Valuations
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The Economy and Bond Market Radar (December 4, 2011)

Sunday, December 4th, 2011

The Economy and Bond Market Radar (December 4, 2011)

Long-term Treasury yields ended the week higher as coordinated global central bank action helped alleviate immediate fears of a liquidity crisis in European banks.

The chart below depicts the 10-year Italian Government Bond yield which hit new highs last week but rallied sharply on this week’s central bank intervention. This was a “risk off” week with relatively risky assets rallying.

Strengths

• Coordinated action by global central banks lessens the odds of another financial crisis.
• Economic data in the U.S. remained relatively strong as the economy created 120,000 jobs in November, consumer confidence jumped, manufacturing indicators improved and auto sales were generally better than expected.
• International data was mixed, but Japanese industrial production rose 2.4 percent in October, well ahead of expectations.

Weaknesses

• The negative aspect of the central bank action this week was on rumors a European bank was on the cusp of a liquidity crisis and the central bankers were forced to act to avert a crisis.
• S&P downgraded many large global banking institutions.
• China’s purchasing managers index (PMI) fell into negative territory for the first time since 2009.

Opportunities

• The European Central Bank (ECB) indicated a willingness to provide additional support if European leaders agree to a fiscal union.

Threats

• The situation in Europe remains extremely fluid and negative news is almost expected at this point, unfortunately it is politically driven and difficult to predict outcomes and ramifications.

Tags: Banking Institutions, Bond Yield, Central Bank Intervention, Central Banks, Consumer Confidence, European Banks, European Leaders, Global Banking, Government Bond, Italian Government, Liquidity Crisis, Market Radar, Negative Aspect, Negative News, Negative Territory, New Highs, Purchasing Managers Index, Risky Assets, S Central, Treasury Yields
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Bursting the TIPs Bubble (Koesterich)

Tuesday, September 20th, 2011

Call #1: Negative TIPS in the long term; Maintain neutral TIPS in the near term

Recently, investors have been piling into US inflation-linked bonds, or TIPS, as part of their rush to safe-haven assets.

The buying has pushed the real return on TIPS close to negative territory.  In other words, investors have been willing to lock their money up for a decade with the promise of a zero after-inflation return. This makes no sense.

Starting with a bit of history, since the TIPS market was launched in 1997, real yields on 10-Year TIPS have averaged around 2.5%. This is consistent with the long-term historical spread between the yield on the nominal 10-year Treasury and headline inflation. It is also what most of the academic literature suggests is a reasonable real return and is much higher than today’s real yield level.

To be sure, for some investors, current nearly negative real yields are justified due to the anemic nature of the economic recovery. When growth is weak, as it currently is, there is less demand for capital so the price of money drops.

But even when you correct for economic growth, TIPS currently look expensive. Based on the historical relationship between real yields and unemployment, you would expect the yield-to-maturity on the 10-year TIPS to be around 1.10%, not zero. In fact, current real yields are actually suggesting a much more significant collapse in the labor market and an unemployment rate of roughly 12%. This begs the question: Is this a realistic scenario?

While I think the United States will suffer through a prolonged period of slow growth, most evidence still suggests that the United States is not entering a deflationary spiral similar to what has been going on in Japan for most of the past twenty years.

Starting with actual inflation, the path of US inflation looks very different than Japan’s own path a decade ago. In fact, by this point in Japan’s cycle, core inflation was already negative. Whatever is in store for the US economy, deflation appears to be less of a threat.

Second, while there is no lack of bad news for the US economy, there is a difference between a slow recovery and a death spiral. For example, from the peak of Japan’s deflationary spiral in 1990 through 2002, lending by Japanese banks collapsed for a dozen years.

In contrast, while US lending is still weak as consumers are trying to rebuild their balance sheets, it is starting to improve. Bank lending to commercial clients has risen for 10 straight months, and is now 6% above its level a year ago. It will take a long time for banking to return to a more normal environment, but the situation looks much better than it did a year ago.

The bottom line: By piling into US TIPS, investors are driving up prices and driving down yields to a point where these instruments now make little sense for long-term investors. As such, I’m changing my long-term view of TIPS to underweight. Still, I’m keeping my near-term view neutral given the anemic state of the economic recovery and the growing risk aversion in market places.

Call #2: Maintain overweight mega caps

Bonds, in general, are considered less risky than stocks. But I think investors can do better than a zero percent real return. While volatility is likely to stay high in the near term, instead of focusing on TIPS, a better alternative may be to consider focusing on a portfolio of large, dividend paying stocks such as can be accessed through the iShares High Dividend Equity Fund (HDV), the iShares Dow Jones Select Dividend Index Fund (DVY) or the iShares S&P Global 100 Index Fund (IOO).

Disclosure: Author is long IOO and DVY

Source: Bloomberg

TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, not iShares exchange traded funds.

There is no guarantee that dividends will be paid.

Tags: Academic Literature, Assets, Bonds, Collapse, Core Inflation, Decade, Deflationary Spiral, Economic Growth, Economic Recovery, Headline Inflation, Inflation Linked Bonds, Investors, Negative Territory, Prolonged Period, Realistic Scenario, Rush, Safe Haven, Treasury, Twenty Years, Unemployment Rate, Yield To Maturity
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Underfunded Pensions Making Riskier Bets?

Monday, September 12th, 2011

Underfunded Pensions Making Riskier Bets?

John Mellow of CNBC reports, Underfunded Pensions Pressured to Make Riskier Bets:

After a tumultuous August, pension funds for companies, governments and unions are falling further under water, raising pressure on boards to take on more risk at a time when the economic and policy outlook has never been more uncertain.

Entering 2011, pension plans for companies in the S&P 500 were just 75 percent funded, down from 85 percent in 2010 and roughly 78 percent following the Lehman collapse, according to Goldman Sachs. Funding levels—likely even uglier on a municipal and union level—just got worse.

“The recent fall in equity prices and in interest rates has led to sharp declines in the funding position of many institutional investors,” wrote Jim O’Neill, head of Goldman Sachs Asset Management, in a note to clients Thursday. “Recent market movements have left many institutional investors wary of taking risk, but at the same time mindful of the necessity of doing so in a thoughtful way.”

After a volatile August that ultimately brought the S&P 500 into negative territory for the year, September kicked off with its worst 3-day start post WWII. Meanwhile, the 10-year Treasury yield is trading at a lowly 2 percent.

Stocks added to losses Thursday as Federal Reserve Chairman Ben Bernanke failed in a speech to hint at the specific stimulus he will use to fight the next stage of this struggling recovery. Pessimism that any proposals from President Obama will be voted down by Republicans added to the drop and cloudy outlook.

But regardless, Goldman Sachs Asset Management Thursday advised its pension clients today to increase exposure in emerging markets, crude oil and high yield corporate bonds. Goldman also advised using options to hedge equity downside risk.

“While market volatility is, in our view, likely to stay elevated in the near term, we remain reasonably constructive on the global economy, particularly on the outlook for growth and emerging markets,” said the note, citing favorable demographics and rising productivity.

Pension fund managers face the difficult choice between taking this advice at a time when conditions seem the most dangerous and staying conservative as these strategies begin to pay off over the long term.

At some point, especially with percentage of the population over 65 years old expected to double in the next 20 years, the funds will be forced to drop their annual return assumptions – typically above 8 percent – upon which their future obligations are calculated. Companies and states are reluctant to do that though because that means an immediate hit to their bottom line. The other choice is cut the benefits side.

Many funds are turning to hedge funds to generate the returns for them in this tumultuous environment.

“Most pension funds should already be in commodities and emerging markets and deploying options strategies,” said Damon Krytzer, a trustee for the San Jose Police and Fire retirement plan and a managing director at Waverly Advisors. “The problem is many are behind the times.”

Krytzer, Goldman and others are not necessarily advising funds “trade their way out” of the funding hole. Instead, they are just advising the funds to get positioned for a long period for this nation of slow growth and low rates where alternative and global strategies work best.

But it’s just a tough sell to traditionally conservative pension boards. Especially when emerging markets, based on the iShares MSCI Emerging Markets ETF, plunged more than 11 percent in August alone.

So what’s going on? Are pensions de-risking or making riskier bets? In recent comments I’ve highlighted how pensions like GM are de-risking moving into bonds, but likely taking on more risk than they’re aware of.

But with long-term bond yields at historic lows, most underfunded pension plans are cranking up the risk to meet their actuarial return targets which are based on rosy investment assumptions using an insanely high discount rate of 8%. The mismatch between reality and rosy investment assumptions is what’s prompting underfunded pensions to take on more risk in all asset classes, including alternative investments like hedge funds.

However, one truism in markets is that more risk means more potential upside and more potential downside. And the downside skew is enormous in this wolf market dominated by high frequency trading computers. So I warn pensions to be careful allocating to hedge funds, especially the ones focused on asset gathering not performance, stay nimble, be opportunistic and use options to mitigate downside risk. The added cost of protection will pay off if another crisis erupts.

Finally, we’ll see if President Obama’s $450 billion stimulus bill passes Congress but it’s Europe that worries me these days. European leaders are foolishly escalating tough talk on Greece. I agree with Chris Ciovacco, shorts may prey on serious problems in Europe, which is why policymakers and central bankers must exercise caution, be extra vigilant and deliver policies that are in the best interest of the global economy. As President Obama highlighted in his speech below: “The next election is 14 months away. And the people who sent us here — the people who hired us to work for them — they don’t have the luxury of waiting 14 months. Some of them are living week to week, paycheck to paycheck, even day to day. They need help, and they need it now. “

Tags: Bonds, Cnbc, Commodities, Crude Oil, Downside Risk, Emerging Markets, Federal Reserve Chairman, Federal Reserve Chairman Ben Bernanke, Global Economy, Gold, Goldman Sachs, Goldman Sachs Asset Management, High Yield Corporate Bonds, Institutional Investors, Market Volatility, Negative Territory, O Neill, Obama, Outlook, Pension Funds, Pension Plans, Pessimism, Policy Outlook, Stimulus
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Gary Shilling: 20% Drop in Housing to Cause Recession in 2012

Thursday, July 14th, 2011

Gary Shilling, author of the Age of Deleveraging, and President of Gary Shilling & Company, says there is another recession looming on the horizon, and at this point, it will be irrelevant what the Fed does next.

“Economic growth here and abroad is slipping, making a 2012 recession a distinct possibility,” writes Shilling, in his July newsletter. And, “when you have slow growth it doesn’t take much of a shock to throw you in negative territory.”

‘Another leg down in housing,’ will be the shock that precipitates the next economic decline, as the Fed has been unable to recessitate this asset class. Shilling’s forecasts are known for being generally bearish, but much to his credit, he was among a very small number of economists who foresaw and correctly predicted the jeopardy of the subprime mortgage market, and the destructive effect it would have on the broader U.S. economy.

Shilling’s research highlights that a huge excess inventory is the ‘achilles heal’ in the real estate market. His estimates show there are 2 million to 2.5 million excess homes in the country – roughly 4-5 years worth of slack. In the end, he predicts housing prices will fall another 20% and the proportion of underwater mortgages will rise to 40%, from a current level of 23%.

On that basis, Shilling says a recession is “coming to a town near you.”

Source: Yahoo Tech Ticker, July 14, 2011

Tags: 5 Million, Achilles, asset class, Destructive Effect, Distinct Possibility, Economic Decline, Economic Growth, Economists, Estimates, Excess Inventory, Gary Shilling, Horizon, Jeopardy, July 14, Negative Territory, Proportion, Recession, Shock, Slack, Subprime Mortgage Market
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Stock Price Correction Mostly Played Out, But Duration Could Go Longer (BCA)

Wednesday, June 29th, 2011

In the context of this macro-economic climate, BCA Research says that investors will need to become more tactically involved in asset allocation, than they needed to be during the initial period of the equity rally, and that technical signals will become very important as far as the timing of moves is concerned.

BCA’s U.S. Equity Strategy service has watched numerous key technical measures during the current correction. It appears sentiment has retraced back to levels that indicate previous bull market troughs. More NYSE stocks are currently reaching new lows than highs, indicating that selling or ‘distribution’ pressure is advancing.

BCA has two proprietary indices, the Intermediate Equity Indicator, and the Capitulation Index, and both have dropped sharply and are getting close to neutral territory. In past corrections, both of these slipped slightly into negative territory by the time broader markets hit the floor.

According to BCA, when you combine these technical signals, what shines through is that the bulk of the corrective phase may be over as far as magnitude, though none of these indicators has been fully played out, especially if you consider the VIX has yet to ‘spike.’

In conclusion, BCA says that while the market has already experienced an advanced correction, where price is concerned, its duration still has room to run.

Copyright © BCA Research

Tags: Asset Allocation, Capitulation, Corrective Phase, Distribution Pressure, Duration, Economic Climate, Equity Strategy, Initial Period, Lows, Magnitude, Negative Territory, Neutral Territory, Nyse Stocks, Sentiment, Signals, Stock Price, Strategy Service, Technical Measures, Troughs, Vix
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