Equity Gains Likely to Continue, But at a Slower Pace (Doll)

Wednesday, February 29th, 2012

by Bob Doll, Chief Equity Strate­gist, Black­Rock

Mar­kets Climb to 12-Month Highs

Stock prices rose again last week, although at a more labored pace than has been the case for most of 2012. For the week, the Dow Jones Indus­trial Aver­age rose 0.3% to 12,982 (and did move above the psy­cho­log­i­cally impor­tant 13,000 level a few times), the S&P 500 Index advanced 0.3% to 1,365 and the Nas­daq Com­pos­ite climbed 0.4% to 2,963. With these gains, mar­kets have reached new 12-month highs and have ral­lied close to 25% from their low point of Octo­ber 2011.

A Quiet Week for the Econ­omy, But Good News Nonetheless

It was a rel­a­tively sub­dued week in terms of eco­nomic data, with the high­light per­haps being the weekly ini­tial unem­ploy­ment claims, which were unchanged (a stronger-than-expected result). This data helps con­firm that improve­ments in the labor mar­ket have been gain­ing trac­tion. This Fri­day we will see the Feb­ru­ary employ­ment report and most econ­o­mists are call­ing for a new jobs num­ber of 200,000 or higher with a flat or per­haps slightly lower unem­ploy­ment rate.

One area of the econ­omy that has long been trou­bled is the res­i­den­tial hous­ing sec­tor, but this area of the econ­omy is begin­ning to show some lim­ited signs of improve­ment. New home sales, mort­gage appli­ca­tions and home build­ing lev­els are all show­ing some gains and the large inven­tory of unsold homes is begin­ning to clear. We believe that the hous­ing mar­ket remains in the midst of a multi-year bot­tom­ing process that began in 2009 and we expect that res­i­den­tial con­struc­tion will be a mod­est pos­i­tive con­trib­u­tor to growth in 2012, as it was last year.

From a global per­spec­tive, the world econ­omy has expe­ri­enced a decent start to 2012, but the ongo­ing recov­ery does have some risks and ques­tion marks. Fis­cal pol­icy remains tight in some quar­ters of the globe and there is still room for eas­ing (as we saw with the Bank of Japan's recent deci­sion to enact some new quan­ti­ta­tive eas­ing mea­sures). Addi­tion­ally, ongo­ing debt delever­ag­ing remains a con­cern, as does the recent move higher in oil prices. Of course, we would also add the ongo­ing Euro­pean debt cri­sis to the list of issues that could poten­tially dis­rupt the global economy's pos­i­tive momentum.

Climb­ing Oil Prices Spark Concerns

Sev­eral of the risks that we have been dis­cussing for some time now have ebbed over the last sev­eral months, such as the removal of the uncer­tainty over the US pay­roll tax cut exten­sion, some addi­tional clar­ity over the Greek debt restruc­tur­ing and China's pol­icy eas­ing and likely eco­nomic soft land­ing. An addi­tional risk, how­ever, has sur­faced in the form of higher oil prices. The oil price spike from early 2011 is fresh in investors' minds and the recent advance in oil prices has some won­der­ing whether his­tory will repeat itself. Last year's price spike came as a result of social and polit­i­cal unrest through­out the Mid­dle East and in North Africa and this year esca­lat­ing geopo­lit­i­cal ten­sions with Iran has been the pri­mary culprit.

While higher oil prices are unam­bigu­ously a neg­a­tive for global eco­nomic growth and have the poten­tial to act as a drag on equity mar­kets, the scale of the recent increase has still been rel­a­tively mod­est. To put it in con­text, oil prices have advanced by around 20% over the last few months. In con­trast, oil jumped 50% between Sep­tem­ber 2010 and March 2011. While higher oil prices bear watch­ing, we would not con­sider oil a sig­nif­i­cant risk unless the price increase grows more severe.

Fur­ther Gains for Stocks?

The impres­sive advance we have seen in stock prices over the past sev­eral months has largely come about from a string of pos­i­tive eco­nomic news and the absence of the emer­gence of addi­tional down­side risk. In other words, a few months ago, stocks were priced for a weaker macro envi­ron­ment than the one that has come to pass. So what will it take for stocks to con­tinue to move higher? We believe we would need to see some broader improve­ments in eco­nomic data and/or fur­ther polit­i­cal progress in terms of reduc­ing macro uncertainty.

Regard­ing that sec­ond point, last week's announced Greek debt restruc­tur­ing deal should help reduce some uncer­tainty, assum­ing the mea­sures are suc­cess­fully imple­mented. There was lit­tle mar­ket response to the announced deal as it gen­er­ally met investors' expec­ta­tions and there is still more work to be done on this front. We expect the sit­u­a­tion in Greece to worsen from both a fis­cal and social per­spec­tive, but we also believe that the debt restruc­tur­ing will move forward.

Equity risk pre­mi­ums have fallen in recent months as mar­kets have ral­lied and we do believe that there is room for fur­ther advances. At the same time, how­ever, we expect the pace of price appre­ci­a­tion to become slower and more uneven. As we have been say­ing for the last cou­ple of weeks, we would not be sur­prised to see some sort of pull­back or cor­rec­tion in the near term, but we also believe that stock prices will end the year higher than where they are today.

About Bob Doll

Bob Doll is Chief Equity Strate­gist for Fun­da­men­tal Equi­ties at Black­Rock^® a pre­mier provider of global invest­ment man­age­ment, risk man­age­ment and advi­sory ser­vices. Mr. Doll is also Lead Port­fo­lio Man­ager of BlackRock's Large Cap Series Funds. Prior to join­ing the firm, Mr. Doll was Pres­i­dent and Chief Invest­ment Offi­cer at Mer­rill Lynch Invest­ment Managers.

You should con­sider the invest­ment objec­tives, risks, charges and expenses of any fund care­fully before invest­ing. The funds' prospec­tuses and, if avail­able, the sum­mary prospec­tuses con­tain this and other infor­ma­tion about the funds, and are avail­able, along with infor­ma­tion on other Black­Rock funds by call­ing 800–882-0052. The prospec­tus and, if avail­able, the sum­mary prospec­tuses should be read care­fully before investing.

The infor­ma­tion on this web site is intended for U.S. res­i­dents only. The infor­ma­tion pro­vided does not con­sti­tute a solic­i­ta­tion of an offer to buy, or an offer to sell secu­ri­ties in any juris­dic­tion to any per­son to whom it is not law­ful to make such an offer.

Sources: Black­Rock, Bank Credit Ana­lyst. This mate­r­ial is not intended to be relied upon as a fore­cast, research or invest­ment advice, and is not a rec­om­men­da­tion, offer or solic­i­ta­tion to buy or sell any secu­ri­ties or to adopt any invest­ment strat­egy. The opin­ions expressed are as of Feb­ru­ary 27, 2012, and may change as sub­se­quent con­di­tions vary. The infor­ma­tion and opin­ions con­tained in this mate­r­ial are derived from pro­pri­etary and non­pro­pri­etary sources deemed by Black­Rock to be reli­able, are not nec­es­sar­ily all-inclusive and are not guar­an­teed as to accu­racy. Past per­for­mance is no guar­an­tee of future results. There is no guar­an­tee that any fore­casts made will come to pass. Reliance upon infor­ma­tion in this mate­r­ial is at the sole dis­cre­tion of the reader. Invest­ment involves risks. Inter­na­tional invest­ing involves addi­tional risks, includ­ing risks related to for­eign cur­rency, lim­ited liq­uid­ity, less gov­ern­ment reg­u­la­tion and the pos­si­bil­ity of sub­stan­tial volatil­ity due to adverse polit­i­cal, eco­nomic or other devel­op­ments. The two main risks related to fixed income invest­ing are inter­est rate risk and credit risk. Typ­i­cally, when inter­est rates rise, there is a cor­re­spond­ing decline in the mar­ket value of bonds. Credit risk refers to the pos­si­bil­ity that the issuer of the bond will not be able to make prin­ci­pal and inter­est pay­ments. Index per­for­mance is shown for illus­tra­tive pur­poses only. You can­not invest directly in an index.

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Tags: Bank Of Japan, Bob Doll, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Economic Data, Employment Report, Fiscal Policy, Global Perspective, Housing Market, Initial Unemployment Claims, Mortgage Applications, Nasdaq Composite, New Jobs, Question Marks, Residential Construction, Stock Prices, Strategist, Unemployment Rate, World Economy
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LTRO 2: Goldman's Take

Wednesday, February 29th, 2012

Gold­man waited exactly 20 min­utes to try to com­fort the mar­ket, espe­cially the EURUSD which is get­ting increas­ingly jit­tery, that €1 tril­lion in Dis­count Win­dow bor­row­ings is a "pos­i­tive." We beg to dif­fer that tril­lions in more debt col­lat­er­al­ized by candy bar boxes and con­doms will cure an excess debt prob­lem, espe­cially with all the good col­lat­eral now gone, and we are con­fi­dent that ongo­ing delever­ag­ing needs will put a major cog in the sys­tem, espe­cially since the only liq­uid­ity expan­sion move now is "fade", at least until the next major crisis.

Banks take out ECB “fund­ing insurance”

The ECB has today – through its long-term refi­nanc­ing oper­a­tion (LTRO) – fully allot­ted €529 bn of 3-year funds to 800 banks. Together with the first auc­tion, the ECB has now injected €1 trn of 3-year funds into the sys­tem. This is an extremely high amount and equals, for exam­ple, 131% of total (249% unse­cured) Euro­pean bank bond matu­ri­ties in 2012 and 72% (130% unse­cured) for 2012 and 2013 com­bined. Euro­pean banks are now effec­tively pre-funded through to 2014.

Fund­ing sta­bi­lized, rev­enues supported

Large take-up is an impor­tant pos­i­tive. Key rea­sons are: (1) banks are now largely insu­lated from shocks in the fund­ing mar­ket, hav­ing pre­funded through 2014; (2) con­se­quently, the costs of bank and sov­er­eign fund­ing have now been detached; (3) pres­sures for forced delever­ag­ing should reduce (first evi­dence of this is vis­i­ble in the recent ECB loan data); (4) deposit pric­ing pres­sures should fall (this too is already tak­ing place), result­ing in a pos­i­tive rev­enue effect.

Coun­try aggre­gates in com­ing weeks

While the focus is on the aggre­gate take-up, we see coun­try aggre­gates as arguably more impor­tant. Over the course of the next weeks, we will get dis­clo­sure of coun­try aggre­gates where we expect the Span­ish and Ital­ian take-up fig­ures to be high.

ECB’s actions expand the investable group

We derive our group of ‘investable’ banks by: (1) incor­po­rat­ing P&L effects of ECB action; and (2) over­lay­ing these esti­mates with ‘extreme’ credit losses (as per the EBA stress test). Within this group, our Euro­zone top picks are Erste Bank, BBVA, BNP Paribas (all Con­vic­tion Buy), and Intesa San­paolo (Buy).

We iden­tify banks likely to be “dis­pro­por­tion­ate ben­e­fi­cia­ries” of the ECB LTRO includ­ing: Banesto (Buy), Banco Pop­u­lar Espanol (Not Rated), Ban­coPopo­lare, Banca Monte dei Paschi di Siena and UBI Banca (all Neutral).

Tags: Aggregates, Bn, Borrowings, Candy Bar, Cog, Condoms, Debt Problem, ECB, European Banks, Eurusd, Excess Debt, First Evidence, Goldman, Key Reasons, liquidity, Loan Data, Maturities, Shocks, Trillions, Trn
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Dow Jones – Hi or Lo?

Wednesday, February 29th, 2012

This Week: SPDR DJIA TRUST Ticker: DIA / NYSE

The Dow Jones Indus­trial Aver­age just touched the 13,000 level this week after nearly four years. Where to from here? Well, the moun­tain is high. The val­ley is low. We think it will climb, but not with­out woe.

The biggest woe is Greece. The indebted nation agreed a $170 bil­lion res­cue plan, but will only get the money if its gov­ern­ment fires work­ers, slashes pen­sions and wages, and raises taxes, all by month’s end. Greeks are riot­ing and oppo­si­tion lead­ers are threat­en­ing reversal.

Pri­vate hold­ers of Greek bonds are being squeezed too: for every 2 bonds they hold, they’ll be offered a new one that is longer-dated and lower-yielding. If enough hold­ers refuse the offer, Greece could default. There will be more on this by March. Until then, global equity mar­kets will remain nervous.

A Euro­pean reces­sion would be woe #2. For all their sanc­ti­mo­nious lec­tur­ing, France and espe­cially Ger­many prof­ited from exports to their spend­thrift, Euro-neighbors. But two years of fis­cal clam­p­down have hurt eco­nomic growth. Now fur­ther aus­ter­ity threat­ens to push it into recession.

The aus­ter­ity hurt Chi­nese exports. And growth within China was damp­ened by cen­tral bank efforts to tame infla­tion and spec­u­la­tion, espe­cially in hous­ing (noth­ing we’d know about in Toronto). Slower growth in China will have a knock-on effect, espe­cially on us hew­ers and dig­gers, but more broadly too.

Short-term tech­ni­cals are also bear­ish. After climb­ing for five straight months, the Dow is show­ing signs of fatigue. Our pro­pri­etary indi­ca­tor sug­gests a pull-back of about 5% in the next few weeks.  Also, since the start of Feb­ru­ary, the DJ Indus­tri­als has been climb­ing alone. The DJ Trans­porta­tion Index, more closely tied to eco­nomic fun­da­men­tals, has lagged by 5.6%. Not a good sign.

This list of woes sug­gests a short-term cor­rec­tion for mar­kets. Let’s get to the pos­i­tives. What will take us higher on the Dow after the cor­rec­tion? Three things: stocks are cheap, bond yields are thin and the econ­omy is improving.

Qual­ity stocks are cheap by sev­eral mea­sures. The Dow is trad­ing at 13.3 times its earn­ings, near the bot­tom of its long-term range, as prices have lagged earn­ings growth. The Dow’s earnings-per-share is up 134% from the March 2009 lows, while the Dow’s price is up 70%. True, earn­ings growth has plateaued in the last two quar­ters, but that still leaves a large gap.

In the same period, cor­po­ra­tions have dras­ti­cally cut debt lev­els, bring­ing it to par with equity and the low­est level in over a decade. Lit­tle debt, lots of profit…it’s no won­der div­i­dend yields have risen to 2.5% and are expected to rise fur­ther. Com­pare that to a yield of 3.2% on a sim­i­lar qual­ity 10-year bond.

From the tech­ni­cals, look­ing past the next few weeks and out to the next few quar­ters, the view is pos­i­tive too. Though not quite there yet, our pro­pri­etary indi­ca­tor is near a Buy lev­els not seen since March 2009. A cor­rec­tion in the short term would put it firmly in the Buy camp. And while the recent new year rally has been on rel­a­tively light vol­umes, we expect low val­u­a­tions and good div­i­dend yields will lure investors back in.

Finally, the econ­omy: It’s improv­ing. Man­u­fac­tur­ing and ser­vices have con­tin­ued to gain. Unem­ploy­ment is down, with ini­tial job­less claims falling to the low­est level in four years. Con­sump­tion is ris­ing again. Hous­ing prices have bot­tomed.  The yield spread – the dif­fer­ence between long and short term inter­est rates – remains healthy at about +1.9 per­cent­age points. Over many decades, this spread has proved an excel­lent reces­sion fore­caster, best­ing all econ­o­mists. When it turns neg­a­tive – that is, when the rate on a 3 month loan is higher than on a 10 year – watch out.

There are a cou­ple of Exchange-Traded Funds to con­sider for the Dow Jones Indus­trial Aver­age. The first is the SPDR DJIA ETF (DIA/NYSE), traded in U.S. dol­lars in New York. The sec­ond is the BMO DJIA Hedged to C$ ETF (ZDJ/TSX). Both are plain vanilla and hold all the 30 shares of the Index. For Cana­dian investors, with ZDJ you avoid a cur­rency trade and you’re returns will mimic those received by a U.S. investor, regard­less of how the U.S. dol­lar does against the Loonie.

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Please call us at TF 1–866-469‑7990 for more information.

Tags: Austerity, Bond Yields, Canadian, Canadian Market, Chinese Exports, Clampdown, Dj Industrials, DJIA, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Economic Fundamentals, Global Equity Markets, Greek Bonds, Nyse, Opposition Leaders, Private Holders, Signs Of Fatigue, Slashes, Spendthrift, Tame Inflation, Technicals, Transportation Index
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iBubble: Apple's Market Cap Is Now The Same As The Entire Retail Sector, Bigger Than All The Semis

Wednesday, February 29th, 2012

This is sim­ply stun­ning: one com­pany, which has two flag­ship prod­ucts, has a big­ger mar­ket cap than the entire Semi­con­duc­tor space, and is just shy of the entire S&P Retail sector.

The 216 hedge funds in the name as of Decem­ber 31 is hope­lessly stale. We are cer­tain that by now this num­ber is at least 250, if not 300.

Sus­tain­able:

Tags: Amp, Apple, December 31, Flagship Products, Hedge Funds, Market Cap, Retail Sector, S Market, Sector Funds, Semiconductor Space, Semis
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Silver Surges 4.5% To Over $37/Oz On "Massive Fund Buying"

Wednesday, February 29th, 2012

From Gold­Core

Sil­ver Surges 4.5% To Over $37/Oz On "Mas­sive Fund Buy­ing"

Gold’s Lon­don AM fix this morn­ing was USD 1,788.00, EUR 1,329.96, and GBP 1,120.79 per ounce..

Yesterday's AM fix was USD 1,774.75, EUR 1,321.48, and GBP 1,120.42 per ounce.

Cross Cur­rency Table – (Bloomberg)

Gold rose 1% in New York yes­ter­day and closed at $1,783.90/oz. Gold rose in Asia to a high of $1,790.16 it’s high­est since mid Novem­ber then edged down.  Europe this morn­ing saw side­ways trad­ing until unusu­ally volatile trad­ing around the Lon­don AM fix saw gold rise from $1785.oz to over $1790/oz at 1030 GMT and then fall quickly to $1783/oz.

Spot sil­ver has gained another 0.5% to $37.05 an ounce, after surg­ing 4.5% yes­ter­day once it rose above resis­tance at $35.50/oz. Sil­ver reached a 5 month high of $37.21 but remains more than 30% below its nom­i­nal high in of April last year of $48.44.

Sil­ver Spot $/oz – (Bloomberg)

Over 800 Euro­pean banks have taken €529.5 bil­lion from the ECB today after tak­ing €489 bil­lion euros at the first ten­der in Decem­ber. The ECB’s 3 year lend­ing is now near 1 tril­lion euros ($1.35 tril­lion) and the ECB’s bal­ance sheet looks increas­ingly precarious.

Although the flood of paper has been cred­ited with fuelling a rally on Europe’s dis­traught bond mar­kets and safe­guard­ing the region’s banks, it is another exer­cise in kick­ing the beer keg down the road as it fails to address the fun­da­men­tal issue which is the insol­vency of many Euro­pean banks and many Euro­pean nations and the obvi­ous risk of con­ta­gion from that.

The con­tin­u­a­tion of ultra loose mon­e­tary poli­cies increases the risk of infla­tion which will ben­e­fit gold which is an excel­lent infla­tion hedge. Extremely low yields on deposits and “risk free” sov­er­eign debt means the oppor­tu­nity cost of car­ry­ing non yield­ing bul­lion remains very low.

Spot sil­ver gained 0.4% to $37.05 an ounce, after surg­ing 4% and hit­ting a 5 month high of $37.21 in the pre­vi­ous session.

Sil­ver as ever out­per­formed gold yes­ter­day and traders attrib­uted the surge to “mas­sive fund buy­ing” and to “panic” short cov­er­ing. Some of the bul­lion banks with large con­cen­trated short posi­tions cov­ered short posi­tions after the tech­ni­cal level of $35.50/oz was breached easily.

Mas­sive liq­uid­ity injec­tions and ultra loose mon­e­tary poli­cies make sil­ver increas­ingly attrac­tive for hedge funds, insti­tu­tions and investors.

This time last year (Feb­ru­ary 28th 2011) sil­ver was at $36.67/oz. Two months later on April 28th it had risen to $48.44/oz for a gain of 32% in 2 months.

There then came a very sharp cor­rec­tion and a period of con­sol­i­da­tion in recent months. Silver’s fun­da­men­tals remain as bull­ish as ever and the tech­ni­cals look increas­ingly bull­ish with strong gains seen in Jan­u­ary and February.

Very bull­ish is the fact that sil­ver also remains more than 30% below its record nom­i­nal high 32 years ago in 1980 and more than 75% below its infla­tion adjusted high of $140/oz in 1980.

The gold-silver ratio dropped to its low­est level in 5 months, after sil­ver rose more than 12% so far this month and an enor­mous 34% this year, out­per­form­ing other pre­cious metals.

Ris­ing hold­ings of silver-backed ETF’s also indi­cated grow­ing investor inter­est in the metal. The over­all sil­ver Exchange Traded Funds hold­ings rose to 491.079 mil­lion ounces, the high­est since last May.

Spot plat­inum gained nearly 0.5% to $1,722.24, as investors await the lat­est in Impala Platinum's deal­ing with an ille­gal strike that has dis­rupted pro­duc­tion at Rusten­burg, the world's largest plat­inum mine.

For break­ing news and com­men­tary on finan­cial mar­kets and gold, fol­low us on Twit­ter.

OTHER NEWS
(AP) — Sil­ver Prices Jump, Play­ing Catch-up to Gold
Sil­ver prices shot up 4.5 per­cent Tues­day, play­ing catch-up to gold.

Sil­ver is both a pre­cious and an indus­trial metal. Traders can buy it to hedge against a volatile stock mar­ket, as they do with gold. But it can also be used to make prod­ucts like com­puter chips, mean­ing prices can rise when traders expect demand from man­u­fac­tur­ers to go up.

In March con­tracts, sil­ver rose $1.616 to $37.14 per ounce. It's up roughly 10 per­cent from where it was a year ago. Ster­ling Smith, senior mar­ket ana­lyst at Coun­try Hedg­ing in St. Paul, Minn., said part of the rea­son sil­ver is surg­ing is that traders believe it's under­val­ued com­pared to gold. Gold closed at $1,788.40 an ounce, up $13.50 for the day. It's up about 26 per­cent com­pared to a year ago.

Cop­per rose 3.15 cents to $3.912 per pound, and plat­inum rose $9.20 to $1,723.50.

Energy con­tracts fell, partly because investors were pulling back after price gains last week. Oil prices remain close to nine-month highs because of con­cerns that Iran could cut ship­ments of crude to Europe and inter­fere with sup­plies else­where. The Euro­pean Union and the U.S. are using sanc­tions against Iran because they fear the coun­try is devel­op­ing a nuclear weapon.

Bench­mark oil fell $2.01 to fin­ish at $106.55 per bar­rel on the New York Mer­can­tile Exchange. Nat­ural gas prices fell 8.5 cents to end at $2.627 per 1,000 cubic feet. Heat­ing oil fell 6.28 cents to $3.2201 per gallon.

Smith said grains and other agri­cul­tural prod­ucts have been enjoy­ing a "win­ning streak" for the past week. Those move­ments are espe­cially impor­tant now as farm­ers decide what to plant this year.

Soy­bean prices on Mon­day topped $13 a bushel for the first time in five months. That's because traders think there will be greater demand for U.S. exports of the protein-rich beans because smaller har­vests from South Amer­ica are expected.

On Tues­day, soy­beans for March deliv­ery rose less than 1 per­cent, to $13.125 per bushel from $13.025. March wheat rose 15.5 cents to fin­ish at $6.6825 per bushel. Corn ended up 8.75 cents to $6.5725 per bushel.

The price of orange juice also rose. Cocoa and sugar fell.

(Bloomberg) – Gold-Oil Cor­re­la­tion Rises to Eight-Month High
Gold’s strength­en­ing cor­re­la­tion with oil means more gains for the metal as Brent near a nine– month high spurs demand for an infla­tion hedge, UBS AG said.

The CHART OF THE DAY shows Brent prices reached $125.55 a bar­rel in Lon­don on Feb. 24, the high­est since early May, and are up 15 per­cent this year. Bul­lion has gained 14 per­cent in the period and reached $1,787.55 an ounce last week, the high­est since Nov. 14. The 30-week cor­re­la­tion coef­fi­cient between the com­modi­ties rose to 0.61 today, the most since June. A fig­ure of 1 means the two always move in the same direction.

Gold’s “rolling cor­re­la­tion with oil is slowly inch­ing higher and we think this sig­nals that some catch­ing up lies ahead,” Edel Tully, an ana­lyst at UBS in Lon­don, wrote today in a report. “To the extent that ris­ing oil prices feed into higher infla­tion expec­ta­tions, gold is bound to reap benefits.”

Some investors buy gold to hedge against accel­er­at­ing con­sumer prices and as a pro­tec­tion from slow­ing growth and geopo­lit­i­cal risk. The metal, which gen­er­ally earns hold­ers returns only through price gains, ral­lied for an 11th year in 2011 as cen­tral banks in Europe and the U.S. kept inter­est rates near record lows. Oil advanced this year on con­cern the west’s dis­pute with Iran over the Islamic republic’s nuclear pro­gram may lead to a dis­rup­tion in exports from the Mid­dle East.

Investors are hold­ing a record 2,398.2 met­ric tons of gold in exchange-traded prod­ucts backed by the metal, val­ued at about $137.1 bil­lion, accord­ing to data com­piled by Bloomberg. The ton­nage exceeds the hold­ings of all but four cen­tral banks, which are expand­ing reserves for the first time in a generation.

The Islamic repub­lic has threat­ened to close the Strait of Hor­muz, a tran­sit point for about 20 per­cent of glob­ally traded crude oil, if its exports are banned in sanc­tions. While UBS fore­casts Brent at $110 a bar­rel in the sec­ond quar­ter, “any Iran-related head­lines, mil­i­tary threats or small inci­dents in the Per­sian Gulf are likely to push oil prices sharply higher and poten­tially boost gold in turn,” Tully said.

(Bloomberg) – Oil Set for Best Month Since Octo­ber on Recov­ery Signs, Iran
Oil rose, head­ing for its best month since Octo­ber in New York, amid signs of eco­nomic recov­ery and con­cern that ten­sion with Iran threat­ens global crude supplies.

West Texas Inter­me­di­ate futures climbed as much as 0.6 per­cent after slid­ing yes­ter­day the most in five weeks. Indus­trial out­put in Japan and South Korea beat esti­mates and U.S. con­sumer con­fi­dence rose to the high­est level in a year. Oil has advanced 8.8 per­cent in Feb­ru­ary, its first monthly gain in three, as sanc­tions tighten against Iran, OPEC’s sec­ond– biggest producer.

(Bloomberg) – Impala Says Strike Halts 2 Bil­lion Rand of Plat­inum Out­put
Impala Plat­inum Hold­ings Ltd. said 100,000 ounces of out­put, equiv­a­lent to sales of 2 bil­lion rand ($265 mil­lion), was halted by a strike at its Rusten­burg mine.

The com­pany, based in Johan­nes­burg, is work­ing to resume out­put at the world’s biggest plat­inum mine after bring­ing back 9,800 of 17,200 staff fired dur­ing the ille­gal strike, Impala said today in a state­ment. About 15,800 didn’t join the strike.

“It is depen­dent on oper­a­tional turnout of staff,” Impala said. Fired work­ers have until tomor­row to return on their prior terms after the walk­out, which has entered a sixth week.

SILVER
Sil­ver is trad­ing at $37.14/oz, €27.64/oz and £23.30/oz.

PLATINUM GROUP METALS
Plat­inum is trad­ing at $1,723.00/oz, pal­la­dium at $710.00/oz and rhodium at $1,475/oz.

NEWS

(Reuters)
Gold edges up ahead of ECB loan offer‎

(Reuters)
Sil­ver up 4 per­cent, gold races toward $1800 on ECB

(Reuters)
Iran to accept pay­ment in gold from trad­ing partners

(The Finan­cial Times)
Tehran con­sid­ers trade pay­ments in gold

COMMENTARY

(The Globe and Mail)
Don Coxe on Why Buf­fett Has Gold All Wrong

(Mar­ket­Watch)
Buf­fett rebuffs gold, but infla­tion says 'buy'‎

(Chatham House)
Gold and the Inter­na­tional Mon­e­tary System

(The Wash­ing­ton Post)
UBS's Hick­son Expects Gold Will Rise to $2025 in 2012‎

(Zero Hedge)
Sil­ver Explodes As DJIA Closes Above 13,000

Tags: agricultural, Balance Sheet, Beer Keg, Bloomberg, Bond Markets, Bullion, Contagion, Currency Table, ECB, Eur 1, European Banks, Fundamental Issue, Gbp, Insolvency, Monetary Policies, Opportunity Cost, Ounce, Silver Spot, Sovereign Debt, Spot Silver, Trillion
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The Outlook for Oil

Wednesday, February 29th, 2012

“Are we headed for another oil shock and if so what are the invest­ment impli­ca­tions?” Many investors are ask­ing these ques­tions given recent devel­op­ments in the Mid­dle East and Africa.

Ten­sions have been esca­lat­ing lately in the Mid­dle East. West­ern coun­tries have sought to con­tain Iran’s nuclear pro­gram by impos­ing new sanc­tions. Mean­while, there’s a grow­ing per­cep­tion among mar­ket watch­ers that Israel has a dwin­dling win­dow of time if it’s going to attempt any mil­i­tary action against Iran’s nuclear research. Else­where, the mar­ket has also had to con­tend with grow­ing unrest in Nige­ria, a coun­try that pro­duces two mil­lion bar­rels of oil daily.

As such, it’s easy to see why the price of crude is once again climb­ing and why investors are won­der­ing about prices ris­ing fur­ther.

So what could cause even higher prices? Should Israel attack Iran, it’s pos­si­ble that Iran would at least attempt to pre­vent the pas­sage of oil through the Strait of Hor­muz, a nar­row water way through which 20% of the world’s oil passes. If this hap­pens, at least a tem­po­rary oil spike would prob­a­bly occur. While it’s doubt­ful that Iran has the mil­i­tary capac­ity to close the Strait for any length of time, even an attempt would likely push oil north of $150 a barrel.

To be sure, it’s dif­fi­cult to pre­dict the odds of an Israeli strike and a major esca­la­tion in oil prices. But even in the absence of an attack, crude prices are likely to remain ele­vated for three rea­sons, sup­port­ing my view that investors should con­sider over­weight­ing global energy com­pa­nies through instru­ments like the iShares S&P Global Energy Sec­tor Index Fund (NYSEARCA: IXC).

First, it appears that most emerg­ing mar­kets are likely to engi­neer a soft land­ing. This is impor­tant as vir­tu­ally all new demand for energy is cur­rently com­ing from emerg­ing markets.

Sec­ond, while Saudi Ara­bia and OPEC have spare capac­ity, this capac­ity will be stretched if Iran­ian pro­duc­tion slows or an oil embargo takes place. It would likely not be able to ade­quately cover replac­ing Iran­ian and Niger­ian pro­duc­tion, as well as pro­duc­tion from other smaller Gulf coun­tries also expe­ri­enc­ing unrest.

Finally, even if oil reaches more than $100 a bar­rel, many of the largest oil pro­duc­ers — includ­ing Saudi Ara­bia and Rus­sia — are unlikely to ramp up pro­duc­tion as they might have in the past. This is because the largest oil pro­duc­ers now require much higher oil prices to bal­ance their budgets.

In short, even with­out a mil­i­tary con­fronta­tion in the Gulf, I expect oil prices to remain high for the near term and I con­tinue to advo­cate an over­weight to global energy companies.

Source: Bloomberg

Dis­clo­sure: Author is long IXC

In addi­tion to the nor­mal risks asso­ci­ated with invest­ing, 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. Narrowly focused invest­ments typ­i­cally exhibit higher volatility.

Tags: Crude Prices, Emerging Markets, energy sector, Global Energy Companies, Index Fund, Investment Implications, Ishares, Military Capacity, Narrow Water, Nuclear Program, Nuclear Research, Oil Embargo, Oil Prices, Oil Shock, Opec, Saudi Arabia, Sector Index, Water Way, Western Countries, Window Of Time
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The Bull Market in Stocks Looks Set to Continue – For Now

Wednesday, February 29th, 2012

Guest con­tri­bu­tion by Dominic Frisby, Mon­ey­Week

There are, as I see it from the van­tage point of my South Lon­don hide-out, two huge finan­cial forces at work in the global economy.

We have the nat­ural forces of defla­tion. Debt being paid down, credit tight­en­ing, houses being put in order — the inevitable delever­ag­ing after a period of excess.

And we have the arti­fi­cial forces of infla­tion. Sys­tem­atic cur­rency deval­u­a­tion — the print­ing of money to buy bonds and supress inter­est rates in an attempt to re-inflate asset prices and stim­u­late growth.

The secret of suc­cess as far as trad­ing equity and bond mar­kets is con­cerned has been to cor­rectly iden­tify which force is dom­i­nant. In other words, to fig­ure out whether or not we're in an infla­tion­ary or defla­tion­ary cycle.

But how can you tell? And which are we in now?

Which way will the mar­ket head next?

Although things have slowed over this past week, we do still seem to be in an infla­tion­ary phase as far as stock mar­kets are con­cerned. But are mar­kets top­ping out before the next inevitable phase of defla­tion? Or is this a gen­tle slow­ing before the next bout of price rises? How does one know?

I sug­gested a sim­ple method of tech­ni­cal analy­sis last week that takes the think­ing out of the decision-making process — think­ing can be a dan­ger­ous thing after all.

Nev­er­the­less, we all do it at least some of the time. And I've been think­ing hard this week about other ways to iden­tify whether we're in an infla­tion­ary or defla­tion­ary phase. And I may have come up with something.

Just as gold is a key hold­ing of any hard-core infla­tion­ist, so gov­ern­ment bonds make up a large por­tion of any hard-core deflationist's port­fo­lio. The US gov­ern­ment bond mar­ket is the biggest mar­ket in the world. It can reveal a great deal about where money is flowing.

In the chart below you can see US gov­ern­ment bond prices (in black), and the S&P 500 (in green), between 1981 and 2001.

As you can see, US gov­ern­ment bonds, which had a rot­ten time of it dur­ing the infla­tion­ary 1970s, have been in a bull mar­ket since late 1981. And broadly speak­ing, for much of the time, they traded in the same direc­tion as equi­ties. When the S&P 500 rose, so did 30-year gov­ern­ment bonds. When bonds fell, equi­ties were either flat or they even­tu­ally fell too.

This was the case until mid-1998. Then they decou­pled. Equi­ties fell with the Asian cri­sis, while gov­ern­ment bonds rose. When equi­ties recov­ered, bonds fell. In other words, dur­ing equity routs, investors have flooded to the per­ceived safety of gov­ern­ment bonds and bond prices have risen. When investors get greedy again and decide equi­ties are OK, they move their money from bonds back into the stock market.

Here we see bonds and stocks from 1998 onwards. US bonds fell as equi­ties rose into 2000. Then the bond mar­ket ral­lied to 2003, as equi­ties fell in the dot­com bust. Dur­ing the mega-run in equi­ties between 2003 and 2007, US bonds traded in a range while equi­ties surged ahead. Then bonds had a huge rally with the 2008 stock-market bust, fell with the sub­se­quent rally from 2009, and then ral­lied with the bear mar­ket in stocks of 2011.

As you can see, US gov­ern­ment bonds, which had a rot­ten time of it dur­ing the infla­tion­ary 1970s, have been in a bull mar­ket since late 1981. And broadly speak­ing, for much of the time, they traded in the same direc­tion as equi­ties. When the S&P 500 rose, so did 30-year gov­ern­ment bonds. When bonds fell, equi­ties were either flat or they even­tu­ally fell too.

This was the case until mid-1998. Then they decou­pled. Equi­ties fell with the Asian cri­sis, while gov­ern­ment bonds rose. When equi­ties recov­ered, bonds fell. In other words, dur­ing equity routs, investors have flooded to the per­ceived safety of gov­ern­ment bonds and bond prices have risen. When investors get greedy again and decide equi­ties are OK, they move their money from bonds back into the stock market.

Here we see bonds and stocks from 1998 onwards. US bonds fell as equi­ties rose into 2000. Then the bond mar­ket ral­lied to 2003, as equi­ties fell in the dot­com bust. Dur­ing the mega-run in equi­ties between 2003 and 2007, US bonds traded in a range while equi­ties surged ahead. Then bonds had a huge rally with the 2008 stock-market bust, fell with the sub­se­quent rally from 2009, and then ral­lied with the bear mar­ket in stocks of 2011.

The bond mar­ket is sig­nalling that we’re back in infla­tion mode

But here's the thing. Since the Octo­ber 2011 low, the stock mar­ket has ral­lied some 30%. But the bond mar­ket has not suf­fered the cor­re­spond­ing falls you might have expected. It is trad­ing damn near its all-time highs.

There are all sorts of pos­si­ble rea­sons for this: money flee­ing Europe, or the rel­a­tive strength of the US dol­lar, for exam­ple – you could come up with any num­ber of things.

But here's what I've noticed. Below is the same chart as the one above, except in this case, I've popped in a red arrow to mark each time the US bond mar­ket (black line) has moved to the top of its range.

Now look at what's hap­pened to the S&P 500 (green line) in the sub­se­quent few months. Can you see? Highs in the bond mar­ket have fre­quently antic­i­pated ral­lies in the stock mar­ket. It even worked to a lim­ited extent in the delever­ag­ing fiasco of 2008.

Why am I men­tion­ing this now? I don't know how much lower inter­est rates can go — or how much higher US gov­ern­ment bond prices can get. How­ever, I wouldn't have thought that yields can go much lower than this. If they do, and the bond mar­ket breaks above say 145, then I'm wrong and we're prob­a­bly into another defla­tion­ary phase. But for now we are cer­tainly at the upper end of their range. I sug­gest that equi­ties are not a sell until bonds move to the lower end.

Yes, I know that it goes against the grain to buy into any­thing after it's just had a 30% move up. I know val­u­a­tions are get­ting a lit­tle rich, par­tic­u­larly in tech stocks. I know that sen­ti­ment is a lit­tle too bull­ish. I can find a hun­dred rea­sons why equi­ties are set to crash. And it may be that bonds and equi­ties have re-coupled again after their 13-year divorce and, just as the Asian cri­sis sep­a­rated them, the Euro­pean cri­sis has re-united them. The jury is still out on that one.

But for now the bond mar­ket is telling me that the infla­tion trade — or that risk — is back on. That means that cash is not the place to be, but assets — be it gold, equi­ties or com­modi­ties — are. I’m still look­ing for a cor­rec­tion in equi­ties, by the way, but I don’t think it’ll be the big kahuna and so pull­backs could be a buy­ing oppor­tu­nity. If the bond mar­ket heads back to the lower end of its range — in the low 120s — well, that'll be your cue to start head­ing back into the defla­tion bunker.

And just before I go: I'm head­ing out to Canada next week for the PDAC, which is the biggest min­ing con­fer­ence in the world. All the great and the good — not to men­tion the das­tardly and the incom­pe­tent — of the dig­ging and drilling world will be there. I'll let you know what I learn when I get back.

Copy­right © MoneyWeek.com

Tags: Asset Prices, Bond Markets, Bond Prices, Currency Devaluation, Dangerous Thing, Dominic, Forces At Work, Frisby, Global Economy, Government Bond Market, Government Bonds, Hard Core, Large Portion, Moneyweek, Natural Forces, Secret Of Success, South London, Stock Markets, Us Government, Vantage Point
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“Fun, Fun, Fun” (Jeffrey Saut)

Tuesday, February 28th, 2012

“Fun, Fun, Fun”

by Jef­frey Saut, Chief Invest­ment Strate­gist, Ray­mond James

Feb­ru­ary 27, 2012

“... and she’ll have fun fun fun ‘til her daddy takes the t-bird away.”

... The Beach Boys, 1964

Except in this case it should be “fund, fund, fund” because I am in the Washington/Baltimore area speak­ing at con­fer­ences, renew­ing con­tacts on Capi­tol Hill, and see­ing mutual fund man­agers. Some of the folks I will be see­ing hang their hats at Fried­man, Billings & Ram­sey; aka, FBR & Co. I remem­ber when in 1989 Manny Fried­man scraped together $1 mil­lion and departed the Washington-based bro­ker­age firm of John­son, Lemon & Co. to formed FBR with his two part­ners Eric Billings and Russ Ram­sey. The firm became a research bou­tique focus­ing on finan­cial com­pa­nies spurred by Manny’s pre­scient “calls” on the banks and real estate. That focus con­tin­ues to this day, punc­tu­ated by a saga­cious port­fo­lio man­ager named David Elli­son, cap­tain of the FBR Small Cap Finan­cial Fund (FBRSX/$18.31). I used to chat with David back in the 1980s when he was at Fidelity man­ag­ing Fidelity’s Select Finan­cial Fund. Inter­est­ingly, David cur­rently owns a num­ber of the smaller banks I have com­mented on in these mis­sives. Even more inter­est­ing is that David is my kind of investor since when he can’t find attrac­tive invest­ment oppor­tu­ni­ties he is con­tent to hold cash. Case in point, unable to find attrac­tive invest­ments going into the 2008 finan­cial fiasco David held 60% of his fund in cash. Indeed, my kind of investor. Accord­ingly, par­tic­i­pants want­ing to fill the finan­cial sleeve of their asset allo­ca­tion model should con­sider David’s fund.

I spoke with yet another fund man­ager last week when I hosted a con­fer­ence call for our finan­cial advi­sors with Tom O’Halloran, who man­ages Lord Abbett’s Devel­op­ing Growth Fund (LAGWX/$21.85). In its space LAGWX is the num­ber one per­form­ing fund on a five-year basis accord­ing to Morn­ingstar [replay (855) 859‑2056; pass­word 49023178]. While that fund is cur­rently closed to new investors, the good folks at Lord Abbett have started another fund run by Tom using the same invest­ment style. The fund is called The Growth Lead­ers Fund (LGLAX/$15.67) and is rep­re­sen­ta­tive of the “smaller more nim­ble” funds I have cham­pi­oned for more than 12 years. The con­fer­ence call began with some com­ments from me about the cur­rent state of the econ­omy and the stock mar­ket. I con­cluded by not­ing that while the econ­omy is not going to slip back into reces­sion, GDP is also not likely to grow by more than 3.5% for awhile. In such an envi­ron­ment com­pa­nies that can increase their rev­enues and earn­ings at a decent rate should pro­duce good invest­ment returns; and with that I turned the call over to Tom.

He began by talk­ing about the four traits nec­es­sary for great com­pa­nies. First, they must have a great busi­ness model. Sec­ond, the man­age­ment team has to be com­pe­tent and cred­i­ble. Third, they must be oper­at­ing in a healthy indus­try. And fourth, the com­pany needs to demon­strate a com­pet­i­tive advan­tage. Tom believes that grow­ing rev­enues, and earn­ings, at an out­sized rate leads to stock out­per­for­mance and I agree. Inter­est­ingly, Tom uses tech­ni­cal analy­sis as an over­lay to sup­port his fun­da­men­tal views. This is not an unim­por­tant point because in this busi­ness price is real­ity! Ladies and gen­tle­men, I have seen a plethora of port­fo­lio man­agers stay with los­ing posi­tions far too long because they ignored the fact the share price was break­ing down rather dra­mat­i­cally in the charts. By the time they saw the fun­da­men­tals dete­ri­o­rate, the shares were off some 50% when if they would have had some kind of tech­ni­cal analy­sis dis­ci­pline the loss would have been con­tained at 15% — 20%, but I digress.

Tom then dis­cussed some themes like the Inter­net, the cloud, soft­ware, servers, social net­work­ing, the Inter­net gone mobile, health­care, Amer­i­can­ism, the rein­dus­tri­al­iza­tion of Amer­ica, etc. If that sounds a lot like me it should given this para­graph from last week’s letter:

“In addi­tion to the theme that tech­nol­ogy is mak­ing build­ing more for less a real­ity, other themes I am encour­aged by include: com­pa­nies mak­ing prod­ucts for Amer­i­can con­sump­tion are mov­ing jobs back to the U.S.; the rein­dus­tri­al­iza­tion of Amer­ica; Amer­i­can­ism; a move toward energy self suf­fi­ciency that will shrink our trade deficit; and then there are the themes out­lined in the book Abun­dance: Why the Future Will Be Much Bet­ter Than You Think writ­ten by Peter H. Dia­man­dis and Steven Kotler.”

Tom then pro­ceeded to dis­cuss select com­pa­nies in the Growth Lead­ers Fund and why he owns them. Names men­tioned included: Apple (AAPL/$522.41); Con­ti­nen­tal Resources (CLR/$94.75/Strong Buy); Google (GOOG/$609.90/Outperform); EMC (EMC/$27.52/ Strong Buy); Fortinet (FTNT/$26.99/Outperform); and Zynga (ZNGA/$12.93). Almost as if it were a “planted” ques­tion, one of our finan­cial advi­sors stated, “You buy the kind of stocks that my clients should have some expo­sure to, but I am afraid to buy them because of their volatil­ity.” My response was, “Pre­cisely, and that is why you want to own this fund and let Tom man­age the risk.”

Speak­ing to Tom’s posi­tion in Con­ti­nen­tal Resources, a lot of our energy stocks have gone par­a­bolic over the past few weeks, includ­ing CLR. If you had fol­lowed our rec­om­men­da­tion and made CLR shares a 3% posi­tion in a $100,000 port­fo­lio when our fun­da­men­tal ana­lyst ini­ti­ated research cov­er­age, hold­ing all the other stocks in said port­fo­lio at a con­stant price shows that your posi­tion in CLR has now grown into a 16% port­fo­lio “bet.” Accord­ingly, it makes asset allo­ca­tion sense to rebal­ance that posi­tion back towards a smaller weight­ing and let some long-term cap­i­tal gains accrue to the port­fo­lio. The same can be said of other port­fo­lio posi­tions that have grown into too big of a weight­ing in port­fo­lios. Also of note, our long-standing love affair with Wal-Mart (WMT/$58.79/Market Per­form) ended last week with Budd Bugatch’s down­grade of WMT from Strong Buy to Mar­ket Per­form, which has now become another rebal­anc­ing candidate.

As for the stock mar­ket, last week the S&P 500 (SPX/1365.74) eclipsed its pre­vi­ous reac­tion high, recorded on April 29, 2011 of 1363.61, and now stands at its high­est level since June 6, 2008. The clos­ing high, how­ever, came on very low vol­ume and with numer­ous diver­gences. The two most egre­gious are the lack of upside con­fir­ma­tion from the D-J Trans­porta­tion Aver­age (TRAN/5139.14) and the Rus­sell 2000 (RUT/826.92). While there are clearly other diver­gences like the non-confirmation from the Oper­at­ing Com­pany Only Advance/Decline Line, the fact that there have been no 90% Upside Days this year, the nar­row­ing lead­er­ship, too many three-digit stocks, etc., the Tran­nies and the Rus­sell are indeed the two most wor­ri­some. That’s because the RUT is more than 5% below its one-year high, while the Trans­ports are ~9% below their one-year high. His­tor­i­cally, when the S&P 500 was at a fresh 52-week high, but the Rus­sell 2000 and the DJ Trans­ports were more than 5% below their respec­tive 52-week highs, stocks have been vul­ner­a­ble. There­fore, if I am going to err it is going to be by being too cau­tious (not bear­ish), con­sis­tent with Ben Graham’s mantra – The essence of invest­ment man­age­ment is the man­age­ment of risks not the man­age­ment of returns. Good port­fo­lio man­age­ment begins (and ends) with this tenant.

The call for this week: There have now been 37 trad­ing ses­sions in 2012 and so far the S&P 500 has yet to expe­ri­ence a 1% Down­side Day. This 37-session, or more, skein has occurred 11 other times in the past 84 years and has on every occa­sion except one seen the equity mar­kets higher by the end of the year. Still, the rise since the “buy­ing stam­pede” ended, which stopped on Jan­u­ary 26, 2012 at Dow 12841.95, has felt unnat­ural to me. Sur­pris­ingly, the Indus­tri­als reside only 141 points above their intra­day high of Jan­u­ary 26th, caus­ing one mar­ket maven to exclaim, “no won­der I feel like we’re in the Trad­ing Twi­light Zone.” Maybe there will be a res­o­lu­tion to that “unnat­ural feel­ing” this week when we expe­ri­ence Leap Day (Feb­ru­ary 29th). As our friends at Bespoke write, “There have been 21 leap days in which the mar­ket was open since 1900. ... The aver­age per­for­mance of the Dow on leap days has been –0.05% with a median return of –0.22%. ... There have been three leap days that fell on a Wednes­day (as it does this year) since 1900, and the index has risen once and fallen twice. The last leap day was Feb­ru­ary 29, 2008, and that day the Dow had a big fall of 2.51%.” I’ll speak to you next week.

Copy­right © Ray­mond James

Tags: Asset Allocation Model, Attractive Investment Opportunities, Attractive Investments, Baltimore Area, Brokerage Firm, Chief Investment Strategist, David Ellison, Eric Billings, Fbr Small Cap, Fbr Small Cap Financial Fund, Friedman Billings, Fun Fun Fun, Halloran, jeffrey saut, Lord Abbett, Missives, Morningstar, Mutual Fund Managers, Portfolio Manager, Two Partners, Washington Baltimore
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Time to Add the VIX to Your Equity Portfolio?

Tuesday, February 28th, 2012

The interim solv­ing of the debt cri­sis in Greece has restored calm in the mar­kets, with the CBOE S&P 500 Volatil­ity Index (VIX) set­tling at 17.3 com­pared to its long-term aver­age of 20.0. The big ques­tion now is whether the VIX will return to the low lev­els of 1991–1996 and 2004–2006.

Sources: CBOE; Plexus Holdings.

But why is it impor­tant? The two peri­ods men­tioned coin­cided with sus­tained strong ris­ing equity mar­kets. Let us take a look at the period 2004 to end 2006. The VIX fell to an aver­age of approx­i­mately 13 over that period, while val­u­a­tion lev­els as mea­sured by Robert Shiller’s PE10 increased sig­nif­i­cantly. Please note that in the graph below I used the inverse of the PE10, which is in fact the earn­ings yield or EY10. The period was marked by strong steady global eco­nomic growth on the back of China’s for­tunes, strong cor­po­rate profit growth and a sig­nif­i­cant increase in risk appetite.

Sources: Robert Shiller; CBOE; Plexus Holdings.

At this stage the market’s rat­ing reflects the VIX, but where to now? While sim­i­lar strong eco­nomic growth etc. may await us fur­ther down the road the same can­not be said for the next two years, let alone this year, as the weak global eco­nomic envi­ron­ment (a much weaker Chi­nese econ­omy, the Eurozone’s con­tin­ued woes and the rel­a­tively weak U.S. econ­omy) is likely to per­sist. I am there­fore of the opin­ion that a VIX of around 20 and a PE10 of 22 can be seen as fair value. These com­pare with the cur­rent VIX of 17.3 and PE10 of 22.6. Yes, opti­mism may drive the VIX down to 15 again and the PE10 to 25 but to me that will indi­cate a sig­nif­i­cant sell­ing oppor­tu­nity. Sim­i­larly, the more reg­u­lar occur­rence of black swans has led to a sig­nif­i­cantly changed invest­ment envi­ron­ment. Yes, it has led to the VIX being more volatile than in the past.

So much for volatil­ity, but what about the under­ly­ing eco­nomic fun­da­men­tals? I have often referred to the rela­tion­ship between con­sumer con­fi­dence and mar­ket val­u­a­tion. Con­sumer spend­ing is the back­bone of the U.S. econ­omy and is there­fore the rea­son why con­sumer con­fi­dence gauges are closely watched by the major mar­ket play­ers. At this stage it is evi­dent that the S&P 500 Index (SPX 1367.59 ↑0.00%) at a PE10 of 22.6 is fully reflect­ing the Con­fer­ence Board Con­sumer Con­fi­dence Index and there­fore the under­ly­ing econ­omy as it stands.

Some may argue that the employ­ment sit­u­a­tion in the U.S. remains dire and is likely to lead to another fall-off in con­sumer con­fi­dence. Well, my research indi­cates that con­sumer con­fi­dence in fact leads the U.S. unem­ploy­ment rate by approx­i­mately nine months. With the Con­fer­ence Board Con­sumer Con­fi­dence Index at 61.1 in Jan­u­ary, it points to an unem­ploy­ment rate of approx­i­mately 8% in the third quar­ter of this year com­pared to 8.3% in Jan­u­ary this year.

Sources: I-Net; FRED; Plexus Holdings.

The val­u­a­tion lev­els of the S&P 500, or PE10, lead the unem­ploy­ment rate by approx­i­mately six months and are cur­rently point­ing to an unem­ploy­ment rate of below 8% in the third quar­ter of this year.

I still hold the view that con­sumer con­fi­dence will improve to approx­i­mately 80 through end 2012 and that the val­u­a­tion of the S&P 500 Index will improve to a PE10 of 25, mean­ing fur­ther upside of approx­i­mately 10% from the cur­rent lev­els. The going will be tough, though, as I think volatil­i­ties will remain high, result­ing in the VIX rang­ing between 15 and 30 and the PE10 between 20 and 25.

Time to add the VIX to your equity port­fo­lio? I think so.

Tags: Black Swans, Cboe, Chinese Economy, Consumer Confidence, Corporate Profit, Debt Crisis, Earnings Yield, Economic Fundamentals, Eurozone, Global Economic Environment, Global Economic Growth, Investment Environment, Plexus, Profit Growth, Risk Appetite, Robert Shiller, Swans, Valuation Levels, Volatility Index Vix, Woes
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Bill Gross: Investment Outlook (February 28, 2012)

Tuesday, February 28th, 2012

​

(Defense)

• ​Over the past 30 years, an offen­sively minded Fed­eral Reserve and their global coun­ter­parts were print­ing money, low­er­ing yields and bring­ing for­ward a false sense of mon­e­tary wealth.
• Suc­cess­ful invest­ing in a delever­ag­ing, low inter­est rate envi­ron­ment will require defen­sive in addi­tion to offen­sive skills.
• The PIMCO defen­sive strat­egy play­book: Rec­og­nize zero bound lim­its and sys­temic debt risk in global finan­cial mar­kets. Accept finan­cial repres­sion but avoid its impact when and where pos­si­ble. Empha­size income we believe to be rel­a­tively reliable/safe; seek con­sis­tent alpha.

They say defense wins Super Bowls, but the Man­nings, Bradys and Mon­tanas of grid­iron his­tory are tes­ta­ments to the oppo­site. Putting points on the board, espe­cially in the last two min­utes, has won more games than goal line stands ever have, even if the scor­ing has been done by the field goal kick­ers, the names of whom have been con­fined to the dust­bins of foot­ball his­tory as opposed to the Hall of Fame in Can­ton, Ohio. Can­ton, how­ever, has an approx­i­mately equal num­ber of defen­sive in addi­tion to offen­sively posi­tioned inductees, so there must be a uni­ver­sally acknowl­edged role for both sides of the scrim­mage line. What fan can for­get Mean Joe Greene, Deion Sanders or Mike Ditka? The old, now polit­i­cally incor­rect show­tune laments that “you gotta be a foot­ball hero, to fall in love with a beau­ti­ful girl,” but foot­ball and any of life’s heroes can play on either side of the line, it seems.

My point about pigskin offense and defense is the per­fect metaphor for the world of invest­ing as well. Offen­sively minded risk tak­ers in the mar­kets have his­tor­i­cally been the ones who have dom­i­nated the head­lines and won the hearts of that beau­ti­ful gal (or hand­some guy). Aside from the rare exam­ples of Steve Jobs and Bill Gates, how­ever, the secret to get­ting rich since the early 1980s has been to bor­row some­one else’s money, throw some Hail Mary passes and spike the ball in the end zone as if you had some par­tic­u­lar genius that deserved mon­e­tary rewards 2¹⁰ times more than a Doc­tor, Lawyer or an Indian Chief. Nah, I take that back about the Indian Chief. The Chiefs, at least, have done pretty well with casi­nos these past few decades.

Still, the pri­mary way to coin money over the past 30 years has been to use money to make money. Although the price of it started in 1981 at a rather exor­bi­tantly high yield of 15% for long-term Trea­suries, 20% for the prime, and real inter­est rates at an almost unbe­liev­able 7–8%, the grad­ual decline of yields over the past three decades has allowed P/E ratios, real estate prices and bond fund NAVs to expand on a seem­ingly end­less vir­tu­ous time­line. Books such as “Stocks for the Long Run” or arti­cles such as “Dow 36,000” cap­tured the public’s imag­i­na­tion much like a Mon­tana to Jerry Rice pass that always seemed to clinch a 49ers vic­tory. Yet an instant replay of these past few decades would have shown that accel­er­at­ing asset prices weren’t due to any par­tic­u­lar wis­dom on the part of acad­e­mia or the invest­ment com­mu­nity but an offen­sively minded Fed­eral Reserve and their global coun­ter­parts who were print­ing money, low­er­ing yields and bring­ing for­ward a false sense of mon­e­tary wealth that was depen­dent on per­pet­ual motion. “Rinse, lather, repeat – Rinse, lather, repeat” was in effect the sin­gu­lar mantra of cen­tral bankers ever since the depar­ture of Paul Vol­cker, but there was no sense that the sham­poo bot­tle filled with money would ever run dry. Well, it has. Inter­est rates have a math­e­mat­i­cal bot­tom and when they get there, the wash­ing of the finan­cial market’s hair pro­duces a lot less lather when it’s wet, and a lot less body after the blow dry. At the zero bound, not only are yields ren­dered impo­tent to ele­vate P/E ratios and lower real estate cap rates, but they begin to poi­son the finan­cial well. Low yields, instead of fos­ter­ing cap­i­tal gains for investors via the magic of present value dis­count­ing and lower credit spreads, begin to reduce house­hold incomes, lower cor­po­rate profit mar­gins and wreak havoc on his­tor­i­cal busi­ness mod­els con­nected to bank­ing, money mar­ket funds and the pen­sion indus­try. The offen­sively ori­ented invest­ment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Invest­ment defense is com­ing of age.

This tran­si­tion is not com­monly observed, although it is rel­a­tively easy to prove sta­tis­ti­cally and even com­mon­sen­si­cally. Take for instance the rather quizzi­cal notion that lower yields must pro­duce an equal num­ber of win­ners and losers since there is a bor­rower for every lender and the net/net there­fore should have no effect on the real econ­omy or its finan­cial mar­kets. Chart 1 shows that since 1981, which marks the begin­ning of the sec­u­lar decline of inter­est rates, per­sonal inter­est income has rather grad­u­ally (and now some­what sud­denly) shrunk rel­a­tive to house­hold debt ser­vice payments.

It is Main Street that has failed to keep up with Wall Street and cor­po­rate Amer­ica in the race to see who can ben­e­fit more from lower yields. As the inter­est com­po­nent of per­sonal income grad­u­ally weak­ens, the abil­ity of the con­sumer to keep up its fre­netic spend­ing is reduced. Metaphor­i­cally, it’s akin to a 4th quar­ter two minute Super Bowl drill, but one where the receivers haven’t been prop­erly hydrated. They’re a half step slow, their legs are cramp­ing, and it shows. Lower inter­est rates are hav­ing a neg­a­tive impact on house­holds because their water bot­tles are filled with 50 basis point CDs instead of Gatorade.

While Wall Street and lev­ered investors have fared bet­ter than their Main Street coun­ter­parts, it’s not as if they’re in “prime­time Deion Sanders” shape either. Con­cep­tu­al­ize the his­tor­i­cal busi­ness model of any financially-oriented firm for the past 30 years and you will see what I mean. Insur­ance com­pa­nies, for instance, whether they be life insur­ance with their long-term lia­bil­i­ties, or property/casualty insur­ance with more imme­di­ate poten­tial pay­outs, have mod­eled their long-term prof­itabil­ity on the assump­tion of stan­dard long-term real returns on invest­ment. AFLAC, GEICO, Pru­den­tial or the Met – take your pick – have hired, staffed, adver­tised, priced and expensed based upon the assump­tion of using their cash flows to earn a pos­i­tive real return on their invest­ment. When those returns fall from 7% pos­i­tive to an approx­i­mate 1% neg­a­tive, then assump­tions – and prac­ti­cal real­i­ties – begin to change. If these firms can’t cover infla­tion with his­tor­i­cal real returns from their float, then they begin to down­size in order to stay prof­itable. The down­siz­ing is just another way of describ­ing a tran­si­tion from offense to defense in a zero bound nom­i­nal inter­est rate world where almost any level of infla­tion pro­duces neg­a­tive real yields on invest­ment.
Not only insur­ance com­pa­nies but banks suf­fer from this inabil­ity to main­tain mar­gins at the zero bound. In the process, they close retail branches that once were assumed to be the golden key to suc­cess­ful bank­ing. Defense! And here’s one of the more inter­est­ing anec­do­tal obser­va­tions on our cur­rent zero-based envi­ron­ment, one to which my invest­ment paragon – War­ren Buf­fett – would prob­a­bly imme­di­ately admit. His busi­ness model – and that of Berk­shire Hath­away – has long ben­e­fit­ted from what he has described as “free float.” Those annual pol­icy pay­ments, whether for hur­ri­cane, life or auto­mo­bile insur­ance, have long given him a com­pet­i­tive fund­ing advan­tage over other busi­ness mod­els that couldn’t bor­row for “free.” Today, how­ever, almost any large busi­ness or wealthy indi­vid­ual can bor­row or lever up with min­i­mal inter­est expense. Buffett’s “Omaha/West Coast” offense is being dupli­cated around the world thanks to cen­tral bank mon­e­tary poli­cies, plac­ing an increas­ing empha­sis on stock and invest­ment selec­tion as opposed to busi­ness model lia­bil­ity fund­ing. Buf­fett will suc­ceed based upon his con­tin­ued strong offen­sive play call­ing, but the rules of the game are changing.

The plight of Buf­fett of course is in some respects the plight of PIMCO or any investment/financially-oriented firm in this new age of the zero bound. And it seems to us at PIMCO that suc­cess­ful invest­ing in a delever­ag­ing, low inter­est rate envi­ron­ment will require defen­sive in addi­tion to offen­sive skills. What does that mean? Well, let’s briefly describe PIMCO’s own his­tor­i­cal invest­ment offense for the past 30 years in order to pro­vide a defen­sive contrast:

PIMCO Offen­sive Strat­egy 1981 – 2011
Ready, Set, Hut 1, Hut 2 –

1. Rec­og­nize down­ward trend in inter­est rates and scale dura­tion accordingly.

   A. Empha­size income and cap­i­tal gains. PIMCO Total Return Strat­egy.
   B. Uti­lize pru­dent deriv­a­tive struc­tures that ben­e­fit from sys­temic lever­ag­ing – finan­cial futures,
   swaps (but no sub­primes!)
   C. Com­bine A and B along with care­ful bottom-up secu­rity selec­tion to seek con­sis­tent alpha.

PIMCO Defen­sive Strat­egy 2012 – ?
Ready, Set, Hut, Hut, Hut –

1. Rec­og­nize zero bound lim­its and sys­temic debt risk in global finan­cial mar­kets. Accept finan­cial repres­sion but avoid its impact when and where pos­si­ble.
   
   A. Empha­size income we believe to be rel­a­tively reliable/safe.
   B. De-emphasize deriv­a­tive struc­tures that are fully val­ued and poten­tially volatile.
   C. Com­bine A and B along with secu­rity selec­tion to seek con­sis­tent alpha with admit­tedly lower nom­i­nal returns than his­tor­i­cal indus­try examples.

So there you have it – the PIMCO play­book. I sup­pose if I had any com­mon sense I would hold up that clip­board to the front of my mouth like side­line coaches do dur­ing big games. Don’t want to chance any of the com­pe­ti­tion read­ing our lips to get a heads up on PIMCO’s next offen­sive play call. But then that’s never been my or Mohamed’s style, given the impor­tance of inform­ing you, our clients, of what we are think­ing when it comes to invest­ing your hard-earned cap­i­tal. Go ahead com­peti­tors and read our lips, we’ll just pound that pigskin down the field any­way. Besides, as I’ve pointed out, the empha­sis these days should be on the defen­sive coach. Lever­ag­ing has turned into delever­ag­ing. 15% yields have turned into 0% money. The Super Bowls of the future will have their Man­nings and Bradys, but the defen­sive line may record more sacks and make more head­lines than ever before.

William H. Gross
Man­ag­ing Director

Tags: Bill Gross, Bradys, Debt Risk, Defensive Strategy, Deion Sanders, Derivative Structures, Downward Trend, Dustbins, Field Goal Kickers, Financial Repression, Football Hero, Global Financial Markets, Gross Investment, Hail Mary, Handsome Guy, Interest Rate Environment, Investment Outlook, Joe Greene, Lamentation, Mike Ditka, Monetary Wealth, Offensive Skills, Offensive Strategy, Pigskin, Printing Money, Rare Examples, Ready Set, Risk Takers, Ron Paul, Scrimmage Line, Superpac, Whimper, Zirp
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Golden Boy: Paul Brodsky on Warren Buffett

Tuesday, February 28th, 2012

War­ren Buf­fett deserves the public’s respect. His great suc­cess and appar­ent mod­esty, kind­ness and rea­son in a field replete with pro­mot­ers and chest thumpers have allowed him to stand out in our soci­ety. He is to most an hon­est bro­ker among char­la­tans, uniquely capa­ble of sep­a­rat­ing truth from fic­tion, the way it is and will always be ver­sus cock­eyed the­o­ries touted by igno­rant new­bies. He has been the most suc­cess­ful and most char­i­ta­ble financier of the last hun­dred years, and his procla­ma­tions become, ipso facto, the com­mon per­cep­tion of truth.

Buf­fett may be a sage, a wiz­ard, and an ora­cle when it comes to nom­i­nal rel­a­tive value pric­ing of finan­cial assets, but it is well worth not­ing that Buffett’s procla­ma­tions are not nec­es­sar­ily wor­thy of being con­sid­ered “fact” in mat­ters unre­lated to finance, just as the leg­endary Joe Paterno’s judg­ment seems to have been sorely lack­ing when it came to sort­ing out mat­ters unre­lated to a win­ning foot­ball program.

That has not seemed to stop Mr. Buf­fett from express­ing wide rang­ing views from tax pol­icy to the value of gold. In fact, over the last two weeks — in a Forbes inter­view, in Berk­shire Hathaway’s annual report and this morn­ing on CNBC — Buf­fett chose to com­ment on gold even though he does not have a pub­licly dis­closed posi­tion in it. We must assume his aggres­sive gold com­ments have been meant to force the price of gold lower. (We do not know why he is so inter­ested in doing so though we do have a rea­son­able the­ory, for another time). We strongly dis­agree with Mr. Buffett’s views and we thought it would be best to explore his com­ments and pro­vide our counter-arguments.

Pro­duc­tive Assets vs. True Savings

The crux of Buffett’s argu­ment is that he prefers pro­duc­tive assets (pro­cre­ative, he calls them) and that gold is not one. This implies cor­rectly that gold is a form of sav­ings. Regret­tably, the rest of his argu­ment relies on con­fus­ing the two, which leads him to two-dimensional logic that clearly fails in prac­ti­cal terms.

We would share Buffett’s pref­er­ence for pro­duc­tive assets in a Utopian world where money was scarce and credit was funded exclu­sively with organic sav­ings. In such a world sim­ply deposit­ing our sav­ings in a bank would pass-on our cap­i­tal to pro­duc­tive busi­nesses that would in turn earn the pro­duc­tive return, all while we (the saver) would retain the risk. That would be a great deal for the bank and the pro­ducer but a lousy deal for the saver.

Such a warn­ing to savers (gold hold­ers) is a ridicu­lous posi­tion to take, how­ever, in the con­text of our mod­ern global mon­e­tary sys­tem char­ac­ter­ized by over-levered cur­rency and unre­served bank credit. Though Buf­fett is cor­rect that sav­ing in the form of inces­santly inflat­ing fiat cur­rency is a fool’s game today, he is dan­ger­ously wrong in not see­ing that exchang­ing fiat cur­rency for finan­cial assets and busi­nesses with egre­giously inflated enter­prise val­ues, (via the egre­giously inflated and inflat­ing cur­ren­cies in which they are denom­i­nated), is not equally foolish.

War­ren Buffett’s argu­ment against gold falls woe­fully short of the mark because he does not acknowl­edge that there is always a role for robust sav­ings wherein the saver nei­ther suf­fers the dilu­tion­ary pain of fiat cur­rency deval­u­a­tion nor the defla­tion­ary pain of acquir­ing over-levered assets. The medium that allows the true saver to escape both trap doors is gold. It is sim­ply a form of sav­ings that can­not be diluted and the nom­i­nal prices of all things lever­aged (includ­ing finan­cial assets) will revolve around it and other scarce, unlev­ered items.

Within this con­text, we re-print and rebut Mr. Buffett’s spe­cific obser­va­tions related to gold from Berkshire’s annual report, below:

Buf­fet:

“…the sec­ond major cat­e­gory of invest­ments involves assets that will never pro­duce any­thing, but that are pur­chased in the buyer’s hope that some­one else – who also knows that the assets will be for­ever unpro­duc­tive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buy­ers in the 17th century.

This type of invest­ment requires an expand­ing pool of buy­ers, who, in turn, are enticed because they believe the buy­ing pool will expand still fur­ther. Own­ers are not inspired by what the asset itself can pro­duce – it will remain life­less for­ever – but rather by the belief that oth­ers will desire it even more avidly in the future.

The major asset in this cat­e­gory is gold, cur­rently a huge favorite of investors who fear almost all other assets, espe­cially paper money (of whose value, as noted, they are right to be fear­ful). Gold, how­ever, has two sig­nif­i­cant short­com­ings, being nei­ther of much use nor pro­cre­ative. True, gold has some indus­trial and dec­o­ra­tive util­ity, but the demand for these pur­poses is both lim­ited and inca­pable of soak­ing up new pro­duc­tion. Mean­while, if you own one ounce of gold for an eter­nity, you will still own one ounce at its end.”

QB:

Gold is not an asset and is not meant to be pro­cre­ative. Above all else it is a cur­rency, like US dol­lars, and its daily spot pric­ing reflects its exchange rates with cur­ren­cies cur­rently being issued by global cen­tral banks on behalf of their host gov­ern­ments and used as media of exchange. Gold is not cur­rently a medium of exchange (although to some peo­ple it remains a store of pur­chas­ing power vis-à-vis other cur­ren­cies cur­rently in use as exchange media). Thus, in today’s fiat mon­e­tary sys­tem gold is sim­ply poten­tial money and its spot price indi­cates the degree to which global wealth hold­ers are will­ing to hand­i­cap the pos­si­bil­ity that the future pur­chas­ing power of cen­tral bank-issued cur­rency will be diluted against it.

Gold is no more or less “life­less” than Dol­lars, Euros or Yen. One needs to lend each in order to have a return on them. (We argue one would be fool­ish to lend gold and receive inter­est denom­i­nated in other cur­ren­cies when gold is rel­a­tively scarce — and get­ting scarcer — to them.) As for being “not of much use”, yes gold is pretty useless…until it isn’t.

Mr. Buf­fet is wrong when he implies gold is a bub­ble (like Tulips). In fact, in spite of all the noise there is very lit­tle spon­sor­ship of gold today rel­a­tive to finan­cial assets. As indi­ca­tors, the value of the world’s largest gold ETF is one-fifth the mar­ket cap­i­tal­iza­tion of Apple, and total pre­cious metal expo­sure rep­re­sents just 0.15% of global pen­sion assets.

Mr. Buf­fet is again wrong in argu­ing gold needs more avid buy­ers to keep the bub­ble inflat­ing. It does not, and in fact we think it is unlikely there will be many buy­ers rel­a­tive to finan­cial asset hold­ers as time goes on. Rather, we believe the price of gold will increase in fiat terms with or with­out wide­spread sec­ondary mar­ket endorse­ment pre­cisely because cen­tral banks must increase their mon­e­tary bases to de-lever their bank­ing sys­tems, which in turn de-values the cur­ren­cies in which lever­age is denominated.

Paper claims on gold, such as futures, swaps and dubiously-backed ETFs, will fluc­tu­ate with the chang­ing sen­ti­ment of finan­cial asset investors until, one day, for some rea­son that can­not be pre­dicted, claim hold­ers begin to demand phys­i­cal bul­lion. All it will take to trig­ger “a run” will be more demand for phys­i­cal bul­lion than the amount avail­able on-hand for deliv­ery. When this hap­pens there will not be a “rea­son­able” price at which an exchange can be made. Spot pric­ing will cease to exist and all paper claims on gold will set­tle in bro­ker­age accounts at the price of the last spot trade. We think very few com­mit­ted finan­cial asset investors will own gold in any size at the pre­cise moment they will need it most.

Those that do hold phys­i­cal gold (or shares in gold min­ers) would be able to then set the exchange rate to fiat cur­ren­cies (gold price) at which they would part with their bul­lion. Any exter­nal­i­ties, such as gov­ern­ment inter­ven­tion or price con­trols that would serve to try to set the exchange rate at a lower-than-market rate, would likely be met with indif­fer­ence among bul­lion hold­ers and miner share­hold­ers. So yes, Mr. Buf­fet may be cor­rect that an ounce of gold will always be only an ounce of gold, but he does not seem to be con­sid­er­ing its exchange rate.

Buf­fet:

“What moti­vates most gold pur­chasers is their belief that the ranks of the fear­ful will grow. Dur­ing the past decade that belief has proved cor­rect. Beyond that, the ris­ing price has on its own gen­er­ated addi­tional buy­ing enthu­si­asm, attract­ing pur­chasers who see the rise as val­i­dat­ing an invest­ment thesis.

As “band­wagon” investors join any party, they cre­ate their own truth – for a while. Over the past 15 years, both Inter­net stocks and houses have demon­strated the extra­or­di­nary excesses that can be cre­ated by com­bin­ing an ini­tially sen­si­ble the­sis with well-publicized ris­ing prices. In these bub­bles, an army of orig­i­nally skep­ti­cal investors suc­cumbed to the “proof” deliv­ered by the mar­ket, and the pool of buy­ers – for a time – expanded suf­fi­ciently to keep the band­wagon rolling. But bub­bles blown large enough inevitably pop. And then the old proverb is con­firmed once again: “What the wise man does in the begin­ning, the fool does in the end.”

QB:

The great bub­ble from 1981 to 2006 was in unre­served global credit dis­tri­b­u­tion, which explains the fund­ing behind Mr. Buffett’s mar­ket psy­chol­ogy dis­cus­sion. The cur­rent bub­ble is in global base money print­ing, which has risen over 200% just since 2008 and must increase five times more from cur­rent lev­els to cover unre­served bank assets. Finan­cial assets are the direct ben­e­fi­ciary of credit expan­sion and real assets are the direct ben­e­fi­ciary of base money expan­sion. Gold is sim­ply respond­ing to the bub­ble pol­icy mak­ers are admin­is­ter­ing. We believe gold is the most under-valued and most opti­mal risk-adjusted hedge against the cur­rent bubble.

Buf­fett:

“Today the world’s gold stock is about 170,000 met­ric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Pic­ture it fit­ting com­fort­ably within a base­ball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 tril­lion. Call this cube pile A. Let’s now cre­ate a pile B cost­ing an equal amount. For that, we could buy all U.S. crop­land (400 mil­lion acres with out­put of about $200 bil­lion annu­ally), plus 16 Exxon Mobils (the world’s most prof­itable com­pany, one earn­ing more than $40 bil­lion annu­ally). After these pur­chases, we would have about $1 tril­lion left over for walking-around money (no sense feel­ing strapped after this buy­ing binge).

Can you imag­ine an investor with $9.6 tril­lion select­ing pile A over pile B? Beyond the stag­ger­ing val­u­a­tion given the exist­ing stock of gold, cur­rent prices make today’s annual pro­duc­tion of gold com­mand about $160 bil­lion. Buy­ers – whether jew­elry and indus­trial users, fright­ened indi­vid­u­als, or spec­u­la­tors – must con­tin­u­ally absorb this addi­tional sup­ply to merely main­tain an equi­lib­rium at present prices.

A cen­tury from now the 400 mil­lion acres of farm­land will have pro­duced stag­ger­ing amounts of corn, wheat, cot­ton, and other crops – and will con­tinue to pro­duce that valu­able bounty, what­ever the cur­rency may be. Exxon Mobil will prob­a­bly have deliv­ered tril­lions of dol­lars in div­i­dends to its own­ers and will also hold assets worth many more tril­lions (and, remem­ber, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still inca­pable of pro­duc­ing any­thing. You can fon­dle the cube, but it will not respond.

Admit­tedly, when peo­ple a cen­tury from now are fear­ful, it’s likely many will still rush to gold. I’m con­fi­dent, how­ever, that the $9.6 tril­lion cur­rent val­u­a­tion of pile A will com­pound over the cen­tury at a rate far infe­rior to that achieved by pile B.”

QB:

As we’ve writ­ten in the past, our pre­ferred piles (we call them “buck­ets”) are these: Bucket A is the stock of money and Bucket B is the value of all things not money. At any given point of mea­sure­ment the value of Bucket A must equal the value of Bucket B. Thus, the debate reduces to “what is money?” If one pre­sumes that fiat cur­ren­cies and unre­served bank credit have no mar­ginal cost of pro­duc­tion (elec­tronic ones and zeros), then their ter­mi­nal value in exchange must be zero. This leaves gold in the money bucket to assume the value of all things not money. Mr. Buf­fet again misiden­ti­fied gold as an asset, not as money.

Sum­mary

We think it is impru­dent to advise legit­i­mate savers to invest in lev­ered finan­cial assets. The extra­or­di­nary rel­a­tive wealth one may have amassed over the last forty years in the finan­cial mar­kets was most likely legit­imized by nom­i­nal scale that can­not be sus­tained in real terms. Such ben­e­fi­cia­ries of lever­age and infla­tion typ­i­cally built very lit­tle sus­tain­able cap­i­tal and inno­vated noth­ing. The largest ben­e­fi­cia­ries of lever­age and infla­tion had a near infi­nite fund­ing advan­tage, either near zero-rate short-term fiat cur­rency fund­ing or very low term fund­ing. Insur­ers like Berk­shire could effec­tively divert wages from their country’s fac­tors of pro­duc­tion (by charg­ing insur­ance pre­mi­ums) and rein­vest those wages by pro­vid­ing financ­ing to busi­nesses that would main­tain their pric­ing power (through strong brand­ing or demand inelas­tic­ity). That great fund­ing advan­tage is now gone and Mr. Buf­fett does not seem too happy about it.

The nar­row gap sep­a­rat­ing wage growth and asset price growth had to widen fol­low­ing the demise of Bret­ton Woods. Mr. Buf­fett may have known about this oppor­tu­nity ear­lier and bet­ter than almost any­one else because his father, (Howard Buf­fett, US Con­gress­man from Nebraska), was out­spo­ken in aggres­sively sup­port­ing gold and a fixed exchange cur­rency sys­tem. It would be coun­ter­pro­duc­tive and beyond our area of study to try to under­stand what psy­cho­log­i­cal impulse might com­pel Mr. Buf­fett to pur­sue and achieve life­long finan­cial suc­cess in a man­ner directly con­trary to his father’s views on the value of gold and paper cur­ren­cies. So we can only guess whether his astound­ing suc­cess in con­sis­tently posi­tion­ing a lever­aged infla­tion port­fo­lio has been the result of a sound pre-meditated strat­egy passed down from his father or has merely been very ironic.

Mr. Buffett’s moti­va­tions are not impor­tant. He is rich and we think he will always be rich in rel­a­tive terms because most wealth hold­ers will remain com­mit­ted to finan­cial assets. Nev­er­the­less, we sus­pect Mr. Buf­fet is aware that his wealth is about to be greatly deval­ued in real terms, just as he cor­rectly fore­saw the fate of dot-com bil­lion­aires who held their out­lets for unre­served credit too long (in the form of cor­po­rate shares). Fur­ther, we think Mr. Buf­fett must be aware that the pro­cre­ative assets he touts are cur­rently priced at mul­ti­ples of their future nom­i­nal cash flows and dis­counted for almost 0% inter­est rates, ensur­ing their future pur­chas­ing power will be destroyed in an infla­tion­ary envi­ron­ment no mat­ter how much rev­enue growth they produce.

We believe true savers across the world not beholden to West­ern finan­cial assets under­stand or will soon under­stand the dif­fer­ence between rel­a­tive nom­i­nal returns and absolute real returns. They do (or will) not care about the views of very suc­cess­ful lever­aged money chang­ers. Yes, an inert rock today will be an inert rock tomor­row. But it will be an even scarcer inert rock tomor­row rel­a­tive to the fiat cur­rency in which it is priced (same for fine art). Lev­ered pro­duc­tive assets will lose their value against both unlev­ered scarce inert rocks and unlev­ered inelas­tic com­modi­ties. The only things they will out­per­form in a period of great mon­e­tary infla­tion are bonds and cash (both also levered).

Mr. Buf­fett is no doubt bril­liant but we respect­fully dis­agree with his sense of real value. We find inspi­ra­tion in the good sense and gra­cious­ness of Sir John Tem­ple­ton who became fab­u­lously wealthy invest­ing in cap­i­tal build­ing enter­prises and always seemed to main­tain an objec­tive and flex­i­ble invest­ment perspective.

Kind regards,

Lee Quain­tance & Paul Brod­sky
pbrodsky@qbamco.com

(h/t: Barry Ritholtz, The Big Pic­ture)

Tags: Berkshire Hathaway, Brodsky, Buffett Warren, Charlatans, Cnbc, Financial Assets, Football Program, Honest Broker, Joe Paterno, Legendary Joe, Mr Buffett, Price Of Gold, Proclamations, productive assets, Relative Value, Thumpers, True Savings, Truth From Fiction, Value Of Gold, Warren Buffett
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Jeremy Grantham's 10 Investment Lessons

Monday, February 27th, 2012

Nice list from Jeremy Grantham, via Mar­ket­watch:

1. Believe in his­tory
“All bub­bles break; all invest­ment fren­zies pass. The mar­ket is glo­ri­ously inef­fi­cient and wan­ders far from fair price, but even­tu­ally, after break­ing your heart and your patience … it will go back to fair value. Your task is to sur­vive until that hap­pens.”

2. ‘Nei­ther a lender nor a bor­rower be’
“Lever­age reduces the investor’s crit­i­cal asset: patience. It encour­ages finan­cial aggres­sive­ness, reck­less­ness and greed.”

3. Don’t put all of your trea­sure in one boat
“The more invest­ments you have and the more dif­fer­ent they are, the more likely you are to sur­vive those crit­i­cal peri­ods when your big bets move against you.”

4. Be patient and focus on the long term
“Wait for the good cards this will be your mar­gin of safety.”

5. Rec­og­nize your advan­tages over the pro­fes­sion­als
“The indi­vid­ual is far bet­ter posi­tioned to wait patiently for the right pitch while pay­ing no regard to what oth­ers are doing.”

6. Try to con­tain nat­ural opti­mism
“Opti­mism is a lousy invest­ment strat­egy”

7. On rare occa­sions, try hard to be brave
“If the num­bers tell you it’s a real out­lier of a mis­priced mar­ket, grit your teeth and go for it.”

8. Resist the crowd; cher­ish num­bers only
“Ignore espe­cially the short-term news. The ebb and flow of eco­nomic and polit­i­cal news is irrel­e­vant. Do your own sim­ple mea­sure­ments of value or find a reli­able source.”

9. In the end it’s quite sim­ple. really
“[GMO] esti­mates are not about nuances or Ph.D.s. They are about ignor­ing the crowd, work­ing out sim­ple ratios and being patient.”

10. ‘This above all: To thine own self be true’
“It is utterly imper­a­tive that you know your lim­i­ta­tions as well as your strengths and weak­nesses. You must know your pain and patience thresh­olds accu­rately and not play over your head. If you can­not resist temp­ta­tion, you absolutely must not man­age your own money.”

(H/t: Barry Ritholtz, The Big Picture)

Tags: Aggressiveness, Barry Ritholtz, Critical Periods, Ebb And Flow, Grit, Investment Lessons, Investment Strategy, Jeremy Grantham, Lousy Investment, Margin Of Safety, Marketwatch, Nuances, Optimism, Outlier, Political News, Rare Occasions, Recklessness, Strengths And Weaknesses, Term News, Thresholds
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GMO's Jeremy Grantham's Q4 2011 Letter: "The Longest Quarterly Letter Ever"

Monday, February 27th, 2012

While War­ren Buffet's annual let­ter received all the atten­tion this week­end, I am one more likely to be try­ing to catch what GMO's Jeremy Grantham is espous­ing.   Both of course are quite bril­liant men.  As the title indi­cates it's a bit on the long side but Grantham starts with a Shake­spearean angle (Ham­let!), giv­ing us his 10 points of invest­ing advice.    The next por­tion is titled "Your Grand­chil­dren Have No Value (and Other Defi­cien­cies of Cap­i­tal­ism", and then he fin­ishes the quar­terly let­ter off with his mar­ket out­look – which is not actu­ally that bear­ish.  Any­how, always a sharp read.

The Longest Quar­terly Let­ter Ever-Jeremy Grantham-February 2012

Tags: Brilliant Men, capitalism, Deficiencies, Gmo, Grandchildren, Hamlet, Investing Advice, Jeremy Grantham, Market Outlook, Quarterly Letter, Sharp, Warren Buffet
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The ‘High Oil Prices = Recession’ Fallacy

Monday, February 27th, 2012

Every time we see oil prices go up we hear that it will cause infla­tion and/or the econ­omy will go into the tank.

... 7 out of the 8 post­war U.S. reces­sions had been pre­ceded by a sharp increase in the price of crude petro­leum. Iraq’s inva­sion of Kuwait in August 1990 led to a dou­bling in the price of oil in the fall of 1990 and was fol­lowed by the ninth post­war reces­sion in 1990–91. The price of oil more than dou­bled again in 1999–2000, with the tenth post­war reces­sion com­ing in 2001. Yet another dou­bling in the price of oil in 2007–2008 accom­pa­nied the begin­ning of reces­sion num­ber 11, the most recent and fright­en­ing of the post­war eco­nomic downturns. So the count today stands at 10 out of 11, the sole excep­tion being the mild reces­sion of 1960–61 for which there was no pre­ced­ing rise in oil prices. [Hamil­ton, 2009. Rv. 2010]

The premise is wrong. What causes price infla­tion is an expan­sion of money sup­ply (and a desire of peo­ple to spend it, often quickly). What causes reces­sions is mal­in­vest­ment of cap­i­tal caused, again, by money sup­ply expansion.

The clas­sic argu­ment is that because 70% of the econ­omy is dri­ven by con­sumer spend­ing, an increase in gaso­line prices will cause a decrease in con­sumer spend­ing, which will cause an eco­nomic decline. Sounds log­i­cal on its face. There are empir­i­cal stud­ies that show either increases in gaso­line prices will not impact dis­cre­tionary spend­ing (McCarthy, 20110) or that large increases in petro­leum prices will cause reces­sions (Hamil­ton). Take your pick.

The above chart¹ shows the peak of real YoY GDP per­cent­age change (light blue lines) and the rel­a­tive price of gaso­line (red), the prod­uct that most directly affects con­sumers. If gaso­line prices have been increas­ing prior to the peak, then there is sta­tis­ti­cal data show­ing that those prices may have had an impact on GDP. From that one might con­clude that because oil prices were ris­ing prior to the peak in GDP, and because GDP sub­se­quently declined, then high oil prices may have caused a decline in GDP.  (Because A hap­pened and then B hap­pened, thus A caused B?) Or, is it just a coincidence?

What we see in the data is coin­ci­dence rather than confirmation.

Take price increases of oil and gaso­line. It doesn't cause price infla­tion (i.e., all prices rise). Instead it's a sup­ply and demand thing. When OPEC jacks up oil prices, peo­ple spend more on gas and less on other things. The con­sumer goods they don't buy decline in price. Money is redi­rected by mar­ket forces to petro­leum pro­duc­ers who are incen­tivized to dis­cover and pro­duce more oil. Ulti­mately, under nor­mal cir­cum­stances, prices come down. This process is a bit dis­torted because we have a cartel-controlled mar­ket. But, if OPEC keeps prices too high, peo­ple reduce con­sump­tion, car­tel rev­enues go down, and OPEC reduces prices to stim­u­late con­sump­tion. This is what hap­pened in the cur­rent busi­ness cycle.

It is the same with reces­sions and oil prices. Each of the reces­sions we've had in the last 40 years can be ade­quately explained by causes other than oil/gas prices. For exam­ple, while oil/gas prices shot up prior to the 2008 Crash, no one sug­gests that was a cause of it. Rather we know that oil prices went up as a result of a fiat money fueled boom that drove up all com­mod­ity prices.

Look­ing at our chart, we can start with the 1973 — 1975 reces­sion. That was the time of the Arab Oil Embargo (Oct. 1973 to March 1974). If the the­ory that high oil prices equals reces­sion holds true then why did the econ­omy recover when gas prices con­tin­ued to rise post-recovery? What really hap­pened was that the Fed cut inter­est rates by half in 1970–1971, and then started rais­ing them in 1973 to com­bat ris­ing prices. By the time the reces­sion started in Novem­ber 1973, the Fed Funds rate peaked at just over 10%. It isn't as if the oil embargo didn't cause dis­rup­tion in the econ­omy; it did, but most of the eco­nomic dis­rup­tion was caused by the government's price con­trols and rationing. But it didn't cause the recession.

Next, GDP peaked in April 1978  (gasoline-PPG $0.631) and declined until Octo­ber 1980 ($1.223). Recall that price infla­tion almost hit 15% in 1980.  The reces­sion started in Jan­u­ary 1980 ($1.11) and ended in July 1980 ($1.247). Gaso­line prices con­tin­ued to increase dur­ing the sub­se­quent recov­ery. There is no cor­re­la­tion between oil prices and reces­sion or price inflation.

GDP peaked again in Q2 1981 ($1.353) and bot­tomed out in Novem­ber 1982 ($1.268). We went into reces­sion in July 1981 ($1.353) until Novem­ber 1982 ($1.268). You can see an oil price cor­re­la­tion here, but other things were going on: high infla­tion. By June 1981, the CPI was still over 10%. Carter had appointed Paul Vol­cker as Fed Chair­man in August 1979 and he started rais­ing the Fed Funds rate from around 10% until it reached 19% in Jan­u­ary 1981, and kept it high (8% to 10%) for much his term (ended in 1987). This broke price infla­tion (it set­tled in the 3.5 to 4.5 range). Thus mon­e­tary pol­icy rather than oil prices was the cause of the recession.

From then on, gaso­line prices declined and remained rel­a­tively sta­ble until 1999 ($0.90 to $1.30) when it started climb­ing again. The July 1990 ($1.139) to March 1991 ($1.138) reces­sion shows that GDP peaked in late 1987 (about $0.95) and gaso­line prices peaked in Jan­u­ary 1991 ($1.304) and the reces­sion ended in March 1991. But again, other things were dri­ving the econ­omy: a real estate boom-bust cycle, and that was largely dri­ven by cheaper money and accel­er­ated depre­ci­a­tion rules (those rules ended in 1986).

Prices fluc­tu­ated but remained in the $1.20s for most of the next eight years.

By 1999, the rise in gaso­line prices coin­cided with peak GDP in late 1999 (Dec., $1.353) and gas prices rose, almost steadily since then. The 2001 reces­sion came and went (March-$1,503) — November-$1.324). But, what else was going on? This was a time of incred­i­ble pro­duc­tion and tech­no­log­i­cal inno­va­tion that again ben­e­fited from the Fed's cheap money (spurred by Greenspan to revive the econ­omy from the 1990 — 1991 reces­sion). It worked. But Dot Com boom turned into Dot Bomb bust as the Fed raised inter­est rates and cooled the econ­omy off from its "irra­tional exuberance".

The Fed decided it needed to stim­u­late the econ­omy from the bust and from Novem­ber 2000 to June 2004, the Fed low­ered inter­est rates from 6.5% to 1.00%. From then on oil prices fol­lowed com­modi­ties prices and gaso­line prices con­tin­ued to climb.

By late 2003 ($1.578) the rate of growth of GDP peaked and there­after was slow­ing, although it con­tin­ued to grow until Jan­u­ary 2006 ($2.359). At this point, the Fed again sought to cool down the econ­omy and the Fed Funds rate went from 1.00% up to 5.26% by July 2007. Again, it worked and the real estate mar­kets began to come apart. By H2 2008 ($4.142), GDP began to decline, thus begin­ning the bust phase of our cur­rent boom-bust cycle. Cur­rent price is $3.591.

Thus, while you can argue that ris­ing oil and gas prices may have had some neg­a­tive effects on the econ­omy because of some eco­nomic dis­rup­tion, in every case, the cause of our reces­sion was any­thing but ris­ing prices.

Regard­less you are still going to hear that ris­ing oil and gas prices are going to ruin the econ­omy and cause us to go back into reces­sion. While I believe the econ­omy will decline start­ing in H2 2012, the rea­sons have noth­ing to do with oil prices. Don't let the pun­dits scare you with this eco­nomic fal­lacy. There is enough to worry about.

1. Note that gaso­line prices (red line) are not scaled to prices, but are scaled to an index (100). The GDP scale (blue line) shows YoY per­cent change.

Tags: Crude Petroleum, Discretionary Spending, Economic Decline, Economic Downturns, Empirical Studies, Fallacy, Gasoline Prices, Invasion Of Kuwait, Money Supply, Number 11, Percentage Change, Petroleum Prices, Price Inflation, Price Of Gasoline, Price Of Oil, Recession, Recessions, Relative Price, Sole Exception, Yoy
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David Rosenberg: "It's a Gas, Gas, Gas!"

Monday, February 27th, 2012

Once again, if one wants to get noth­ing but schiz­o­phrenic noise from sev­eral momen­tum chas­ing vac­uum tubes which very way may take the mar­ket to all time highs on 1 ES con­tract churned back and forth, by all means focus on the "mar­ket" which for the past three years is merely a pol­icy vehi­cle of the monetary-fiscal fusion régime (thank you Plosser for con­firm­ing what we have been say­ing for years). For every­one else, here is the tra­di­tion­ally solid eco­nomic com­men­tary from David Rosen­berg. Con­sid­er­ing that the cen­tral plan­ners have pumped $7 tril­lion, or 50% of their bal­ance sheet, in the stock mar­ket in the past 4 years, to off­set pre­cisely the warn­ings that Rosen­berg issues on a daily basis, we are far beyond debat­ing whether or not those who observe the econ­omy real­is­ti­cally are right or wrong. The only ques­tion is whether the cen­tral banks can con­tinue to expand their bal­ance sheet at an expo­nen­tial phase to off­set the inevitable. Answer: they can't.

From Gluskin Sheff's David Rosenberg

IT'S A GAS, GAS, GAS!

"There are fluc­tu­a­tions in the mar­ket that don't mean anything."

Ira Gluskin, Feb­ru­ary 14, 2012

If there was a Rule #11 added to Bob Farrell's list of gems, this would be it. We have added this ditty before from Ira, and will con­tinue to do so as a reminder. A reminder of what you ask? A reminder of how the stock mar­ket can be divorced from eco­nomic real­i­ties for a period of time. The stock mar­ket ignored the per­ils of the busted tech bub­ble for a good eight months back in 2000, ulti­mately to its own cha­grin. It ignored the melt­down in the hous­ing and mort­gage mar­ket for at least 10 months back in 2007. The exam­ples can go on, but hope­fully the point is taken.

At any given moment of time, the mar­ket is dri­ven by a vari­ety of fac­tors. Some are more impor­tant than oth­ers, and they include tech­ni­cals, sea­son­als, sen­ti­ment. fund flows, val­u­a­tions and, Of course, the fun­da­men­tals. The key dri­ving force this year has been the expanded P/E mul­ti­ple, in line with a 16 read­ing on the VIX index, as the mar­kets seem to believe that the mas­sive expan­sions of global cen­tral bal­ance sheets will end up sav­ing the day for dilap­i­dated sov­er­eign gov­ern­ment bal­ance sheets and woe­fully under­cap­i­tal­ized Euro­pean banks. Too bad the Gra­ham and Dodd clas­sic text on value invest­ing didn't include a chap­ter on cen­tral bank money-printing.

From our lens, liquidity-based ral­lies are fun to trade, but tend to have a rel­a­tively short shelf life. Imag­ine what is on everyone's minds for the com­ing week is not the eco­nomic data or earn­ings results but instead the sec­ond LTRO round on Wednes­day — this is what investors are bit­ing their nails over: will it be 1 tril­lion euros or 'just' 300 bil­lion? Page M10 of Barron's dubs this the 'LTRO put', which "sparked a mas­sive risk-on rally in global mar­kets". Incred­i­ble how easy it is to avert a bear mar­ket why didn't the Fed do this in 2007 and 2008, sim­ply print money — and help us avoid the Great Recession?

What about the fun­da­men­tals? Well, let's have a look at earn­ings. It is com­pletely ironic that we would be expe­ri­enc­ing one of the most pow­er­ful cycli­cal upswings in the stock mar­ket since the reces­sion ended (the S&P 500 is now up 25% from the Octo­ber 3rd nearby low) at a time when we are clearly com­ing off the poor­est quar­ter for earn­ings, in every respect. The YoY trend in oper­at­ing [PS is now below 6%, and with­out Apple, growth has basi­cally van­ished alto­gether (down to a mere +2.8%). Cor­po­rate guid­ance over the past three months is at the low­est point since August 2009 — before the term 'green shoots' was invented! Only 44% of com­pa­nies beat their rev­enue tar­gets, the weak­est since the first quar­ter of 2010: and 64% sur­passed their profit esti­mates and this too is the low­est since the third quar­ter of 2008.

If mem­ory serves me cor­rectly, you did not want to go long the mar­ket head­ing into either the sec­ond quar­ter of 2010 or the fourth quar­ter of 2008 with these fac­toids in hand. I have to admit that I find it per­plex­ing as to why so many folks dub this a tech-led rally when we came off a week that saw both Hewlett– Packard and Dell dis­ap­point in their Q4 earn­ings results — the for­mer with a 7% YoY rev­enue dive.

All that said, the S&P 500 did man­age to close out the week at 1,365.74 and estab­lish a level not seen since June 5, 2008 (only 200 points shy of set­ting a new all-time high —Jeremy Siegel must be lick­ing his chops). If you are won­der­ing why it is that con­sumer sen­ti­ment jumped to 75.3 in Feb­ru­ary (bet­ter than the read­ing that was widely expected), this is the rea­son. The Uni­ver­sity of Michi­gan index does a much bet­ter job track­ing the equity mar­ket than it does the labour mar­ket or con­sumer spend­ing for that matter.

Page 13 of the week­end FT quotes a strate­gist as saying

"... we also had a com­bi­na­tion of a cou­ple of good earn­ings reports and lit­tle bright signs com­ing from the hous­ing and labour mar­kets. Some peo­ple are even talk­ing about the S&P 500 hit­ting the 1,400 mark."

Actu­ally, earn­ings growth and earn­ings esti­mates are going down on net. As is cor­po­rate guid­ance, what lit­tle of it there is. The bright signs from hous­ing are really a com­men­tary on the balmy weather skew­ing the sea­son­ally adjusted data and there is cer­tainly no sign of any recov­ery in prices (it's incred­i­ble how so many peo­ple get excited over a 321,000 new home sales tally — never mind that they are still near record lows in per capita terms). To be sure, the new hous­ing inven­tory is down to a six-year low of 5.6 months sup­ply, but tak­ing into account the sup­ply com­ing down the pike from fore­clo­sures, the entire back­log in the pipeline is at least dou­ble that posted number.

...

The pre­cious met­als mar­ket is hardly sig­nalling good times ahead — rather more tur­bu­lent times ahead — as gold fin­ished last week near a three-month high (sil­ver has been behav­ing even bet­ter and plat­inum has hit its best level in five months).

Mean­while, what is largely being ignored is the rapid move up in oil prices as Iran-based ten­sions esca­late fur­ther. The WTI crude price rose to nearly $110/bbl and more impor­tantly. Brent has soared over $125/bbl (high­est level since August 2008), and for­ward con­tracts are point­ing to gaso­line break­ing back above $4 a gal­lon in the next two to three months (already there in Cal­i­for­nia and within 10 cents in New York state). The nation­wide aver­age has already risen 37 cents in just the past month and 7 cents last week alone — it hasn't been long enough to show through in the con­fi­dence sur­veys, though let's face it, we are see­ing early signs already of some fray­ing at the edges in the retail sec­tor — despite the appar­ent improve­ment in the labour mar­ket (indeed, it is income that peo­ple spend, and growth on this front, let's be hon­est, has been less than stellar).

Mean­while, as if to rep­re­sent the con­sen­sus of opin­ion out there. page A2 of the week­end WSJ quotes a pun­dit as say­ing "$4 prob­a­bly isn't going to be the thresh­old that changes peo­ples' behav­ior this time. I think peo­ple have got­ten used to $4".

What clap­trap. Its not that peo­ple have got­ten used to $4 — it's only there in the Golden State, Hawaii and Alaska ... wait until it grips the whole coun­try. And con­sumers have yet to fully process this rapid move up in gas prices, but recall what hap­pened a year ago. To be sure, there was no reces­sion, but eco­nomic growth came to a vir­tual halt in the first half of the year because of the impact that energy costs exerted on the GDP price defla­tor. Sec­ond, it is not the level but the change in prices at the pump that influ­ences the growth rate of the econ­omy — every penny at the pumps siphons away around $1.5 bil­lion from con­sumer wal­lets into the gas tank. More­over, a lit­tle his­tory les­son for the pun­dit quoted above. Accord­ing to work con­ducted by the Uni­ver­sity of Cal­i­for­nia at San Diego and cited on page 14 of the week­end FT. all but one of the 11 post-WWII reces­sions fol­lowed an oil shock (the lone excep­tion was the 1960 down­turn). Recall what hap­pened the last two times Brent hit cur­rent lev­els — in 2008 (reces­sion) and 2011 (stall speed). Nei­ther out­come was very good.

The key is how long this ele­vated energy price envi­ron­ment sticks around in terms of over­all eco­nomic impact. Brent had already been hov­er­ing near $110/bbl for 12 months but this most recent price run-up has actu­ally taken the 200-day mov­ing aver­age higher now than it was in the 2008 reces­sion year. Let's keep in mind that the jump in crude prices has occurred even with the Saudis pro­duc­ing at its fastest clip in 30 years — under­scor­ing how tight the back­drop is. Even with slow­ing demand in the weak economies of the 'devel­oped world', con­tin­ued rapid growth in emerg­ing mar­kets is pro­vid­ing an off­set on the demand side (which does lit­tle good for the Amer­i­can or Euro­pean consumer).

Mean­while, esti­mates of spare capac­ity are all over the map but what we do know is that just to meet the bur­geon­ing demands of the emerg­ing mar­ket world requires a fur­ther 1 mbd this year of pro­duc­tion — and yet sup­plies are being with­drawn. It will not be very dif­fi­cult to see oil retest $150 a bar­rel, and we are talk­ing WTI here, not Brent.

...

It is also fas­ci­nat­ing to watch the action in the much-despised Trea­sury mar­ket (the net spec­u­la­tive short posi­tion on the 10-year 1-note is 63,328 con­tracts on the CBOT while the com­pa­ra­ble for Dow con­tracts is net long 14.803 con­tracts). Despite the slate of sup­ply last week ($99 bil­lion of new issue activ­ity) the yield on the 10-year T-note closed at 1.98%. Some­one out there (Bernanke?) is
com­ing in and buy­ing when­ever the yield pops above 2% — a level that sim­ply is not being sus­tained on appar­ent break-outs. The long bond yield actu­ally fin­ished the week lower in yield at 3.1% from 3.14% (the 10-year was down 2bps).

At a time when energy prices are spik­ing, this is a clear sign that the bond mar­ket is treat­ing this as a defla­tion­ary shock rather than a durable increase in infla­tion. That makes total sense to us. It's not as if global con­sump­tion is going up — even with higher auto sales, Amer­i­cans are spend­ing less time on the road: miles dri­ven are down 1% over the past year. And the IEA (Inter­na­tional Energy Agency) has cut its 2012 fore­cast for global oil demand twice since the begin­ning of the year. This is an exoge­nous sup­ply shock, pure and simple.

...

And now the con­sen­sus is that the reces­sion in the euro area will be mild because of one month's worth of dif­fu­sion indices. Such is human nature — extrap­o­late the most recent eco­nomic indi­ca­tor into the future. The region suf­fers from a credit shock, a fis­cal shock, and now an oil shock and at the same time, an over­val­ued cur­rency. What is the euro doing at an 11-week high and how does this help the region export its way out of its eco­nomic down­turn? Yet there are still a net short 137,479 spec­u­la­tive euro con­tracts on the CME, which could have a fur­ther impact as they cover in the near-term; there are 17,136 net long yen con­tracts and 29,101 net long spec­u­la­tive U.S. dol­lar contracts.

Brent crude oil hit a record high in euro terms (in Ster­ling as well) last week and has surged 11% in just the past month on this basis, and even if prices stay where they are, what energy is going to absorb out of Euro­zone GDP this year will be 5.5%, which would sur­pass the 2008 reces­sion shock of 4.8% (the high­est drainage from the econ­omy in three decades — see Soar­ing Oil Price Threat­ens Recov­ery on page 14 of the week­end FT).

...

The U.S. econ­omy is either gen­er­at­ing jobs in low-paying ser­vice sec­tor jobs or the employ­ment that is com­ing back home in man­u­fac­tur­ing is doing so at lower wage rates than when these jobs left for Asia years ago. So much for wage stick­i­ness. Throw in ris­ing gaso­line prices and real incomes are in a squeeze, and there is pre­cious lit­tle room for the per­sonal sav­ings rate to decline from cur­rent low lev­els. On a year-to-year basis, real after tax incomes are run­ning frac­tion­ally neg­a­tive and in the past that was either asso­ci­ated with an econ­omy in reces­sion, about to head into reces­sion or just com­ing out of reces­sion. So per­haps there is no con­trac­tion in real GDP just yet. but there is one in real incomes.

What else do peo­ple spend? Their wealth. And here too, cour­tesy of a flat equity mar­ket per­for­mance and renewed declines in home val­ues, house­hold net worth also con­tracted in the past year. So here we have real incomes and wealth both deflat­ing and the masses believe that reces­sion is off the table because of a liquidity-induced four-month rally in the stock mar­ket. Go figure.

Tags: All Time Highs, Bob Farrell, Central Banks, Central Planners, Chagrin, Daily Basis, David Rosenberg, Ditty, Economic Commentary, Economic Realities, Eight Months, Fund Flows, Gluskin Sheff, Inevitable Answer, Meltdown, Mortgage Market, Perils, S David, Stock Market, Vacuum Tubes
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Accessing Emerging Markets While Keeping Risk in Check

Sunday, February 26th, 2012

by Daniel Morillo, Ph. D, iShares

One of the most com­mon con­ver­sa­tions we’ve been hav­ing with clients recently relates to the trade­off between the upside poten­tial of an increased allo­ca­tion to emerg­ing mar­kets equi­ties and the addi­tional risk that such an invest­ment brings into an over­all port­fo­lio. Clients are becom­ing more inter­ested in emerg­ing mar­kets, yet they remain con­cerned about risk and how the ongo­ing Euro­pean finan­cial cri­sis and the U.S. polit­i­cal sit­u­a­tion will affect equity risk in general.

One poten­tial way to increase your emerg­ing mar­kets expo­sure while also keep­ing risk in your com­fort zone is by using a minimum-volatility approach to invest­ing in emerg­ing markets.

Minimum-volatility port­fo­lios, as I explain in this video, are designed to pro­vide expo­sure to a par­tic­u­lar mar­ket with lower risk than a tra­di­tional capitalization-weighted port­fo­lio. As might be expected, min­i­mum volatil­ity strate­gies may sac­ri­fice some upside dur­ing strong mar­ket ral­lies. What’s sur­pris­ing, though, is that over longer time peri­ods min­i­mum volatil­ity port­fo­lios have gen­er­ally been shown to deliver sim­i­lar return to their cap-weighted coun­ter­parts but do so with lower risk[1].

How can an investor take advan­tage of this fea­ture of min­i­mum volatil­ity port­fo­lios in the case of emerg­ing markets?

Con­sider, as a start­ing point, a port­fo­lio con­structed with a typ­i­cal 60%/40% allo­ca­tion split between stocks and bonds. Assume, in addi­tion, that the allo­ca­tion to emerg­ing mar­kets within the equity por­tion of the port­fo­lio is 10%, using a broad emerg­ing mar­kets bench­mark like the MSCI Emerg­ing Mar­kets Index. Over the last 10 years this 60/40 port­fo­lio would have deliv­ered an aver­age annu­al­ized return of 6.3% and annu­al­ized risk of 10.6%[2].

Base­line Port­fo­lio with 6.3% annu­al­ized return and 10.6% annu­al­ized risk

Now imag­ine swap­ping out the tra­di­tional cap-weighted emerg­ing mar­ket expo­sure for a minimum-volatility emerg­ing mar­kets strat­egy, for exam­ple the MSCI Emerg­ing Mar­kets Min­i­mum Volatil­ity Index[3]. How would the swap affect your port­fo­lio? Because the minimum-volatility expo­sure to emerg­ing mar­kets is less risky than the tra­di­tional cap-weighted expo­sure (19.3% vs. 24.4% over the last 10 years), this means that it is pos­si­ble to increase the allo­ca­tion to emerg­ing mar­kets while keep­ing the same total risk of the portfolio.

Port­fo­lio using min­i­mum volatil­ity emerg­ing mar­kets expo­sure with 9% annu­al­ized return and 10.6% annu­al­ized risk

In par­tic­u­lar, within the equity port­fo­lio it would be pos­si­ble to go from 10% cap-weighted expo­sure to emerg­ing mar­kets to about 40% minimum-volatility expo­sure to emerg­ing mar­kets while keep­ing to the same 10.6% total risk of the port­fo­lio over the last 10 years.

To com­pare, a 40% expo­sure to emerg­ing mar­kets within equi­ties in the form of a cap-weighted expo­sure such as the broad MSCI Emerg­ing Mar­kets Index would have resulted in annu­al­ized risk of about 12% over the same time period. That’s a sig­nif­i­cant increase over the orig­i­nal risk bud­get — 10.6% — of the base­line portfolio.

Access­ing equity expo­sure via minimum-volatility alter­na­tives can allow investors to take on more expo­sure to risky assets, includ­ing equi­ties, while keep­ing to a sta­ble risk bud­get.  A min­i­mum volatil­ity strat­egy could be com­pelling in the cur­rent envi­ron­ment, where equity risk remains a con­cern for many investors.

Index returns are for illus­tra­tive pur­poses only. Index per­for­mance returns do not reflect any man­age­ment fees, trans­ac­tion costs or expenses. Indexes are unman­aged and one can­not invest directly in an index. Past per­for­mance does not guar­an­tee future results.

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.

Asset allo­ca­tion may not pro­tect against mar­ket risk.

Tags: Annualized Return, Capitalization, Comfort Zone, Emerging Market, Equity Risk, Financial Crisis, Investing In Emerging Markets, Ishares, Market Exposure, Morillo, Msci Emerging Markets, Msci Emerging Markets Index, Political Situation, Portfolios, Stocks And Bonds, Strong Market, Time Periods, Tradeoff, Volatility, Weighted Portfolio
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Confused By The Market? Here Is What The Smart Money Is Doing

Sunday, February 26th, 2012

Want to get into the head of a hedge fund man­ager, and see how they view the mar­ket: why just buy Apple of course, how­ever good luck explain­ing to your LPs why you deserve 2 and 20 for "active asset man­age­ment" aka just fol­low­ing the herd into the biggest hedge fund hotel in his­tory (for at least 216 hedge funds it may be a tough sell). So for every­one else, Goldman's David Kostin (who still has a 1250 year end S&P tar­get — the defin­i­tive indi­ca­tor to sell every­thing will be when he too gives up) has com­piled the data in all the just released 13Fs and has sum­ma­rized the results as follows...

From Gold­man

Our most recent Hedge Fund Trend Mon­i­tor report ana­lyzed 674 hedge funds with $1.1 tril­lion of gross equity posi­tions con­sist­ing of $715 bil­lion of long single-stock and ETF equity assets and an esti­mated $383 bil­lion of short single-stock and ETF posi­tions. We have pub­lished our Hedge Fund Trend Mon­i­tor quar­terly for the past six years and ana­lyzed constituent-level port­fo­lio hold­ings of US hedge funds since 2001. The cur­rent report focuses on hedge fund posi­tions at the start of 1Q 2012 and is based on 13-F fil­ings as of Feb­ru­ary 15, 2012. We high­light 7 conclusions:

1. The typ­i­cal hedge fund oper­ates 46% net long ver­sus 36% in 3Q 2011. Aggre­gate net expo­sure equals $332 bil­lion. We esti­mate 17% of short posi­tion­ing is con­ducted via ETFs with 13% occur­ring at the index level.

2. Com­bin­ing long and short posi­tion data, hedge funds have the great­est net port­fo­lio expo­sure to Infor­ma­tion Tech­nol­ogy (21%), Con­sumer Dis­cre­tionary (20%), and Energy (14%). Hedge funds are not bench­marked but rel­a­tive to the Rus­sell 3000 uni­verse they are 800 bp over­weight Con­sumer Dis­cre­tionary (20% vs. 12%) and 750 bp under­weight Con­sumer Sta­ples (3.5% vs. 11.0%). Net expo­sure rose in every sec­tor in 4Q.

3. Turnover of all hedge fund hold­ings aver­aged just 28% dur­ing 4Q 2011, an all time low. The top quar­tile of posi­tions (largest hold­ings)  turned over just 14% while the bottom-quartile (small­est posi­tions) turned over 41%. Since 2001, quar­terly turnover of fund posi­tions aver­aged 35%, peak­ing in 4Q 2008 at 45% but falling steadily since. Turnover fell in 4Q in all sectors.

4. Hedge fund returns are highly depen­dent on the per­for­mance of a few key stocks. The typ­i­cal hedge fund has an aver­age of 64% of its long equity assets invested in its 10 largest posi­tions com­pared with 34% for the typ­i­cal large-cap mutual fund, 18% for a small-cap mutual fund, 20% for the S&P 500 and just 2% for the Rus­sell 2000 index.

5. Apple (AAPL) mat­ters. One out of five long/short hedge funds has AAPL among its ten largest long posi­tions and approx­i­mately 30% of  hedge funds own at least one share of AAPL. When it ranks among the top ten hold­ings, AAPL rep­re­sents an aver­age of 8% of single-stock long equity expo­sure. In aggre­gate, hedge funds own only 4% of AAPL equity cap. The aver­age hedge fund AAPL posi­tion equals 1.6%, given 70% of funds own no AAPL.

6. Five stocks have been in our VIP bas­ket since incep­tion in 2007 (18 quar­ters). AAPL, GOOG, MSFT, QCOM, and CVS have ranked among fundamentally-driven hedge funds’ top 10 hold­ings for more than 5 years. AAPL (+195%), QCOM (63%) and CVS (12%) out­per­formed the S&P 500 return of 4% dur­ing the same period. MSFT (-4%) and GOOG (-8%) lagged.

7. Turnover for the VIP bas­ket in 4Q 2011 was below the his­tor­i­cal aver­age. 12 new con­stituents entered the VIP bas­ket in 4Q 2011 com­pared with an aver­age quar­terly turnover of 17 stocks since 2001. New con­stituents include the fol­low­ing: BAC, DLPH, ESRX, HAL, HPQ, LMCA, MCD, PXD, PCLN, STX, TYC, and VIAB. The fol­low­ing stocks are no longer in the bas­ket: AMT, ABX, CHK, CMCSA, CCI, EMC, EXPE, HES, M, ORCL, PG, and WLP. Exhibit 50 on page 17 con­tains a list of all 50 cur­rent con­stituents in our VIP basket.

Tags: 3q, Consumer Staples, Current Report, Definitive Indicator, Equity Assets, Equity Positions, Fund Positions, Hedge Fund Manager, Hedge Funds, Index Level, Kostin, Portfolio Holdings, Position Data, Quartile, Russell 3000, S David, Short Position, Smart Money, Target, Tough Sell
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Outlook: Can Normalization in a Non-Normal Market Persist? (Alfred Lee)

Sunday, February 26th, 2012

Can Nor­mal­iza­tion in a Non-Normal Mar­ket Persist?

by Alfred Lee, Vice Pres­i­dent and Chief Invest­ment Strate­gist,
BMO ETFs and Global Struc­tured Invest­ments
alfred.lee[@]bmo.com

With­out ques­tion, equity mar­kets around the world are off to a good start in 2012 with a gen­eral rota­tion out of defen­sive areas and into more cycli­cal ori­ented themes. More impres­sive is the market’s abil­ity to shake off a num­ber of neg­a­tive head­lines already seen in the new year. These include credit rat­ing agency Stan­dard & Poor’s (S&P) recent move to down­grade a num­ber of Euro­zone coun­tries includ­ing France and fol­low­ing that up with the down­grade of the Euro­pean Finan­cial Sta­bil­ity Facil­ity (EFSF). Though lower credit rat­ings typ­i­cally results in higher bor­row­ing costs when bonds are auc­tioned, yields of the down­graded Euro­pean sov­er­eign bonds barely rose after the news. More­over, credit default swaps (CDS), or insur­ance against a default on sov­er­eign bonds, have actu­ally been trad­ing at lower prices since the news of the down­grades. This sug­gests that the moves by S&P were already priced-in, as the down­grades were largely con­sid­ered to be telegraphed to the mar­ket months ago. In addi­tion, the Euro­pean Cen­tral Bank’s (ECB) Long-Term Refi­nanc­ing Oper­a­tion (LTRO)¹ and the co-ordinated moves by the six cen­tral banks in Novem­ber to pro­vide cheaper swap bor­row­ing rates has largely removed the per­cep­tion of tail-risk² in the short term. Through the newly revised rules of the LTRO, the ECB allows banks to bor­row funds for three years by post­ing col­lat­eral, to which eli­gi­bil­ity require­ments have been relaxed sig­nif­i­cantly. Thus, the per­cep­tion of sol­vency of Euro­pean banks have been sig­nif­i­cantly improved, despite a num­ber French, Ital­ian and more recently Span­ish banks hav­ing been downgraded.

From a fun­da­men­tal per­spec­tive, we have con­sid­ered that most equity mar­kets around the world to offer attrac­tive val­u­a­tions over the last three months. Though we have reduced our “over­weight bonds” rec­om­men­da­tion intro­duced last August to “slightly over­weight” last month, we were still overly defen­sive in our allo­ca­tion in Jan­u­ary. While we remained largely favourable to U.S. equi­ties through­out 2011, which in hind­sight proved to be the right call, we have been wait­ing for momen­tum to return to Cana­dian stocks to avoid being caught in a value trap. The Dow Jones Indus­trial Aver­age (Dow), our top broad equity mar­ket pick in 2011, showed a return of pos­i­tive momen­tum in Octo­ber, break­ing out of its range-bound pat­tern and also recently reg­is­ter­ing a “golden-cross”³ pat­tern, early Jan­u­ary. The S&P/TSX Com­pos­ite Index (TSX), on the other hand, remained in a clear down­trend pat­tern since last March and has only recently bro­ken out of that trend. In our equity allo­ca­tion over the last year, we favoured more defen­sive ori­ented themes such as util­i­ties, REITs and low volatil­ity strate­gies. We con­tinue to favour these themes as longer term core invest­ments but given the strong mar­ket rally, we would use equity mar­ket pull­backs to tac­ti­cally rotate some equity expo­sure to higher beta⁴ areas, as defen­sive names may lag over the next sev­eral months.

What Lurks Beneath?

Last year, the U.S. Fed­eral Reserve (“Fed”) announced they would pledge to keep record low inter­est rates until 2013. Sev­eral weeks ago, in a sur­prise move, the Fed extended its com­mit­ment to low rates to 2014, which was largely rec­og­nized as an overly aggres­sive move, par­tic­u­larly con­sid­er­ing that U.S. eco­nomic data has been com­ing in bet­ter than expected in most cases. Nev­er­the­less, the move showed that the Fed is will­ing to take sig­nif­i­cant mea­sures to main­tain a risk-rally and the mar­ket now believes that there is a higher like­li­hood for fur­ther quan­ti­ta­tive eas­ing should the improve­ment in eco­nomic data lose momen­tum. As a result, over the next sev­eral months we believe an equity mar­ket rally may be pos­si­ble, despite risk assets look­ing very over­bought over the short-term. From a fun­da­men­tal per­spec­tive, global equity mar­kets are attrac­tive and short-term liq­uid­ity mea­sures may lead to a mul­ti­ple expan­sion in val­u­a­tions. How­ever, the many global macro-economic con­cerns that weighed on the mar­ket last year largely remain unre­solved and any polit­i­cal responses ques­tioned by the mar­ket could poten­tially cause a mar­ket sell-off. Sen­ti­ment indi­ca­tors such as the
CBOE/S&P Implied Volatil­ity Index (VIX) are cur­rently below his­tor­i­cal aver­ages but are finally showed some reac­tion to neg­a­tive news, sev­eral weeks ago. As a result, we rec­om­mend using pull backs and trail­ing stop-loss orders to real­lo­cate to equity mar­kets. Risk mit­i­ga­tion tools such as stop-loss orders are crit­i­cal given mar­gin debt lev­els remain exces­sive, which makes a delever­ag­ing event pos­si­ble should investor sen­ti­ment sour over the ongo­ing Euro­pean sov­er­eign debt saga.

Tags: Alfred Lee, Attractive Valuations, BMO, Canadian, Canadian Market, Central Banks, Chief Investment Strategist, Credit Default Swaps, Downgrades, ECB, Efsf, Eligibility Requirements, European Banks, Eurozone Countries, Financial Stability, Fundamental Perspective, Negative Headlines, Risk 2, Solvency, Sovereign Bonds, Spanish Banks, Structured Investments
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Eric Sprott: Investment Outlook (February 24, 2012)

Sunday, February 26th, 2012

Unin­tended Consequences

By Eric Sprott & David Baker

2012 is prov­ing to be the 'Year of the Cen­tral Bank'. It is an excit­ing cel­e­bra­tion of all the won­der­ful maneu­vers cen­tral banks can employ to keep the sys­tem from falling apart. West­ern cen­tral banks have gone into com­plete over­drive since last Novem­ber, con­ven­ing, col­lud­ing and print­ing their way out of the mess that is the Euro­zone. The scale and fre­quency of their maneu­ver­ing seems to increase with every pass­ing week, and speaks to the des­per­ate fragility that con­tin­ues to define much of the finan­cial sys­tem today.

The first major maneu­ver took place on Novem­ber 30, 2011, when the world's G6 cen­tral banks (the Fed­eral Reserve, the Bank of Eng­land, the Bank of Japan, the Euro­pean Cen­tral Bank [ECB], the Swiss National Bank, and the Bank of Canada) announced "coör­di­nated actions to enhance their capac­ity to pro­vide liq­uid­ity sup­port to the global finan­cial sys­tem".¹ Long story short, in an effort to avert a total col­lapse in the Euro­pean bank­ing sys­tem, the US Fed agreed to offer unlim­it­e­dUS dol­lar swap agree­ments with the other cen­tral banks. These US dol­lar swaps allow the other cen­tral banks, most notably the ECB, to bor­row US dol­lars from the Fed­eral Reserve and lend them to their respec­tive national banks to meet with­drawals and make debt pay­ments. The best part about these swaps is that they are lim­it­less in scope — mean­ing that until Feb­ru­ary 1, 2013, the Fed­eral Reserve is, and will be, pre­pared to lend as many US dol­lars as it takes to keep the finan­cial sys­tem from implod­ing. It sounds absolutely great, and the Euro­peans should be noth­ing but thank­ful, except for the tiny lit­tle fact that to sup­ply these unlim­ited US dol­lars, the Fed­eral Reserve will have to print them out of thin air.

Don't worry, it gets bet­ter. Since unlim­ited US swap lines weren't enough to solve the prob­lem, roughly three weeks later, on Decem­ber 21, 2011, the Euro­pean Cen­tral Bank launched the first tranche of its lauded Long Term Refi­nanc­ing Oper­a­tion (LTRO). This is the pro­gram where the ECB flooded 523 sep­a­rate Euro­pean banks with 489 bil­lion euros worth of 3-year loans to keep them going through Christ­mas. A sec­ond tranche of LTRO loans is planned to launch at the end of Feb­ru­ary, with expec­ta­tions for size rang­ing from 300 bil­lion to more than 1 tril­lion euros of uptake.² The good news is that Ital­ian, Por­tuguese and Span­ish bond yields have dropped since the first LTRO went through, which sug­gests that at least some of the ini­tial LTRO funds have been rein­vested back into sov­er­eign debt auc­tions. The bad news is that the Euro­zone banks may now be hooked on what is clearly a back-door quan­ti­ta­tive eas­ing (QE) pro­gram, and as the warn­ing goes for addic­tive drugs — once you start, it can be very hard to stop.

Britain is def­i­nitely hooked. On Feb­ru­ary 9, 2012, the Bank of Eng­land announced another QE exten­sion for 50 bil­lion pounds, rais­ing their total QE print to £325 bil­lion since March 2009.³ Japan's hooked as well. On Feb­ru­ary 14, 2012, the Bank of Japan announced a ¥10 tril­lion ($129 bil­lion) expan­sion to its own QE pro­gram, rais­ing its total QE pro­gram to ¥65 tril­lion ($825 bil­lion).⁴ Not to be out­done, in the most recent Fed news con­fer­ence, US Fed Chair­man Bernanke sig­naled that the Fed will keep inter­est rates near zero until late 2014, which is 18 months later than he had promised in Fed meet­ings last year. If Bernanke keeps his word, by the end of 2014 the US gov­ern­ment will have enjoyed near zero inter­est rates for six years in a row. Granted, extended zero per­cent inter­est rates is not nearly as sat­is­fy­ing as a proper QE pro­gram, but who needs tra­di­tional QE when the Fed already buys 91 per­cent of all 20–30 year matu­rity US Trea­sury bonds?⁵ Per­haps they're sav­ing tra­di­tional QE for the upcom­ing election.

All of this per­va­sive inter­ven­tion most likely explains more than 90 per­cent of the market's pos­i­tive per­for­mance this past Jan­u­ary. Had the G6 NOT con­vened on swaps, had the ECB NOT launched the LTRO pro­grams, and had Bernanke NOT expressed a con­tin­u­a­tion of zero inter­est rates, one won­ders where the equity indices would trade today. One also won­ders if the Euro­pean bank­ing sys­tem would have made it through Decem­ber. Thank good­ness for "coör­di­nated action". It does work in the short-term.

But what about the long-term? What are the unin­tended con­se­quences of repeat­edly juic­ing the sys­tem? What are the reper­cus­sions of all this money print­ing? We can think of a few.

First and fore­most, with­out con­tin­ued cen­tral bank sup­port, inter­bank liq­uid­ity may cease to func­tion entirely in the com­ing year. Con­sider the impli­ca­tions of the ECB's LTRO pro­gram: when you cre­ate a loan pro­gram to save the EU banks and make its par­tic­i­pa­tion vol­un­tary, every one of those 523 banks that par­tic­i­pates is essen­tially admit­ting that they have a prob­lem. How will they ever lend money to each other again? If you're a bank that par­tic­i­pated in the LTRO pro­gram because you were on the verge of bank­ruptcy, how can you pos­si­bly trust other banks that took advan­tage of the same pro­gram? The ECB's LTRO pro­gram has the poten­tial to be very dan­ger­ous, because if the EU banks start to rely on the loans too heav­ily, the ECB may find itself inad­ver­tently attached to the bro­ken EU bank­ing sys­tem forever.

The sec­ond unin­tended con­se­quence is the impact that inter­ven­tions have had on the non-G6 coun­tries' per­cep­tion of west­ern sol­vency. If you're a for­eign lender to the United States, Britain, Europe or Japan today, how com­fort­able can you pos­si­bly be in lend­ing them money? How do you lend to coun­tries whose sole basis as a going con­cern rests in their abil­ity to wran­gle cash injec­tions printed by their respec­tive cen­tral banks? Going fur­ther, what hap­pens when the rest of the world, the non-G6 world, starts to ques­tion the G6 Cen­tral Banks them­selves? What entity exists to bailout the finan­cial sys­tem if the mar­ket moves against the Fed or the ECB?

The fact remains that there are few rungs left in the finan­cial con­fi­dence chain in 2012, and cen­tral banks may end up push­ing their print­ing schemes too far. In 2008–2009, it was the banks that lost cred­i­bil­ity and required mas­sive bailouts by their respec­tive sov­er­eign states. In 2010–2011, it was the sov­er­eigns, most notably those in Europe, that lost cred­i­bil­ity and required mas­sive bailouts by their respec­tive cen­tral banks. But there is no lender of last resort for the cen­tral banks them­selves. That the IMF is now try­ing to raise another $600 bil­lion as a secu­rity buffer doesn't go unno­ticed, but do they hon­estly think that's going to make any dif­fer­ence?⁶

When review­ing today's macro envi­ron­ment, we keep com­ing back to the same con­clu­sion. The non-G6 world isn't blind to the efforts of the Fed and the ECB. When the Fed openly tar­gets a 2 per­cent infla­tion rate, for­eign lenders know that means they will lose, at a min­i­mum, at least 2 per­cent of pur­chas­ing power on their US loans in 2012. It there­fore shouldn't sur­prise any­one to see those lenders pil­ing into alter­na­tive assets that have a bet­ter chance at pro­tect­ing their wealth, long-term.

Tags: Bank Of Canada, Bank Of England, Bank Of Japan, Central Banks, David Baker, Debt Payments, Eric Sprott, European Banking System, Eurozone, Firs, Fragility, Global Financial System, Investment Outlook, Last November, Liquidity Support, Maneuvers, National Banks, Swiss National Bank, Thin Air, Unintended Consequences
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The Emotions of Fear and Apathy Create Good Buying Opportunities

Sunday, February 26th, 2012

The Emo­tions of Fear and Apa­thy Cre­ate Good Buy­ing Opportunities

By Frank Holmes
CEO and Chief Invest­ment Offi­cer
U.S. Global Investors

One of the most debil­i­tat­ing forms of human emo­tion isn’t anger, fear or sad­ness, it is apa­thy. Apa­thy can be defined by an “I don’t care” atti­tude, an indif­fer­ence to events and the world around them. Helen Keller once said: “We may have found a cure for most evils; but we have found no rem­edy for the worst of them all, the apa­thy of human beings.”

Over the past few years, an onslaught of oner­ous reg­u­la­tions, mar­ket volatil­ity and a lack of polit­i­cal lead­er­ship has pushed investor apa­thy to new highs.

Many of the new, “one size fits all” reg­u­la­tions are poorly thought out and haven’t received suf­fi­cient cost-benefit analy­sis. I’ve been dis­cussing this theme for sev­eral years and now it’s on the cover of The Econ­o­mist mag­a­zine this week. From the Patriot Act to Sarbanes-Oxley to Dodd-Frank, it appears we have wrapped a suf­fo­cat­ing amount of red tape around Amer­i­can busi­ness over the past decade, accord­ing to the magazine.

Even with good intentions—we need checks in place to pre­vent the next Enron or Bernie Madoff—the faulty design of some reg­u­la­tions has resulted in sev­eral unin­tended con­se­quences. Money is the lifeblood of the Amer­i­can econ­omy. A healthy econ­omy is depen­dent on money flow­ing freely. Busi­ness, like life, needs to cycle and cir­cu­late, or it declines. How­ever, the cost of com­pli­ance, in terms of dol­lars, time and resources, has clogged the arter­ies of Amer­i­can enter­prise. Exces­sive reg­u­la­tion is an injec­tion of cho­les­terol when the econ­omy needs a dose of Lip­i­tor to heal and grow stronger.

The Econ­o­mist uses the Vol­cker Rule as an exam­ple of unhealthy reg­u­la­tion. The rule, which is intended to limit pro­pri­etary trad­ing by banks, includes more than 1,400 ques­tions banks must answer in order to ver­ify com­pli­ance. This means that it would take one full year to assure com­pli­ance if a firm answered 27 of these ques­tions (four a day) each week. Instead of beef­ing up busi­ness, finance and research & devel­op­ment (R&D) depart­ments, busi­ness lead­ers are hes­i­tant to com­mit cap­i­tal because of uncer­tainty about how much they’ll need to allo­cate toward compliance.

If bur­den­some reg­u­la­tions are the bad cho­les­terol in the sys­tem, then tax breaks have acted as a stent, keep­ing the econ­omy alive. Remov­ing these stents and rais­ing taxes could spell car­diac arrest for the recovery.

Busi­ness own­ers aren’t the only ones feel­ing out of sorts; uncer­tainty sur­round­ing eco­nomic pol­icy has dispir­ited the gen­eral pub­lic. Accord­ing to a recent Barron’s arti­cle, an index mea­sur­ing economic-policy uncer­tainty from Stan­ford and the Uni­ver­sity of Chicago jumped to an all-time high toward the end of last year.

Investors need hope and a vision of coöper­a­tion and build­ing together. This is what we expe­ri­enced dur­ing the 1990s when Pres­i­dent Clin­ton stream­lined and dereg­u­lated indus­tries such as telecom­mu­ni­ca­tions and finan­cial ser­vices. Add in the Inter­net, a pub­lic gate­way to the world, and you had an econ­omy that boomed.

Today, a lack of faith and trust has dri­ven investors to the side­lines and halted the flow of cap­i­tal in the U.S. Accord­ing to the Invest­ment Com­pany Insti­tute (ICI), investors pulled more than $130 bil­lion from equity mutual funds dur­ing 2011. This rep­re­sents the second-largest with­drawal of funds in the past 25 years and is four times the amount with­drawn in 2010. The Barron’s arti­cle cites an Invest­ment News sur­vey that found just 43.6 per­cent of finan­cial advi­sors planned to increase their stock allo­ca­tions in 2012.

Find­ing a Solution

The arti­cle offers a solu­tion: The Econ­o­mist says “rules need to be much sim­pler” because “all-purpose instruc­tion man­u­als” get lost in an “ocean of ver­biage.” I agree. What makes the U.S. spe­cial is our entre­pre­neur­ial spirit, and we must adopt poli­cies that pro­mote pros­per­ity and effi­ciency in order to empower the world’s most inno­v­a­tive companies.

This dis­cus­sion is not intended to con­demn either polit­i­cal party or claim that all reg­u­la­tion is bad. Busi­ness, just like sports, needs ratio­nal ref­er­ee­ing in order to ensure a fair game is played. How­ever, we need to be care­ful that we don’t put more ref­er­ees on the court than players.

Rays of Sun­shine in the Market

Just like you wouldn’t spend a day on the golf course with­out sun­block, investors need to pro­tect them­selves. Think of these obser­va­tions as your sun­block and don’t step foot into global mar­kets with­out it.

Now that you’ve got some sun­block on, it’s time to go search­ing for rays of sun­shine in the mar­ket­place. All great bull mar­kets climb a wall of worry and one of today’s bright­est spots is the “Amer­i­can Dream Trade,” which can be found in emerg­ing economies. Designed to inject liq­uid­ity into the sys­tem and stim­u­late eco­nomic growth, a global liq­uid­ity boom that began in Decem­ber has ini­ti­ated the resur­gence of mar­kets around the globe. In total, 77 coun­tries have insti­tuted stim­u­la­tive mea­sures since late last year. With per capita GDP increas­ing and local mar­kets ris­ing, it is shap­ing up to look like a strong year for nat­ural resources.

A sec­ond dri­ver could be the recent improve­ment in investor atti­tudes, which can have a sig­nif­i­cant effect on mar­ket per­for­mance. Back in early Octo­ber, we dis­cussed how Citigroup’s Panic/Euphoria model, which mea­sures a com­bi­na­tion of nine facets of investor beliefs and fund man­agers’ actions, had been stuck in panic mode for months.

This was a sig­nal to us that mar­ket sen­ti­ment was des­tined to improve and lift share prices with it. Since then, the S&P 500 has jumped 18 per­cent and is cur­rently at lev­els not seen since before the credit cri­sis. Small caps have felt an even greater lift, ris­ing 26 per­cent over the same time period.

One of the rea­sons money has found its way back to the mar­ket is that low inter­est rates and a bub­ble in bonds have upped the attrac­tive­ness of equi­ties rel­a­tive to other asset classes. In fact, many large-cap equi­ties come with a higher yield. Cur­rently, 222 com­pa­nies (roughly 44 per­cent) of the S&P 500 are pay­ing div­i­dends at an annu­al­ized rate of at least 2 per­cent. This is greater than the yield on a 10-year gov­ern­ment note. This means that investors can wait for the growth, while receiv­ing the income.

Over­all, it looks like the market’s dark clouds are lift­ing and we could be in for a period of sunny skies in the months ahead.

Tags: American Economy, Apathy, Bernie Madoff, Care Attitude, Chief Investment Officer, Cost Benefit Analysis, Economist Magazine, Excessive Regulation, Faulty Design, Frank Holmes, Helen Keller, Human Emotion, I Don T Care, Lifeblood, Market Volatility, New Highs, Political Leadership, Proprietary Trading, U S Global Investors, Unintended Consequences
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