The Economy and Bond Market Radar (July 30, 2012)

Sunday, July 29th, 2012

The Economy and Bond Market Radar (July 30, 2012)

After hitting a new low on Tuesday, Treasury yields bounced back sharply on Friday as ECB president Mario Draghi vowed to do whatever it takes to save the euro. This news sparked a “risk on” rally driving risky assets higher and bond prices lower. Yields on Spanish 10-year government bonds reversed course and dropped sharply on the news as it appears the likelihood of a sovereign default has diminished.

Strengths

• In addition to the ECB news discussed above, there was a front page story in the Wall Street Journal earlier this week that was widely believed to be leaked from the Fed to prep the market for potential Fed policy actions as soon as next week. Monetary policy-makers are taking action around the globe.
• Second quarter GDP grew 1.5 percent. While this is a slow level of absolute growth, it modestly beat expectations.
• Several homebuilding companies reported earnings this week which indicated orders in the second quarter were very robust.

Weaknesses

• June durable goods orders ex-transportation fell 1.1 percent, indicating broad-based weakness.
• The U.K. economy contracted by 0.7 percent in the second quarter, while Mexico’s economy shrank by 0.36 percent in May.
• Markit’s July eurozone manufacturing Purchasing Managers Index (PMI) fell to the lowest level since June 2009. The more traditional PMI reports will be released next week, but the indications obviously look weak.

Opportunity

• The Fed and ECB are both talking about additional monetary stimulus. Interest rates are likely to remain very low for the foreseeable future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.

Tags: Bond Market, Bond Prices, Durable Goods Orders, Ecb President, Fed Policy, Government Bonds, Homebuilding Companies, Mario Draghi, Market Radar, Markit, Monetary Policy, Pmi, Policy Actions, Purchasing Managers Index, Quarter Gdp, Risky Assets, Shifting Focus, Stimulus, Treasury Yields, Wall Street Journal
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Is Higher Inflation on the Horizon?

Wednesday, July 18th, 2012

by Orhan Imer, Ph.D., Columbia Asset Management

For nearly two decades, inflation in the U.S. has been fairly contained except for a few periods of moderate acceleration around peak levels of economic activity. More recently, headline inflation as measured by the year-over-year change in the CPI-U (Consumer Price Index for Urban Consumers) declined from 3.9% in September 2011 to 1.7% in May 2012, driven primarily by the slowdown in the U.S. economy and the sharp drop in energy and commodity prices.

While the current level of inflation remains subdued, investors should be prepared for risk of longer-term inflation associated with highly accommodative monetary and fiscal policy actions taken by the Fed and the U.S. Government since 2008.

During the past several years, the Fed’s monetary policy decisions, intended to stimulate U.S. growth, have become less centered on containing inflation. In particular, the Fed’s near-zero interest rate policy and expanded balance sheet along with deficit spending by the government to lift the economy out of recession have raised the risk of future inflation. Other conditions that may add to inflationary pressures over the next decade and beyond include:

1. Accelerated government spending on healthcare and other non-discretionary spending programs (such as Social Security, Medicare and Medicaid) necessitating continued high levels of federal borrowing
2. Demographic shifts in the U.S. population as baby boomers begin to retire leading to lower savings and productivity
3. Higher tax rates on income and capital gains raising the cost of capital dampening capital investment and productivity
4. Weakening of the U.S. dollar due to Fed’s interest rate policy and massive monetary easing which may promote inflation through higher energy and commodity prices
5. Emerging market countries representing a growing share of global GDP and driving up the demand for scarce resources (commodities, land and other real assets)

While the recent slowdown of the global economy along with the continuing weakness in the U.S. housing market and excess manufacturing capacity in many industries may keep inflationary pressures at bay near term, investors should protect themselves against unexpected inflation, as surprises in inflation can have a meaningful impact on the performance of inflation-sensitive assets.

Read more in this week’s Perspectives.

See more Market Insights from Columbia Management.

Tags: Baby Boomers, Columbia Asset Management, Commodity Prices, Consumer Price Index, Deficit Spending, Demographic Shifts, Discretionary Spending, Emerging Market Countries, Global Gdp, Headline Inflation, Imer, Inflationary Pressures, Interest Rate Policy, Monetary And Fiscal Policy, Monetary Policy Decisions, Peak Levels, Policy Actions, Real Assets, Term Inflation, Urban Consumers
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U.S. Equity Market Radar (July 16, 2012)

Saturday, July 14th, 2012

U.S. Equity Market Radar (July 16, 2012)

The S&P 500 Index rose 0.16 percent this week driven by a strong rally on Friday as Chinese GDP was in line with expectations and earnings from JP Morgan were well received after recent intense attention surrounding a recently acknowledged trading loss. Along with financials, defensive areas such as utilities and healthcare tended to outperform.

Strengths

• The financial sector was the best performer rising 1.62 percent with J.P. Morgan rising 6.4 percent as the company reported earnings on Friday that were well received by the market.
• The utility sector wasn’t far behind with broad-based gains as 30 of 31 S&P 500 constituents rose for the week.
• The best individual stock performer this week was Diamond Offshore which rose 7.57 percent. Other deepwater offshore drillers were also strong on reports of increased rig tender activity and the signing of a deep water contract by Noble Corp. at attractive levels.

Weaknesses

• The technology sector lagged as negative preannouncements from Lexmark International, Applied Materials and Advanced Micro Devices. In addition, Acer (the world’s third largest computer maker) cut its 2012 PC shipment forecast.

• The materials sector also lagged as Freeport-McMoRan fell by more than 5 percent on China slowdown concerns and Alcoa falling by 3.65 percent on disappointing earnings results.
• Lexmark International was the worst performer this week, falling by more than 24 percent as the company preannounced second quarter results and reduced forecasts due to weaker demand in Europe.

Opportunity

• We saw additional monetary easing this week with rate cuts from Brazil and South Korea after a barrage of activity last week with rate cuts from the European Central Bank (ECB) and Bank of China, along with more quantitative easing from the Bank of England. These government policy actions are positive for the equity markets and risky assets in general.

Threat

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

Tags: Advanced Micro Devices, Applied Materials, Bank Of China, China Slowdown, Computer Maker, Diamond Offshore, Earnings Results, Freeport Mcmoran, Intense Attention, Jp Morgan, Largest Computer, Lexmark International, Market Radar, Materials Sector, Noble Corp, Offshore Drillers, Policy Actions, Risky Assets, Utility Sector, Water Contract
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U.S. Equity Market Radar (July 9, 2012)

Sunday, July 8th, 2012

U.S. Equity Market Radar (July 9, 2012)

The S&P 500 Index fell 0.55 percent this week, driven lower by a disappointing employment report on Friday. Defensive areas tended to outperform such as consumer staples and telecommunications services, along with select retail names in the consumer discretionary sector.

Strengths

• The consumer staples sector rose 0.54 percent this week as defensive tobacco stocks rose along with names such as Wal-Mart, Constellation Brands and Monster Beverage.
• The consumer discretionary sector was also able to eke out a small gain this week as discount stores such as Ross Stores and Family Dollar tended to do well. Homebuilders were also among the best performers for the week continuing a recent trend.
• The best individual stock performer this week was Netflix which rose 19.6 percent as the company announced that subscribers streamed more than 1 billion hours of video in June.

Weaknesses

• The industrials sector lagged as heavyweights such as General Electric, Emerson Electric and Joy Global all fell by more than 2.5 percent this week.

• The financial sector also lagged with Bank of America and JP Morgan both falling by more than 5 percent.
• Fossil, Inc. was the worst performer this week, falling by more than 10 percent on fears that excessive discounting and promotions at the company’s retail stores indicate soft demand.

Opportunity

• A barrage of government policy actions out this week with rate cuts from the European Central Bank (ECB) and Bank of China, along with more quantitative easing from the Bank of England, appears likely to propel the recent rally in risky assets even further.

Threat

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

Tags: Bank Of America, Bank Of China, Constellation Brands, Consumer Discretionary Sector, Consumer Staples, Emerson Electric, Family Dollar, Fossil Inc, Joy Global, Jp Morgan, Market Radar, Netflix, Policy Actions, Retail Names, Risky Assets, Ross Stores, Sector Strengths, Telecommunications Services, Tobacco Stocks, Wal Mart
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U.S. Equity Market Radar (January 23, 2012)

Sunday, January 22nd, 2012

U.S. Equity Market Radar (January 23, 2012)

The domestic stock market as measured by the S&P 500 Index was higher this week by 2.04 percent. We have seen a global rally in January with much of this performance coming this week. When trying to decipher the underlying cause it is often helpful to look at significant government policy actions.

On December 21, 2011 the European Central Bank (ECB) implemented the first tranche of the three-year long-term refinancing operation (LTRO) of approximately $635 billion, as the ECB attempted to secure long-term funding for banks that would allow them time to work through their current difficulties without the fear of a run on the bank. Another round of funding is scheduled for February. The chart below compares the timing of the current LTRO to the Federal Reserve’s quantitative easing and TARP program in 2008. The LTRO program is a form of quantitative easing and judging by the effect on the global equity markets, it appears to be working. The chart below looks at the global equity risk premium as a proxy for equity risk aversion and as can be easily seen in the chart , the end of 2011 was a very fearful time for equity investors. If 2008 and 2009 set precedent, then 2012 is shaping up to be a good year.

Strengths

• The information technology sector was the best-performing sector this week as several bellwether technology companies reported earnings that were well received by the market.
• The semiconductor equipment group was particularly strong, increasing by more than 8 percent as strong earning results combined with increased orders or capital expenditure announcements from Intel and Taiwan Semiconductor.
• The investment bank and brokerage industry group was also strong with Goldman Sachs and Morgan Stanley both up around 10 percent for the week on the back of well received earnings reports.

Weaknesses

• The utilities sector underperformed and was the only sector to post negative performance for the week, as the market rotates away from defensive areas.
• The auto parts and equipment industry group underperformed as Johnson Controls lowered guidance on weak European production and currency effects.
• The educational services group also underperformed as talk surfaced on possible legislation that would reduce incentives for for-profit colleges to target and aggressively recruit veterans and service members.

Opportunities

• Early earning results have been encouraging so far and the market has responded, and we move into the heart of earnings season next week.

Threats

• An escalation in concerns over sovereign debt obligations in Europe would be negative for stocks.

Tags: Brokerage Industry, Capital Expenditure, Domestic Stock Market, Earnings Reports, Equity Investors, Equity Risk Premium, Global Equity Markets, Goldman Sachs, Good Year, Government Policy, Industry Group, Information Technology Sector, Investment Bank, Market Radar, Morgan Stanley, Policy Actions, Risk Aversion, Semiconductor Equipment Group, Set Precedent, Taiwan Semiconductor
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James Paulsen: Investment Outlook (November 2011)

Friday, November 11th, 2011

The Next Investment Catalyst?
Accelerating Economic Growth??

by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
November 2011

At least for the time being, the stock market seems to have survived yet another round of “Euro-Crisis Mania.” Recent policy actions announced yesterday by European officials have at least temporarily calmed fears of an imminent calamity. Most believe the rally in the S&P 500 Index to almost 1300 in the last month is due almost entirely to improvements in the European crisis outlook. While recent European developments certainly helped improve the mood of investors, we believe the recent stock market rally mostly reflects a huge reassessment of the potential recession risk in the U.S. economy.

The stock market collapsed in early August after a significant downward revision to real GDP growth in late July suggesting the pace of economic growth nearly flat lined in the first half of this year. Thereafter, the probabilities economists placed on an imminent U.S. recession rose significantly, and many prominent forecasters suggested a recession was indeed forthcoming. In recent weeks, however, a steady stream of “better-than-feared” timely economic reports from Main Street USA has calmed fears of an imminent recession. In combination with another robust corporate earnings season (which looks anything but recessionary) and capped by yesterday’s report that U.S. third quarter real GDP growth was a much stronger-than-anticipated 2.5 percent (with a robust and totally surprising real final demand growth of 3.6 percent!) has ultimately elevated investor greed beyond diminishing recession fears.

So now what? Investors have backed away from the recession cliff and the S&P 500 has returned to its approximate 1250 to 1350 trading range evident prior to the recession scare between February and July. Does the stock market remain trendless next year? Will it again come under intense selling pressure? Or is there a catalyst (beyond the notable currently attractive stock market valuation—that is, the stock market has trended sideways this year while earnings have continued to rise and competitive bond yields have declined) which would allow the stock market break out to new recovery highs?

Is Economic Growth Accelerating?

Although most have backed away from an imminent recession expectation, the consensus forecast still calls for only “muddling along” economic growth during the coming year. According to Bloomberg, the consensus economic forecast for real GDP growth is an anemic 2 percent for both the fourth quarter of this year and for all of 2012. Most believe the U.S. economy is destined for “sluggishness” since policy officials can no longer assist. Monetary officials are widely perceived as out of bullets and fiscal authorities seem helplessly gridlocked. Without another dose of stimulus, why should the economy improve?

Although policy official assistance for the economy may be limited, the private sector has adopted a policy of “self-medication” which could produce a surprising acceleration in real GDP growth next year. Exhibit 1 illustrates six sources of “stimulus” implemented in recent months which should improve economic prospects in the coming year.

Exhibit 1: Economic Self-Medication

First, the national average mortgage interest rate has declined by more than 1 percent since early this year. Long-term interest rates have declined by similar amounts on Treasury securities and on corporate and municipal bond yields. Although no policy official is responsible, long-term credit costs for many economic sectors have been significantly reduced in the last several months.

Tags: Chief Investment Strategist, Corporate Earnings, Downward Revision, Early August, Earnings Season, Economic Reports, European Developments, European Officials, Forecasters, GDP Growth, Investment Outlook, Market Rally, Outlook, Policy Actions, Real Gdp, Reassessment, Recession Fears, Steady Stream, Street Usa, Wells Capital Management, Wells Fargo
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James Paulsen: Investment Outlook (October 31, 2011)

Tuesday, November 1st, 2011

The Next Investment Catalyst? Accelerating Economic Growth??
by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)

At least for the time being, the stock market seems to have survived yet another round of “Euro-Crisis Mania.” Recent policy actions announced yesterday by European officials have at least temporarily calmed fears of an imminent calamity. Most believe the rally in the S&P 500 Index to almost 1300 in the last month is due almost entirely to improvements in the European crisis outlook. While recent European developments certainly helped improve the mood of investors, we believe the recent stock market rally mostly reflects a huge reassessment of the potential recession risk in the U.S. economy.

The stock market collapsed in early August after a significant downward revision to real GDP growth in late July suggesting the pace of economic growth nearly flat lined in the first half of this year. Thereafter, the probabilities economists placed on an imminent U.S. recession rose significantly, and many prominent forecasters suggested a recession was indeed forthcoming. In recent weeks, however, a steady stream of “better-than-feared” timely economic reports from Main Street USA has calmed fears of an imminent recession. In combination with another robust corporate earnings season (which looks anything but recessionary) and capped by yesterday’s report that U.S. third quarter real GDP growth was a much stronger-than-anticipated 2.5 percent (with a robust and totally surprising real final demand growth of 3.6 percent!) has ultimately elevated investor greed beyond diminishing recession fears.

So now what? Investors have backed away from the recession cliff and the S&P 500 has returned to its approximate 1250 to 1350 trading range evident prior to the recession scare between February and July. Does the stock market remain trendless next year? Will it again come under intense selling pressure? Or is there a catalyst (beyond the notable currently attractive stock market valuation—that is, the stock market has trended sideways this year while earnings have continued to rise and competitive bond yields have declined) which would allow the stock market break out to new recovery highs?

Is Economic Growth Accelerating?

Although most have backed away from an imminent recession expectation, the consensus forecast still calls for only “muddling along” economic growth during the coming year. According to Bloomberg, the consensus economic forecast for real GDP growth is an anemic 2 percent for both the fourth quarter of this year and for all of 2012. Most believe the U.S. economy is destined for “sluggishness” since policy officials can no longer assist. Monetary officials are widely perceived as out of bullets and fiscal authorities seem helplessly gridlocked. Without another dose of stimulus, why should the economy improve?

Although policy official assistance for the economy may be limited, the private sector has adopted a policy of “self-medication” which could produce a surprising acceleration in real GDP growth next year. Exhibit 1 illustrates six sources of “stimulus” implemented in recent months which should improve economic prospects in the coming year.

Exhibit 1: Economic Self-Medication

First, the national average mortgage interest rate has declined by more than 1 percent since early this year. Long-term interest rates have declined by similar amounts on Treasury securities and on corporate and municipal bond yields. Although no policy official is responsible, long-term credit costs for many economic sectors have been significantly reduced in the last several months.

Second, since the summer, the annualized growth in the U.S. money supply has surged! The annualized six-month growth rate in the M2 money supply has nearly tripled since June from about 5 percent to more than 15 percent. While some of this money supply surge is probably due to fallout from worries over the European crisis, it nonetheless has massively improved economic liquidity conditions, and similar to last year, should help improve the pace of economic growth in future quarters. During the 2010 economic soft patch, the annualized growth rate in the M2 money supply rose from about zero percent in June to about 6 percent by October probably helping lift the pace of economic growth by late 2010.

Third, despite a recent surge in the value of the U.S. dollar, the trade-weighted dollar index is still currently more than 15 percent below its highs in mid-2010 and about 8 percent lower than it was at the beginning of 2011. A weak dollar has typically been a good indicator of future improvements in U.S. net exports. After regularly subtracting from U.S. real GDP growth throughout 2010 and into early 2011, net exports have now “added” to real GDP growth in each of the last two quarters. U.S. dollar weakness during the last 18 months implies net exports should regularly add to real GDP growth in the coming year.

Fourth, although not by a large amount, energy prices have fallen since late spring. Overall, the S&P GSCI Energy Commodity Price Index is off by about 15 percent since April. The national average nonleaded gasoline price is down by a similar amount. Is a lower “energy bite” already evident in producing stronger consumer spending trends than most had anticipated?

Fifth, U.S. corporate profits posted yet another solid quarter of growth in the third quarter probably rising at an annualized pace of about 20 percent! Total U.S. corporate profits are more than 20 percent “higher” than their peak during the last recovery cycle in late 2006. This record-setting profit recovery cycle has produced tremendous “dry powder” in the business sector which could (with just a little improvement in business confidence which may be forthcoming as European fears calm and U.S. recession fears evaporate) be used to quicken business spending and improve job creation during 2012.

Finally, as evidenced by the recent recovery in U.S. auto sales, as the Japanese economy bounces back from its early-year tsunami, U.S. manufacturing supply chain problems are rapidly diminishing. This post-Japan disaster recovery is also illustrated by a bounce recently in most ISM manufacturing surveys across the country. A full year of economic growth without earthquakes and floods in Japan should allow even further U.S. manufacturing revival in the coming year.

The potential positive impact from “self-medicated economic stimulus” is probably being greatly underappreciated. Indeed, rather than muddle along at only about 2 percent growth, we expect U.S. real GDP growth to surprisingly jump to between 3 to 3.5 percent during 2012.

What About Europe and the Emerging World?

Our expectation for U.S. growth in 2012 is not based on a big recovery in Europe. Rather, the euro zone may already be in a mild recession or at best will exhibit nearly flat lined performance next year. However, we do think the slowdown evident among emerging world economies during the last year is coming to an end. Economic authorities in most of these economies now recognize inflation risk is ebbing and will soon likely begin adopting more accommodative economic policies. By early next year, we anticipate a consensus developing of a “soft landing” in the emerging world which will improve confidence in the longevity of the global economic cycle. Weaker growth in the European region may be largely offset by somewhat stronger growth next year among most emerging economies.

Investing Implications?

In the last month, the stock market has “reset” values as expectations backed away from an imminent recession thesis. The upside price action in the stock market from decaying recession probabilities has mostly already been incorporated into the stock market with the S&P 500 now near 1300. However, an “economic acceleration” catalyst is what may now carry the stock market to new recovery highs during 2012.

Exhibit 2 overlays the S&P 500 Stock Price Index with initial unemployment insurance claims. Since 2000, there has been an extremely close relationship between momentum on Main Street (as evidenced by declining jobless claims signaling an improving job market) and stock market momentum. As shown by this exhibit, during 2011 both the economic and stock market recoveries stalled (i.e., both the dotted and solid lines trended sideways).

If real GDP growth continues to remain sluggish in 2012 at about 2 percent, then both the level of unemployment claims and the stock market will likely remain range bound. However, if as we expect, the pace of real GDP growth surprisingly accelerates (and unemployment claims finally decline below 400 thousand towards 350 thousand) the stock market should again prove rewarding for “riskon” investors.

Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT® is a registered service mark of Wells Capital Management, Inc.

Copyright © Wells Capital Management

Tags: Chief Investment Strategist, Corporate Earnings, Downward Revision, Early August, Earnings Season, Economic Reports, European Developments, European Officials, Forecasters, GDP Growth, Investment Outlook, Market Rally, Outlook, Policy Actions, Real Gdp, Reassessment, Recession Fears, Steady Stream, Street Usa, Wells Capital Management, Wells Fargo
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The Economy and Bond Market Cheat Sheet (October 24, 2011)

Saturday, October 22nd, 2011

California Union Iron Works Turbine Machine Shop, c. 1918

The Economy and Bond Market Cheat Sheet (October 24, 2011)

Treasury yields were flat to down this week. It was a choppy week, up one day and down the next, and even though economic news flow and earnings data were supportive of continued economic growth, lingering concerns surrounding a possible Greek default and government policy actions to deal with that were likely responsible for the positive bias in fixed income.

One encouraging bit of information came from the Philadelphia Federal Reserve’s manufacturing data, which showed new orders bouncing back strongly and hitting the highest level since April. The recent economic data has not matched the gloom on the economy and so far third quarter earnings announcements have not indicated a significant economic slowdown. At this time it appears concerns of a “double dip” are overblown and the economy may even positively surprise.

Strengths

• Industrial production rose 0.2 percent in September, matching estimates.
• The Conference Board’s index of leading economic indicators (LEI) rose 0.2 percent in September and is up 5.9 percent on a year-over-year basis.
• Housing starts jumped a surprising 15 percent in September, with the greatest demand seen in multi-family housing.

Weaknesses

• China’s GDP grew 9.1 percent in the third quarter. While 9.1 percent is very strong in absolute terms, it was below the 9.3 percent expected and the slowest growth in more than two years.
• Consumer prices in the U.K. hit 5.2 percent in September, which is a three year high. Commodity prices have receded in recent months and expectations are for lower inflation so this data point is somewhat troubling.
• Mortgage applications hit a 15-year low even as mortgage rates have hovered around 4 percent in recent weeks.

Opportunities

• With the economy weak and concerns brewing about an additional financial crisis, the Fed will remain accommodative for some time and bonds appear well supported in the current environment.
• Globally, central banks have become attuned to the risks of a global slowdown and will likely act to bolster economic growth.

Threats

• All eyes will be on the European Summit this weekend. A positive outcome could be a threat to the treasury market which has benefitted from a “flight to quality.”
• The treat of another global financial crisis cannot be ruled out.

Tags: Absolute Terms, Bond Market, Bonds, California Union, Cheat Sheet, Commodity Prices, Double Dip, Earnings Announcements, Earnings Data, Economic Data, Economic News, Economic Slowdown, Fixed Income, Government Policy, Housing Starts, Index Of Leading Economic Indicators, Leading Economic Indicators, Mortgage Applications, Mortgage Rates, Policy Actions, Quarter Earnings, Treasury Yields
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Talking Points for the “Occupy Wall Street” Protesters (Hussman)

Monday, October 10th, 2011

Talking Points for the “Occupy Wall Street” Protesters

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

Just a note – by the end of last week, Greek 1-year yields had surged to 144%. European leaders have shifted from promising to prevent a Greek default to promising instead to ensure that European banks are well capitalized. Here, I would repeat that it is essential for policy makers to make a distinction between liquidity and solvency. Banks that are solvent, and countries that are solvent, should be within the ring-fence, in the sense that it is sensible for policy makers to follow Bagehot’s Rule – freely provide liquidity, but only at high rates of interest, and only to the solvent and well-collateralized. Those institutions and countries that are not solvent should not be “saved” by using public funds to make private bondholders whole. The proper policy is to restructure, not bail out, the debt of banks and countries that have no reasonable prospect of paying off those obligations.

It remains in the best interest of Greece to default, and to leave the euro so it can depreciate its currency, but if it is going to default, it would be well-advised to default big. The only way to get new international capital after a default is for Greece to clear out enough of its legacy obligations that investors reasonably expect it to make good on any new funding they might (eventually) provide.

Talking Points for the “Occupy Wall Street” Protesters

We’re all for a good peaceful protest. As long-time readers know, I’ve been an adamant critic of the bailouts of mismanaged financial institutions, as well as various illegal policy actions that have been pursued by the Fed since the financial crisis began in 2008. Undoubtedly, there is good and bad on Wall Street, and we know a lot of smart, well-meaning financial advisors who go to work every day with the goal of improving the financial security of their clients, who do careful research, avoid speculation, and provide a service to others through their profession. A functioning economy needs to allocate capital effectively, and there Wall Street can be essential.

Unfortunately, over the past 15 years or so, the basic function of the financial markets has been corrupted into what I’ve grown to view as a self-serving carnival of speculation, where many participants are interested in nothing except getting the next rally going at public expense, regardless of how badly market signals are distorted, how recklessly capital is misallocated, or even whether what they do has any positive effect on the economy or the country (some of the sleazier ones even have their own shows on basic cable).

There is no single source of this transformation. Part of it is a remnant of the dot-com and technology bubbles, when market valuations moved to nearly triple the historical norm, and investors began to view perpetual market advances and high returns as a birthright. The subsequent decade of zero overall returns for the stock market largely reflects a reversion to more normal (but still cyclically elevated) valuations.

Another part of this transformation is due to the activist policies of Federal Reserve, which has continually attempted to short-circuit every instance of short-term economic discomfort by distorting the menu of investment returns (e.g. zero interest rate policies) in an effort to provoke investors to accept fresh speculative risk. Ironically, the long-term effect of distorting market signals has been to drive good, potentially productive capital into wholly unproductive uses – the housing bubble being a prime example. As a result, real U.S. gross domestic investment has not grown at all since 1998, and the portion financed by domestic U.S. savings has collapsed, so much of the new capital we’ve accumulated is owned by foreigners.

Undoubtedly, one of the greatest rhetorical victories of Wall Street has been to successfully plant in the minds of the public the idea that some financial institutions are simply “too big to fail,” and that the “failure” of “systemically important” institutions will result in global financial meltdown and Depression. The reality is much different.

So, with the hope of providing the Occupy Wall Street protesters with some talking points, what follows are some perspectives that might be useful in framing the issues that we are facing as an economy.

1) “Failure” only means that corporate bondholders don’t get every penny

Background: When Wall Street talks about the “failure” of a bank or other financial institution it means the failure of the company to pay off its own bondholders. It does not mean that depositors, counterparties or other bank customers lose money (See Recession, Recovery, and the Ring-Fence ). A bank is essentially a big portfolio of assets, about 70% which are typically financed by depositors, customers and other liabilities, about 20% by the bank’s own bondholders, and about 10% with the capital of the bank’s stockholders. In a typical bank “failure,” the bank is taken into receivership by regulators, the liabilities to stockholders and bondholders are cut away, the remaining package of assets and liabilities is sold as a single entity to some other firm (or can be reissued to investors as a new company), the old bondholders get the proceeds of that sale, and the stockholders are wiped out. When investors willingly take a risk, and buy the stocks and bonds issued by an institution that goes on to mismanage its business, this is the appropriate outcome. Depositors and customers typically don’t lose a penny (See the section on “How to Restructure A Major Bank” in Not Over By A Longshot ).

If public funds are provided during a financial crisis, and it cannot be clearly demonstrated that the institution is solvent, the funds should be provided post-failure, as senior loans to a restructured institution where shareholders and existing bondholders have already been subject to losses. The interest rate should be relatively high, to encourage replacement of public funds with private ones. With few exceptions, when public funds are used to avoid major restructuring and shield private investors from losses, the result is almost inevitably a larger, less transparent, and more recklessly managed institution.

The same is true for government or “sovereign” debt. When Wall Street talks about “failure” of Greece, for example, it means failure of Greece to pay off its own bondholders. In trying to avoid this failure, Greece is instead forced to impose extreme austerity and depression on its citizens. From the standpoint of those citizens, Greece has already failed them painfully. Those are the choices – let bad debt “fail” or force depression on innocent citizens.

Of course, there is a cost to any financial crisis, which is “contagion” where the failure of one institution or government calls others into question. The main way to contain this is to follow the century-old “Bagehot’s Rule” – lend freely, at high rates of interest, but only to institutions that are solvent and able to provide collateral for the loans. When policy makers behave as if every institution, solvent or not, is within the ring-fence, or that some institutions are simply “too big to fail,” saving these institutions comes at enormous costs, because true economic losses that should properly be taken by private investors are instead forced upon the public.

Keep in mind that money is fungible – not all losses are taken directly by the institution that created them. Many of the losses that should have been borne by banks were instead assumed by Fannie Mae and Freddie Mac. This allowed TARP to seem largely successful even while hundreds of billions of public funds are still being spent to bail out Fannie and Freddie. Recent efforts by government overseers of Fannie Mae to claw back these losses from the banking system are appropriate, but they also demonstrate how easy it is for private institutions to transfer their mistakes onto the public balance sheet.

2) The Federal Reserve’s purchases of Fannie Mae’s and Freddie Mac’s debt obligations were illegal

Background: Beginning in 2009, the Federal Reserve began buying nearly $1.5 trillion in obligations of Fannie Mae and Freddie Mac, both which were insolvent and in government receivership. The Fed justified these purchases by appealing to Section 14.2 of the Federal Reserve Act, which allows the Fed to purchase securities which are a “direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States.” Now, Ginnie Mae, the financing arm of the Federal Housing Administration (FHA) is a bona-fide government agency. So there would have been no legal problem if the Fed had purchased Ginnie Maes. In contrast, however, Fannie Mae and Freddie Mac were not, and are not, U.S. government agencies. Nor are the obligations held by the Fed “fully guaranteed as to principal and interest” by the U.S. government. At best, the obligations of these GSEs have implicit and informal backing, as any member of Congres will tell you, and simply taking a failing institution into conservatorship doesn’t confer government backing to its debt. In fact, the stop-gap measure enacted by Congress during the crisis only provides temporary backing for the obligations of Fannie and Freddie maturing by the end of 2012. Very simply, the Fed broke the law by buying Fannie and Freddie’s debt.

3) Creating shell companies to buy Wall Street’s bad assets is not “discounting,” and was therefore also illegal

Background: In 2008, the Federal Reserve created a set of off-balance sheet shell companies called “Maiden Lane” to buy undesirable long-term assets of Bear Stearns and other financial companies, justifying the purchases by appealing to Section 13.3 of the Federal Reserve Act. But if you actually read Section 13, it is clear that under the law, “discounting” means (as it has always meant) providing short-term liquidity by essentially providing a check-cashing service for obligations that are short-dated, well-collateralized, and promptly collectible (See also Outside the Oval / The Case Against the Fed ). The Fed’s creation of the Maiden Lane companies to purchase bad assets was, and remains, illegal under the language and intent of the Federal Reserve Act.

Keep in mind that we have only three branches of government: the executive, the legislative, and the judicial. The Federal Reserve is not an independent fourth branch of government, but operates under the legislation of Congress and therefore cannot be “independent” of Congressional control. While nobody wants monetary policy to be “politicized” in the sense of Congress telling the Fed what policy actions should be taken and before which election, it is quite a different matter to require the Fed to operate within the law. Here, Congress could use some encouragement.

4) The skewed distribution of wealth in the U.S. is worsened by policies that misallocate capital and divert public funds to bail out investments that have already gone bad.

Background: If you think about the “standard of living” in a country, you can roughly define it as the amount of goods and services that individuals are able to consume in return for their work. If you think about the “productivity” of a country, you can roughly define it as the amount of goods and services that individuals are able to produce for their work. Clearly, over the long-term, the productivity and the standard-of-living of a country go hand in hand. The best way to create both, over the long-term, is for an economy to build a stock of productive capital (inventions, new technologies, plants, equipment, public infrastructure, etc), and human capital (labor skills, education).

Still, even a generally productive economy can produce a skewed distribution in the standard of living enjoyed by its citizens. In a competitive and undistorted economy, the distribution of wealth is determined by the ability of each individual to a) provide a useful service, b) distribute the services they provide over a large number of “units”, and c) maintain the scarcity of what they provide.

So for example, professional football players earn more than teachers not because playing football has more virtue, but because professional football players are among a very small group, and distribute their “services” over millions and millions of spectators, each which implicitly pays a few cents to each player per game. Mark Zuckerberg at Facebook is able to distribute his services across hundreds of millions of users, each which implicitly pays him a tiny amount by viewing advertising. Bill Gates distributed his services over every computer that ran Windows, while the factory workers who built those computers were each able to distribute their skills over a smaller number of units. Teachers represent a large professional group, but are typically able to distribute their services over a limited number of students, each which implicitly pays a portion of their family’s income to the teacher. One-on-one aides tend to earn less, despite often being extremely skilled, because in order for them to earn a high income, their earnings would have to capture much of the income of their single student’s family.

The distribution of wealth has become increasingly skewed as trade has become more globalized and technology has allowed the innovations of a single person to be spread across millions of consuming “units.” At the same time, the economic emergence of China and India has brought forth literally billions of new workers who dilute the scarcity of the existing labor force. An economy where capital is scarce, protectable, and can easily be distributed over numerous units, while labor is plentiful, homogeneous and can only be applied to a smaller number of units, is an economy that is prone to an enormously skewed distrbution of wealth.

This process takes on a grotesque character when it becomes possible for a company to distribute its impact over a very large number of units, and government policy protects that ability even when the impact of the company reflects not skill but ineptitude. This is essentially what has happened with the “too big to fail” institutions. Despite inflicting massive damage on the economy, they are afforded a protected status that allows them to extract “rents” that don’t reflect the cost they have imposed. From that standpoint, the Occupy Wall Street protests are a welcome reflection of public frustration over Washington’s slavish coddling of reckless financial institutions.

Policy Responses

The proper way to address the present economic imbalances is pursue policies that encourage the restructuring of bad debt, the allocation of public funds and private savings to productive investment and new research, the accumulation of education and labor skills (“human capital”) to allow workers to capture a greater share of their own productivity, and the continuation of social safety nets to ease the economic adjustments that are necessary in a deleveraging economy. In my view (which not everyone will like), this requires:

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James Paulsen (Wells): Investment Outlook (October 5, 2011)

Wednesday, October 5th, 2011

Wells Capital Management’s Chief Investment Strategist, Jim Paulsen, has just released his exhaustive investment outlook. The complete report, which is longer than the following prefacing text, follows in a slidedeck, which you can either download or fullscreen.

by James Paulsen, Chief Investment Strategist
Wells Capital Management

Since its collapse in early August, the stock market has experienced extreme daily price volatility oscillating within a broad range. These emotional daily price swings reflect a skittish investor struggling with a dichotomy between extremely attractive relative stock market valuations and an array of escalating fears. Investor worries include a widening contagion from the European sovereign debt crisis, the potential for a hard landing among emerging world economies, uncertainty introduced by uncommon and confusing Federal Reserve policy actions, and the likelihood of yet another debt ceiling debate looming on the horizon.

While these concerns should keep daily price volatility elevated, how the stock market ultimately breaks from its recent trading range will probably be determined by whether the U.S. economy avoids recession. In the next several weeks, economic reports will either galvanize recession expectations or consensus fears will once again calm, embracing the likelyhood that the U.S. economic recovery will persevere. Should a recession become obvious, the stock market would likely suffer a further significant decline. Alternatively, investor greed may dominate the rest of this year should recession fears fade as investors act to take advantage of a valuation metric (about 11 times earnings with a sub-2 percent 10-year Treasury) which, without a recession, represents a fire sale!

A U.S. Recession?

An imminent U.S. recession is unlikely. First, the traditional economic policies which precede a recession are not evident. The U.S. does not possess an inverted yield curve, has not been subjected to significant short-term nor long-term interest rate hikes, and is not suffering from restrictive liquidity conditions or tight fiscal policies.

Second, can the U.S. suffer a recession when there is nothing to recess? Recessions often result from “excesses in need of a correction.” Since the last recession ended only two years ago and since it was so extreme, private sector players have thus far been well-behaved in the contemporary recovery. Are individuals paying up too much for houses today? Have consumers extinguished pent-up demands for durable goods? Is the savings rate too low (the savings rate has been hovering about a 20-year high since the recovery began)? Are household debt burdens oppressive (the household debt service burden is in its lowest quartile since 1980 and no higher today than it was in 1985)? Have banks been aggressively overextending loans? Has anyone been borrowing too much lately? Are companies overstaffed? Overinventoried? Have businesses over invested in the last couple years? Has the Fed tightened too aggressively? Have bond vigilantes raised bond yields too much? Too much fiscal tightening lately? Is anyone lacking for liquidity? Are households overexposed to the stock market today? Is optimism over the top? It is hard to see why the U.S. would experience a recession when almost nothing requires a “correction.” Indeed, before the next U.S. recession, the answer to at least some of these questions will likely be yes!

Third, despite a significant economic slowdown since early this year (annualized real GDP growth rose only 0.7 percent in the first half and real GDI growth rose by only 2 percent), the economy is already showing some signs of bouncing. After flattening earlier this year, real personal consumption is on pace to rise more than 1.5 percent in the third quarter, weekly retail chain store sales have remained relatively robust, and the annualized U.S. auto sales rate has risen by more than 14 percent since June to 13.1 million, helped by Japan bouncing back from its tsunami. Weekly unemployment insurance claims remain in the low 400,000 range, reported private sector ADP employment gains have averaged 100,000 in the last two months and layoff announcements as recorded by the Challenger Job Cuts Index have remained subdued.

Corporate profits are still robust, industrial production posted back-to-back gains in July and August, and recent reports for factory orders and durable goods shipments suggest business spending may have accelerated. The ISM manufacturing survey surprisingly increased in September to 51.6 and the ISM services survey is at a solid 53.3. Finally, U.S. net exports improved significantly in July suggesting international trade will add to third quarter growth. Overall, we expect real GDP growth to be between 2 to 2.5 percent in the third quarter— hardly a recessionary reading.

Fourth, new “policy stimulus” added in recent months should soon improve the pace of economic growth. Many worry the Fed is out of bullets and fear fiscal authorities have been neutralized by gridlock leaving the economic recovery without policy assistance. Although the abilities of policy officials may be limited, the economy has turned to “self-medication.” The national average 30-year mortgage rate has fallen from 5.2 percent in February to only about 4 percent today! Similar yield declines since the spring have been recorded by investment grade corporate bonds and by municipal securities. This “large” decline in long-term credit costs should help boost economic performance in the next several months. Both consumers and businesses should also get a boost from lower energy cost. Crude oil and gasoline prices have declined by more than 20 percent from peak levels earlier this year. Furthermore, even though the U.S. dollar has recently risen, the real broad U.S. Dollar Index is still about 10 percent lower today than it was in 2010 suggesting additional improvement is forthcoming in U.S. trade flows. The U.S. M2 money supply has exploded since June growing at an annualized pace of about 25 percent! Finally, as Japan bounces back from its economic collapse after the early-year earthquake, U.S. manufacturing supply chain problems should alleviate further in the next several months. Indeed, U.S. auto sales have already strengthened significantly in recent months as the Japanese impact diminishes.

What About Europe?

Unlike the U.S., the Euro region has been subjected to significant monetary and fiscal tightening in the last year and does exhibit characteristics of a pre-recessionary economy. However, how serious is the risk of either a recessionary or sluggishly growing Euro region for investors?

The best news surrounding the Euro crisis is it has finally gotten so bad! When the Euro sovereign debt crisis first broke in January 2010, the major players (EMU policy officials, Germany and France) perceived the problem as a political issue. Consequently, the crisis has not received any substantial assistance aimed at ending the economic and financial contagion. Only recently have the major powers in the region decided it is an economic threat and have begun to treat it more appropriately. Since officials have done so little yet to arrest the crisis, many weapons are still left in the tool box. Only recently, EMU officials finally suggested they will stop raising interest rates. Soon they will begin to lower interest rates, perhaps pursue some non-sterilized bond purchases (i.e., those that actually expand the central banks balance sheet and thus represent a true easing of monetary conditions), and even entertain a European-style TARP program similar to the U.S. approach used in 2008 to backstop ailing banks. After almost two years of smoldering into a major economic threat, there is understandably great concern the crisis cannot be controlled nor extinguished. However, the lack of success to date is primarily because so little has been done to address the crisis. This is beginning to change and will likely lead to much better results in the coming year.

The most serious threat for the U.S. economy is not a period of sluggish or nonexistent Euro region growth but rather a full-blown global financial contagion. Although possible, this seems highly unlikely in our view. First, the problems are well-known and have been for some time. A more serious financial contagion could hardly be a “surprise” which is often the most difficult aspect of crises. Second, most U.S. financial institutions do not hold large amounts of troubled sovereign securities. Third, even if a financial contagion were to infiltrate the U.S. financial system, because of responses to the 2008 U.S. crisis, the U.S. system is now very well capitalized, it has already experienced a major write down of bad debts, and is more highly liquid than in decades. Perhaps this is why for the first time, European and U.S. 10-year government swap spreads have significantly delinked. Euro swap spreads have exploded to 2008 wides while U.S. spreads remain near their lowest levels of the last decade.

The more likely U.S. fallout from the Euro crisis is a sluggish Euro region economic performance which would reduce U.S. export markets. While this is very likely, it may have much smaller impact then most fear. Outside of the Euro region, economic growth is likely to be maintained including Japan, Canada, Australia, the emerging world economies, and in the U.S. It is worth remembering that in 1990 the world’s largest economy at the time, Japan, fell into a depression from which it would not return. Nonetheless, the rest of the world including the U.S. proceeded to enjoy an economic boom during the balance of the 1990s! Today, the world economy is comprised by a new economic force (emerging world economies), which did not exist in any meaningful fashion in 1990, which should help diminish the impact of a smaller growth contribution from Europe.

How About China and the Emerging World?

A much more serious blow to the global economic recovery would be a recession in the emerging world. Despite widespread fears of such an event, we think a “soft landing” is a better description of what is happening among emerging world economies. During much of 2010, investors worried about China and other emerging economies overheating and collapsing. As a result, most emerging economy policy officials have been tightening conditions in the last year leading to a noticeably slower growing emerging world. However, now policy officials in this region are beginning to turn back toward easing policies after most economies have slowed. For example, Chinese real GDP growth has slowed to a still very robust 9 percent rate from about 12 percent last year. This is probably a healthy development and makes it more likely the global economic recovery will prove longer-lasting. Recently, China reported the second consecutive monthly rise in its manufacturing ISM survey to 51.2 in September! The easing policies now being increasingly employed throughout the emerging world suggests a quicker economic growth from this part of the globe in the coming year.

Market Signals are Flashing Caution???

U.S. recession expectations have risen primarily because several financial market indicators are providing signals which often precede a recession. That is, recession fears are due less to worsening economic fundamentals than they are being driven by worsening financial market signals.

The good news is the old adage which goes something like “the stock market has predicted 12 of the last five recessions.” While financial markets always worsen prior to recessions, poor financial market action also frequently precedes temporary economic slowdowns or panics. Consequently, it is hard to interpret the message of the markets. However, given the extraordinarily fearful, crisis-phobic culture which has dominated since 2008, a good deal of caution should be employed when relying on survey reports and market signals (markets which have been amazingly emotional driven) to access where the economy is headed. We are certainly in the middle of an intense panic. A panic which may last longer and take financial markets even lower before it is extinguished. However, fundamentally the U.S. economy remains sound, has some momentum, and because of self-applied stimulus since spring, is likely to improve in the months ahead. Moreover, Euroland problems finally seem to be receiving the “economic/ policy” attention it deserved a lot sooner. Finally, the rest of the global economy, like the U.S., is still growing (more likely in a temporary slowdown) or even growing quite rapidly (e.g., emerging world). Contemporary financial market signals, owing to the current remarkably emotionally-volatile period, may be exaggerating upcoming economic problems and underestimating the potential for an economic reacceleration.

Outlook for the Stock Market?!?

The fate of the U.S. stock market during the balance of this year will not likely be determined by Euro crisis fears, by Fed actions, by a jobs bill, or by debt ceiling debates. Rather, the stock market is likely to be driven by whether or not the U.S. avoids a recession. That is, the stock market will ultimately rally or fail based on economic data flow coming from Main Street USA.

Should the data convincingly portray a U.S. recession, the stock market will likely decline significantly further from current levels. With the S&P 500 Index currently slightly below 1100, the stock market already seems to be discounting a recessionary decline in earnings to about $70 (from the current likely yearend level without a recession of about $100). That is, based on this recessionary earnings expectation, the stock market currently sells at about 15 to 16 times which is a reasonable recession valuation given a sub-2 percent 10-year Treasury bond yield. Moreover, we believe if a recession does actually occur, “panic” will likely cause a much deeper decline in earnings producing further downside risk in the stock market.

Fortunately, we believe the chance of a U.S. recession remains quite low. If, during the next few weeks, the upcoming jobs report shows positive gains (even if sluggish) and if unemployment claims, retails chain store sales, and other timely economic data do not fall off a cliff suggestive of a recession, investor greed will likely return and begin to dominate the financial markets. If a consensus comes to believe a U.S. recession is “off the table,” the current valuation metric of less than 11 times year-end earnings while the 10-year Treasury yield is at a record low will become far too enticing.

We think a consensus which agreed the economic recovery will persist would result in a stock market willing to pay perhaps around 14 times for 2012 earnings of between $105 and $110 or a target price of about 1500! This is not necessarily our forecast for next year, but rather an illustration of the investment potential which exists should consensus recession fears fade.

The incredible daily volatility exhibited by stock prices during the last two months is frightening and tiring. It seemingly makes no sense when valuations can change so radically, so quickly, with little or no new fundamental information. However, the character of these types of markets, these periodic “gut checks,” may be what is in store for investors during this highly crisisphobic period in financial history. Our best guess is investors should try to stay focused on fundamentals and not on the “market’s daily assessment of its worst crisis fears.” Ultimately, we believe the U.S. and global economy is in a recovery—a recovery which will prove bumpy but will also likely prove persistent. And, if it does, those investors which approach this decline in the stock market as an opportunity to raise exposure to cyclical sectors will likely fare best in the coming years.

James W. Paulsen, Ph.D.
Chief Investment Strategist, Wells Capital Management

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