Q2 Markets: Don’t Expect Smooth Sailing

Wednesday, April 18th, 2012

by Russ Koesterich, iShares

After a disappointing, frustrating and, at times, terrifying 2011, patient investors were rewarded with a stellar start to 2012. In the first quarter, equity markets banked a performance that would have been respectable for the full year. Developed markets gained nearly 11%, while emerging markets advanced more than 13%. However, equity markets have lost some steam in recent days, and now many investors are wondering if there’s anything to look forward to in the second quarter.

The good news is that even after the rally, valuations still appear reasonable. Developed markets are currently trading at around 14x earnings, no longer a screaming bargain but below historic averages. Emerging markets, meanwhile, are even cheaper, trading at less than 12x trailing earnings. In addition, inflationary pressures remain well contained and while last Friday’s disappointing employment report reminded everyone that the recovery will continue to be slow and uneven, both the US and global economies are stabilizing.

That said, I don’t expect markets in the second quarter to be all smooth sailing. While markets can still move higher, gains are likely to be predicated on earnings growth, which in turn will depend on further improvement in the global economy. And even if the economy continues to stabilize, we’re unlikely to see another round of quantitative easing until at least July as the Fed’s Operation Twist is set to continue through June.

Without the sedative of easier monetary policy, markets are likely to be more volatile. I expect volatility to be in the high teens to low 20s, above the mid-teen levels that characterized the first quarter. In fact, it’s probably fair to say that the first quarter rally was more a function of continuing, and arguably intensifying, central bank generosity rather than a reflection of fundamentals experiencing a complete turnaround.

Given this environment, as the second quarter kicks off, investors should consider repositioning their portfolios to access international equity income, prepare for more volatility and shift into investment grade credit.

As I’ve mentioned before, in an environment of slow growth and more volatility, higher income stocks are more likely to outperform. However, such stocks currently look expensive in the United States, meaning investors may want to cast a wider net to get their dividend exposure through vehicles such as the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE).

In addition, as the market becomes more volatile, investors may want to consider equity funds that employ a minimum volatility methodology that can potentially help insulate portfolios from wild market swings. Such funds typically hold lower-beta stocks than similar, cap-weighted benchmarks and have historically produced higher risk-adjusted returns over the long-term.

Finally, as I wrote earlier this month, while high yield can still offer a good coupon, investment grade debt, accessible through the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA: LQD), looks cheaper and should hold up better during a more volatile quarter.

Source: Bloomberg

The author is long LQD and IDV

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There is no guarantee that dividends will be paid.

Minimum volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Bonds and bond funds will decrease in value as interest rates rise.

Past performance does not guarantee future results.

Tags: Asset Allocation, Columbia Management, Credit Crisis, Diversification, Earnings Growth, Emerging Markets, Employment Report, Financial Situation, First Quarter, Generosity, Global Economies, Global Economy, Inflationary Pressures, Investment Advisers, Investment Mix, Iranian Hostage Crisis, Ishares, Last Friday, Market Crash Of 1987, Market Fluctuations, Monetary Policy, Ned Davis Research, Patient Investors, Portfolio Holdings, Q2, Quarter Rally, Rebalancing, Reflection, Risk And Reward, Risk Tolerance, Russ, Second Quarter, Sedative, Smooth Sailing, Stock Market Crash, Stock Market Crash Of 1987, Substantial Market, Time Horizon, Turnaround, Valuations, Volatility, Weather Market
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3 Reasons Why The BoJ May Ease Within 2 Days

Monday, April 9th, 2012

Tomorrow will bring the end of a two-day policy meeting at the Bank of Japan which SocGen expects will result in the announcement of additional easing measures. Whether medium-term macro-economic issues or short-term risk tolerance fading weighs heavier on their minds as their efforts from the previous easing announced on Feb 14 are rapidly losing their effectiveness – especially evident in their recent inability to restrain JPY appreciation (which notably JPM believes will continue on the back of a disconnect between Commitment of Traders positioning and the JPY carry divergence – via Bloomberg’s chart-of-the-day). Critically the exchange rate is a cornerstone of BoJ policy and while risk-off will drive JPY appreciation via carry unwinds (in a purely technical world) the political, currency, and economic factors that SocGen lays out suggests strongly that the BoJ (under increasing attack from politicians for its failure to reflate the economy) will bring out yet another bazooka to show its worth – and prove this time is different even as we noted here with inflationary concerns rising. Lastly, will JPY lose its carry-trade attractiveness and implicitly its impact on US equities even if they do ease dramatically or when will the market/politicians lose patience with a drip-drip-drip approach and side with China’s view of a rising devaluation risk as we noted here recently.

via Bloomberg

Societe Generale: Further Easing Likely

We have previously predicted that the BoJ would maintain a wait-and-see stance for the time being. However, we now expect the Monetary Policy Meeting scheduled for April 9-10 to result in additional easing measures. There are three reasons why Japan’s central bank will opt to implement monetary easing measures next week.

1) Political factors:

The BoJ reform proposal revealed by the Liberal Democratic Party (LDP), Japan’s leading opposition party, will push Prime Minister Noda into a difficult position. Under the proposed reform, the BoJ will be required to end deflation with a specific time limit, and the government may dismiss BoJ executives when the central bank fail to meet its objective. This would naturally be unacceptable for the BoJ. But unless the BoJ adopts a clear stance as a deflation fighter, Mr. Noda will find it difficult to oppose the LDP’s reform bill. Many Diet members within the Democratic Party of Japan (DPJ) also appear to support the aims of the reform bill, and Mr. Noda will want to avoid any proliferation of issues that could divide the party. In this sense, both the BoJ and the Noda cabinet would benefit considerably if the central bank decides to implement monetary easing measures at this time and to maintain its deflation fighter stance.

2) Currency factors:

Since 2009, the BoJ has focused on the exchange rate as its channel for influencing the real economy through monetary policies. All of the key shifts in the BoJ’s monetary policy over the past few years, including the introduction of 3-month fixed-rate operations with a price stability goal centering on 1% in December 2009, the establishment of the Asset Purchase Program in October 2010, and more recently the adoption of an inflation goal in February 2012, have been targeted toward the reversal of expectations of a higher yen. The easing of monetary policy in February 2012 triggered a shift in the trend toward a higher yen, but the effects appear to have waned in recent weeks. The BoJ can stave off the emergence of high yen expectations by indicating that it cannot rule out additional easing measures.

3) Economic factors:

In 2012, the Japanese economy is expected to achieve high growth thanks to the stimulatory effect of reconstruction demand. We are predicting 2.4% growth in this calendar year and 2.6% in the fiscal year ending March 2013. However, reconstruction demand will start to fade in 2013 and beyond, and the economy will also come under considerable downward pressure from the consumption tax increase in 2014. Japan needs to ensure that the baton is passed smoothly from reconstruction demand to other sources of demand, especially capital investment and consumer spending. BoJ could help ensure such transition through holding down the expected real interest rate with the combination of keeping its virtually zero nominal interest rate and higher inflation expectation. Since it takes between six months and year for the effects of monetary easing to permeate through to the real economy, it is appropriate to implement easing measures now in anticipation of an economic slowdown in 2013.

Specific easing measures

What measures would be appropriate if the BoJ decides to implement monetary easing measures on April 10?

Raising the inflation goal to 2%?…

As indicated in the minutes for February 14, the BoJ appears to be considering an increase in the inflation goal from 1% to “a positive range of 2% or lower.” Lifting the inflation goal posts to 2% would certainly strengthen the effectiveness of the policy interest rate along the time axis. We believe that the inflation goal should be moved to 2% in the medium/long-term perspective. However, Japan’s CPI remained at the low end of the 1% range even during the bubble era of the early 1990s, while the average for the period since 1980 is just 0.5%. It would be necessary to think carefully about whether a CPI rate of increase in the high end of the 1% range would be appropriate for Japan. Furthermore, trends in the OIS market already suggest that the rate is unlikely to rise for about five years, which means that there would be little benefit in terms of strengthening the time axis.

An increase in the Purchase Program…

An increase in the Purchase Program, especially for government bonds, seems an appropriate way for the BoJ of ease monetary policy at this stage. If purchases are increased by around ¥5 trillion, it would be necessary to expand the scope of purchasing, which is currently limited to bonds up to two years, to include bonds up to five years. However, we do not believe that the BoJ needs to specify this next week. The announcement of an increase in the Purchase Program would be sufficiently effective in its own right. The prices of risk assets, such as stocks, purchases of which have not increased recently, are now higher than previously. It would not be inappropriate to include a certain amount of these assets in the scope of purchasing as a way of emphasizing the BoJ’s stance as an inflation fighter.

Tags: Attractiveness, Bank Of Japan, Bazooka, Boj, Carry Trade, Commitment Of Traders, Devaluation Risk, Drip Drip Drip, Economic Factors, Economic Issues, Ldp Japan, Liberal Democratic Party, Noda, Opposition Party, Political Factors, Reform Proposal, Risk Tolerance, S Central, Societe Generale, Term Macro
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A Tailwind for Gold? Low Rates.

Thursday, March 1st, 2012

In recent months, the Federal Reserve (Fed) and the European Central Bank (ECB) have been lowering — or maintaining low — interest rates in an effort to support growth. One unintended beneficiary of the aggressive easing by the developed world’s central banks: Gold.

Historically, the most important driver of gold returns has not been inflation or the dollar, but rather the level of real interest rates. In the past, environments with interest rates at or below the level of inflation have been very supportive of commodities, and particularly gold. Today’s rate environment fits this bill and so should that of the near future.

As the Fed and the ECB are determined to maintain their low-rate policy for the remainder of the year and probably through 2013, real rates will likely remain negative into next year. This should provide a nice tailwind for commodities in general and for gold.

As such, I continue to advocate that investors maintain a strategic allocation to gold as a distinct asset class. In addition, commodities such as gold can help to diversify a portfolio and provide a hedge against erosion in purchasing power.

But what about silver? For now, I prefer gold for two reasons.

First, gold tends to benefit more than silver from negative real rates. Second, 50% of the demand for silver is driven by industrial usage. As economic growth can still best be described as weak, global industrial demand isn’t likely to support silver prices.

So how much of a portfolio should investors consider allocating to gold? The exact amount of gold in a portfolio will obviously depend on an investors’ risk tolerance and on the portfolio’s other components. Still, according to work from the iShares’ portfolio research team, an allocation of around 1% is probably reasonable for the average investor. Investors should discuss their own portfolio allocation with their advisors.

Source: Bloomberg

Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals. Diversification may not protect against market risk.

Tags: asset class, Beneficiary, Central Banks, Commodities, ECB, Economic Growth, Erosion, Federal Reserve, inflation, Low Interest Rates, Portfolio Allocation, Portfolio Research, Precious Metal Prices, Purchasing Power, Rate Environment, Remainder, Risk Tolerance, S Central, Silver Prices, Tailwind
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Breaking Commentary: Fed Gains Disappear (Sonders)

Thursday, August 11th, 2011

Breaking Commentary: Fed Gains Disappear

Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research

August 10, 2011

Key points

• Stocks fell sharply again today (August 10), continuing the extreme volatility seen recently.
• Concerns over the state of the financial industry in France drifted into the United States, contributing to the sell-off.
• Confidence appears very fragile right now and investors should use this volatility to judge their level of risk tolerance and adjust long-term allocations as appropriate.

Yesterday’s sharp gains are nothing but a memory now as equity investors endured another day of aggressive selling, with the Dow plunging over 500 points, and financials getting hit the hardest on European bank contagion fears rearing up again. Meanwhile, investors again flocked to Treasuries, pushing the 10-year to below 2.10%. One of the positive sides to these record low yields was reported today as refinancing activity surged 30.4% last week, the most since March 2009. Lower house payments, combined with lower energy costs, can help consumers’ pockets as we continue to look for a bit of an economic upswing in the coming months, but further deterioration in confidence can damage that outlook.

To us, the story remained somewhat familiar today as already shaky confidence appeared to be exacerbated by rumors of financial problems popping up in France, including concern they may lose their AAA-credit rating much as the US did last Friday. Although the ratings agencies quickly denied they were looking at downgrading France, it appears confidence is so tenuous that investors are selling first and asking questions later.

Europe back in the spotlight
The downgrade of the credit rating for the US has been a complicating factor for Europe in our opinion, as France has maintained its AAA-credit rating, which some view as inconsistent with the US rating and may be unsustainable given the possible implied liability of funding bailouts for other European sovereigns. Additionally, the current bailout fund for the region, the European Financial Stability Facility (EFSF), is likely dependent on the AAA-rating for Germany and France to access capital, which in turn is used to provide aid to the weaker countries. Concern could also be seen in the currency markets as the euro fell sharply, with questions about growth and the very viability of currency long term seemingly creeping into some traders’ minds.

Just as Italy and Spain are likely too big to bailout given the current structure of the EFSF, it is destabilizing when doubts begin to creep up about the stability of France. We believe France will make whatever necessary adjustments needed to calm markets, and will be more proactive than other nations so far, as they’ve demonstrated a leadership role during recent weeks. Of course an upcoming election and unpopular decisions don’t usually mix well, so nothing is guaranteed.

Meanwhile, the rolling crisis of confidence appears to continue to infect European banks. There is a question of the chicken or the egg here, but the interaction between banks and governments appears to be reinforcing this negative feedback loop. Reasons include large holdings of sovereign debt by banks, which may end up having write-downs, governments tend to be the backstop for banks, banks can have funding issues if they are using government debt as collateral for loans, etc.

Tags: Aaa Credit, Allocations, August 10, Charles Schwab, Chief Investment Strategist, Contagion, Credit Rating, Deterioration, Economic Upswing, Energy Costs, Equity Investors, Extreme Volatility, Last Friday, Liz Ann, Market Analyst, Nothing But A Memory, Outlook, Risk Tolerance, Sector Analysis, Senior Vice President, Treasuries
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What a Multi-Speed World May Mean for Equities (PIMCO)

Thursday, July 14th, 2011

What a Multi-Speed World May Mean for Equities

by Masha Gordon and Anne Gudefin, PIMCO

• ​An apparent rebound in risk tolerance since the financial crisis has supported higher equity valuations.
• Emerging market economies appear to be undergoing a mid-cycle rebalancing. We view this as a welcomed cyclical adjustment rather than the end of their growth cycle; long-term fundamentals remain intact.
• We believe advanced economies should continue to see headwinds to growth, and that potentially means investors may be generally willing to pay lower multiples to earnings. But we see select opportunities, including developed-nation companies with exposure to the developing world.

Certain developed nations appear to be facing the potential for flat, or even tepid, economic growth, while some emerging nations are beginning to face inflationary pressures and other challenges resulting from their faster growth rates. Investors may find asset allocation challenging in this multispeed world.

In the fifth of a series of Q&A articles accompanying the recent release of PIMCO’s Secular Outlook, portfolio managers Maria (Masha) Gordon and Anne Gudefin discuss global growth and inflationary dynamics and what they may specifically mean for equity markets in the years ahead.

Q. PIMCO has said low real interest rates have pushed investors out the risk spectrum. Could you discuss what that means for equity valuations?

Gudefin: There definitely seems to have been a rebound in risk tolerance since the financial crisis, which in turn has supported higher equity valuations. We believe this higher appetite for risk has been encouraged by central bank activities that tend to ultimately suppress real interest rates.

But we do view some pockets of opportunities in the equity market. This can work in investors’ favor as it allows them to remain contrarian and look for good investment opportunities. And considering that PIMCO sees gradually rising inflation in the years ahead, I believe some equities may outperform fixed-rate securities over the next three to five years since certain companies appear to have the potential to translate nominal growth into higher nominal earnings.

Q. Some economic indicators suggest growth may be slowing in parts of the world. What is PIMCO’s outlook, and how are companies positioned for that outlook?

Gordon: After two years of strong growth, emerging market (EM) economies appear to be undergoing a mid-cycle rebalancing. We view this as a welcomed cyclical adjustment rather than the end of their growth cycle. Fiscal consolidation, macro prudential measures and monetary tightening are likely to have the desired effects of slowing domestic demand and curtailing asset bubbles. In some places, such as China, this process appears to be well advanced.

These countercyclical measures are likely to put modest pressure on earnings of select EM corporates, particularly EM banks in countries where growth in credit has been buoyant. However, we still see the EM corporate profit pool growing at a healthy clip of 10% to 12% in 2011.

Gudefin: As part of PIMCO’s New Normal worldview, advanced economies should see headwinds to growth including deleveraging and greater regulation, and these could persist for the next few years. This potentially means investors may be generally willing to pay lower multiples to earnings, especially if high unemployment persists and growth remains moderate in advanced economies, as we expect.

Still, many developed market companies have greatly improved their cash positions, though they seem to favor investing in developing economies and distributing their earnings through dividends or share buyback programs. Perhaps they feel it is better to distribute their earnings than increase production capacity in the developed world, given the limited growth outlook for that part of the world.

Q: Does PIMCO still view emerging markets as a compelling growth story over the long term? What about inflation risks?

Gordon: Yes. We believe that the long-term fundamentals remain intact, and they include demographics favorable to growth, unleveraged consumers and a thirst for investment that is poised to underpin further productivity gains. Over a secular horizon, we expect to see a move to a more balanced growth model across the larger EM economies, such as China, with diminishing reliance on exports and greater contribution of domestic consumption. Along with these trends we anticipate appreciation in EM currencies.

As to inflationary pressures, while they appear to have started homogeneously across emerging economies emanating from higher food prices and robust gross domestic product (GDP) growth, they are likely to become less synchronous over time. For example, Mexico seems to be experiencing little if any price pressures due to a weak labor market and less robust domestic demand. Differentiation is key as reality appears to be far more nuanced. This underscores the importance of incorporating a global macro framework to one’s bottom-up stock selection process.

Over the secular horizon, we are likely to see a rise in wages in EM countries that may lead to a somewhat higher level of trend inflation. On average, emerging market companies should be able to adjust to this environment since they tend to have pricing power due to the health of EM consumers and because corporate leverage is only about 20%. Clearly, there will be exceptions to this rule such as companies that depend on wholesale funding to finance working capital or firms that are involved in low-end manufacturing.

Q. Considering PIMCO’s outlook, what are the key metrics you look at when evaluating companies?

Gudefin: We are attracted to good business models. We have observed over the years that quality companies tend to perform well, and we look for companies with high barriers to entry and strong cash flow generation and the ability to pay down debt. And we evaluate businesses based on what kind of pricing power they might have in the face of rising inflation. We also look at management’s ability to successfully steer the ship and catalysts for value to be unlocked. This is usually in the form of a new CEO, a restructuring program or maybe plans to spin off or divest non-core assets. We look to buy these high quality companies at times when short-term issues bring valuation to what we feel are attractive levels.

Our strategy, as it relates to the global economy and its many influences, remains opportunistic. For example, companies in developed economies with significant exposure to developing ones could be a place to search for attractive opportunities. Also, part of our worldview is for the potential for heightened market volatility – as our CEO Mohamed El-Erian likes to say we are on a bumpy journey – and that can create attractive opportunities as well.

In addition to discerning security selection, we aim to mitigate downside risk through the use of appropriate risk hedging strategies. I believe the ability to hedge our portfolios is a key differentiator for us.

Gordon: We spend a lot of time thinking about the return profile of businesses, favoring those that have high cash flow return on invested capital. Another important consideration for us is an ability to self-finance growth. A number of emerging market franchises may look great from the revenue growth perspective but they often rely on continued financing from new equity issuance that may not be return accretive or sustainable.

The maturity profile of a company’s debt is also an important consideration as business cycles in emerging economies tend to be shorter and companies that rely on short-term financing may find themselves locked out of the market.

Q: Finally, are there any secular equity market considerations that haven’t received much attention but deserve to?

Gordon: We believe China should continue its move up the value chain in select industries. Over the medium term, this could result in significant margin pressure for the European and U.S. industrials that have enjoyed unchallenged dominance of the Chinese domestic market.

Separately, a potential retreat of the United States from dominating global geopolitics is likely to lead to a power vacuum giving rise to regional powers. In light of this, we think defense spending will likely grow considerably in larger EM economies.

Gudefin: In the energy sector, many have written down nuclear energy after the Fukushima tragedy. Although some reactors will be closed, we believe it is not the end of nuclear. Safety norms will tighten, but a number of developing economies will likely continue their aggressive construction plans, starting with China, India and South Korea. Saudi Arabia reaffirmed in June its commitment to build 16 reactors by 2030.

Thank you, Masha and Anne.

Masha Gordon is a portfolio manager heading the recently launched Emerging Markets Equity Strategy, an actively managed equity strategy focused on attractively priced stocks with exposure to emerging markets. Anne Gudefin and Charles Lahr are portfolio managers heading the PIMCO Pathfinder Strategy, a deep value approach to global equities.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. References to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Copyright © 2011, PIMCO.

Tags: Appetite, Asset Allocation, Developed Nations, Developing World, Economic Growth, Emerging Market Economies, Financial Crisis, Global Growth, India, inflation, Inflationary Pressures, Investment Opportunities, Masha Gordon, Mid Cycle, PIMCO, Portfolio Managers, Rebound, Risk Spectrum, Risk Tolerance, Speed World, Valuations
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Howard Marks: “How Quickly They Forget”

Tuesday, June 7th, 2011

Memo to: Oaktree Clients
From: Howard Marks
Re: How Quickly They Forget

***

In January 2004 I received a letter from Warren Buffett (how’s that for name dropping?) in which he wrote, “I’ve commented about junk bonds that last year’s weeds have become this year’s flowers. I liked them better when they were weeds.”

Warren’s phrasings are always the clearest, catchiest and most on-target, and I thought this Buffettism captured the thought particularly well. Thus for Oaktree’s 2004 investor conference we used the phrase “Yesterday’s Weeds . . . Today’s Flowers” as the title of a slide depicting the snapback of high yield bonds. It showed the 45% average yield at which a sample of ten bonds could have been bought during the Enron-plus-telecom meltdown of 2002 and the 6% average yield at which they could have been sold in 2003; on average, the yields had fallen by 87% in just thirteen months. The idea went full-circle in 2005, when Warren used our slide at the Berkshire Hathaway annual meeting to illustrate how rapidly things can change in the world of investing.

And that’s the point of this memo. Asset prices fluctuate much more than fundamentals. This happens because, rather than applying moderation and balancing greed against fear, euphoria against depression, and risk tolerance against risk aversion, investors tend to oscillate wildly between the extremes. They apply optimism when things are going well in the world (elevating prices beyond reason) and pessimism when things are going poorly (depressing prices unreasonably). Shortness of memory plays a major part in abetting these swings. If investors remembered past bubbles and busts and their causes, and learned from them, the swings would moderate. But, in short, they don’t. And they may be forgetting again.

High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.

The Importance – and Shortcomings – of Investment Memory

A number of my favorite quotations are on the subject of history and memory, and I’ve used them all in past memos. Humorist and author Mark Twain talked about the relevance of the past:

History doesn’t repeat itself, but it does rhyme.

The philosopher Santayana stressed the penalty for failing to attach sufficient importance to history:

Those who cannot remember the past are condemned to repeat it.

And economist John Kenneth Galbraith described the shabby way investors treat history and those who consider it important:

Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

String together these three pearls of wisdom and you get a pretty accurate picture of investment reality. Past patterns tend to recur. If you ignore that fact, you’re likely to fall prey to those patterns rather than benefit from them. But when markets get cooking, the lessons of the past are readily dismissed. These are nothing short of eternal verities, and their collective message is indispensible.

Why Does Investment Memory Fail?

Think back to the emotions you felt so strongly during the recent financial crisis, and the terrifying events that brought them on. You swore at the time that you’d never forget, and yet their memory has receded and nowadays has relatively little influence on your decisions. Why does the collective memory of investment experiences – and especially the unpleasant ones – fade so thoroughly? There are a number of reasons.

• First, there’s investor demographics. When the stock market declined for three straight years in 2000-02, for example, it had been almost seventy years since that had last happened in the Great Depression. Clearly, very few investors who were old enough to experience the first such episode were around for the second.

For another example, I believe a prime contributor to the powerful equity bull market of the 1990s and its culmination in the tech bubble of 1999 was the fact that in the quarter century from 1975 through 1999, the S&P 500 saw only three minor annual declines: 6.4% in 1977, 4.2% in 1981, and 2.8% in 1990. In order to have experienced a bear market, an investor had to have been in the industry by 1974, when the index lost 24.3%, but the vast majority of 1999’s investment professionals doubtless had less than the requisite 26 years of experience and thus had never seen stocks suffer a decline of real consequence.

• Second, the human mind seems to be very good at suppressing unpleasant memories. This is unfortunate, because unpleasant experiences are the source of the most important lessons. When I was in army basic training, I was sure the memories would remain vivid and provide material for a great book. Two months later they had disappeared. After the fact, we may remember intellectually but not emotionally: that is, the facts but not their impact.

• Finally, the important lessons of the past have to fight an uphill battle against human nature, and especially greed. Memories of crises tell us to apply prudence, patience, moderation and conservatism. But these things seem decidedly outdated when the market’s in a bull phase and risk bearing is paying off, and if practiced they appear to yield nothing but opportunity costs.

Charlie Munger contributed a great quote to my recent book, from Demosthenes: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” In other words, there’s a powerful tendency to believe that which could make one rich if it were true.

I’ve tried to spend the last 42 years with my eyes open and my memory engaged. As a result, a lot of what I write is based on recognition of past patterns. It’s time to put my recollections to work, because I’m definitely seeing a trend in the direction of Galbraith’s “same or closely similar circumstances.”

The Not-So-Distant Past

It seems it was impossible – unless you were John Paulson – to escape entirely unscathed from the financial crisis of 2007-08. Most investors could only hope to have turned cautious in the run-up to the crisis, sold assets, increased the defensiveness of their remaining holdings, reduced or eschewed leverage, and secured capital with which to buy at the bottom in order to benefit from the subsequent recovery.

What might have prompted investors to do these things in advance of the mid-2007 onset of the crisis? Almost no one fully foresaw the impending subprime meltdown, and few macro-forecasts and market analyses were sufficiently pessimistic. Rather, I think investors would have been most likely to take the appropriate actions if they were aware of the pro-risk behavior taking place around them.

Tags: Asset Prices, Berkshire Hathaway, Berkshire Hathaway Annual Meeting, Busts, Darlings, Depressing Prices, Euphoria, High Yield Bonds, Investment Media, Investor Conference, Junk Bonds, Pariahs, Pessimism, Risk Aversion, Risk Tolerance, Snapback, Target, Thirteen Months, Warren Buffett, Weeds
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Down the Home Stretch (Sonders)

Monday, November 15th, 2010

Schwab Market Perspective: Down the Home Stretch

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research
November 12, 2010

Key points

• Economic data has shown signs of strengthening. We believe we could be emerging from the soft patch and that stronger-than-expected growth could be in the offing.
• The elections are done and the Federal Reserve made its move, but the question remains as to whether much-needed confidence returns to businesses. Additionally, housing remains a problem that may not be helped substantially by either event.
• Competitive currency devaluations are dominating the international conversation, while investors are flocking to emerging markets, making us a bit skittish in the near term.

The midterm elections in the United States are over, the Fed announced a new round of quantitative easing (QE2—injecting cash into the economy and pushing rates lower by purchasing Treasury securities), and the final earnings reporting season of the year has come and gone. So what happens as we head toward the end of the year?

First, it’s important to remember that equity investing should be viewed in a longer-term context, with a three-to-five year time horizon. Also, this is a good time of the year to make sure your allocation aligns with your risk tolerance and make adjustments as necessary, keeping tax considerations in mind.

We’ve been optimistic about the prospects for the market for some time and continue to believe the general trend of the equity market will be higher. However, we expect, and would like to see, a pullback in the near term as some technical and sentiment indicators are getting to levels indicating we may be stretched.

A bit of a retrenchment could set the stage for the next run higher. Election-cycle seasonality between now and the third quarter of next year is very supportive for equities, but we do caution that trends are not guaranteed, as we saw in September of this year, which posted robust gains despite, historically, being the worst month of the year.

Is the soft patch ending?
Our optimism has been supported of late by economic data that is largely improving. The Institute for Supply Management (ISM) reported that its Manufacturing Index improved in October to 56.9 from 54.4, above expectations. Additionally, some leading indicators within the report also showed surprising improvement. New orders jumped to 58.9 from 51.1, while inventories dropped to 53.9 from 55.6, resulting in the new order/inventory ratio improving, which has been a good indicator of future activity.

Forward Indicator Looking Better

Click to enlarge
Source: FactSet and the Institute of Supply Management, as of November 9, 2010.

On the service side, which makes up close to 70% of the US economy, the ISM Non-Manufacturing Index also improved, moving to 54.3 from 53.2. Employment readings in both indexes also posted improvement, providing some hope for future job gains.

There are other glimmers of improvement, although the overall job picture remains sluggish, with the leading indicator of initial jobless claims only recently breaking below the 450,000 range, which has typically coincided with a relatively flat labor market. The October labor report did surprise on the upside, showing that although the unemployment rate remained at 9.6%, private payrolls were up by 159,000.

Tags: Brazil, Charles Schwab, Chief Investment Strategist, China, Confidence Returns, Currency Devaluations, Home Stretch, India, Liz Ann, Market Analyst, Market Perspective, Midterm Elections, Pullback, Reporting Season, Retrenchment, Risk Tolerance, Sector Analysis, Senior Vice President, Sentiment Indicators, Tax Considerations, Term Context, Time Horizon, Treasury Securities
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Risk and Recovery in Russia

Tuesday, August 10th, 2010

Russia has a lot of upside, and a big part of why is the risk trade.

Russia was one of the top emerging markets in July, rising 10.3 percent as risk tolerance came back into the market.

And we think this upward trend can continue – Russia has a lot of catch-up potential. Its stock market remains 51 percent down from its May 2008 peak despite a 143 percent rally from its bottom in January 2009, according to Credit Suisse.

While the other BRICs have taken measures to keep their economies from overheating, Russia is just starting to benefit from stimulus implemented during the crisis.

Rising consumer demand accelerated GDP growth to 5.4 percent during the second quarter, and we think the consumer story is just getting started. Money supply is growing at a historically high rate of 30 percent, which should grease the economic engines for further expansion during the back half of the year.

U.S. dollar strength had been a headwind for Russian markets but that appears to have reversed. We’ve also seen a turnaround in the banking sector, which has historically been a positive for emerging markets.

The Russia story is just catching on. Capital inflows have been slightly positive so far in 2010, but still lagging the 2006-07 period, when monthly inflows exceeding $150 million were not uncommon.

Despite the promising outlook, some potential hurdles remain. For instance, to raise capital, Moscow is selling $35 billion of its equity in Russian companies between 2011 and 2013. This large amount of shares could pressure equity markets until this overhang is removed.

Tags: Banking Sector, BRIC, BRICs, Capital Inflows, Credit Suisse, Dollar Strength, Economic Engines, Emerging Market Countries, Emerging Markets, GDP Growth, Headwind, Hurdles, Money Supply, Overhang, Promising Outlook, Risk Tolerance, Russia, Russia Russia, Russian Companies, Russian Markets, Stimulus, Stock Market, Upward Trend
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Risk and Recovery in Russia

Friday, August 6th, 2010

Russia has a lot of upside, and a big part of why is the risk trade.

Russia was one of the top emerging markets in July, rising 10.3 percent as risk tolerance came back into the market.

And we think this upward trend can continue – Russia has a lot of catch-up potential. Its stock market remains 51 percent down from its May 2008 peak despite a 143 percent rally from its bottom in January 2009, according to Credit Suisse.

While the other BRICs have taken measures to keep their economies from overheating, Russia is just starting to benefit from stimulus implemented during the crisis.

Rising consumer demand accelerated GDP growth to 5.4 percent during the second quarter, and we think the consumer story is just getting started. Money supply is growing at a historically high rate of 30 percent, which should grease the economic engines for further expansion during the back half of the year.

U.S. dollar strength had been a headwind for Russian markets but that appears to have reversed. We’ve also seen a turnaround in the banking sector, which has historically been a positive for emerging markets.

The Russia story is just catching on. Capital inflows have been slightly positive so far in 2010, but still lagging the 2006-07 period, when monthly inflows exceeding $150 million were not uncommon.

Despite the promising outlook, some potential hurdles remain. For instance, to raise capital, Moscow is selling $35 billion of its equity in Russian companies between 2011 and 2013. This large amount of shares could pressure equity markets until this overhang is removed.

BRIC refers to the emerging market countries Brazil, Russia, India and China.

Tags: Banking Sector, Brazil, BRIC, BRICs, Capital Inflows, Credit Suisse, Dollar Strength, Economic Engines, Emerging Market Countries, Emerging Markets, GDP Growth, Headwind, Hurdles, India, Money Supply, Overhang, Promising Outlook, Risk Tolerance, Russia, Russia Russia, Russian Companies, Russian Markets, Stimulus, Upward Trend
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We’re All Chartists Now (Rosenberg)

Tuesday, July 27th, 2010

This is a guest contribution by David Rosenberg, Chief Market Economist, Gluskin Sheff.

WHILE YOU WERE SLEEPING

The risk trade is intact with bonds selling off fractionally (the Treasury market is bracing for $104 billion of new supply this week), commodities holding onto their recent hefty gains and the equity market globally in the green column (save for Japan, China and Korea, which were down marginally).

The earnings news overnight from Europe looks to be solid and helping bolster investor optimism (in 3D no less – Daimler, Deutsche Bank, Danone; UBS beat as well though SAP did miss). German consumer confidence (GfK survey) rose unexpectedly in July (to the grand total of a two-month high!). Against this background, European bourses are riding a six-day winning streak.

In the FX market, safe-havens such as the Swiss franc and the Yen are softer; the DXY has also broken decisively below the 100-day moving average and the 50-day is now rolling over. How the tide has changed. It looks like the real kicker in this latest runup in the equity market was the raised guidance out of UPS and Fedex, which has supported the view that the expansion in global trade flows was not derailed by the recent debt flare-up in Europe.

In another sign that risk-tolerance is back, the high-yield market (which we like) has generated a total return (in the U.S.A.) of 3% so far this month and there are still three days to go (retail inflows into high-yield funds have totalled $2 billion in the past two weeks)! Credit default swaps on the largest global banks have receded to their lowest level in 12 weeks to boot; overall corporate default risks are being repriced to 10-week lows as well. Emerging market bond spreads have tightened to 279 bps from 359 bps at the end of May – and are still 50 bps wider compared to the mid-April lows.

And there has been a sustained narrowing in Club Med bond spreads too (Spanish spreads tightened 11 bps to 129 bps.). This is despite the fact that the stress tests did not really deal with the major challenge, which is a sovereign debt default and if one thinks the odds of such an event are trivial, then it may pay to look into the future at the massive amount of refinancings these countries confront in the next few years (in a word, daunting). Calm has been restored, at least for now. With the equity short-long ratio down to a two-year low (the market is really overbought here) according to Data Explorers, it will be interesting to see how much more upside there is now that the bears have gone back into hibernation.

Let’s remind ourselves that the U.S. economy is still operating with a need to have jobless benefits extended for 99 weeks. This would make seasonal workers in Newfoundland blush. Here we are with a near-10% deficit/GDP ratio and a debt/GDP ratio a year away from hitting 100% – talk about a game-changer. Both the FT and the WSJ run with articles today highlighting the debate in the economics community over the effectiveness of U.S. fiscal policy.

What an indictment. This is an economy hanging on by tenterhooks because the Fed was supposed to have enough confidence in the economy to begin to stand on its own two feet so that the central bank’s pregnant balance sheet was supposed to have been in the unwinding phase by now. Instead, the Fed has pledged to do even more quantitative easing, if warranted by the circumstances. And both newspapers also discuss today the continued fiscal crunch in the State & Local government sector, which represents 13% of GDP or double the share of business capital spending.

MARKET COMMENT … WE’RE ALL CHARTISTS NOW

We’re 142 trading days into the year – 52 days (37%) have seen 1% or greater moves. And the S&P 500 is now flat as a beaver’s tail on the year. I call this the meat-grinder market. Again, a huge rally into yesterday’s close – and now the S&P 500 is sitting right at the 200-day moving average. This is starting to get interesting. Again, the lack of ratification from Mr. Bond as the 10-year note yield came back and closed the day a smidgen below 3%.

Tags: Chartists, Chief Market, Commodities, Consumer Confidence, Credit Default Swaps, David Rosenberg, Dxy, Earnings News, Emerging Market Bond Spreads, European Bourses, Fx Market, Global Banks, High Yield Funds, Investor Optimism, Market Economist, Risk Tolerance, Runup, Safe Havens, Swiss Franc, Treasury Market, Ups And Fedex
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