Economy and Bond Market Highlights

Monday, March 8th, 2010

The Economy and Bond Market

The yield on the 10-year U.S. Treasury Note increased by 7 basis points during the week to 3.68 percent. The entire move came on Friday after the February jobs report showed fewer job losses than expected and the unemployment rate holding steady.

U.S. manufacturing expanded in February for the seventh consecutive month. Although February’s ISM Manufacturing Index came in at 56.5, a drop from January’s 58.4 and lower than the consensus of 57.9, any reading above 50 indicates an expansion. This expansion from August thru February can be seen in the graph below.

Strengths

• The February nonfarm payroll report showed a loss of 36,000 jobs, fewer than the 68,000 than was expected. The unemployment rate for February was unchanged at 9.7 percent, better than expectations of 9.8 percent.
• As explained above, U.S. manufacturing expanded in February for the seventh consecutive month.
• Service industries in the U.S. strengthened more than anticipated. The ISM Non-manufacturing Index for February was 53.0, above the 51.0 expected and the level of 50.5 that was reported in January.
• Same-store retail sales increased for the third consecutive month in February. The International Council of Shopping Centers’ Index of 31 retailers (excludes Wal-Mart) showed a 3.7 percent same-store sales increase in February from a year earlier.
• Figures from the Commerce Department showed that personal spending rose by 0.5 percent in January over December, slightly more than the 0.4 percent expected.

Weaknesses

• Pending sales of existing homes fell 7.6 percent month-over-month in January, below expectations for a 1.0 percent increase. Poor winter weather was a contributing factor.
• Commerce Department figures showed that personal income rose month-over-month in January by 0.1 percent, less than the 0.4 percent expected.

Opportunities

• If financial markets are a good mechanism for discounting the future, the future appears relatively robust. The markets have been able to shake off bad news relatively easily recently, a good sign for the economic recovery.

Threats

• When governments around the world begin to wind down the monetary and fiscal stimulus programs put in place during the economic crisis, it will likely present a headwind for the economy.

Tags: Advertisement Opportunities, Basis Points, Bond Market, Commerce Department, Consensus, Financial Markets, Graph, International Council Of Shopping Centers, International Shopping, Ism Manufacturing Index, Job Losses, Jobs, Market Economy, Nonfarm Payroll Report, Personal Income, Retail Sales, U S Treasury, Unemployment Rate, Wal Mart, Winter Weather
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Chinese Yuan v The U.S. Dollar: In The Case of Global Reserve Currency

Wednesday, March 3rd, 2010

By Dian L. Chu, Economic Forecasts & Opinions

The practice of accumulating dollar reserves by the central banks has become more pronounced after the 1997 Asian financial crisis, when currency speculators hastened a balance of payments crisis in Thailand, Indonesia and South Korea by demanding dollars for local currency, depleting the central banks’ dollar reserves.

Fast forward 13 years later, the dollar’s status as the world’s preferred reserve currency has come into question amid a ballooning budget deficit that keeps the U.S. dependent on foreign financing. Both Russia and China last year suggested a type of “super-sovereign reserve currency” to challenge the dollar, while Brazil and India also discussed substituting other assets for their dollar holdings.

IMF - “That Day Has Not Yet Come”

Reigniting the argument, Dominique Strauss-Kahn, the head of the International Monetary Fund (IMF), said last Friday that it would be “intellectually healthy to explore” the creation of a new global reserve currency to reduce dependence on the dollar.

Mr. Strauss-Kahn did say there could be a globally issued reserve asset some day, but “that day has not yet come.” However, his remarks signaled broader concern over the dominance of the dollar, and “the extent to which the international monetary system as a whole depends on the policies and conditions of a single, albeit dominant, country.”

All these beg the question - Who could be the next global reserve currency succeeding the dollar?

Dollar Reserve - A Decade of Decline

The most recent foreign exchange report from the U.S. Treasury Dept. shows that the dollar reserve holding percentage has been on a steady decline - even before the financial crisis. As of 2009, the dollar still comprised about 60% of foreign reserves, compared with less than 30% for the euro, followed far behind by the pound and the yen. (see graph)

According to the Peterson Institute for International Economics, although the dollar remains the most important reserve currency over the last ten years through the first quarter of 2009, adjusting for the exchange rate effects, the dollar’s share in foreign exchange reserves has declined on balance 4.3%.

Reserve Currency Factors

The U.S. Treasury report points to several key factors identified by economists that determine the use of a currency for reserves:

• the size of the domestic economy
• the importance of the economy in international trade
• the size, depth, and openness of financial markets
• the convertibility of the currency
• the use of the currency as a currency peg
• domestic macroeconomic policies

PIIGS Decimate Euro

Based on these criteria, the euro zone, similar to the United States in size, share of global trade, and currency convertibility, makes the euro a viable contender for the dollar’s crown. And in contrast to the dollar, the euro has steadily taken market share regarding global foreign reserves during the past ten years, and has become the second most popular reserve currency. (see graph)

Unfortunately, the debt and budget woes of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) have seriously damaged the confidence and credibility of the European Union and the euro, essentially decimating the euro’s chances as an alternative to the dollar.

The euro has already hit a one-year low against the yen, and nine-month low against the dollar on speculation that Greece’s credit rating will be downgraded further. The viability of the European Union and the euro as a going concern has also come into question.

Dollar Reigns Liquidity Supreme

Even without the Greece debacle, the lack of liquidity within the euro zone also makes it difficult to compete against the dollar.  One important reason the US dollar remains the reserve currency is that the U.S. treasury market is the most liquid market of its sort. A liquid debt market allows central banks to intervene in foreign exchange markets in order to smooth currency fluctuations.

As noted by the U.S. Treasury Dept. report:

“The euro has not become the dollar’s equal as a reserve currency because there is no common sovereign-debt market across the euro zone.”

From that perspective, sterling and yen, the next two preferred reserve currencies following the euro, pale in comparison to the dollar in terms of liquidity and facilitating global trade. Moreover, Moody’s (MCO) warned of possible downgrades on UK and Japan due to high debt, interest payments and slow GDP growth.  (The pound was in virtual free-fall at one stage this Monday and sank to a ten-month low against the dollar on renewed worries about a hung parliament.)

Gold or Yuan?

While there are many advocating an international gold standard, or another international standard currency based on a basket of commodities and/or currencies, it is very difficult to see sufficient international consensus for this to be practical or feasible.

So, waiting in the wings is the Chinese renminbi (RMB) or yuan. The appointment of Zhu Min, the deputy governor of China’s central bank, as a special adviser to the IMF seems to signal China’s assertion in the global currency scheme. The fund, historically led by a European but dominated by the United States, has tried to engage emerging economies like Brazil, China, India and Russia.

But according to economist Geng Xiao, director of the Brookings-Tsinghua Center for Public Policy, it’s still in China’s—and the world’s—best interest not to dump the dollar just yet.

Yuan Revaluation Solves Nothing

In an interview with McKinsey Quarterly, Xiao noted that there’s no argument on either side about the trade imbalance between China and the US. However, there are some philosophical differences between the two as the US places more emphasis on the short-term adjustment through price and the RMB exchange rate, whereas the Chinese put more emphasis on medium and long-term structural and institutional change.

Xiao finds it quite difficult for the exchange rate to correct the trade balance:

“Even if you change the exchange rate, it will have very little impact on US trade deficit because the US is going to buy from some other countries.”

Time To Reform & Float

China needs time to push through difficult economic reforms at home before it can allow its currency to float freely against the dollar, as Xiao explains:

“China needs a benchmark so that the price can be compared to the global price, to the price structure, compatible with efficiency. That’s why price reform is more important than exchange-rate change… Exchange-rate change would not really change the inefficiencies … [as] the internal subsidies are still there.”

Xiao estimates it’s going to take 5 to 10 years for China to correct its distortions - land reform, reform of the energy sector, state-owned-enterprise reform, and social welfare. Only when the productivity of China reaches that of the United States will the two countries’ price structures converge.

The Worst-Case Scenario

A worst-case scenario might come to fruition if China allows RMB appreciation expectation to continue, building up more foreign-exchange reserves, as Xiao cautions:

“I don’t see that there’s any way that China can significantly reduce its holding of the dollar assets….But if pushed hard, China can always do more. And even marginally, a little bit more is going to have a big impact in the market.”

Dollar Rules … For Now

Indeed, overtime, China should be able to transform into a modern market economy. And if the Chinese economy continues to grow at its current pace, the RMB will eventually become one of the important reserve currencies, just like the US dollar.

But for now, there are several factors strongly supporting the dollar. In addition to a liquid debt market, many commodities, including oil and gold, are quoted in the US currency. Roughly 88% of daily foreign exchange trades involve US dollars. One currency essentially facilitates global trade, and commodities can be priced homogenously wherever traded.

And China, the top U.S. debtor with a massive holding of $894.8 billion in Treasury securities at the end of last December, is shifting to longer-term US treasuries and at the same time accumulating US stocks, raising its overall holdings of long-term American securities.

China’s huge holdings of dollar reserves in the form of Treasury securities has become a concern for officials on both sides of the Pacific. However, the fact remains that the dollar is still the most liquid, the most stable currency, comparatively speaking. In that sense, it is unlikely for China to significantly reduce its holding of dollar assets in the foreseeable future.

Dethroned By 2050?

Most Western experts seem to agree that the prospect of a dollar replacement for a new world reserve currency is unlikely to materialize anytime soon because there is no serious alternative on the horizon.

Doubts also remain that the Chinese can challenge the greenback. Nevertheless, there seems to be more or less a consensus forming among many Western experts that the Chinese are on an unmistakable path toward challenging the dollar in a transition period of 10 to 15 years, roughly coinciding with the projections of Mr. Geng Xiao.

British economist Angus Maddison predicts that China will surpass the US by 2015. Drawing historic parallels of the last switch in reserve currency (from pound sterling to the US dollar) would imply the Chinese renminbi may be expected to replace the US dollar as a reserve currency around 2050, the mid-21st century.

Dollar Demise by A Greece-Like Crisis?

Meanwhile, even though the debt crisis of troubled southern European nations have taken hold of headlines lately, Moody’s and its peers have expressed concerns about the financial health in Japan, UK and the U.S., mostly centered around debt and debt service in these larger nations.

For instance, interest paid on U.S. Treasury debt has been soaring the last two years and is expected to reach over $700 billion a year by the end of the decade. The U.S.’s ratio of total debt to GDP is likely to exceed 90% this year, making it more indebted even than Spain and Portugal.

While the US has been enjoying the reserve currency status, this is by no means assured for the future. For now, investors are seeking refuge in the U.S. Treasury market. However, a broken-down political system, the debt and the deficit inevitably could sink America into a Greece-like crisis, nudging the dollar’s demise sooner, rather than later.

Tags: Asian Financial Crisis, Balance Of Payments, Budget Deficit, Central Banks, China, Chinese Yuan, Currency Speculators, Dian, Dollar Terms, Dominant Country, Dominique Strauss Kahn, Economic Forecasts, Exchange Report, Gold Price, International Monetary Fund, International Monetary Fund Imf, International Monetary System, Investment Demand, Minor Currencies, Reserve Asset, Reserve Currency, South Korea, Steady Decline, Story Source, Treasury Dept, U S Treasury, Vote Of No Confidence
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China Cuts Its Holdings in Treasuries?

Tuesday, February 16th, 2010

It appears that China is doing its best to keep the dollar from strengthening, employing a strategy of “covert easing.” Is this Act One of the US-China divorce Harvard’s Niall Ferguson predicted last year, or is this an intervention on China’s part to moderate the short covering rally in the dollar, as a way to hedge its exports recovery? Only time will tell; either way, it looks as though China is selling U.S. treasuries.

AP/MSNBC reports China cuts holdings of U.S. Treasuries:

The government said Tuesday that foreign demand for U.S. Treasury securities fell by the largest amount on record in December with China reducing its holdings by $34.2 billion.

The reductions in holdings, if they continue, could force the government to make higher interest payments at a time that it is running record federal deficits.

The Treasury Department reported that foreign holdings of U.S. Treasury securities fell by $53 billion in December, surpassing the previous record of a $44.5 billion drop in April 2009.

On the surface, this is a story that is likely to get politicized, used in Washington, as bait for continuance of QE. Scratching below, there is far more to this than meets the eye, in what amounts to a very sophisticated monetary shell game of keeping the dollar moderately cheap that is being played out between the U.S and China. Keep your eyes on the ball. The agenda belongs to China, the recovery in its export sector, and currency balance in the yuan/dollar pair.

Is China tightening? Not Really.

Source: MSNBC, February 16, 2010.

Tags: Act One, April, China, Continuance, Control, Currency, Divorce, Dollar, Emerging Markets, Export Sector, Federal Deficits, Federal Treasury, Harvard, Interest Payments, Intervention, Msnbc, Msnbc Reports, Niall Ferguson, Qe, Rally, Shell Game, Short Covering, Treasuries, Treasury Department, Treasury Securities, U S Treasury, Yuan
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Economy and Bond Market Highlights

Monday, February 1st, 2010

The Economy and Bond Market The 10-year U.S. Treasury note was relatively stable this week, with the yield decreasing by one basis point to end the week at 3.60 percent. As reported this week, real gross domestic product (real GDP) increased at an annual rate of 5.7 percent in the fourth quarter of 2009, besting the consensus estimate of 4.7 percent. This was the best performance since the third quarter of 2003. The figure below shows the annualized quarter-over-quarter percentage changes.

Strengths

• The Reuters/University of Michigan final index of consumer sentiment for January rose to 74.4, exceeding the consensus of 73.0 and the preliminary estimate of 72.8. This was the highest level in two years.
• The Chicago Purchasing Managers Index increased to 61.5 in January, higher than the consensus estimate of 57.2. This was the highest level since November 2005.
• The S&P Case-Shiller 20-city home price index for November rose a seasonally adjusted 0.24 percent from October, the sixth straight monthly gain. The index was down 5.32 percent year-over-year, the smallest year-over-year decline in two years.
• The Conference Board’s index of consumer confidence rose to 55.9 in January from a revised 53.6 in December, besting the 53.5 median estimate of economists.

Weaknesses

• Durable goods orders for December rose 0.3 percent from November, less than the 2 percent advance expected by economists. Orders for durable goods excluding transportation increased by 0.9 percent, more that the 0.5 percent consensus.
• Initial jobless claims for the week ended January 23 were reported at 470,000, more than the 450,000 expected.
• December new home sales declined 7.6 percent month-over-month to 342,000, less than the forecast of 366,000.
• Sales of existing U.S. homes in December fell 16.7 percent from November levels to an annual rate of 5.45 million, worse than the consensus of 5.90 million. November sales had been helped by the government tax credit, which was originally scheduled to expire on November 30.
• The Richmond Fed’s manufacturing index for the central Atlantic region for January came in at -2.00, slightly worse than the consensus estimate of 0.00. It did edge up a bit from December’s index of -4.00. For each of the seven months prior to December, the index had been positive.
• The Mortgage Banker’s Association index of mortgage applications for the week ended January 22 dropped by 10.9 percent after rising for the preceding three weeks.

Opportunities

• The fourth-quarter GDP of 5.7 percent reported this week provides another indication that the global economic recovery appears to be taking hold.

Threats Coordinated global removal of fiscal and monetary stimulus are the biggest threats to the financial markets.

Tags: Basis Point, Best Performance, Bond Market, Consensus Estimate, Durable Goods Orders, Economists, Fourth Quarter, Government Tax, Gross Domestic Product, Home Price Index, Index Of Consumer Confidence, Index Of Consumer Sentiment, Initial Jobless Claims, Median Estimate, Percentage Changes, Purchasing Managers Index, Real Gdp, Reuters, Treasury Note, U S Treasury
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Roundup: Gold Market

Sunday, January 17th, 2010

Gold Market
For the week, spot gold closed at $1,130.93 per ounce down $7.32 or 0.64 percent. Gold equities, as measured by the XAU Gold & Silver Index, fell 4.93 percent rise for the week. The U.S. Trade-Weighted Dollar Index slid 0.34 percent.
Strengths

• Gold Fields Mineral Services has said in its latest gold survey that official central bank sales declined 90 percent in 2009 as they shifted onto the buy-side of the market during the second quarter and have remained there since.
• Central bank gold sales for the year were only 157 tonnes, significantly lower than the Central Bank Gold Agreement’s quota of 500 tonnes.
• World investment tonnage more than doubled last year, rising by 482 percent to 1,375 tonnes, as investors piled into bullion-backed exchange traded funds and other investment vehicles that track the price of gold.

Weaknesses

• China’s decision to raise reserve requirements by 50 basis points for banks hurt commodities and caused gold to erase earlier gains in the week as risk-averse trades strengthened the dollar and Greece’s fiscal crisis dented investor confidence. Analysts see the tightening in China as a weakness because it is believed it will curb demand for raw materials.
• Peng Junming, an investment strategist at China’s sovereign wealth fund has said the U.S. dollar has most likely bottomed as there will be very limited space for the dollar to drop further, and has said that there is no urgent need for China to increase gold buying for now because of high prices.
• Reports from the U.S. Treasury calculated $15 billion profits from the Capital Purchase Program for banks and another $4.4 billion in profits from other bank investments and lending programs. However, the figures are miniscule when compared to the estimated net losses on its $700 billion bailout program which totaled $68.5 billion for the fiscal year ended in September 2009 primarily due to the continued weakness from AIG, automaker bailouts, and mortgage payment losses.

Opportunities

• The World Economic Forum (WEF) has expressed that sovereign credit risks are rising and has said that unsustainable debt levels ranked among the top three risks for the year ahead. WEF has said debt levels have risen from 78 percent in 2007 to 118 percent of GDP in the G-20. Continued weaknesses in Dubai, Greece, and Ukraine may entice investors to seek refuge in gold.
• The World Gold Council has said that gold sales across the countries in the Middle East will considerably pick up in 2010 thanks to better market conditions and rising demand for gold as an alternative asset.
• Notable gold investor, Rob McEwen believes gold prices may increase to $5,000 an ounce between 2012 and 2014 and maintains his forecast that gold will rise to $2,000 an ounce by the end of the year.

Threats

• Governor Schwarzenegger is refusing to consider tax hikes and is relying mostly on $8.5 billion in expenditure cuts from medical insurance programs, among others. He is also counting on the U.S. government contributing nearly $7 billion to plug the budget deficit gap. As a result, Standard & Poor’s cut California’s debt yet again citing “severe fiscal imbalance and the impending recurrence of a cash deficiency if the state’s revenue and spending trajectories continue.”
• The chairman of the Commodity Futures Trading Commission said that the agency’s planned meeting in early March to discuss possible position limits on metal futures and options contracts will focus on gold and silver contracts.
• Inflation fears in Venezuela have risen after President Hugo Chavez decided to devalue the bolivar by 50 percent to benefit the largest state-owned oil producer after margins fell due to the fall in crude prices last year. It will raise cash for social projects and will increase wages ahead of parliamentary elections in September. Chavez has warned businesses that raise prices ahead of the devaluation will be seized by the government.

Tags: Bailout, Bank Gold, Bank Investments, Central Bank Gold Sales, China, Commodities, Dollar Index, Emerging Markets, Exchange Traded Funds, Fiscal Crisis, Gold, Gold Equities, Gold Fields, Gold Market, Gold Survey, Investment Strategist, Investment Vehicles, Investor Confidence, Mineral Services, Mortgage Payment, oil, Silver Index, Spot Gold, U S Treasury, World Investment
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Roundup: Emerging Markets

Sunday, January 10th, 2010

Emerging Markets

Strengths

• China’s December headline Purchasing Managers Index rose 1.4 points to 56.6. This represents continued evidence that China’s growth momentum is still in place. The new orders index, an indicator of future growth, rose 1.6 points to 61. .
• Passenger car sales in Turkey were 121 percent higher last month than they were in December 2008, while light commercial vehicle sales were up 96 percent. Promotional campaigns attracted buyers to dealers’ lots even though the tax incentives expired in October.

Weaknesses

• Moody’s Investors Service said the outlook for Hong Kong’s banking industry will remain negative because Hong Kong banks may still be vulnerable to volatility in the global economy.
• According to Citi estimates, consumer price inflation in Hungary edged up in December, reaching 5.5 percent year-over-year versus 5.2 percent in November. Higher food and fuel prices were to blame.

Opportunities

• China’s Securities Regulatory Commission has given approval for the launch of stock index futures, margin trading and short selling at an unspecified date in the future. This is another step in the reform of its capital markets and can be taken as a sign of confidence that China is past the global financial crisis of 2008.
• Thermal coal prices have risen in Central and Eastern Europe, increasing the cost of producing electricity for utilities operating lignite plants. The Czech Republic’s largest utility plans to produce almost half of its electricity in 2010 at its nuclear plants.

Threats

• One of the areas of concern in China’s PMI report was the rise of input prices by 3.3 points to 66.7. This is an indicator of rising inflationary pressures. This, coupled with the rise in food prices, should be monitored closely in the coming months.



• Rising U.S. Treasury yields negatively impact equity valuations, but Morgan Stanley research shows only a weak historical relationship with emerging markets. Higher real interest rates resulting from stronger economic growth are likely to have a much more benign impact on equities than if rates rise during a period of weak economic growth.

Tags: Central And Eastern Europe, China, Coal Prices, Consumer Price Inflation, Emerging Markets, Futures Margin, Global Financial Crisis, Growth Momentum, Hong Kong Banks, Input Prices, Lignite Plants, Margin Trading, Morgan Stanley, Nuclear Plants, Passenger Car Sales, Purchasing Managers Index, Securities Regulatory Commission, Stanley Research, Stock Index Futures, Tax Incentives, Thermal Coal, U S Treasury
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Economic Threats and Investment Opportunities

Monday, December 14th, 2009

In an article, published today at GlobeAdvisor.com, Pierre Daillie, Managing Editor, AdvisorAnalyst.com discusses how economic threats translate into different investment opportunities.

Confused about what’s in store for the economy? The long-in-the-teeth rally in equities, falling U.S. treasury bond yields, and record gold prices reflect both the uncertainty, and the conflicting wagers on inflation and deflation. It appears we’re at an inflection point, the outcome of which will depend on how economic policy makers act. The debate as to what happens next rages on.

To read the story, please visit http://www.globeadvisor.com/advisoranalyst/aa200912132.html

Tags: Act, Advertisement, Amp, Avw, Cb, Ck, Economic Policy Makers, Economic Threats, Economy, Gold, Gold Prices, Img Src, inflation, Inflection Point, Investment Opportunities, Lt, Managing Editor, Openx, Policy Debate, Rages, Rally, Random Number, Teeth, Translate, Treasury Bond Yields, Treasury Yields, U S Treasury, Uncertainty, Wagers
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Stocks for the Long Run? Not so fast Jeremy

Friday, October 9th, 2009

John Keefe, columnist for CBS MoneyWatch, FT.com, and ex-Wall Streeter, refutes Jeremy Siegel’s “Stocks For the Long Run,” FT.com Op-Ed, stating that there is no long run, only many short runs.

Here is an excerpt:

The author and promoter of Stocks For The Long Run, Professor Jeremy Siegel of The Wharton School, is back. A few days ago in an op-ed submission Siegel revved up his old hypothesis - that investing in stocks always beats investing in bonds, sort of. In my view, his advice for individual investors was simplistic and dangerous when it was fresh in 1994, and seeing that Dr. Siegel’s patter has not been informed by the two stock market crashes since then, the message has become only more so. (This is a long post, but worth it; please bear with me.)

I. The beating stocks took in 2008 and 2009 did plenty to disprove, or at least soften up, Siegel’s hypothesis. At the stock market low in March, “stocks for the long run” (hereinafter SFTLR) was in tatters, because at that point, the returns to U.S Treasury bonds had beaten equities for the prior 40 years. (If 40 years doesn’t constitute the long term, I don’t know what does.)

Therefore this week I was disappointed to see that the Financial Times, a publication that I adore and sometimes have the privilege of writing for, had given Dr. Siegel time on its podium. Here’s a sample of his defense of SFTLR:

[F]or the 13 10-year periods of negative returns stocks have suffered since 1871, the next 10 years gave investors real returns that averaged more than 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all 10-year periods, and is twice the return offered by long-term government bonds.

Strong future returns also followed poor returns if one extends the analysis to the worst-performing of all 127 10-year stretches since 1871. Without exception, for each 10-year return that fell in the bottom quartile, the following 10-year period yielded positive real returns and the median return exceeded the long-run average…

He went on to suggest that the comparison with bonds for the last 40 years wasn’t fair, because their returns had been above average. Huh? He didn’t omit the above-average years for stocks.

You can read the whole article here.

Tags: Bottom Quartile, Cbs Moneywatch, Financial Times, Future Returns, Government Bonds, Hypothesis, Individual Investors, Investing In Bonds, Investing In Stocks, Jeremy Siegel, John Keefe, Patter, Professor Jeremy, Promoter, Stock Market Crashes, Tatters, U S Treasury, U S Treasury Bonds, Wall Streeter, Wharton School
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David Swensen: How to Sleep Soundly

Monday, March 16th, 2009

Yale’s Alumni Magazine for March/April 2009, features Marc Gunther’s interview with Yale Endowment’s Super-Investor, David Swensen, and details some of Swensen’s key advice to investors about portfolio management. It is a must read. Here is an excerpt.

In just under a quarter-century as Yale’s chief investment officer, David Swensen ‘80PhD has generated Bernard Madoff-like returns — except that Swensen made his money honestly. Under his leadership, Yale’s endowment has generated an astonishing 20 consecutive years of positive returns, from 1988 to 2008.

Yale Alumni Magazine: Has it been a difficult time for you?

Swensen: In some ways, yes. I absolutely love the idea of producing ever-increasing levels of support for Yale. Looking ahead to the next few years, that’s not going to be in the cards. That’s a difficult reality to deal with.

But in terms of the day-to-day work, managing through this economic and financial crisis is absolutely fascinating. It’s exhausting, but fascinating.

Y: It may be fascinating to you, but it’s discouraging for those of us who have watched our 401(k) values plummet. Given all the turmoil and uncertainty, what should individual investors do?

S: If an individual investor followed the program I outlined in Unconventional Success [see box], they probably did reasonably well, through the crisis, thus far. They’d have 15 percent of their assets in U.S. Treasury bonds. They’d have another 15 percent in U.S. Treasury inflation-protected securities. Those two asset classes have performed well.

Of course, the other 70 percent of assets are in equities, which have not done well. With all assets, I recommend that people invest in index funds because they’re transparent, understandable, and low-cost. So, the equity holdings have gone down step-by-step with the declines in the market.

I recommend that investors rebalance.

But I also recommend that investors rebalance. Rebalancing is even more important amidst these huge declines in the stock market because it presents a great opportunity. People can sell the Treasury securities that have appreciated dramatically to bring their allocation to the 15 percent target, and they can redeploy those funds into domestic equities and foreign equities and emerging market equities and real estate investment trusts, all of which are now much cheaper, and therefore have higher prospective returns.

Y: Explain this idea of asset allocation, please.

S: Asset allocation is the tool that you use to determine the risk and return characteristics of your portfolio. It’s overwhelmingly important in terms of the results you achieve. In fact, studies show that asset allocation is responsible for more than 100 percent of the positive returns generated by investors.

Y: How can that be?

S: It’s because the other two factors, security selection and market timing, are a net negative. That’s not surprising. They’re what economists would call zero-sum games. If somebody wins by buying Microsoft, then there has to be a loser on the other side who sold Microsoft. If it were free to trade Microsoft, the amount by which the winner wins would equal the amount by which the loser loses. But it’s not free. It costs money. It costs money in the form of market impact and commissions if you’re trading for your own account, and it costs money in terms of paying fancy fees if you are relying upon an investment advisor or mutual fund to make these security-specific decisions. For the community as a whole, all those fees are a drag on returns.

That’s why the most sensible approach is to come up with specific asset allocation targets that you can implement with low-cost, passively managed index funds and rebalance regularly. You’ll end up beating the overwhelming majority of participants in the financial markets.

Y: So people should not be afraid of stocks now?

S: Not only should they not be afraid, they should be enthusiastic. One of the great ironies is that if you had talked to the average investor 18 months ago, he or she would have thought it was a pretty good idea to buy stocks. In recent months, the same investors despair about their portfolio and are fearful about putting money into the equity market.

That’s 180 degrees wrong. They should have been cautious 18 months ago, when prices were much higher than they are now. They should be enthusiastic today.

Y: That runs counter to human nature.

S: That’s one of the really tricky things about the investment world. It’s very different from a lot of things we deal with, day in and day out. If you talk to a businessman, a businessman is going to feed the winners and kill the losers. But in the investment world, when you’ve got a winner you should be suspicious about what’s next. And if you’ve got a loser, you should be hopeful — although not naively hopeful.

To read the whole interview, plus the additional material, click here. (make sure you read the items highlighted in blue on the right hand side)

Tags: Asset Classes, Bernard Madoff, Chief Investment Officer, David Swensen, Equity Holdings, Index Funds, Individual Investor, Individual Investors, Inflation Protected Securities, Marc Gunther, Portfolio Management, Quarter Century, Rebalance, Rebalancing, Treasury Inflation Protected Securities, U S Treasury, U S Treasury Bonds, Unconventional Success, Yale Alumni Magazine, Yale Endowment
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Prem Watsa: 2008 Letter to Shareholders

Tuesday, March 10th, 2009

Prem Watsa, Chairman and CEO, Fairfax Financial, one of Canada’s most successful investors, and often compared to Warren Buffett, has been vindicated with blockbuster returns arising from the company’s investments in 2008. Below are excerpts from his letter to shareholders for 2008, where Mr. Watsa discusses his observations of the year that has past and his outlook.

The letter opens with Watsa describing the results of the vindicating year:

Since we began 23 years ago, book value has compounded by 25% while our common stock price has followed at 23% per year. The last two years have made up significantly for the biblical seven lean years that you have suffered. In the seven lean years (1999-2005),we made no money on a cumulative basis. In the three years since (2006-2008), we have earned $2.8 billion after tax and book value per share has more than doubled. While we are pleased that our forecast of “the seven lean years are over” did come true, we much prefer the Noah principle, “Forecasting doesn’t count, building an ark does”!

On Page 5, the company’s moves in the market are described in some detail:

In November of 2008, after the stock markets had dropped 50% from their highs, we decided to remove the equity hedges on our portfolio investments. Also, as the yield on long (30-year) U.S. Treasuries began to drop below 3%, we sold almost all our U.S. Treasuries (at year-end we had only $985 million left, compared to $6.4 billion on December 31, 2007), having realized net gains of $583 million in 2008 on sales of U.S. Treasuries. Both the equity hedges and the U.S. Treasuries have done an outstanding job in protecting our capital. Our U.S. Treasury bond position was to a large extent replaced by $4.1 billion in U.S. state, municipal and other  tax-exempt bonds (of which $3.6 billion carry a Berkshire Hathaway guarantee) with an average yield (at purchase) of approximately 5.79% per annum. During the fourth quarter of 2008, we also increased our cash and short term investments by $752 million and invested an additional $2.3 billion in common stocks. The annualized pre-tax equivalent interest and dividend income has increased significantly for our company by virtue of our significant holdings of tax-exempt bonds and as we have taken advantage of the significant widening in corporate and non-Federal Government spreads.

In previous annual reports, we have discussed the holding of some common stock positions for the very long term. Last year we identified Johnson & Johnson as one name and said that Mr. Market may give us more opportunities in the future. As shown in the table below, at the end of 2008 we had taken advantage of the major decline in stock prices to purchase additional positions in outstanding companies with excellent long term track records which we contemplate holding for the long term.

On Page 10, Watsa describes the year that was in terms of Hamblin Watsa’s triumph in the market:

2008 was another very good year for Hamblin Watsa’s investment results, even excluding our CDS position which is not included in the results shown above. These results are due to Hamblin Watsa’s outstanding investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami, Sam Mitchell, Paul Rivett, Frances Burke and Enza La Selva.

As I said earlier, the return that our investment team produced in 2008 was the best since we began in 1985 - 23 years ago! All of the investment risks that we worried about and have written to you about for at least the past five years simultaneously reared their ugly head as the 1 in 50 or 1 in 100 year storm in the financial markets landed in the fall of 2008. All the major stock markets worldwide were down about 50% and all corporate and non-Federal Government bond spreads widened to historically high levels. Risk was back with a vengeance and, as Grant’s Interest Rate Observer wrote back in 1996, “the return of one’s money, the humblest investment attribute in good times, is always prized in bad times”.

Long U.S. Treasury yields declined to 2.5% - a low not seen since 1954 - and 3-month T-Bills were yielding close to 0% for much of the fourth quarter of 2008. All parts of the U.S. economy and financial markets began to deleverage at the same time, led by financial institutions, hedge funds, businesses and individuals. Mutual fund redemptions began worldwide and the risk in common stock investing was exposed as stock markets declined viciously in the fourth quarter of 2008 and have continued to decline in 2009. Comparing levels at the end of 2008 and the end of 1998, most U.S. and worldwide stock market indices had not provided any return for the past 10 years. For example, the S&P 500 had a compound annual return of minus 3.0% (excluding dividend reinvestment) over the past 10 years. Of course, for the investor in late 2008, the returns in the future may be very different from the past.

Watsa writes of the various points of vindication, discussing where in past years he quoted Hyman Minsky, and Ben Graham admonishing investors to remain patient:

Last year, I quoted Hyman Minsky who said that history shows that “stability causes instability”. He said that prolonged periods of prosperity lead to leveraged financial structures that cause instability – and did we see that in spades in 2008!! With SIVs, CDOs, CDOs squared, among any other structures, leverage on leverage was exposed in 2008. Private equity firms that could do no wrong in 2005/2006 were down 90% from their IPO price in 2007. While Madoff may be the  biggest Ponzi scheme yet unearthed, what Mr. Minsky calls Ponzi financial structures, where interest and principal cannot be financed by internal operations, are being unmasked daily in the financial markets.

Structured investments based upon consumer debt that we warned you about for some time took a real beating in 2008, as 47% of the original AAA ratings on U.S. residential mortgage-backed and various other asset-backed securities issued between 2005 and 2007 were downgraded.

In fact, as of January 9, 2009, over 13% of those securities which had originally been rated as AAA had been downgraded to CCC+ or lower!

Last year, we quoted Ben Graham who said that only 1 in 100 of the investors who were invested in the stock market in 1925 survived the crash of 1929-32. Our experience has been the same.

On his outlook and investments:

We had to endure years of pain before harvesting the gains in 2007 and 2008.

We think this recession is going to be long and deep and the only comparable data points are the debt deflation that the U.S. experienced in the 1930s and Japan experienced from 1989 to the present time. While the U.S. government has initiated a massive stimulus program and is providing up to $2 trillion for its Financial Stability Program, the effect of these programs will be diminished by the enormous deleveraging going on by businesses and individuals: government in the U.S. only accounts for less than 20% of GNP while the private sector accounts for more than 80%. The situation will have to be monitored carefully over the next few years. Of course, many of these negatives are being discounted in the stock market and credit markets as stock prices are down more than 50% and credit spreads are at record levels. We have not had as many opportunities in both markets in our investing career and we are busy!

For the first time in more than a decade, we are very excited about the long term prospects of our common stock investments and believe that these investments have been purchased at prices well below their intrinsic values. This, of course, does not mean stock prices cannot go lower! Mark-to-market gains or losses on these investments will make our book value more volatile, but in the next five years, these investments should be a major reason for our success.

And if you happen to be in Toronto on April 15, 2009, that is when the company’s AGM will take place:

9:30 a.m. on Wednesday, April 15, 2009 in the John W.H. Bassett Theatre, Room 102, Metro Toronto Convention Centre, 255 Front Street West.

Our Presidents, the Fairfax officers and the Hamblin Watsa principals will all be there to answer any and all of your questions.

Download the letter here.

Tags: 23 Years, Berkshire Hathaway, Blockbuster, Canada, Common Stock, Cumulative Basis, December 31, Fourth Quarter, Hedges, Lean Years, Letter To Shareholders, Noah, Portfolio Investments, Stock Markets, Stock Price, Tax Exempt Bonds, Treasuries, Treasury Bond, U S Treasury, Warren Buffett, Year End
Posted in Bonds, Canadian Stocks, Credit Markets, Economy, Markets, Outlook | No Comments »

Byron Wien: Ten Surprises for 2009

Tuesday, January 6th, 2009

Byron R. Wien, Chief Investment Strategist of Pequot Capital Management, Inc., today issued his list of Ten Surprises for 2009. Mr. Wien has issued his economic, financial market and political surprises annually since 1986. The 2009 list follows:

1. The Standard and Poor’s 500 rises to 1200. In anticipation of a second-half recovery in the U.S. economy, the market improves from a base of investor despondency and hedge fund and mutual fund withdrawals. The mantra changes from “fortunes have been lost” to “fortunes can still be made.” Higher quality corporate bonds, leveraged loans and mortgages lead the way.

2. Gold rises to $1,200 per ounce. Heavy buying by Middle Eastern investors and a worldwide disenchantment with paper currencies drive the price of precious metals higher. In a time of uncertainty, investors want something they can count on as real.

3. The price of oil returns to $80 per barrel. Production disappointments and rising Asian demand create an unfavorable supply/demand balance. Other commodities also rise, some doubling from their 2008 lows. Natural gas goes to $9 per mcf.

4. Low Treasury interest rates coupled with huge borrowing by the Treasury send the dollar into a serious downward slide. Overseas investors become concerned that the currency printing presses will never stop. The yen goes to 75 and the euro to 1.65.

5. The ten-year U.S. Treasury yield climbs to 4%. Later in the year, as the economy shows signs of recovery, economists and investors shift their mood from concern about deflation to worries about inflation. A weak dollar, rapid growth in money supply and record-setting deficits (over $1 trillion) are behind the change.

6. China’s growth exceeds 7% and its stock market revives. World leaders credit China’s authoritarian government for its thoughtful stimulus policies and effective execution during a challenging period. The Chinese consumer begins to spend more and save less and this shift is behind the unexpected strength in the economy.

7. Falling tax revenues from the financial sector cause New York State to threaten bankruptcy and other states and municipalities follow. The Federal government is forced to step in and provide substantial assistance. The New York Post screams “When will the bailouts stop?”

8. Housing starts reach bottom ahead of schedule in the fall, and house prices stabilize after dropping 15% from year-end 2008 levels. The Obama stimulus program proves effective and a slow growth recovery begins before year-end. Third and fourth quarter real gross domestic product numbers are positive.

9. The savings rate in the United States fails to improve beyond 3%, as most economists expect. The concept of thrift seems to have vanished from American culture. Peak job insecurity and negative growth drive increased savings early in the year, but spending resumes as the economic growth turns positive in the second half, making Christmas 2009 the best ever.

10. Citing concerns about Iraq’s fragile democratically elected government and the danger of a Taliban-controlled Afghanistan, Barack Obama slows his plan for troop withdrawal in the former and meaningfully increases U.S. military presence in the latter. In a hawkish speech he states that the threat of terrorism forces the United States to maintain a strong military force in this strategic area.

Mr. Wien believes these surprises, which the consensus would assign only a one-in-three chance of happening, have at least a 50% probability of occurring at some point during the year. In previous years, more than half of the elements of the list have proven correct.

Pequot Capital Management is a private investment firm.

Source: Business Wire
http://www.businesswire.com/portal/site/home/permalink/?ndmViewId=news_view&newsId=20090105005763&newsLang=en

Tags: Authoritarian Government, Capital Management Inc, Chief Investment Strategist, Chinese Consumer, Corporate Bonds, Demand Balance, Despondency, Disenchantment, Downward Slide, Leveraged Loans, Overseas Investors, Paper Currencies, Pequot Capital Management, Pequot Capital Management Inc, precious metals, Price Of Oil, Printing Presses, U S Treasury, Unexpected Strength, Weak Dollar
Posted in Bonds, Commodities, Credit Markets, Economy, Gold, Markets, Oil and Gas | No Comments »

Yale’s Swensen: “Extraordinary Opportunities in Distressed Debt

Monday, January 5th, 2009

Legendary Yale University Endowment investor, David Swensen, says there are extraordinary investment opportunities in the credit world and is “pursuing a recovery” by acquiring distressed debt.

Bloomberg says:

“There are some really extraordinary opportunities in the credit world,” said David Swensen, the school’s investment chief, in a phone interview from his office at the New Haven, Connecticut, university. “Everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels.”

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Among Swensen’s core principles identified in “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment” (Free Press, 408 pages, $35) is the importance of diversifying holdings while focusing on equities. In a recession, the advantages of diversification get overwhelmed by investors’ selling equities in favor of U.S. Treasury bonds in a “flight to quality,” he said.

“When you have a market in which any type of equity exposure is being punished, it’s going to hurt long-term investors,” he said.

In the current environment, distressed corporate securities can produce “equity-like” returns, Swensen said.

“You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” he said, declining to name any of the companies.

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Until financial institutions resume lending, the economy will remain stagnant, Swensen said.

“I don’t think the Fed or the administration has figured out how to fix credit markets,” he said. “We are going to experience economic and financial stress as long as the credit markets are broken and it’s not until we start seeing the credit markets functioning properly will we be able to see a path to economic recovery.”

Swensen advocates federal guarantees for deposits in money- market funds as a way to encourage investment in the vehicles that buy corporate debt.

Source: Bloomberg.com, January 2, 2009

Tags: Advantages Of Diversification, Bank Loans, Connecticut University, Corporate Securities, Credit Markets, David Swensen, Distressed Debt, Equity Exposure, ETF, Federal Guarantees, Financial Stress, Institutional Investment, Investment Grade Bonds, Money Market Funds, New Haven Connecticut, Term Investors, U S Treasury, U S Treasury Bonds, Unconventional Approach, University Endowment, Yale Endowment, Yale University
Posted in Bonds, Credit Markets, Economy, Markets | No Comments »