From Idiosyncratic to Idiotsyncratic. Greece and HY ETF’s (Tchir)

Thursday, May 17th, 2012

by Peter Tchir, TF Mar­ket Advisors

The idio­syn­cratic risk is really com­ing from two sources and the fact that at the mar­gin they col­lide is adding to the con­fu­sion and the volatil­ity in the market.

Right now the prob­lems in Europe are directly tied to Greece. Spain and Italy con­tinue to have prob­lems, and noth­ing is close to being resolved, but the real next cat­a­lyst in Europe is Greece. All this talk of a “Grexit” seems some­where between pre­ma­ture and dan­ger­ous. I think Greece is likely to leave at some point, but sev­eral things have to hap­pen before it can leave with­out caus­ing a tidal wave of destruc­tion across Europe and the global economies:

• Deter­mine what will hap­pen to the money owed to the ECB and the IMF. They too need to be rede­nom­i­nated at the very least, and pos­si­bly defaulted on in order for the new Greece to have a chance. What does that do for the rep­u­ta­tions of those two insti­tu­tions? How will the ECB make up for the loss? Will the IMF fire­wall remain intact after losses? Real issues that can­not be dis­missed, and address­ing some worst case, rather than best case reac­tions needs to be dealt with.
• Will Greece have the nat­ural resources stock­piled to sur­vive the imme­di­ate after effects? I see the risk of spik­ing energy costs as being one of the biggest risks. If the Drachma trades poorly against the Euro, and the Euro trades poorly against the dol­lar, how are peo­ple and busi­nesses going to be able to afford items that need to be imported. For all the bizarre ways in which the bailout has been done so far, Greece has the lux­ury of not being forced into an imme­di­ate deval­u­a­tion, so has time to pre­pare for some of the obvi­ous risks.
• Por­tu­gal, Spain and Italy. I don’t see any­thing in place that would stop these coun­tries from being imme­di­ately dragged down. Cur­rency con­trols and a force rede­nom­i­na­tion in Greece will scare peo­ple in these coun­tries. Cap­i­tal flight at all lev­els will become a big issue. Trade in Europe could grind to a halt. How will con­tracts with Greek com­pa­nies be dealt with. Peo­ple will assume the worst in other coun­tries and there is a real risk that trade dries up because even short term credit becomes com­pletely unavail­able. The ECB is likely to have to take unprece­dented actions such as guar­an­tee­ing repo lines, and even set­tle­ment risk.
• The EFSF incu­bates con­ta­gion. Now maybe the EU will real­ize what many of us have being say­ing all along. The EFSF (and ESM) ensures that con­ta­gion will spread. If the EFSF is to be a source of money for any­one (notwith­stand­ing its own losses on Greek loans), they will either be rely­ing on Span­ish and Ital­ian guar­an­tees, adding to the mis­ery in those two coun­tries, or, far worse, those coun­tries will become “step­ping out” mem­bers as well.
• Target2? Bank debt? Bank debt guar­an­teed by Greek cen­tral bank? So many other ques­tions, so few of which have been addressed.

I don’t know what will hap­pen if Greece leaves. I am not cer­tain that we will see con­ta­gion quickly spread and Europe grind to a halt, but that sce­nario, given the cur­rent level of prepa­ra­tion, and the pre­car­i­ous sit­u­a­tions in Spain and Italy, I find it impos­si­ble to believe politi­cians will ignore that risk in the end. The other issue here is that the enti­ties that you would nor­mally expect to see step in after a default, like the IMF, have already stepped in. The IMF, ECB, and EFSF, all of whom would be relied on to help after a big event, are already part of the big event. That is unusual and makes the sit­u­a­tion far more dif­fi­cult to con­tain.

The Greek drama will play out, but Grexit will not hap­pen yet, and both sides will find enough ways to claim vic­tory that some con­ces­sions will be made to give Europe and Greece more time to pre­pare. At this stage, that would be a big pos­i­tive for the mar­kets which right now are largely ignor­ing that most log­i­cal outcome.

You can­not men­tion idiot­syn­cratic risk with­out talk­ing about JPM. What­ever the trade was, in all of its iter­a­tions, it is clear that it got so big rel­a­tive to the liq­uid­ity in the mar­ket, that it was dri­ving prices. Too tight at one point in hind­sight, and pos­si­bly too wide right now, but that is yet to be deter­mined. Every part of the fixed income world is being affected by the alleged unwind. It really doesn’t mat­ter at this stage what posi­tion JPM has or doesn’t have. Whether they are unwind­ing or adding, whether they are being front run or not? The only thing that mat­ters is that liq­uid­ity has dried up. No one wants to be the other side of a trade if they think it can be part of some alleged mas­sive unwind. Liq­uid­ity, already lim­ited with every­thing going on in Europe basi­cally dis­ap­peared after the JPM announce­ment. The swings in CDS and now cash have been large. It takes very lit­tle trad­ing to move the mar­ket. At cer­tain prices, for what­ever rea­son, big vol­umes go through, but the gap to the next “clear­ing” level seems ran­dom and large.

You can­not ignore these moves, but being dragged around by a bat­tle that is occur­ring on a higher plane has its own risks. The mar­kets will revert quickly and in ways that don’t let you get back in if you want. Not one to say “close your eyes” and ignore it, but to some extent you have to “close your eyes” and ignore it. It is impos­si­ble to sep­a­rate out what is tech­ni­cal and spe­cific to the JPM from the usual tech­ni­cals. Games are being played and pic­tures are being painted on a scale that rarely occurs.

IG18 is trad­ing at fair value. IG17 is actu­ally trad­ing cheap to intrin­sic value. MAIN is trad­ing cheap as well. This means that the indices are trad­ing wider than their com­po­nents. Since part of the alle­ga­tions against the whale were that their trad­ing drove indices to trade extremely tight to fair value, that has over cor­rected (it can over cor­rect fur­ther, but that part of the prob­lem is now out of the mar­ket). To me, this is a clear sign that the desire to put on “liq­uid” hedges has got­ten more extreme and weak shorts are being cre­ated. Then look­ing at sin­gle name CDS ver­sus the cash bond mar­ket, and it looks like CDS has under­per­formed here as well. So sin­gle name CDS, another “hedge” vehi­cle has done worse than the cash, and the index has done even worse. We have again a typ­i­cal sit­u­a­tion where rather than sell­ing cash, some peo­ple have bought pro­tec­tion at prices wide rel­a­tive to bonds. That often ends in a big gap where either bonds under­per­form or CDS out­per­forms. I’m lean­ing towards CDS going tighter, but can­not dis­count the poten­tial for bonds to do worse.

Which brings us to HYG and JNK and their weak per­for­mance. There are two key dri­vers here and both are some­what strange. The ETF’s are effec­tively a rep­re­sen­ta­tion of the bond mar­ket and they tend to trade to either the “offer” side of the mar­ket in good times, or to the “bid” side of the mar­ket in bad times. What does that mean? It is rel­a­tively safe to say that the aver­age high yield bond is quoted in 1 point mar­kets. So if a bond was quoted as 98–99, in a strong mar­ket, the ETF tends to trade closer to the “99″ price as the offer get­ting “lifted” is the likely trade. As the cash mar­ket weak­ens, two things tend to hap­pen. The one is obvi­ous, the price drops, the other is that the bid/offer spread also widens. So this same bond that was quoted 98/99 will now be 97/98.5. In spite of the bid drop­ping faster than the offer, that is the more likely side to be exe­cuted on, so the ETF, reflect­ing mar­ket sen­ti­ment, will drift to the bid side, and now reflect a “97″ level. So the ETF could drop 2 points while the fair value, based on “mids” only dropped 0.75%. This move, while large, is as much a func­tion of how high yield bonds trade as it is a reflec­tion of real weak­ness. Remem­ber the ETF’s are only a proxy for the under­ly­ing mar­ket, so this move from the offer to bid side explains a lot of the rel­a­tive weak­ness of the ETF’s.

I’m see­ing both HYG and JNK trade “cheap” to fair value. They are trad­ing at a dis­count. That means the “reverse arb” comes into play, which can put added pres­sure on the ETF’s. It doesn’t sur­prise me, that JNK which gen­er­ally is more lenient on the share redemp­tion (and cre­ation) process is expe­ri­enc­ing more out­flows than HYG, because the arbs will focus on it.

Be care­ful, but also don’t for­get, that although we get lulled into a sense of liq­uid­ity in the ETF’s, at some level, the poor liq­uid­ity and wide bid offers in the under­ly­ing bond mar­ket come into play, and we are see­ing that now.

I think the U.S. credit mar­kets are attrac­tive, I con­tinue to like them, and am look­ing at adding more. I am not sure the time is right, but the price action in the U.S. is start­ing to become encour­ag­ing, and I’m see­ing some signs that the whale feed­ing frenzy is over, which is encour­ag­ing. I would like to see some more evi­dence that Europe under­stands they aren’t ready to kick Greece out and that they will lose more than Greece, but for the first time, I’m see­ing much more bal­anced com­ments and not every­one is on the Grexit bandwagon.

Tags: Bailout, Capital Flight, Catalyst, Currency Controls, Devaluation, ECB, Energy Costs, ETF, Global Economies, Hy, Idiosyncratic Risk, Imf, Natural Resources, Portugal Spain, Redenomination, Reputations, Tidal Wave, Volatility, Wave Of Destruction, Worst Case
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Do Emerging Markets Win, Place or Show in Your Portfolio?

Monday, May 7th, 2012

Do Emerg­ing Mar­kets Win, Place or Show in Your Portfolio?

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

Since the stock market’s gate opened at the begin­ning of 2012, emerg­ing coun­tries were off to a fast start. Stocks in Brazil, Colom­bia and India gal­loped to the lead, increas­ing more than 10 per­cent within the first few weeks of the year.

By the time the end of April came around, Colom­bia had sprinted to the lead, fol­lowed closely by Thai­land and the Philip­pines. All increased more than 20 per­cent in the first four months of 2012.

How­ever, rather than focus­ing on the lead­ers of the pack, spec­ta­tors seemed to have directed their atten­tion toward the S&P 500 Index, as it gal­loped to its best first-quarter gain since 1998.

The recov­ery in U.S. stocks is sig­nif­i­cant and helps restore con­fi­dence in equi­ties. We’re pleased to see mar­kets improv­ing, espe­cially fol­low­ing a rough fin­ish in 2011. Yet there lingers a per­sis­tent neg­a­tiv­ity toward emerg­ing mar­kets growth and com­modi­ties that pre­vents many investors from jock­ey­ing their port­fo­lios into a posi­tion for growth. Rather, they remain spec­ta­tors on the side­lines, with equity fund out­flows continuing.

In con­trast, East­ern Europe exploded on the upside and far out­paced not only the U.S. mar­ket, but also Europe. The chart below shows invest­ment results across three dif­fer­ent mar­kets. Since the begin­ning of the year through April 30, the iShares S&P Europe 350 ETF has trailed, while the SPDR S&P 500 ETF has placed sec­ond. Among these three invest­ments, the East­ern Euro­pean Fund (EUROX) has kept the lead for most of the quar­ter and took first place as of April 30.

You can see above that EUROX and the Euro­pean mar­ket were climb­ing steadily since the begin­ning of the year, but by April, began to fall because of the eurozone’s debt grief and con­cerns over China.

Over the past four months, Russ­ian stocks, which are heav­ily weighted in energy com­pa­nies, have under­per­formed many emerg­ing mar­kets, increas­ing only about 6 per­cent. HSBC Global Research believes that the low val­u­a­tions seem to be “pric­ing in a lot of polit­i­cal risk” sur­round­ing the protests against Russia’s newly elected pres­i­den­tial can­di­date. Investors need to see the oppo­si­tion move­ments against Vladimir Putin as very dif­fer­ent from the Mid­dle East dis­con­tent, says HSBC. The firm says Russia’s protests are “largely lib­eral” with­out “reli­gious dimen­sion” which sug­gest future reforms to reduce the polit­i­cal dis­con­tent are more likely.

HSBC also thinks that the gov­ern­ment will try to improve the invest­ment cli­mate. Putin sug­gested in a recent speech that he would like to increase Russia’s rat­ing in the World Bank’s Ease of Doing Busi­ness report. Cur­rently, Rus­sia ranks 120th; Putin would like to set a goal of 20th place.

What may be hurt­ing investor sen­ti­ment toward Rus­sia in the short term is the polit­i­cal strain that has recently sur­faced between Rus­sia and the U.S. and NATO involv­ing mis­sile defense instal­la­tions in Europe. This is pre­cisely the rea­son we believe investors need to hold actively man­aged invest­ments with experts who under­stand the polit­i­cal sit­u­a­tion to skill­fully maneu­ver around emerg­ing Europe.

China, the Work­horse of the Global Economy

While China did not win, place or show among major mar­kets dur­ing the first few months of the year, its H shares gained nearly as much as the S&P 500. Yet, the neg­a­tiv­ity that I’ve fre­quently dis­cussed con­tin­ues, even though the coun­try is the Clydes­dale of our global econ­omy.
In the first quar­ter, China’s GDP growth was 8.1 per­cent, a likely trough for the year, accord­ing to a Mer­rill Lynch-Bank of Amer­ica con­fer­ence call recently. The firm listed sev­eral rea­sons that China will see an improved GDP over the next three quarters:

1. Although spring made an early appear­ance in many parts of North Amer­ica, this past win­ter in China was the cold­est in 27 years. This extremely chilly weather slowed down eco­nomic activity.
2. Credit growth has bot­tomed out and bank lend­ing has been reac­cel­er­at­ing. BCA Research echoed this thought in its China Invest­ment Strat­egy this week, say­ing there’s been a “sharp turn­around in bankers’ con­fi­dence in recent months, which is also being reflected in ris­ing bank lend­ing of late.”

1. Home devel­oper price cuts and lower mort­gage rates offered to first-time buy­ers have dri­ven a sig­nif­i­cant recov­ery in home sales. In our recent web­cast on China, Andy Roth­man from CLSA made some excel­lent com­ments related to mort­gages, agree­ing with ML-BofA, say­ing that each month it was get­ting eas­ier for new home buy­ers to get mort­gages, and along with lower inter­est rates for mort­gages, this was a clear sign of “the government’s process of eas­ing up on the hous­ing sector.”
2. With lead­er­ship tran­si­tion close to con­clu­sion, local infra­struc­ture con­struc­tion activ­ity is poised to increase.
3. As shown below, crude steel, steel prod­ucts and cement out­put has shown ini­tial signs of recov­ery in the recent month.

While China’s Gov­ern­ment Pur­chas­ing Man­agers’ Index (PMI) for April came in slightly below mar­ket con­sen­sus, the num­ber remains above the three-month num­ber for the fifth con­sec­u­tive month since Decem­ber 2011. We believe the government’s PMI is a far bet­ter indi­ca­tor of over­all man­u­fac­tur­ing activ­ity than the HSBC data because it takes into account domes­tic demand.

From the PMI’s incep­tion in Jan­u­ary 2005, the major­ity of the time the PMI is above the three-month aver­age, Chi­nese and U.S. stocks, as well as cop­per and WTI crude oil, all see gains over the fol­low­ing three months. So far this year, each has proved true.

BCA Research says that the lat­est PMI sub­stan­ti­ates that the “Chi­nese econ­omy may be reac­cel­er­at­ing,” point­ing to three trends: Mon­e­tary eas­ing is work­ing, exter­nal demand seems strong and may be accel­er­at­ing, and the gov­ern­ment has increased fis­cal expen­di­tures on social hous­ing and infra­struc­ture projects, which is sup­port­ive of ML-BofA’s view above.

The race in the stock mar­ket isn’t over until it’s over. While a top con­tender may ulti­mately win in the Run for the Roses, the assumed “long shot” might come from behind and race to first place. Rather than place all your money on the mar­ket you believe will win, place or show, we believe diver­si­fi­ca­tion among mar­kets is the way to go.

Which coun­tries are you bet­ting on to top mar­kets in 2012? Email us at editor@usfunds.com.

See Our Pop­u­lar Peri­odic Table of Emerg­ing Markets.

Expense ratios as stated in the most recent prospec­tus. Per­for­mance data quoted above is his­tor­i­cal. Past per­for­mance is no guar­an­tee of future results. Results reflect the rein­vest­ment of div­i­dends and other earn­ings.  Cur­rent per­for­mance may be higher or lower than the per­for­mance data quoted. The prin­ci­pal value and invest­ment return of an invest­ment will fluc­tu­ate so that your shares, when redeemed, may be worth more or less than their orig­i­nal cost. Per­for­mance does not include the effect of any direct fees described in the fund’s prospec­tus (e.g., short-term trad­ing fees of 2.00%) which, if applic­a­ble, would lower your total returns. Per­for­mance quoted for peri­ods of one year or less is cumu­la­tive and not annu­al­ized. Obtain per­for­mance data cur­rent to the most recent month-end at www.usfunds.com or 1–800-US-FUNDS.

For invest­ment objec­tive and risks regard­ing the SPDR S&P and the S&P Europe 350 ETFs, see the “Addi­tional Dis­clo­sures” sec­tion at the bottom.

Tags: Chart Below Shows, Chief Investment Officer, Eastern Europe, Emerging Markets, Equity Fund, ETF, Eurox, Eurozone, Four Months, Frank Holmes, Investment Results, Ishares, Leaders Of The Pack, Negativity, Russian Stocks, S Market, Sidelines, Spdr, Spectators, U S Global Investors
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The Danger of HY ETF’s Trading at Discounts to NAV

Wednesday, April 11th, 2012

by Peter Tchir, TF Mar­ket Advisors

Alcoa helped the mar­kets bounce back after the close, and some indi­ca­tions that the ECB may start buy­ing bonds again helped the mar­ket even more. One company’s earn­ings don’t make a trend, and I am still con­cerned that earn­ings will be mediocre at best. Span­ish bonds are already off their highs, and CDS never really moved on the back of the ECB sto­ries. I remain skep­ti­cal that any­thing mean­ing­ful will be done, and now that we have the “ECB” rally out of the way, I expect to see the weak­ness resume. In the TFMkts Best Ideas which went out ear­lier, we liked adding to shorts this morning.

The fact that the High Yield ETF’s are trad­ing at a dis­count should be a big con­cern to any­one in the high yield mar­ket, not just those who own the ETF. There is a real risk that this dis­count can trans­late into arb activ­ity which leads to fur­ther declines.

With the ETF’s trad­ing at a dis­count, the trade would be to sell bonds in the mar­ket and to buy shares. They would then deliver the shares to the ETF providers as a “redemp­tion” and take the bonds to cover the ones they shorted. Although this has the appear­ance of being risk neu­tral, my expe­ri­ence is that it can become a big dri­ver. I also don’t think many HY bond traders or ETF desks have seen this sce­nario play out in the credit mar­kets. We saw a bit of it on the way up, many of the shares the ETF’s “cre­ated” were for ETF arb clients, but on the way up, where those par­tic­i­pants were buy­ing bonds, no one seemed to care much. In a down­side sce­nario it can be far worse.

I will walk through a rough exam­ple of what used to hap­pen in CDS with “index” arb, and I don’t see what it wouldn’t apply to the ETF’s if they remain at a discount.

Assume there are two vir­tu­ally iden­ti­cal com­pa­nies and most of the time their CDS trades roughly in line. Then one day you notice that over the past week, both went from trad­ing at about 90, to one trad­ing at 100, and the one that is in the index trad­ing at 110. Many accounts will look at this and deter­mine that it doesn’t make sense. They may sell pro­tec­tion on the name at 110 think­ing the mar­ket has moved “too far too fast”. They may put a “pairs” trade on and buy the one at 100 and sell the other at 110. Nei­ther are bad trades, but what they have missed, is the over­all weak­ness in the mar­ket (that saw even the non index name to move 10 bps wider) has been priced into the CDX indices. They are say trad­ing at 115, in spite of fair value being 110 for exam­ple. They tend to trade “rich” or “cheap” to fair value based on mar­ket sen­ti­ment. Hedgers in par­tic­u­lar like to be “tem­porar­ily” short the liq­uid index, while retain­ing spe­cific (and usu­ally less liq­uid) credit bets.

The “index arb” clients will come in and pay 110 for the “index” name, while sell­ing the index at 115 (it is more com­pli­cated than that, but that is the basic premise). The “arb” trader doesn’t care if 110 is a “good” or “fair” price for that CDS, they only care that they can buy all the names in the index at a spread tighter than where they can sell the index. That is it. They have no inter­est in buy­ing the name that trades at 100. They only care about the rich­ness or cheap­ness of the index ver­sus the sin­gle names.

What tends to hap­pen next, is hard to explain, but seems to hap­pen all the time. The sin­gle name traders who sold pro­tec­tion feel­ing it had gone too far, start hav­ing dif­fi­culty find­ing sell­ers to take the other side. They are get­ting long credit risk. What do they do? They buy pro­tec­tion on the index because some­how it makes them feel bet­ter than just clos­ing out their posi­tion. Effec­tively sin­gle name desks put on the oppo­site trade as the arbs. Doesn’t make sense, but hap­pens all the time. So by buy­ing the index as a hedge, they ensure that it con­tin­ues to trade cheap, mean­ing that the index arbs will be back to buy more of the sin­gle name.

But why won’t oth­ers sell that name or put on the pairs trade? The prob­lem here is that the spread between the index and non index name con­tin­ues to widen. So after some decent sized arbs go through, the names now trade at 105 and 120. Any­one who sold at 110, think­ing to make 10 to 20 bps, just lost 10 bps. What is the prob­a­bil­ity that a) they add more, b) they sit tight, or c) they get stopped out on some? I can almost guar­an­tee that option a is the low­est prob­a­bil­ity. Sim­i­larly, any­one who put on the “pairs” trade at 10 bps, is now down 5 bps since the spread is 15 (and that ignores bid/offer). These peo­ple are more likely to add to the posi­tion, but even there, peo­ple start get­ting ner­vous that there is some­thing really wrong with the one com­pany. That fear creeps in. In credit, being wrong means instead of earn­ing 1.1% per annum you lose 60%. That fear, whether ratio­nal or not, makes it dif­fi­cult to find sell­ers of protection.

So the “cheap­ness” of the index feeds on itself and cre­ates a feed­back loop that dri­ves all spreads wider. The index names get hit the worst, but every­thing moves. It doesn’t end usu­ally until the index is at a level that new entrants come into the mar­ket to sell the index, which is not only at a good level, but very cheap to fair value.

I am very con­cerned that this same process can occur in the HY bond mar­ket and liq­uid­ity, as bad as it is in a strong mar­ket, is far worse in a down mar­ket. As of yet there is no sign that this is hap­pen­ing in a mean­ing­ful way, but JNK has seen out­flows for a few days and HYG saw out­flows yes­ter­day.

Copy­right © TF Mar­ket Advisors

Tags: Alcoa, Appearance, Arb, Bond Traders, Bonds, Credit Markets, Declines, Desks, Downside, Earnings, ECB, ETF, high yield, Hy, Participants, Rally, Redemption, S Trading, Tf, Trades
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Rotation (Research Puzzle)

Thursday, April 5th, 2012

by Research Puz­zle

Those investors known as sec­tor rota­tors try to judge the most attrac­tive parts of the mar­ket and weight their port­fo­lios accord­ingly.  Often they do so based upon their assess­ment of where we are in the eco­nomic or mar­ket cycle, as a sim­ple Google search on the term will demonstrate.

The “how” of it varies from man­ager to man­ager, with some being index hug­gers and oth­ers will­ing to have more con­cen­trated bets.  Many of the man­agers have got­ten much more global in the last cou­ple of decades, so the amount of cur­rency risk is another fac­tor to consider.

Inter­est­ingly, the stan­dard reports of many data providers (and those of in-house sys­tems) use those same sec­tors, whether the man­ager is a sec­tor rota­tor or not, which sets up lines of cod­i­fi­ca­tion that affect deci­sion mak­ing that most peo­ple don’t think much about.

In any case, the chart above shows the rel­a­tive per­for­mance of three of the domes­tic sec­tors since the end of 2009, as rep­re­sented by their ETFs.  Energy (XLF) has been under pres­sure of late, while tech­nol­ogy (XLK) has done well (on the back of AAPL espe­cially).  The con­sumer sta­ples (XLP) have lagged the strong mar­ket so far this year.

It’s quite an inter­est­ing pic­ture, with all three close to where they began.  No one said this was easy.  (Chart:  Bloomberg terminal.)

Tags: Aapl, Bets, Codification, Consumer Staples, Currency Risk, Data Providers, Decades, Domestic Sectors, ETF, ETFs, Google, Google Search, Huggers, Investors, Nbsp, Portfolios, Puzzle, Relative Performance, Strong Market, Xlf, Xlk
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Shifting Focus: Behind Country Valuations Today

Thursday, April 5th, 2012

by Russ Koes­terich, iShares

As the Euro­pean finan­cial cri­sis raged last fall, investors were closely mon­i­tor­ing met­rics like credit default swaps and yields on Ital­ian bonds to deter­mine where to place their coun­try bets.

But 2012 has brought some sta­bil­ity to the euro­zone and with it we’ve noticed a shift in the types of indi­ca­tors that investors should be track­ing when it comes to deter­min­ing coun­try val­u­a­tions — met­rics that show eco­nomic growth.

Yes, investors have always kept an eye on eco­nomic growth by track­ing met­rics like lead­ing indi­ca­tors, retail sales and indus­trial pro­duc­tion. But what Nelli Oster, an invest­ment strate­gist on my team, has noticed is that over the last six months, the sen­si­tiv­ity of coun­try val­u­a­tions to eco­nomic growth expec­ta­tions has intensified.

Per­haps six months ago investors were too con­sumed by wor­ries over Euro­pean sol­vency to focus on eco­nomic growth. But today, that appears to have changed as those wor­ries have less­ened and as eco­nomic growth has become more var­ied and harder to find.

Nelli’s research shows that the coun­try val­u­a­tions have become more sen­si­tive to how the near-term growth prospects for a coun­try com­pare to past trends. Take China as an exam­ple. In early March, the Chi­nese gov­ern­ment mod­estly low­ered its annual growth tar­get to 7.5% from 8%. While that is still a very healthy pace com­pared to the devel­oped world, it left investors more wor­ried about a slow­down in China — and the MSCI China index fell 6.9% in US dol­lars in March.

Nelli has also found that the val­u­a­tions of devel­oped mar­ket coun­tries have become more sen­si­tive to absolute growth lev­els, or how the near-term growth pro­jec­tion for a devel­oped coun­try com­pares to those for other devel­oped mar­kets. The growth pro­jec­tions Nelli ana­lyzed were gar­nered from lead­ing indicators.

She also noted that there’s more vari­a­tion in growth rates. Coun­tries such as the United States, Mex­ico and Japan are expected to grow faster rel­a­tive to their past trends than six months ago, while prospects for coun­tries such as Italy and Bel­gium have dete­ri­o­rated. As growth is more dif­fi­cult to find, investors seem will­ing to pay a larger pre­mium to access it.

For investors, the inten­si­fied empha­sis on growth means that in com­ing months, faster grow­ing coun­tries will likely be rewarded with higher returns, and the dif­fer­ence in returns between faster grow­ing coun­tries and slower grow­ing ones will likely stay elevated.

Of coun­tries expected to fare well rel­a­tive to their past growth trends – also tak­ing into account val­u­a­tions, cor­po­rate sec­tor prof­itabil­ity and risk­i­ness – I hold over­weight views of Nor­way and Rus­sia. Of coun­tries expected to slow down fur­ther, I hold under­weight views of Italy and India (poten­tial iShares solu­tions: AMEX: ENOR, NYSEARCA: ERUS).

Sources: Bloomberg, Worldscope

Dis­clo­sure: Author is long ERUS

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. Secu­ri­ties focus­ing on a sin­gle coun­try may be sub­ject to higher volatility.

Tags: China, Chinese Government, Credit Default Swaps, Developed Country, Economic Growth, ETF, ETFs, Eurozone, Growth Expectations, Growth Projection, Growth Projections, Growth Prospects, Growth Target, India, Investment Strategist, Ishares, Leading Indicators, Market Countries, Metrics, Mining, Msci China Index, Russia, Shifting Focus, Slowdown, Solvency, Valuations
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Are Stocks Giffen Goods? (Tchir)

Tuesday, April 3rd, 2012

by Peter Tchir, TF Mar­ket Advisors

So when will retail investors start buy­ing stocks? One of the final legs prop­ping up this rally is the belief that retail investors will finally pile into stocks. There is hope that all this “money on the side­lines” will find its way into the stock mar­ket. The S&P at 1,350 was sup­posed to do the trick. Cer­tainly 1,400 on the S&P was going to be enough to chase retail investors into stocks. Basi­cally the argu­ment that retail will capit­u­late and finally invest in stocks is based on the assump­tion that higher prices increase demand – aka, a Gif­fen Good.

Is it real­is­tic to assume that investors will decide to pur­chase more of some­thing just because the price has gone up? They did it in 2000 with inter­net stocks, that infat­u­a­tion ended badly. They did it with hous­ing in the mid 2000′s, which ended even worse. If any­thing, Amer­i­cans have become more focused on buy­ing things on sale and get­ting things at a bar­gain. Why shouldn’t that apply to stocks as much as it applies to any­thing else?

We have hit multi year highs, yet most peo­ple seem to shrug it off. If the retail investor was about to increase their allo­ca­tion to stocks, do you not think there would be more hype in the media about how well stocks have done? Expect­ing “the masses” to buy just because some­thing is already up 20% seems a lit­tle silly, if not down­right arro­gant. The retail investors are not stu­pid. They can also see that the stock mar­ket has decou­pled from the econ­omy. While pro­fes­sional investors can eas­ily accept that, retail investors still have some level of con­vic­tion that the stock mar­ket should reflect eco­nomic activ­ity and not just cen­tral bank print­ing and gov­ern­ment spend­ing. Retail investors can see that the U.S. debt has con­tin­ued to grow and that in spite of lip ser­vice to deficit reduc­tion, we are cre­at­ing a big­ger deficit. They are ner­vous about what will hap­pen when finally the spend­ing gets pulled in. They are also very ner­vous (as are many pro­fes­sional investors) that they will be the last pur­chase of stocks before the cen­tral banks stop pump­ing fresh money into the sys­tem in their never end­ing attempt to inflate asset prices.

If there is one sec­tor where the upward price move­ment is suck­ing in more money it is amongst cor­po­ra­tions them­selves. The num­ber and size of buy­back announce­ments seems to be increas­ing. That makes sense, since if any group has shown an abil­ity to buy high and sell low, it is cor­po­ra­tions them­selves. In 2007 and the first half of 2008, com­pa­nies, includ­ing AIG, were buy­ing back their own stock aggres­sively. From the sec­ond half of 2008 and all of 2009, most com­pa­nies couldn’t afford to buy back shares and many had to issue. It is just wrong to expect indi­vid­u­als to be as friv­o­lous with their money as cor­po­ra­tions are.

I con­tinue to believe that retail is rea­son­ably allo­cated to equi­ties, under the new allo­ca­tion model. The new allo­ca­tion model takes into account debt before deter­min­ing what is investible. Then there is an actual allo­ca­tion to ultra-safe “rainy day” money. That “investible” money is then allo­cated at a much more real­is­tic per­cent­age to equi­ties and fixed income and “other invest­ments”. A myr­iad of new invest­ment vehi­cles have helped make it eas­ier for investors to par­tic­i­pate in the fixed income mar­ket and other asset classes, help­ing to ensure that the allo­ca­tion to those remains higher than it was through the 90′s and the first part of this century.

I do not believe stocks are a Gif­fen good, at least when it comes to retail, so expect­ing “dumb” money to come in and take out the “smart” money may be just as para­dox­i­cal as a Gif­fen good.

The mar­ket is a lit­tle weaker again this morn­ing, so I bet­ter type quickly, since the “Europe went home” rally now starts before Europe goes home.

Chi­nese ser­vice PMI came in strong, but no one really cares about China as a ser­vice econ­omy, so that news was largely shrugged off.

Euro­zone PPI came in slightly higher than expected and last month was revised slightly higher as well. Noth­ing too earth shat­ter­ing, but ris­ing infla­tion with falling employ­ment makes for a very bad combination.

Span­ish bond yields are once again under pres­sure – as they should be. Italy is also feel­ing weaker again. In 10 years Spain is back to 5.40% and Italy is at 5.15%, out by 5 and 7 bps respec­tively. We have seen sup­port, whether nor­mal mar­ket sup­port, or cen­tral bank pur­chase sup­port around the 5.20% and 5.45% lev­els in the past few days, so need to keep a close eye on these lev­els. Spain is under­per­form­ing more notice­ably in the 5 year sec­tor, but still trades at 4.19% com­pared to Italy at 4.32%. Yes, Spain yields more in 10 years than Italy, but less in 5 years. Span­ish 5 year CDS is at 436, but Ital­ian 5 year CDS is at 388. So the 5 year bond inver­sion is clearly an anom­aly and a func­tion of sup­ply and demand and an obvi­ous sign of how inef­fi­cient bond prices are. There are so many “tech­ni­cals” at work in the bond mar­ket that it is extremely hard to sep­a­rate what part of price is reflect­ing risk as per­ceived by the mar­ket and what part is influ­enced by other non mar­ket fac­tors. That is one rea­son CDS is so pop­u­lar – it is fun­gi­ble and not con­strained by who holds what issue.

CDS indices are all a lit­tle bit bet­ter today. Euro­pean ones were largely catch­ing up to the after­noon move tighter here. IG18 is trad­ing even richer to fair value. This shows a lack of con­vic­tion in the rally by the mar­ket as a whole since it looks like investors want to set their longs in the most liq­uid prod­uct giv­ing them the great­est abil­ity to exit if nec­es­sary. At 7 bps rich with a spread of 90, investors are over­pay­ing for that liq­uid­ity. Look for IG18 to con­tinue to lag.

Other anec­do­tal evi­dence of this ten­ta­tive con­vic­tion can be seen in the bond mar­kets, where once again, new issue trad­ing is dom­i­nat­ing daily flows. Investors have their core longs in bonds, add beta via the index, and look for alpha on new issue allo­ca­tions and flip­ping. While not bad in of itself, it is not a sign of a truly healthy mar­ket. The ETF’s con­tinue to get some inflows, but the pace has slowed dra­mat­i­cally and much of it can be accounted for by div­i­dend re-investment and “arb” activ­ity. While the ETF’s remain at a pre­mium, “arbs” are buy­ing the bonds that the ETF is will­ing to accept and exchang­ing them for new shares, which they then sell into the mar­ket. That form of share cre­ation is far less indica­tive of strength in the mar­ket, than when peo­ple are truly just buy­ing shares and leav­ing deal­ers and ETF man­agers scram­bling to find bonds. That is a sub­tle, but impor­tant difference.

Sources: Bloomberg, TFMA

 

Copy­right © TF Mar­ket Advisors

Tags: Amp, Assumption, Buying Stocks, China, Conviction, Deficit Reduction, Economic Activity, ETF, ETFs, Giffen Good, Giffen Goods, Hype, Infatuation, Internet Stocks, Invest Stocks, Lip Service, Mining, Professional Investors, Retail Investor, Retail Investors, Sidelines, Spite, Stock Market, Tf
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Proceed With Caution in the Hunt for High Yield

Tuesday, April 3rd, 2012

Given high yield credit’s recent rally and surge of inflows, I’m now get­ting a lot of ques­tions about whether or not the asset class still looks appealing.

While high yield pro­vides an attrac­tive pickup in yield and I’m main­tain­ing my neu­tral view of the sec­tor, I believe the easy money has prob­a­bly already been made and the asset class no longer looks cheap. As such, over high yield, I pre­fer invest­ment grade credit and munic­i­pals.

As high yield credit is highly cor­re­lated with equi­ties, it’s hardly sur­pris­ing that the asset class has ral­lied sharply since fall lows, tak­ing part in the strong rebound in stocks and other risky assets. The iShares iBoxx $ High Yield Cor­po­rate Bond Fund (NYSEARCA: HYG) is up more than 12% from its early Octo­ber clos­ing low. Past per­for­mance does not guar­an­tee future results. For stan­dard­ized per­for­mance, please click here. And of course, this surge in price has been accom­pa­nied by a surge in flows. Year to date, $6.5 bil­lion has flowed into high yield exchange traded funds, with half going to HYG.

Fol­low­ing this rally, the yield to matu­rity for high yield is roughly 7% or nearly a 500 basis point pre­mium to the 10-year Trea­sury. That’s close to fair value given the fol­low­ing analysis.

When you look at the his­tor­i­cal spread between high yield and the 10 year-Treasury, spreads typ­i­cally tighten as expec­ta­tions for the econ­omy improve. They widen when investors are wor­ried about a reces­sion and credit qual­ity.  In the past, eco­nomic indi­ca­tors have explained roughly 50% of the vari­a­tion in where high yield spreads rel­a­tive to Trea­suries, tes­ti­fy­ing that the eco­nomic sit­u­a­tion has been a key dri­ver of spreads LQDhistorically.

A com­par­i­son of high yield spreads with lead­ing indi­ca­tors today sug­gests that high yield should be yield­ing roughly 500 bps more than the yield on the 10-year Trea­sury, fairly close to cur­rent levels.

To be sure, I don’t believe investors should avoid high yield. Investors in high yield are still pick­ing up sig­nif­i­cant incre­men­tal yield, and given strong cor­po­rate bal­ance sheets, I don’t expect any sig­nif­i­cant pickup in default rates. But as the asset class no longer appears as inex­pen­sive as it was last fall, I wouldn’t advo­cate aggres­sively putting new money to work in high yield.

Instead, I pre­fer invest­ment grade and high qual­ity munic­i­pals. I hold over­weight views of both asset classes, which still appear rel­a­tively cheap ver­sus Trea­suries. Take invest­ment grade credit, which is a nice sub­sti­tute for those look­ing to lower their expo­sure to Trea­suries. While high yield spreads have con­tracted by 250 bps since last fall, spreads for invest­ment grade credit have not come in nearly as much.

Investors can access invest­ment grade credit through the iShares iBoxx $ Invest­ment Grade Cor­po­rate Bond Fund (NYSEARCA: LQD) and they can access munic­i­pals through the iShares S&P Short Term National AMT-Free Munic­i­pal Bond Fund (NYSEARCA: SUB) and the iShares S&P National AMT-Free Munic­i­pal Bond Fund (NYSEARCA: MUB).

Source: Bloomberg

The author is long LQD and MUB

The per­for­mance quoted rep­re­sents past per­for­mance and does not guar­an­tee future results. Invest­ment return and prin­ci­pal value of an invest­ment will fluc­tu­ate so that an investor’s shares, when sold or redeemed, may be worth more or less than the orig­i­nal cost. Cur­rent per­for­mance may be lower or higher than the per­for­mance quoted. Per­for­mance data cur­rent to the most recent month end may be obtained by call­ing toll-free 1–800-iShares (1–800-474‑2737) or by vis­it­ing www.iShares.com.

Bonds and bond funds will decrease in value as inter­est rates rise. High yield secu­ri­ties may be more volatile, be sub­ject to greater lev­els of credit or default risk, and may be less liq­uid and more dif­fi­cult to sell at an advan­ta­geous time or price to value than higher-rated secu­ri­ties of sim­i­lar matu­rity. A por­tion of a munic­i­pal bond fund’s income may be sub­ject to fed­eral or state income taxes or the alter­na­tive min­i­mum tax. Cap­i­tal gains, if any, are sub­ject to cap­i­tal gains tax.

Tags: 10 Year Treasury, asset class, Basis Point, Bond Fund, Bps, Corporate Bond, Credit Quality, Easy Money, Economic Indicators, Economic Situation, ETF, ETFs, Exchange Traded Funds, high yield, Hyg, Ishares, Leading Indicators, Municipals, Neutral View, Risky Assets, Treasuries, Yield To Maturity
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Stocks: Still A Bargain (Koesterich)

Friday, March 30th, 2012

With global stocks up approx­i­mately 25% from their fall low and many mar­ket watch­ers endors­ing equi­ties in recent weeks, it’s hardly sur­pris­ing that investors are won­der­ing if stocks are still a good bargain.

While some mea­sures of sen­ti­ment – notably abnor­mally low volatil­ity lev­els – could be inter­preted as flash­ing yel­low cau­tion signs, val­u­a­tions and fun­da­men­tals still favor global stocks over the long term.

Cur­rently, equi­ties look rea­son­ably priced on an absolute basis. Devel­oped mar­ket equi­ties are trad­ing at around 14.5x trail­ing earn­ings, while large emerg­ing mar­kets are trad­ing at roughly 12x earnings. These val­u­a­tions are sig­nif­i­cantly above those touched dur­ing last year’s trough, but both emerg­ing and devel­oped mar­ket stocks are now trad­ing at a sig­nif­i­cant dis­count to their long-term aver­ages.

The rel­a­tive case for stocks, how­ever, is even more com­pelling as equi­ties look very cheap com­pared to bonds. While equity val­u­a­tions are mod­estly below their long-term aver­age, bond val­u­a­tions are sig­nif­i­cantly above theirs when mea­sured by vir­tu­ally any metric.

Nowhere is this more evi­dent than in the US Trea­sury mar­ket. Late last year, the yield on the 10-year Trea­sury note dipped below the level of core infla­tion for the first time since 1980. Rather than pay­ing investors the typ­i­cal long-term aver­age real yield of 2.5% to 3%, the US gov­ern­ment is now pay­ing a neg­a­tive real yield to bor­row.  As a result, unless the US is slid­ing toward Japan­ese style defla­tion – and so far there is lit­tle evi­dence of this –US Trea­suries look extremely expen­sive and investors in 10-year notes are accept­ing a loss in pur­chas­ing power and no real income. In addi­tion, because coupons are so low, the dura­tion or inter­est rate risk of Trea­suries is at or near a his­toric high.

Some investors have weighed the volatil­ity of stocks against the low yield on bonds and opted for choice C: Cash. A tac­ti­cal move into cash is cer­tainly rea­son­able for brief peri­ods of time. But if you’re wor­ried about long-term pur­chas­ing power, hav­ing a sig­nif­i­cant, long-term allo­ca­tion to an asset pay­ing zero return makes lit­tle sense. Stocks are a more rea­son­able option to consider.

To be sure, invest­ing in equi­ties has its risks. Some have argued that equity val­u­a­tions are flat­tered by his­tor­i­cally high mar­gins. But in the United States at least, a com­bi­na­tion of just enough gross domes­tic prod­uct growth, ane­mic wage growth and low rates should sup­port mar­gins over the near term.

Among other risks, while US defla­tion looks unlikely, it’s pos­si­ble and it’s a sce­nario that would clearly favor bonds. Under the oppo­site sce­nario – higher US infla­tion – equi­ties would surely suf­fer thanks to lower mul­ti­ples. How­ever, in an infla­tion sce­nario, equi­ties would likely hold up bet­ter than bonds or cash.

In short, equi­ties may not offer the stel­lar prospects of the 1980s or 1990s, but absent a bout of defla­tion, stocks are likely to out­per­form the alter­na­tives over the long term. Pos­si­ble iShares solu­tions include the iShares S&P Global 100 Index Fund (NYSEARCA: IOO), the iShares MSCI ACWI Index Fund (NASDAQGM: ACWI) and the iShares MSCI All Coun­try World Min­i­mum Volatil­ity Index Fund (NYSEARCA: ACWV).

Source: Bloomberg

The author is long IOO.

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. An invest­ment in stocks, bonds or ETFs is not equiv­a­lent to and involves risks not asso­ci­ated with an invest­ment in cash.

Tags: 10 Year Treasury, Absolute Basis, Average Bond, Caution Signs, Choice C, Core Inflation, Deflation, ETF, ETFs, Global Stocks, Gold, Good Bargain, Interest Rate Risk, Japanese Style, Perio, Purchasing Power, Tactical Move, Term Averages, Treasuries, Treasury Market, Us Treasury, Volatility Levels, Year Treasury Note
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Defence That Pays: Dividend Equities as a Long Term Strategy

Thursday, March 29th, 2012

Defence That Pays
Div­i­dend Equi­ties as a Long-term Strategy

by Alfred Lee, CFA, CMT, DMS
Vice Pres­i­dent & Invest­ment Strate­gist
BMO ETFs & Global Struc­tured Invest­ments
BMO Asset Man­age­ment Inc.
alfred.lee@bmo.com

March 29, 2012
Recent Developments:

• Despite the global macro-economic con­cerns that remain, year to date, investors have clearly favoured risk-assets as improv­ing sen­ti­ment has led global equity mar­kets to rally with sig­nif­i­cant breadth. Although, investors should not put too much focus on day-to-day head­lines, last Thursday’s read­ing of Europe and China’s weak Pur­chas­ing Man­agers Index (PMI), shows how the global eco­nomic recov­ery remains vul­ner­a­ble. While we have become more opti­mistic over the mid-term, we still remain con­cerned on the struc­tural issues remain­ing over the long-term, and is why we con­tinue to rec­om­mend that investors do not throw cau­tion to the wind.
• News of Greece’s debt restruc­tur­ing sev­eral weeks ago, has put con­cerns on the back­burner; although we believe Greece’s sol­vency issues remain over the long-term. On a short-term out­look, this has lifted a major over­hang on the equity mar­kets. Investors should note, how­ever, that credit default swap (CDS) prices of Por­tu­gal still remain ele­vated (Chart A). More­over, China’s poten­tial hous­ing bub­ble and infla­tion hand­cuffs the nation’s abil­ity to imple­ment a whole­sale mon­e­tary eas­ing pol­icy. Thus, unlike 2009, China will not be able to shoul­der the global economy.
• The year-to-date rally in risk-assets hinges on whether U.S. eco­nomic data can sus­tain or con­tinue to build pos­i­tive momen­tum. Although we have increased our rec­om­mended allo­ca­tion to Cana­dian equi­ties, we still remain defen­sive in our com­po­si­tion. Con­cerns on China should weigh on some commodity-based equi­ties over the short-term, so we rec­om­mend that investors look at non-cyclical areas such as div­i­dend pay­ing equi­ties in Canada.
• In addi­tion to being more defen­sive in nature, lower bond yields should lead investors to look to div­i­dend pay­ing equi­ties to source yield. Cur­rently, the 10-year gov­ern­ment bond yield is less than the div­i­dend yield of the S&P/TSX Com­pos­ite Index (TSX) (Chart B). An aging demo­graphic search­ing for income dis­tri­b­u­tions should pro­vide a fur­ther tail­wind for div­i­dend pay­ing equi­ties over the long-run.
• Improv­ing eco­nomic data has also recently led the yield curve to shift upwards (Chart C), which has neg­a­tively impacted bonds, espe­cially those of longer matu­rity. As we have become more bull­ish on equi­ties over the short– and mid-term, investors may want to con­sider real­lo­cat­ing some bond expo­sure to div­i­dend pay­ing equi­ties as a way of main­tain­ing over­all port­fo­lio yield while decreas­ing dura­tion risk. Investors should keep in mind that equi­ties and fixed income do react to risk in dif­fer­ent man­ners and there­fore should keep in mind their over­all port­fo­lio risk composition.

Invest­ment Idea:

• Investors may want to con­sider the BMO Cana­dian Div­i­dend Equity ETF (ZDV) as an effi­cient way to gain expo­sure to a bas­ket of 50 large and some mid-cap Cana­dian div­i­dend pay­ing stocks. Cur­rently, the under­ly­ing port­fo­lio yields 4.5%, diver­si­fied across eight dif­fer­ent sec­tors and a man­age­ment fee of only 0.35%. In addi­tion to being eli­gi­ble for a div­i­dend rein­vest­ment plan (DRIP) like our other BMO ETFs, ZDV pays a monthly dis­tri­b­u­tion. We con­tinue to rec­om­mend defen­sive hold­ings such as ZDV as core posi­tions and more cycli­cal ori­ented themes around the periph­eral as more tac­ti­cally ori­ented themes.

Chart A: CDS Prices on Por­tu­gal Remain Elevated

Source: BMO Asset Man­age­ment Inc., StockCharts.com

Chart B: Cana­dian Bonds Yield­ing Less than Cana­dian Equities

Source: BMO Asset Man­age­ment Inc., Bloomberg,

Chart C: Yield Curve Shift­ing Upwards Will Impact Fixed Income

Source: BMO Asset Man­age­ment Inc., Bloomberg

*All prices as of mar­ket close March 27, 2012 unless oth­er­wise indicated.

Dis­claimer:
Infor­ma­tion, opin­ions and sta­tis­ti­cal data con­tained in this report were obtained or derived from sources deemed to be reli­able, but BMO Asset Man­age­ment Inc. does not rep­re­sent that any such infor­ma­tion, opin­ion or sta­tis­ti­cal data is accu­rate or com­plete and they should not be relied upon as such. Par­tic­u­lar invest­ments and/or trad­ing strate­gies should be eval­u­ated rel­a­tive to each individual’s cir­cum­stances. Indi­vid­u­als should seek the advice of pro­fes­sion­als, as appro­pri­ate, regard­ing any par­tic­u­lar investment.

BMO ETFs are man­aged and admin­is­tered by BMO Asset Man­age­ment Inc, an invest­ment fund man­ager and port­fo­lio man­ager and sep­a­rate legal entity from the Bank of Mon­tréal. Com­mis­sions, man­age­ment fees and expenses all may be asso­ci­ated with invest­ments in exchange-traded funds. Please read the prospec­tus before invest­ing. The indi­cated rates of return are the his­tor­i­cal annual com­pound total returns includ­ing changes in prices and rein­vest­ment of all dis­tri­b­u­tions and do not take into account com­mis­sion charges or income taxes payable by any unit holder that would have reduced returns. The funds are not guar­an­teed, their value changes fre­quently and past per­for­mance may not be repeated.

Tags: Alfred Lee, Asset Management Inc, Backburner, BMO, Canadian, Canadian Equities, Canadian Market, Caution To The Wind, Cmt, Credit Default Swap, Debt Restructuring, Economic Concerns, ETF, ETFs, Global Economy, Global Equity Markets, Global Macro, Housing Bubble, Investment Strategist, Purchasing Managers Index, Structured Investments, Swap Cds, Term Outlook, Wind News
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Bernanke's Problem with the Gold Standard

Wednesday, March 28th, 2012

by Axel Merk, Merk Funds

In his new lec­ture series, Fed­eral Reserve (Fed) Chair­man Ben Bernanke is going out of his way to dis­cuss the "prob­lems with the gold stan­dard." To a cen­tral banker, the gold stan­dard may be con­sid­ered "com­pe­ti­tion," as their power would likely be greatly dimin­ished if the U.S. were on a gold stan­dard. The Fed, Bernanke argues, is the answer to the prob­lems of the gold stan­dard. We respect­fully dis­agree. We dis­agree because the Fed ought to look at a dif­fer­ent problem.

Bernanke lists price sta­bil­ity and finan­cial sta­bil­ity as key objec­tives of the Fed. Focus­ing on the lat­ter one first, the Fed was estab­lished to reduce the risk of finan­cial pan­ics. Bernanke points out:

"A finan­cial panic is pos­si­ble in any sit­u­a­tion where longer-term, illiq­uid assets are financed by short-term, liq­uid lia­bil­i­ties; and in which short-term lenders or depos­i­tors may lose con­fi­dence in the institution(s) they are financ­ing or become wor­ried that oth­ers may lose confidence."

Bernanke goes on to blame the gold stan­dard for the pan­ics. While he is cer­tainly not alone in his view – indeed, his very lec­ture to stu­dents at George Wash­ing­ton Uni­ver­sity is pro­mot­ing that view to a new gen­er­a­tion of econ­o­mists -, we beg to differ.

Banks — by def­i­n­i­tion — have a matu­rity mis­match, mak­ing long-term loans, tak­ing short-term deposits. As such, banks are prone to finan­cial pan­ics as described by Bernanke. To mit­i­gate the risk of finan­cial pan­ics, cen­tral banks can do what the Fed is doing, namely to be a lender of last resort. Alter­na­tively, cen­tral banks can focus on the core issue, the struc­tural "prob­lem of bank­ing." Fol­low­ing the Fed's approach, there are inher­ent moral haz­ard issues – incen­tives for finan­cial insti­tu­tions to increase lever­age, to become too-big-to-fail. To address a panic that might hap­pen any­way, the Fed would dou­ble down (pro­vide more liq­uid­ity), poten­tially exac­er­bat­ing future bank­ing pan­ics. After yet another cri­sis, new rules are intro­duced to reg­u­late banks. The result­ing finan­cial sys­tem may not be safer, but it will increase bar­ri­ers to entry, fur­ther bol­ster­ing the lead­er­ship posi­tion of exist­ing, too-big-to-fail banks. With all the gov­ern­ment guar­an­tees and too-big-to-fail con­cerns, banks might then be reg­u­lated in an attempt to have them act more like util­i­ties. Ulti­mately, that might make the finan­cial sys­tem more sta­ble, but will sti­fle eco­nomic growth. Finan­cial insti­tu­tions, as much as we have mixed feel­ings about their con­duct, are vital to finance eco­nomic growth, as they facil­i­tate risk tak­ing and investment.

The prob­lem of all finan­cial pan­ics is not the gold stan­dard — oth­er­wise, the panic of 2008 would not have hap­pened. The prob­lem of finan­cial pan­ics is — again — that "longer-term, illiq­uid assets are financed by short-term, liq­uid lia­bil­i­ties." Miss­ing from Bernanke's def­i­n­i­tion is a key addi­tional attribute, lever­age. A matu­rity mis­match with­out lever­age might cause a lender to go bust, but — in our inter­pre­ta­tion — does not qual­ify as a panic when a lim­ited num­ber of depos­i­tors are affected. The "panic" and the "con­ta­gion" may occur when lever­age is employed, as it cre­ates a dis­pro­por­tion­ate num­ber of cred­i­tors (includ­ing con­sumers with cash deposits).

There's a bet­ter way. To avoid hav­ing finan­cial insti­tu­tions serve as “panic” incu­ba­tors, reg­u­la­tion should address the core of the issue. Bernanke shouldn’t use gold, as a scape­goat for all that was wrong with the U.S. econ­omy pre­vi­ously, to jus­tify a license to print money. First, fail­ure must be an option; indi­vid­u­als and busi­nesses must be allowed to make mis­takes and suf­fer the con­se­quences. The role of the reg­u­la­tor, in our opin­ion, is to avoid an event where someone's mis­take wrecks the entire system.

The eas­i­est way to achieve a more sta­ble finan­cial sys­tem is to reduce incen­tives for lever­age. A straight­for­ward method is through mark-to-market account­ing and a require­ment to post col­lat­eral for lever­aged trans­ac­tions. The finan­cial indus­try lob­bies against this, argu­ing that hold­ing a posi­tion to matu­rity ren­ders mark-to-market account­ing redun­dant. Con­sider the fol­low­ing exam­ple, which high­lights the impli­ca­tion: assume a spec­u­la­tor before the finan­cial cri­sis took a lever­aged bet that oil prices — at the time trad­ing at $80 a bar­rel — would go down to $40 a bar­rel. In the “ideal world” accord­ing to the banks, this spec­u­la­tor would not have been required to post col­lat­eral and would have been proven right when oil (briefly) dropped to $40 a bar­rel after the finan­cial cri­sis. In real­ity how­ever, as oil prices soared to $140 a bar­rel before declin­ing, the typ­i­cal spec­u­la­tor would have been forced to post an ever larger amount of col­lat­eral; likely, the speculator's bro­ker­age firm would have closed out the posi­tion, as the spec­u­la­tor ran out of money. The spec­u­la­tor lost money because he was unable to meet a mar­gin call; impor­tantly, though, the sys­tem remained intact. The spec­u­la­tor might com­plain: the price ulti­mately fell to $40! But such whin­ing is futile because the rules of engage­ment were known ahead of time. As such, the spec­u­la­tor had an incen­tive to use less (or no) lever­age. The bank's atti­tude, in con­trast, incu­bates pan­ics. In this exam­ple, reg­u­lated exchanges exist. But even with­out reg­u­lated exchanges or eas­ily priced secu­ri­ties, sim­i­lar con­cepts can be developed.

Another way to make finan­cial firms more panic prone is to require them to issue stag­gered sub­or­di­nated debt. Rather than rely­ing heav­ily on short-term fund­ing (retail deposits or inter-bank fund­ing mar­kets), banks should be required to stag­ger the matu­ri­ties of their own fund­ing over years. If, say, each year 10% of their loan port­fo­lio needs to be refi­nanced, then — in times of finan­cial tur­moil — it might become exor­bi­tantly expen­sive for a bank to finance that 10% of their loan port­fo­lio. A bank should be able to shrink its loan port­fo­lio by 10% in a year in an orderly fash­ion, with­out jeop­ar­diz­ing the sur­vival of the firm or spread­ing exces­sive risks through­out the finan­cial sys­tem. Note that this is a market-based mech­a­nism to police the finan­cial system.

These con­cepts reduce lever­age in the sys­tem. And that's the point, as lever­age is the mother of all pan­ics. The con­cepts pre­sented above will not solve all the chal­lenges of bank­ing, but blam­ing "the prob­lem of the gold stan­dard" for finan­cial pan­ics is — in our analy­sis — premature.

Mod­ern cen­tral bank­ing is not the answer to mit­i­gate the risk of finan­cial pan­ics because the cost for this per­ceived safety is enor­mous. As a result of respond­ing to each poten­tial panic with ever more "liq­uid­ity", entire gov­ern­ments are now put at risk when a cri­sis flares up.

Beyond that, cen­tral banks have done a hor­ri­ble job in con­tain­ing infla­tion. The wis­dom of cen­tral bank­ing is that 2% infla­tion is con­sid­ered an envi­ron­ment of sta­ble prices. At 2%, a level often touted as a “price sta­ble envi­ron­ment”, the pur­chas­ing power of $100 is reduced to $55 over a 30-year period. It's a cruel tax on the pub­lic. What’s more, in prac­tice, coun­tries with a fiat cur­rency sys­tem have gen­er­ally been unable to keep long-term infla­tion below 2%.

Bernanke warns of defla­tion. To the saver, defla­tion is a gift. Not to the debtor. In a debt dri­ven world, defla­tion stran­gles the econ­omy. Gov­ern­ments don't like defla­tion as income taxes and cap­i­tal gains taxes are eroded. In a defla­tion­ary world, gov­ern­ments would need to rely more on sales taxes (or value added taxes): grad­u­ally reduced rev­enue in a defla­tion­ary envi­ron­ment would be okay as the pur­chas­ing power of those tax rev­enues would increase. That assumes, of course, that the gov­ern­ment car­ries a low debt bur­den — defla­tion would be a good incen­tive to limit spend­ing. Get the pic­ture why gov­ern­ments don't like deflation?

Read John Butler's new book
The Golden Rev­o­lu­tion: How to Pre­pare for the Com­ing Global Gold Standard

With infla­tion, peo­ple have an "incen­tive" to work harder, to take on risks, just to retain their pur­chas­ing power, the sta­tus quo. What about the pur­suit of hap­pi­ness? The idea that if you earn money and save, you can retire and live off your sav­ings? We con­sider it quite an impo­si­tion that unelected offi­cials have such sway over our stan­dard of living.

Bernanke also attacks the gold stan­dard for caus­ing havoc in the cur­rency mar­kets. Please sub­scribe to our newslet­ter to be informed as we pro­vide food for thought about the rela­tion­ship between gold and cur­ren­cies. We will also dis­cuss what investors may want to do in a world that has moved fur­ther and fur­ther away from the gold stan­dard. Sub­scribe to Merk Insights by click­ing here. Also, please click here to reg­is­ter for the Merk Webi­nar: Quar­ter 1 Update on the Econ­omy and Cur­ren­cies which will take place on Thurs­day, April 19th at 4:15pm EF / 1:15pm PT. We man­age the Merk Funds, includ­ing the Merk Hard Cur­rency Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Man­ager of the Merk Hard Cur­rency Fund, Asian Cur­rency Fund, Absolute Return Cur­rency Fund, and Cur­rency Enhanced U.S. Equity Fund, www.merkfunds.com

Axel Merk, Pres­i­dent & CIO of Merk Invest­ments, LLC, is an expert on hard money, macro trends and inter­na­tional invest­ing. He is con­sid­ered an author­ity on currencies.

The Merk Hard Cur­rency Fund (MERKX) seeks to profit from a rise in hard cur­ren­cies ver­sus the U.S. dol­lar. Hard cur­ren­cies are cur­ren­cies backed by sound mon­e­tary pol­icy; sound mon­e­tary pol­icy focuses on price stability.

The Merk Asian Cur­rency Fund (MEAFX) seeks to profit from a rise in Asian cur­ren­cies ver­sus the U.S. dol­lar. The Fund typ­i­cally invests in a bas­ket of Asian cur­ren­cies that may include, but are not lim­ited to, the cur­ren­cies of China, Hong Kong, Japan, India, Indone­sia, Malaysia, the Philip­pines, Sin­ga­pore, South Korea, Tai­wan and Thailand.

The Merk Absolute Return Cur­rency Fund (MABFX) seeks to gen­er­ate pos­i­tive absolute returns by invest­ing in cur­ren­cies. The Fund is a pure-play on cur­ren­cies, aim­ing to profit regard­less of the direc­tion of the U.S. dol­lar or tra­di­tional asset classes.

The Merk Cur­rency Enhanced U.S. Equity Fund (MUSFX) seeks to gen­er­ate total returns that exceed that of the S&P 500 Index. By employ­ing a cur­rency over­lay, the Merk Cur­rency Enhanced U.S. Equity Fund actively man­ages U.S. dol­lar and other cur­rency risk while con­cur­rently pro­vid­ing invest­ment expo­sure to the S&P 500.

The Funds may be appro­pri­ate for you if you are pur­su­ing a long-term goal with a cur­rency com­po­nent to your port­fo­lio; are will­ing to tol­er­ate the risks asso­ci­ated with invest­ments in for­eign cur­ren­cies; or are look­ing for a way to poten­tially mit­i­gate down­side risk in or profit from a sec­u­lar bear mar­ket. For more infor­ma­tion on the Funds and to down­load a prospec­tus, please visit www.merkfunds.com.

Investors should con­sider the invest­ment objec­tives, risks and charges and expenses of the Merk Funds care­fully before invest­ing. This and other infor­ma­tion is in the prospec­tus, a copy of which may be obtained by vis­it­ing the Funds' web­site at www.merkfunds.com or call­ing 866-MERK FUND. Please read the prospec­tus care­fully before you invest.

Since the Funds pri­mar­ily invest in for­eign cur­ren­cies, changes in cur­rency exchange rates affect the value of what the Funds own and the price of the Funds' shares. Invest­ing in for­eign instru­ments bears a greater risk than invest­ing in domes­tic instru­ments for rea­sons such as volatil­ity of cur­rency exchange rates and, in some cases, lim­ited geo­graphic focus, polit­i­cal and eco­nomic insta­bil­ity, emerg­ing mar­ket risk, and rel­a­tively illiq­uid mar­kets. The Funds are sub­ject to inter­est rate risk, which is the risk that debt secu­ri­ties in the Funds' port­fo­lio will decline in value because of increases in mar­ket inter­est rates. The Funds may also invest in deriv­a­tive secu­ri­ties, such as for– ward con­tracts, which can be volatile and involve var­i­ous types and degrees of risk. If the U.S. dol­lar fluc­tu­ates in value against cur­ren­cies the Funds are exposed to, your invest­ment may also fluc­tu­ate in value. The Merk Cur­rency Enhanced U.S. Equity Fund may invest in exchange traded funds ("ETFs"). Like stocks, ETFs are sub­ject to fluc­tu­a­tions in mar­ket value, may trade at prices above or below net asset value and are sub­ject to direct, as well as indi­rect fees and expenses. As a non-diversified fund, the Merk Hard Cur­rency Fund will be sub­ject to more invest­ment risk and poten­tial for volatil­ity than a diver­si­fied fund because its port­fo­lio may, at times, focus on a lim­ited num­ber of issuers. For a more com­plete dis­cus­sion of these and other Fund risks please refer to the Funds' prospectuses.

This report was pre­pared by Merk Invest­ments LLC, and reflects the cur­rent opin­ion of the authors. It is based upon sources and data believed to be accu­rate and reli­able. Opin­ions and forward-looking state­ments expressed are sub­ject to change with­out notice. This infor­ma­tion does not con­sti­tute invest­ment advice. Fore­side Fund Ser­vices, LLC, distributor.

Copy­right © Merk Funds

Tags: Ben Bernanke, Central Banks, Core Issue, Depositors, ETF, ETFs, Fed Chairman, Financial Institutions, Financial Panic, Financial Panics, Financial Stability, George Washington University, Gold Standard, Hazard Issues, Illiquid Assets, India, Key Objectives, Lecture Series, Lender Of Last Resort, Long Term Loans, Moral Hazard, Price Stability, Short Term Deposits, Term Lenders
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Buy Commodities, Sell Brands (Smead)

Wednesday, March 28th, 2012

by William Smead, Smead Cap­i­tal Management

We saw War­ren Buf­fett quoted the other day say­ing, “We like com­pa­nies which buy a com­mod­ity and sell a brand”. We thought it would be very help­ful to unpack his thought and put it into the con­text of today’s cir­cum­stances. We at Smead Cap­i­tal Man­age­ment believe these cur­rent cir­cum­stances are framed by the his­tor­i­cal over-pricing of com­modi­ties, the com­ing eco­nomic con­trac­tion of China, the suc­cess­ful cleans­ing of the income state­ments of US house­holds and the inevitable rebound in hous­ing in the US. We will look at the makeup of our port­fo­lio com­pa­nies which buy a com­mod­ity and sell a brand to con­sider their upside poten­tial in this inter­est­ing environment.

When non-economic investors load up on invest­ments in any­thing which has had a big run up, please cir­cle the wag­ons. When com­modi­ties were at their low point in 1999, it was hard to find any insti­tu­tional investor or finan­cial advi­sor rec­om­mend­ing expo­sure in com­modi­ties for investors. As of the end of 2010, insti­tu­tions are ded­i­cat­ing as much as 52% of their port­fo­lio to alter­na­tive invest­ments. This includes com­modi­ties, gold and energy. These invest­ments are made today for diver­si­fi­ca­tion pur­poses and are sim­ply bets on ris­ing prices. These bets look good in a rearview mir­ror as we’ve had a once in a gen­er­a­tion move into this asset class. We believe that com­modi­ties have never been more over-priced in the US and are enter­ing a decade-long bear market.

We believe the rea­son com­modi­ties have been in a bull mar­ket for so long is the unin­ter­rupted eco­nomic boom in China. When a coun­try with 1.3 bil­lion peo­ple grows at over 10% for a num­ber of years with­out an occa­sional reces­sion, it ends up rely­ing on fixed asset invest­ments for growth. When fixed asset invest­ments dom­i­nate your GDP num­bers, bor­rowed money pre­pares to turn sour and ulti­mately lead to a recession/depression. This is some­thing that “get­ting rid of cable” can’t cure.

The Fed­eral Reserve came out with their house­hold debt ser­vice ratio (HDSR) last week. It shows that by the end of 2011, Amer­i­can house­holds had brought the ratio down below 11% to 10.88%. This matches up with the lev­els seen in the early 1980’s reces­sion and the “ane­mic” eco­nomic recov­ery of 1990–93. These ear­lier read­ings pre­ceded two of the best mod­ern eco­nomic growth peri­ods since World War II. While the doom­say­ers moan about absolute debt lev­els, we feel they are miss­ing the story on the health of the income state­ment of the aver­age house­hold. This has boded well for the econ­omy his­tor­i­cally. Also, if we con­tinue to be slow to buy houses and cars, this HDSR could put dis­cre­tionary spend­ing into its most favor­able posi­tion in decades.

Lastly, this cur­rent “ane­mic” eco­nomic recov­ery has been severely retarded by the boom com­mod­ity prices of the last two years, in our opin­ion. We’ve had to work off a huge num­ber of fore­closed and short-sale hous­ing inven­to­ries, while the deep reces­sion tem­porar­ily crip­pled house­hold for­ma­tion (Jeff, Who lives at Home). It is rebound­ing as 20-somethings get sick of liv­ing with the par­ents and the par­ents get sick of liv­ing with Jeff. As Mr. Buf­fett said recently, “even­tu­ally hor­mones take over” and as Brett Arends pointed out in Smart Money,” rent­ing is more expen­sive than buy­ing in about 75% of Amer­i­can cities.” You add high lum­ber, cop­per, iron ore and oil prices to this mix and you get the worst depres­sion in hous­ing and blue-collar employ­ment since the depres­sion. All these head­winds are about to become tail­winds, in our vision, over the next five years.

There­fore, bet­ting on the US econ­omy and the US con­sumer looks very favor­able to us, espe­cially where the rebounds in employ­ment and con­sumer con­fi­dence have an impact. In fairy tales, peo­ple are asked to spin straw into gold. We like to own com­pa­nies which spin milk and cof­fee (SBUX), cot­ton (JWN and CAB), inter­net access (EBAY and ACN), tax returns (HRB) and chem­i­cals (MRK, AMGN, BMY, ABT, PFE and MYL) into gold. Profit mar­gins on commodity-related com­pa­nies and com­pa­nies reliant on emerg­ing mar­ket growth could plum­met in the near future. Just ask the folks at BHP Bil­li­ton. They announced March 20th, 2012 that they are see­ing in a big drop off in demand from China. In turn, we believe mar­gins could go up for any­one who is pos­i­tively impacted by lower energy prices and/or com­mod­ity prices in gen­eral. This is espe­cially true if you “buy com­modi­ties and sell brands”.

Best Wishes,

William Smead

The infor­ma­tion con­tained in this mis­sive rep­re­sents SCM’s opin­ions, and should not be con­strued as per­son­al­ized or indi­vid­u­al­ized invest­ment advice. Past per­for­mance is no guar­an­tee of future results. Some of the secu­ri­ties iden­ti­fied and described in this mis­sive are a sam­ple of issuers being cur­rently rec­om­mended for suit­able clients as of the date of this mis­sive and do not rep­re­sent all of the secu­ri­ties pur­chased or rec­om­mended for our clients. It should not be assumed that invest­ing in these secu­ri­ties was or will be prof­itable. A list of all rec­om­men­da­tions made by Smead Cap­i­tal Man­age­ment with in the past twelve month period is avail­able upon request.

Tags: Alternative Investments, asset class, Asset Investments, Bear Market, Bets, Capital Management, Circle The Wagons, Commodities, Commodity, Diversification, Economic Boom, Economic Contraction, ETF, ETFs, Generation Move, Income Statements, Institutional Investor, Portfolio Companies, Rearview Mirror, Rebound, Recession, Warren Buffett
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Corporate Bond Intrigue (Video)

Monday, March 26th, 2012

  
Despite the slug­gish econ­omy, US cor­po­ra­tions have a few good things going for them right now.   Does this trans­late to their abil­ity to repay debt?  Spend a minute with Matt Tucker as he explores the cur­rent case for cor­po­rate bonds.

Tags: Corporate Bond, Corporate Bonds, Corporate Video, Corporations, Current, ETF, ETFs, Intrigue, Matt Tucker, Nbsp, Sluggish Economy
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Alfred Lee: Investment Outlook (March-April 2012)

Sunday, March 25th, 2012

Invest­ment Out­look, March 2012

Silent Waters Run Deep

by Alfred Lee, CFA, CMT, DMS, Vice Pres­i­dent & Invest­ment Strate­gist
BMO ETFs & Global Struc­tured Invest­ments, BMO Asset Man­age­ment
alfred.lee[@]bmo.com

As we artic­u­lated in last month’s report, equity mar­ket volatil­ity remains eerily quiet given the num­ber of macro-economic issues that remain largely unre­solved. With the news of Greece agree­ing to a debt restruc­tur­ing deal, the con­cern of a Euro­pean sov­er­eign debt cri­sis has been put on the back burner and the mar­ket has shifted its focus to U.S. eco­nomic data, which con­tin­ues to come in bet­ter than expected. The deci­sion by the Inter­na­tional Swaps and Deriv­a­tives Asso­ci­a­tion Inc. (ISDA) to deem the Greek bond deal a default, also restores faith in credit default swaps (CDS)1 as a viable insur­ance pol­icy for debt issuances, which will help Euro­pean sov­er­eigns keep their yields lower over the short-term. Although, U.S. eco­nomic data con­tin­ues to impress, con­cerns of the other, and larger, PIIGS2 nations, are being overlooked.

The con­tin­u­a­tion of the cur­rent rally does hinge to a degree on U.S. eco­nomic data and its abil­ity to con­tinue gath­er­ing pos­i­tive momen­tum. Most notably, unem­ploy­ment is down to 8.7% in its Decem­ber read­ing, from 9.1% in Sep­tem­ber. In addi­tion, there is a grow­ing, albeit small, trend of “on-shoring” where man­u­fac­tur­ing jobs are com­ing back state­side, due to ris­ing labour costs in cer­tain emerg­ing mar­kets. Recent opti­mism of the U.S. econ­omy has led the mar­ket to quell their expec­ta­tions for an addi­tional round of quan­ti­ta­tive eas­ing, or fur­ther stim­u­lus from the U.S. Fed­eral Reserve (Fed). As a result, our short-term momen­tum indi­ca­tors show that gold prices have stalled, and is the rea­son we remain neu­tral on pre­cious metals.

Despite the re-pricing of asset mar­kets to reflect improv­ing U.S. eco­nomic fun­da­men­tals and a lower per­cep­tion of tail-risk3, the CBOE/S&P Implied Volatil­ity Index (“VIX”)4 remains abnor­mally sup­pressed. In mid-March, the VIX had an intra­day print of 13.99, which would be con­sid­ered low dur­ing a sec­u­lar bull-market and well below its long-term aver­age of 20. As volatil­ity has a ten­dency to quickly revert to its aver­age, we remain cau­tiously opti­mistic on risk assets. While we have moved over­weight to equi­ties, we remain defen­sively posi­tioned in our equity expo­sure, in order to bet­ter dis­trib­ute risk across our strat­egy. Although we have become more pos­i­tive on equi­ties over the mid-term, we believe there are unre­solved struc­tural issues which will weigh on equi­ties in the long-term.

Notable Changes to the Mix

• Global equi­ties have ral­lied sig­nif­i­cantly over the course of the last five months with the MSCI All Coun­try World Index (ACWI) gain­ing 23.9% from its Octo­ber lows. More encour­ag­ing has been the breadth of the rally, with all sec­tors con­tribut­ing to the strength of its ascent. As the over­hangs on the mar­ket have been more macro-economically related, a ris­ing tide lifts all boats as the mar­kets have re-priced a lower prob­a­bil­ity of an imme­di­ate tail-risk event.

• We have decreased our allo­ca­tion to fixed income and increased our weight in equi­ties and cash. Though attrac­tive from a fun­da­men­tal per­spec­tive, the equity mar­ket con­tin­ues to look over­bought in the short-term based on tech­ni­cal and quantitative-based momen­tum indi­ca­tors. Con­se­quently, we antic­i­pate some short-term con­sol­i­da­tion. By increas­ing our cash posi­tion, it allows us to be more nim­ble and take advan­tage of any upcom­ing oppor­tu­ni­ties and slowly increase our weight towards tac­ti­cal oppor­tu­ni­ties in equi­ties. In addi­tion, the ongo­ing equity rally could put upward pres­sure on inter­est rate expec­ta­tions, which is why we have over-weighted the short-and mid-part of the yield curve to lower our dura­tion risk.

• Com­ing into the new year, we were bear­ish on Cana­dian equi­ties. Though we have raised our posi­tion­ing to neu­tral, we believe that weaker gold prices and con­cerns over China tar­get­ing lower growth expec­ta­tions will weigh on the S&P/TSX Com­pos­ite Index (TSX). We do how­ever remain bull­ish toward cer­tain areas within Cana­dian equi­ties such as lower volatil­ity equi­ties and div­i­dend pay­ing equi­ties, and we are rec­om­mend­ing the BMO Low Volatil­ity Cana­dian Equity ETF (ZLB) and BMO Cana­dian Div­i­dend ETF (ZDV), respec­tively, to access these areas.

New Additions/Deletions to Strategy:

• One of the areas where we have been bull­ish over the last six­teen months has been U.S. equi­ties. More specif­i­cally, we were bull­ish on the large-cap blue chip com­pa­nies, the rea­son why we have been rec­om­mend­ing the BMO Dow Jones Indus­tri­als Aver­age Hedged to CAD Index ETF (ZDJ). Though we still favour the stocks in the Dow Jones Indus­trial Aver­age (Dow), higher oil prices and a buoy­ant U.S. dol­lar, will weigh on the multi­na­tion­als in the Dow. More­over, improv­ing eco­nomic con­di­tions and on-shoring will likely lead to an improv­ing busi­ness envi­ron­ment for some of the smaller, more locally based U.S. com­pa­nies. We are there­fore par­ing back some of our expo­sure to ZDJ in favour of the BMO U.S. Equity Hedged to CAD Index ETF (ZUE) in our strat­egy mix.

• Last week, the Fed released the results of the U.S. bank stress test, which came in over­whelm­ingly pos­i­tive. Of the 19 banks, 15 were given pass­ing grades. Fur­ther­more a num­ber of the banks were given approval by the Fed to raise its div­i­dends. This news added a fur­ther tail­wind to the U.S. bank­ing sec­tor, as it con­tin­ues to show lead­er­ship amongst the U.S. equity sec­tors. Cur­rently, the BMO Equal Weight U.S. Banks Hedged to CAD Index ETF (ZUB), which tracks the Dow Jones U.S. Large-Cap Banks Equal Weight Total Stock Mar­ket Index CAD Hedged Index, trades at a for­ward price-to-earnings (P/E) ratio of 11.9x, a dis­count to the 13.5x for­ward P/E of the S&P 500 Com­pos­ite Index. Our tech­ni­cal indi­ca­tors sug­gests that pos­i­tive momen­tum in ZUB has returned, some­thing we like to see in assets trad­ing at attrac­tive val­u­a­tions as we want to avoid value traps. Given the sec­tor remains vul­ner­a­ble we rec­om­mend investors con­sider uti­liz­ing a trail­ing stop loss order of no more than 10% and limit their allo­ca­tion to mit­i­gate risk.

Things to Keep and Eye On

Last month, we men­tioned that most broad equity mar­ket indices, includ­ing the TSX, were trad­ing at a dis­count to their respec­tive 10-year aver­ages. This month we wanted to take a closer look at the TSX to deter­mine which of the sec­tors look more attrac­tive from a val­u­a­tion stand­point. We used the cur­rent price-to-earnings (P/E) ratios of the sec­tor index rel­a­tive to its own 10-year aver­age using his­tor­i­cal daily data. It should be noted that 10-years may not be a long enough period to demon­strate the sec­u­lar trend in equi­ties; how­ever, the 2008 finan­cial cri­sis should also com­press a 10-year aver­age P/E ratio, mak­ing a more strin­gent bench­mark for deter­min­ing which sec­tors are attrac­tive on a his­tor­i­cal basis. In addi­tion, investors should also note that since the TSX lacks depth in a num­ber of its sec­tors, the val­u­a­tion of those sec­tors can be heav­ily impacted by indi­vid­ual com­pa­nies. Infor­ma­tion tech­nol­ogy and health care are prime exam­ples of sec­tors lack­ing depth.

Rec­om­men­da­tion: A num­ber of the sec­tors trad­ing at a dis­count to their 10-year aver­age in terms of P/E are well rep­re­sented in the BMO Low Volatil­ity Cana­dian Equity ETF (ZLB). Although the mar­ket has rotated into more cycli­cal ori­ented areas, we con­tinue to favour lower volatil­ity areas in the equity mar­ket as a long-term core hold­ing. As men­tioned, in our recent BMO Trade Oppor­tu­nity report, a com­bi­na­tion of ZLB with the BMO S&P/TSX Equal Weight Global Base Met­als Index ETF (ZMT) pro­vides investors with a solid long-term hold­ing com­bined with a more tac­ti­cal ori­ented opportunity.

Since the 2008 finan­cial cri­sis, there has been an increas­ing con­cern of run­away infla­tion due to the stim­u­la­tive mea­sures and accom­moda­tive mon­e­tary poli­cies of cen­tral banks around the world. Although it can be argued that the Con­sumer Price Index (CPI) is not a good rep­re­sen­ta­tion of true infla­tion, espe­cially given the ele­vated prices of hard assets over the decade, CPI for the U.S. remains at 2.9%, well below its long-term aver­age of 3.4%. One of the key rea­sons why an increase in money sup­ply has not trans­lated to infla­tion is due to a slower money velocity7, which has decreased sub­stan­tially since the 2008 finan­cial cri­sis as a result of greater uncer­tainty with the busi­ness envi­ron­ment. Should the recent improve­ment in U.S. eco­nomic data and unem­ploy­ment prove to be a sus­tained trend, the rate at which money changes hands could increase, even­tu­ally mak­ing infla­tion a concern.

Rec­om­men­da­tion: As U.S. mon­e­tary pol­icy indi­rectly affects the actions of other cen­tral banks and par­tic­u­larly the Bank of Canada, investors should keep an eye on the actions of the Fed. Although not an imme­di­ate con­cern, an uptick in money veloc­ity could poten­tially make infla­tion a prob­lem sev­eral years down the road. As a result, we con­tinue to favour short– and mid-term bonds as a means of decreas­ing interest-rate risk (See Cross-Asset Allo­ca­tion Mix Table for our rec­om­mended exposures).

In recent weeks, there has been much dis­cus­sion about the diverg­ing trends between the VIX and the Credit Suisse Fear Barom­e­ter Index (CSFB)5. Both indices are used as a gauge of mar­ket sen­ti­ment with higher read­ings indi­cat­ing increased ner­vous­ness with investors. In recent months, the VIX has dropped sig­nif­i­cantly whereas the CSFB has steadily risen. The VIX is reflec­tive of the market’s cur­rent antic­i­pa­tion of volatil­ity over the next 30-days, annu­al­ized. The CSFB, on the other hand, is cal­cu­lated as a zero-cost collar6, using three-month options. As such, there are a num­ber of dif­fer­ences in the two indices, includ­ing dif­fer­ent matu­rity terms of the under­ly­ing options, mak­ing a diver­gence pos­si­ble depend­ing on the term struc­ture in volatil­ity. Also worth men­tion­ing, is that the VIX cal­cu­lates volatil­ity using options on indi­vid­ual com­pa­nies whereas the CSFB uses index options.

Rec­om­men­da­tion: As we noted at the onset of the year, the term struc­ture in the VIX futures curve is cur­rently upward slop­ing and rel­a­tively steep in the first three con­tracts, which has made a diver­gence between the two “fear indices” pos­si­ble. The term struc­ture for VIX can be inter­preted as the market’s cur­rent expec­ta­tion for volatil­ity in the future. Although the term struc­ture for the VIX futures changes over time, and it is pos­si­ble that the term struc­ture could flat­ten, the VIX is well below its long-term aver­age and can­not get much lower. We con­tinue to advise investors that short– and mid-term bonds should not be neglected as a risk mit­i­ga­tion tool and that investors should con­tinue to main­tain expo­sure to defen­sive ori­ented areas in the equity mar­ket.

Oil prices have seen a steady rise since early Octo­ber reflect­ing an increase in opti­mism of a global eco­nomic recov­ery. Though polit­i­cal tur­moil has had more of a direct impact on the prices of Brent crude (Brent), West Texas Inter­me­di­ate (WTI) which is more reflec­tive of North Amer­i­can oil prices has seen an indi­rect impact due to a chang­ing demand and sup­ply equi­lib­rium. Last year on Sep­tem­ber 26, we rec­om­mended investors invest in energy through our BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO), which has gained 13.7% on a total return basis since. Energy com­pa­nies remain our top invest­ment idea within the com­mod­ity sec­tor based on global macro-economic and polit­i­cal forces. More­over, both Brent and WTI prices tend to strengthen the first seven months of the year, which could pro­vide an addi­tional tail-wind for oil prices.

Rec­om­men­da­tion: Although we would never make an invest­ment rec­om­men­da­tion based on sea­son­al­ity alone, the ten­dency for oil to gain in the first half of the year does pro­vide us with an addi­tional rea­son to be pos­i­tive on energy com­pa­nies. How­ever, as we men­tioned last month, since oil does have a ten­dency to be very reac­tive to macro-economic risk, we con­tinue to rec­om­mend a trail­ing stop-loss order of 10% on BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO). Investors that acted on the trade in Octo­ber may also want to con­sider par­ing back their expo­sure to their orig­i­nal allocation.

Cross-Asset Asset Allo­ca­tion Mix using BMO ETFs (click to enlarge)

Foot­notes

1 Credit Default Swaps (CDS): A swap agree­ment where the seller of the CDS will com­pen­sate the buyer in the event of a loan default or other credit event. The buyer of a credit default swap receives credit pro­tec­tion, whereas the seller of the swap guar­an­tees the credit wor­thi­ness of the debt secu­rity. In doing so, the risk of default is trans­ferred from the holder of the fixed income secu­rity to the seller of the swap. As such, a ris­ing CDS price indi­cates an increas­ing prob­a­bil­ity of a default on a fixed income issue, while a declin­ing price indi­cates a lower prob­a­bil­ity.
2 PIIGS: An acronym used to refer to the five euro­zone nations, which were con­sid­ered weaker eco­nom­i­cally fol­low­ing the finan­cial cri­sis: Por­tu­gal, Italy, Ire­land, Greece and Spain.
3 Tail-risk: The risk of an out­lier or improb­a­ble event occur­ring. Sta­tis­ti­cally, the event is said to be three stan­dard devi­a­tions or more away from the mean, under a nor­mally dis­trib­uted curve.
4 CBOE/S&P 500 Implied Volatil­ity Index (VIX): shows the market’s expec­ta­tion of 30-day volatil­ity. It is con­structed using the implied
volatil­i­ties of a wide range of S&P 500 index options. This volatil­ity is
meant to be for­ward look­ing and is cal­cu­lated from both calls and puts.
The VIX is a widely used mea­sure of mar­ket risk and is often referred to
as the “investor fear gauge”.
5 Credit Suisse Fear Barom­e­ter (CSFB): mea­sures investor sen­ti­ment for 3-month invest­ment hori­zons by pric­ing a zero-cost col­lar. The col­lar is imple­mented by sell­ing of a 10% out-of-the-money call (OTM) option on
the S&P 500 Com­pos­ite (SPX) and using the pro­ceeds to buy an OTM put.
The CSFB level rep­re­sents how far OTM that SPX put is.
6 Zero-cost col­lar: con­sists of the simul­ta­ne­ous sale of one option and using
the pro­ceeds towards the pur­chase of another option at dif­fer­ent strikes.
7 Money veloc­ity: aver­age fre­quency with which a unit of money is spent on new goods and ser­vices pro­duced domes­ti­cally in a spe­cific period of time.

Tags: Alfred Lee, Asset Markets, BMO, Canadian, Canadian Market, Cboe, Cmt, Credit Default Swaps, Debt Crisis, Debt Restructuring, Economic Fundamentals, ETF, ETFs, European Sovereigns, Gold Prices, Investment Outlook, Investment Strategist, Labour Costs, Market Volatility, Mining, Momentum Indicators, precious metals, Silent Waters, Structured Investments, Volatility Index, Volatility Index Vix
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Gold Market Radar (March 26, 2012)

Sunday, March 25th, 2012

Gold Mar­ket Radar (March 26, 2012)

For the week, spot gold closed at $1,661.90 up $1.90 per ounce, or 0.1 per­cent. Gold stocks, as mea­sured by the NYSE Arca Gold Min­ers Index, fell 0.4 per­cent. The U.S. Trade-Weighted Dol­lar Index slid 0.6 per­cent for the week.

Strengths

• U.S. Mint gold and sil­ver bul­lion coin sales rebounded from dis­ap­point­ing lows in Feb­ru­ary. As of Sun­day, March 18, gold bul­lion sales totaled 30,000 ounces, while over­all gold bul­lion coin sales in all sizes were reported at 31,500 ounces. In Feb­ru­ary, these sales were 20,000 ounces and 21,000 ounces, respec­tively. Sales of one-ounce sil­ver bul­lion coins were 1,647,000 ounces, a sub­stan­tial increase over the 1,490,000 ounces reported for the entire month of February.
• Accord­ing to an indus­try source and a Finan­cial Times report, the fall in gold prices has prompted one or more cen­tral banks to buy as much as four tons of bul­lion in recent weeks. The pur­chases, worth about $250 mil­lion at cur­rent prices, were report­edly made through the Bank for Inter­na­tional Set­tle­ments (BIS). The FT said banks have bought between four and six tons in the over-the-counter phys­i­cal mar­ket last week.
• Zambia’s Finance Min­is­ter said that the coun­try will not bring back the 25 per­cent min­ing wind­fall tax it scrapped in 2009 because it may force mine clo­sures. This is the first that we have heard in some time of a coun­try real­iz­ing the neg­a­tive impli­ca­tions for demand­ing an increased share in the min­ing com­pa­nies’ profits.

Weak­nesses

• After clos­ing up shop for five days over the intro­duc­tion of an addi­tional tax on gold imports, bul­lion traders across India decided to open their shops on Thurs­day, fol­low­ing late-night devel­op­ments with gov­ern­ment offi­cials to end the impasse. More than one hun­dred thou­sand bul­lion deal­ers across the coun­try had shut their shops as a form of protest, and traders esti­mate they could have suf­fered a rev­enue loss of over $700 mil­lion in sales.
• Bernanke’s speeches haven’t been falling on deaf ears, with Turk­ish, Indian and Viet­namese gov­ern­ments wary of gold. The gov­ern­ments of the three coun­tries are fac­ing weak­en­ing cur­ren­cies, widen­ing trade deficits, and a pop­u­la­tion buy­ing more and more gold. In line with Bernanke, all believe gold should bear much of the blame.
• Thurs­day morn­ing, news quickly spread of a mil­i­tary coup in Mali, as reports emerged that sol­diers had over­thrown Pres­i­dent Amadou Toumani Toure’s gov­ern­ment and seized power. The stated objec­tive from the Malian army has been to end an “incom­pe­tent régime,” con­demn­ing the gov­ern­ment of its inabil­ity to fight ter­ror­ism. Rand­gold Resources, which owns three mines in Mali, plunged as much as 17 per­cent in Lon­don on the news before rebound­ing to about 12 per­cent off. The CEOs of IAMGOLD, Rand­gold and Angl­o­Gold Ashanti all have main­tained that pro­duc­tion has yet to be affected.

Oppor­tu­ni­ties

• The Finan­cial Times reported this week that Deutsche Bank has plans to open a new pre­cious met­als vault in Lon­don next year, seek­ing to cash in on boom­ing investor demand for phys­i­cal gold and sil­ver. In Lon­don, which is the cen­ter of the global bul­lion mar­ket, vault space is run­ning low even as the growth in exchange-traded funds (ETFs) backed by pre­cious met­als has led to a steep rise in demand for vaults.
• Although India may have increased taxes for gold, the move could present an oppor­tu­nity for sil­ver, the poor man’s gold, to shine. After escap­ing India’s bud­get reforms, investors have shown a keen inter­est in buy­ing one kilo sil­ver bars. On Fri­day, India’s Finance Min­is­ter exempted branded sil­ver jew­elry from excise duty. Sil­ver coins of purity 99.9 per­cent and above were also exempted from excise duty. How­ever, the excise duty on refined gold was dou­bled from 1.5 to 3 per­cent. “Sil­ver has clearly been exempted for a rea­son,” said Prithvi­raj Kothari, pres­i­dent of the Bom­bay Bul­lion Asso­ci­a­tion. “Out of $50 bil­lion worth of imports of pre­cious met­als into India, sil­ver imports were just $4 bil­lion, while that for gold was the other $46 bil­lion,” he said.
• Accord­ing to a sur­vey of fund man­agers, the era of quan­ti­ta­tive eas­ing, a process by which cen­tral banks buy assets such as gov­ern­ment bonds to inject funds into the mar­kets, may be com­ing to an end. Accord­ing to a March sur­vey by Bank of Amer­ica Mer­rill Lynch, investors are “more upbeat about the future and the prospects for growth and they no longer expect fur­ther quan­ti­ta­tive eas­ing mea­sures to be taken by the Fed­eral Reserve or the Euro­pean Cen­tral Bank.” The report, how­ever, did find that fund man­agers still see sov­er­eign debt as the biggest tail risk to the global recov­ery. Investors fore­see higher infla­tion, with a net 13 per­cent expect­ing it to rise in the com­ing year. All in all, the uncer­tainty could con­tinue to bode well for gold prices con­tin­u­ing to rise.

Threats

• In another move to con­trol min­ing com­pa­nies’ finan­cials, Zim­babwe ordered min­ing firms to bank locally this past week, deposit­ing their export earn­ings with local banks. This comes as the government’s lat­est move to exert pres­sure on min­ers as it tries to address the dol­lar crunch afflict­ing its econ­omy. Last week, Impala Plat­inum, the world’s second-biggest plat­inum pro­ducer, bowed to pres­sure and said it would sur­ren­der a 51 per­cent stake in its Zim­plats unit to local black investors.
• The impli­ca­tions of a sil­i­co­sis class action suit for the South African min­ing sec­tor are very seri­ous, but no one yet knows how it will all play out. On Tues­day, a South African lawyer said that he was prepar­ing a class action law­suit against lead­ing gold min­ing firms on behalf of thou­sands of for­mer min­ers who say they con­tracted sil­i­co­sis, a debil­i­tat­ing lung dis­ease, through neg­li­gent health and safety prac­tices. The prin­ci­pal tar­gets of the suit would be Angl­o­Gold Ashanti, Gold Fields and Har­mony Gold—South Africa’s three biggest gold miners—and minor pro­ducer DRDGOLD. The impli­ca­tions for the gold min­ing indus­try and for its rela­tions with the government—already strained by past talk of nationalization—could be huge.

Tags: Bank For International Settlements, Bank For International Settlements Bis, Bullion Dealers, Bullion Traders, Central Banks, Coin Sales, Dollar Index, ETF, ETFs, Gold Bullion Coin, Gold Bullion Sales, Gold Imports, Gold Market, Gold Miners, Gold Prices, gold stocks, Market Radar, Nyse Arca, Silver Bullion Coins, Spot Gold, U S Mint, Windfall Tax
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Horizons ETFS Announces March 2012 Distributions

Friday, March 23rd, 2012

HORIZONS ETFS ANNOUNCES MARCH 2012 DISTRIBUTIONS

TORONTO, March 22, 2012 — Hori­zons Exchange Traded Funds Inc. (“Hori­zons ETFs”) and its affil­i­ate AlphaPro Man­age­ment Inc. are pleased to announce the dis­tri­b­u­tion amounts per unit (the “Dis­tri­b­u­tions”) for cer­tain of the Hori­zons ETFs fam­ily of exchange traded funds (the “ETFs”), for the period end­ing March 31, 2012, as indi­cated in the table below.

The ex-dividend date for the Dis­tri­b­u­tions is antic­i­pated to be March 28, 2012, for all unithold­ers of record on March 30, 2012. The Dis­tri­b­u­tions will be paid in cash or, if the unitholder has enrolled in the respec­tive ETF’s div­i­dend rein­vest­ment plan (DRIP), rein­vested in addi­tional units of the applic­a­ble ETF, on or about April 12, 2012.

Read Com­plete Press Release [PDF] - HORIZONS ETFS ANNOUNCES MARCH 2012 DISTRIBUTIONS

****

HORIZONS ENHANCED U.S. EQUITY INCOME FUND ANNOUNCES MONTHLY DISTRIBUTION

TORONTO, March 22, 2012 — Hori­zons Exchange Traded Funds Inc. (“Hori­zons ETFs”) and its affil­i­ate AlphaPro Man­age­ment Inc. are pleased to announce the monthly dis­tri­b­u­tion of the Hori­zons Enhanced U.S. Equity Income Fund (the “Fund”) for March 2012 in the amount of $0.06667 per Class A unit of the Fund. The Class A units of the Fund are listed for trad­ing on the Toronto Stock Exchange (“TSX”) under the sym­bol HES.UN.

The dis­tri­b­u­tion rep­re­sents an 8.00% annu­al­ized yield on the Fund’s ini­tial pub­lic offer­ing price of $10.00 per Class A unit. The March dis­tri­b­u­tion ex-dividend date is antic­i­pated to be March 28, 2012, for all Class A unithold­ers of record on March 30, 2012. The dis­tri­b­u­tion is payable on April 12, 2012.

Read Com­plete Press Release [PDF] — HORIZONS ENHANCED U.S. EQUITY INCOME FUND ANNOUNCES MONTHLY DISTRIBUTION

For fur­ther infor­ma­tion:
Mar­tin Fab­re­gas, Investor Rela­tions, (416) 601‑2508 or 1–866-641‑5739.

Tags: Complete Press, Distribution Amounts, Distributions, Dividend Reinvestment Plan, Drip, Equity Income Fund, ETF, ETFs, Ex Dividend Date, Exchange Traded Funds, Fabregas, Horizons, Initial Public Offering, Investor Relations, Management Inc, Offering Price, Press Release, Toronto March, Toronto Stock Exchange, Tsx
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Catching the "Silver Crusher" Algorithm in the Act

Thursday, March 22nd, 2012

There was a time when catch­ing the sil­ver "whack-a-mole" algo, or process, or inter­ven­tion, or manip­u­la­tion, or what­ever one wants to call it, in action was a myth: an urban leg­end, per­pet­u­ated by sil­ver con­spir­acy the­o­rists. Until today that is. Cour­tesy of Nanex we now have direct evi­dence of just what the reflex­ive mar­ket (in which deriv­a­tive prod­ucts such as ETFs influ­ence under­ly­ing assets) goes to town by tak­ing sil­ver to the wood­shed at a whop­ping 75,000 times per sec­ond! From the bro­ken mar­ket sleuths at Nanex:  "On March 20, 2012 at 13:22:33, the quote rate in the ETF sym­bol SLV sus­tained a rate exceed­ing 75,000/sec (75/ms) for 25 mil­lisec­onds. Nas­daq quotes lagged other exchanges by about 50 mil­lisec­onds. Nas­daq quotes even lagged their own trades – a con­di­tion we have jok­ingly referred to as fan­tasec­onds." Trans­la­tion: so des­per­ate was the desire to crush sil­ver at pre­cisely 13:22;33, that the Nas­daq order flow direc­tive ended up mov­ing faster than light. Frankly, we don't know about you, but when some­one is will­ing to bend the laws of rel­a­tiv­ity, just to get a cheaper price in sil­ver, to per­pet­u­ate a fail­ing mon­e­tary sys­tem or for any other rea­son, we qui­etly step aside...

From Nanex:

SLV 1 sec­ond inter­val chart show­ing trades col­ored by report­ing exchange.

SLV 1 sec­ond inter­val chart show­ing the NBBO
Shaded black if nor­mal, yel­low if locked (bid = ask) or red if crossed (bid > ask).

SLV 1 mil­lisec­ond inter­val chart show­ing trades col­ored by report­ing exchange.
Chart shows about 200 mil­lisec­onds of time.

SLV 1 mil­lisec­ond inter­val chart show­ing the NBBO
Shaded black if nor­mal, yel­low if locked (bid = ask) or red if crossed (bid > ask). Note the insanely high quote rate in the bot­tom panel. Chart shows about 200 mil­lisec­onds of time.

SLV 1 mil­lisec­ond inter­val chart show­ing the quotes and trades from ARCA (red) and Nas­daq (black).
You can clearly see the delay in Nas­daq quotes, yet their trades aren't delayed at all. Chart shows about 200 mil­lisec­onds of time.

SLV 1 mil­lisec­ond inter­val chart show­ing the quotes and trades from BATS (pur­ple) and Nas­daq (black).
You can clearly see the delay in Nas­daq quotes, yet their trades aren't delayed at all. Chart shows about 200 mil­lisec­onds of time.

SLV 1 mil­lisec­ond inter­val chart show­ing trades col­ored by report­ing exchange.
This chart shows approx­i­mately 150 mil­lisec­onds of time.

SLV 1 mil­lisec­ond inter­val chart show­ing the NBBO.
This chart shows approx­i­mately 150 mil­lisec­onds of time.

Tags: 1 Millisecond, Algorithm, Arca, bottom panel, Conspiracy Theorists, Crusher, Derivative Products, Direct Evidence, ETF, ETFs, Faster Than Light, Interval, Laws Of Relativity, Manipulation, Milliseconds, Monetary System, Nasdaq Quotes, Nbbo, Sleuths, Urban Legend, Whack A Mole, Woodshed
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Falling Treasuries: A Currency Perspective (Merk)

Wednesday, March 21st, 2012

Axel Merk, Merk Funds

March 20, 2012

What are the impli­ca­tions for the U.S. dol­lar and investors’ port­fo­lios if bond prices con­tinue to fall, as they have of late? Within that con­text, should investors care whether the U.S. retains its sta­tus as a “reserve cur­rency”? Should it effect the way investors think about their own cash reserves?

Until the end of last year, China had been a net seller of U.S. Trea­suries for six con­sec­u­tive months, spook­ing some investors that China might start to diver­sify its reserves in earnest. That trend was reversed in Jan­u­ary, when its Trea­sury hold­ings grew by 0.7% in one month to $1.159 tril­lion; year-on-year, China’s hold­ings increased a mere $4.8 bil­lion. China’s year-on-year increase in Trea­sury hold­ings is suf­fi­cient to finance the U.S. cur­rent account deficit for about 3 busi­ness days; that’s a good rea­son why investors should care, as the cur­rent account deficit reflects the amount of U.S. dol­lar denom­i­nated assets for­eign­ers need to buy just to keep the green­back from falling.

Whereas China has taken a breather with regard to pil­ing on U.S. debt, Japan has increased its pur­chases of Trea­suries, pos­si­bly because it is eager to weaken its own cur­rency. Japan’s Trea­sury hold­ings now stand at $1.1 tril­lion. Together, total for­eign hold­ings of U.S. Trea­suries rose 0.9% to a record $5.05 tril­lion in January.

Unfor­tu­nately, for­eign­ers might be attracted to the U.S. dol­lar more for liq­uid­ity and less so for qual­ity con­sid­er­a­tions. Cen­tral banks with bil­lions to deploy are able to do so in U.S. Trea­sury mar­kets with­out influ­enc­ing mar­ket prices too much. Think of it as the upside of issu­ing a huge amount of debt: there’s lots of it one can buy and sell. Liq­uid­ity, how­ever, doesn’t guar­an­tee suc­cess, as the Ital­ian bond mar­ket has clearly shown; when weaker Euro­zone coun­tries are engulfed in a cri­sis of con­fi­dence, Ital­ian bonds have often been sold as a proxy due to the size and depth of the mar­ket. Japan rep­re­sents another large bond mar­ket. Still, the U.S. bond mar­ket dwarfs all of these. When it comes to per­ceived safe havens, Swiss gov­ern­ment bonds may be hard to come by at times; given the erratic actions of the Swiss National Bank in recent months and years, we have to cau­tion that even Switzer­land may not be the safe haven some per­ceive it to be. Mov­ing to Ger­many – con­sid­ered to be a large, mature mar­ket by many – note that even Ger­man Trea­sury bills have been extremely dif­fi­cult to obtain dur­ing stretches of the finan­cial cri­sis, even at neg­a­tive yields.

Indeed, one of the most pos­i­tive global devel­op­ments would be if emerg­ing mar­ket coun­tries develop their domes­tic fixed income mar­kets. If gov­ern­ments, par­tic­u­larly in Asia, were to issue more debt in their domes­tic cur­ren­cies, they would be less depen­dent on U.S. dol­lar fund­ing, reduc­ing the so-called con­ta­gion risk in a finan­cial cri­sis. Ide­ally, emerg­ing mar­kets would fur­ther develop both long-term bond mar­kets, as well as short-term Trea­sury mar­kets. The fol­low­ing exam­ple illus­trates how global mar­kets are so inter­re­lated, and why such a devel­op­ment is so impor­tant: cur­rently, a great deal of emerg­ing mar­ket financ­ing is U.S. dol­lar denom­i­nated, but orig­i­nates from Euro­pean banks. Those Euro­pean banks, with trou­ble at home, are cut­ting their credit lines, to both shrink their loan port­fo­lios, but also as their cost of bor­row­ing U.S. dol­lars soared. That’s because Euro­pean banks his­tor­i­cally obtain much of their U.S. dol­lar financ­ing through U.S. money mar­ket funds. On aver­age, U.S. prime money mar­ket funds held about 50% of their assets in U.S. dol­lar denom­i­nated com­mer­cial paper issued by Euro­pean banks. After lots of pub­lic scrutiny, includ­ing from us (see: Mak­ing the U.S. Dol­lar Safer: Return OF Your Money), those hold­ings fell to about 1/3rd of money mar­ket fund assets in late 2011. As U.S. money mar­ket funds reduced their appetite for debt issued by Euro­pean banks, the Fed­eral Reserve (Fed), in con­junc­tion with other major cen­tral banks, put in place “cen­tral bank liq­uid­ity swaps”, a fancy way of describ­ing U.S. dol­lar loans extended by the Fed to the Euro­pean bank­ing sys­tem via the Euro­pean Cen­tral Bank (ECB) to alle­vi­ate U.S. dol­lar financ­ing con­cerns and ulti­mately, con­ta­gion risks to the global economy.

A key attribute of liq­uid­ity is the abil­ity to take money out of a coun­try. An investor will be more will­ing to invest in a coun­try when there are no cap­i­tal con­trols, when there’s con­fi­dence in the rule of law, con­fi­dence that investors’ rights are pro­tected. And while emerg­ing mar­kets are gen­er­ally on the right path, it’s a path that takes a long time to build, as investors’ trust must be earned over many years.

As such, odds are the reserve cur­rency sta­tus of the U.S. is likely to erode over time rather than overnight, if for no other rea­son than the lack of suit­able alter­na­tives. In our view, how­ever, U.S. pol­icy mak­ers would be well served if they attempted to make the U.S. dol­lar as attrac­tive as pos­si­ble, rather than rely­ing on the fact that for­eign­ers have lim­ited alter­na­tives. As recent years have shown, the Chi­nese, for exam­ple, have gained oper­a­tional expe­ri­ence in deploy­ing their reserves into assets out­side of U.S. Trea­suries, in real assets, through­out the world: notably by invest­ing in nat­ural resources in Aus­tralia, Africa, Latin Amer­ica and Canada.

For many years, until a month ago, the ECB, in its monthly com­mu­niqué, warned of a “poten­tial for a dis­or­derly cor­rec­tion of global imbal­ances.” That was cen­tral bank par­lance for a dol­lar crash. For what it’s worth, the warn­ing was miss­ing for the first time in years in this month’s state­ment.¹ Like the boy who cried wolf, when some­one warns about some­thing repeat­edly, few may take that risk seri­ously any­more. Is it com­pla­cency when one drops the warning?

What many don’t real­ize is that we don’t need a low prob­a­bil­ity / high-risk event – a “black swan” event – to be con­cerned. Take the recent tur­moil in the Trea­sury mar­ket: from the high on Feb­ru­ary 28, 2012 until the close on March 15, 2012, the U.S. 30 year bond had fallen about 8.5% in value (with declines con­tin­u­ing as of this writ­ing). Many have pre­vi­ously been chas­ing yields: a lot of money had moved into longer dated secu­ri­ties, the so-called long end of the yield curve. In that process, volatil­ity in that mar­ket had come down, pro­vid­ing the illu­sion of safety. We don’t need a crash, we need a return to a more nor­mal envi­ron­ment to have what may be a rude awak­en­ing for investors. The plunge in the 30-year bond in just over 2 weeks should serve as a wake-up call. It turns out that for­eign­ers appear to have piled into longer-dated Trea­suries just before the recent cor­rec­tion (net long-term TIC flows of $101 bil­lion in Jan­u­ary vs. $38.5 bil­lion expected), pos­si­bly mak­ing for a few very unhappy, but very impor­tant investors.

What is the rel­e­vance for the dol­lar? For­eign investors tend to own a large amount of Trea­suries. When Trea­suries fall in value, their invest­ments may go down, unless the dol­lar increases by the same amount. While some pun­dits – in an effort to com­ment on short-term cur­rency moves on any one day — point out that falling bond prices make the dol­lar more attrac­tive as yields are higher, that’s lit­tle con­sol­i­da­tion to those already hold­ing Trea­suries. Indeed, his­tor­i­cally speak­ing, our analy­sis indi­cates that the U.S. dol­lar tends to weaken dur­ing early and mid phases of an increas­ing inter­est rate cycle. That’s pre­cisely because the bond mar­ket turns into a bear mar­ket in such an envi­ron­ment. It’s in the late phases of a tight­en­ing cycle that for­eign­ers come back to the bond mar­ket, in antic­i­pa­tion that the next bull mar­ket for bonds is around the cor­ner; in that phase, the dol­lar may get a reprieve.

How­ever, when rates are ris­ing, investors may want to con­sider reduc­ing their inter­est risk, mov­ing from longer dated bond funds to shorter dated ones. Look­ing at it from an inter­na­tional per­spec­tive, the same rela­tion­ship applies; it should not be a sur­prise that the volatil­ity in shorter dated fixed income secu­ri­ties is less than that of longer dated ones:

Per­for­mance data in the chart above rep­re­sents past per­for­mance and is no guar­an­tee of future results.

For investors con­cerned about plung­ing bond prices, the obvi­ous move may be to trim inter­est risk. Some may appre­ci­ate the per­ceived safety of U.S. dol­lar cash, although, as our dis­cus­sion of U.S. money mar­ket funds above has shown, not all cash is equal. Investors con­cerned about the pur­chas­ing power of the U.S. dol­lar may want to con­sider mit­i­gat­ing the poten­tial risk of a declin­ing dol­lar by diver­si­fy­ing to other cur­ren­cies. Be warned, though, that cur­rency risk is then intro­duced. A money mar­ket fund will thrive to hold a sta­ble net asset value in U.S. dol­lar terms; a cur­rency fund will not. Indeed, much of invest­ing is about try­ing to pre­serve pur­chas­ing power. By mov­ing to cash in other cur­ren­cies, one does avoid equity risk, and pos­si­bly mit­i­gates inter­est and credit risk. But risk-free it is not. Indeed, we have argued for a long time that cen­tral banks may be erod­ing the pur­chas­ing power of cur­ren­cies around the world – risk free assets can no longer be thought of as such. It was in 2006 when I first said “there is no such thing any­more as a safe asset: investors may want to con­sider a diver­si­fied approach to some­thing as mun­dane as cash.”

Notes:

Please sign up for our newslet­ter to be informed as we dis­cuss global dynam­ics and their impact on currencies.We man­age the Merk Funds, includ­ing the Merk Hard Cur­rency Fund. To learn more about the Funds, please visit www.merkfunds.com.

¹For­mer ECB Pres­i­dent Willem Duisen­berg men­tioned "risks per­tain­ing to exter­nal imbal­ances" in the first time in March 1999. But he didn't ref­er­ence it again until 2002. (Instead, he men­tioned "there are no major imbal­ances in the euro area which would require a longer-term adjust­ment process" in 2001.) In May 2002, Duisen­berg brought up this topic again at the press con­fer­ence, say­ing "there are still a num­ber of uncer­tain­ties such as those related to ... and to the impact of exist­ing imbal­ances else­where on the world econ­omy". He used the sim­i­lar phras­ing in June, Octo­ber and Decem­ber 2002 but not every meeting.

It was Jan­u­ary 2003 that for the first time Duisen­berg ref­er­enced "a dis­or­derly adjust­ment of global imbal­ances" by say­ing "there are still risks relat­ing to a dis­or­derly adjust­ment of the past accu­mu­la­tion of macro­eco­nomic imbal­ances, espe­cially out­side the euro area." Then he reit­er­ated it a cou­ple of times dur­ing his remain­ing term as ECB pres­i­dent ended in Octo­ber 2003. A note here, cur­rent Greek PM and then ECB vice-president Lucas Papademos hosted the Sep­tem­ber con­fer­ence in 2003, where he also ref­er­enced "macro­eco­nomic imbal­ances in some regions of the world persist."

Since Trichet took office in Novem­ber 2003, it became almost a rou­tine to ref­er­ence "external/global imbal­ances" at the press con­fer­ences, though his word­ing changed over time. Dur­ing Novem­ber 2003 and June 2006, Trichet often used the word "per­sis­tent global imbal­ances" when talk­ing about con­cerns and risks to growth. Then he ref­er­enced "a dis­or­derly unwind­ing of global imbal­ances" for the first time in August 2006. He fre­quently used "pos­si­ble dis­or­derly devel­op­ments owing to global imbal­ances" dur­ing 2007–2008 and "adverse devel­op­ments in the world econ­omy stem­ming from a dis­or­derly cor­rec­tion of global imbal­ances" in 2009, and started to reg­u­larly ref­er­ence "con­cerns remain relat­ing to … and the pos­si­bil­ity of a dis­or­derly cor­rec­tion of global imbal­ances" since Sep­tem­ber 2009, through his last press con­fer­ence in Octo­ber 2011. Dur­ing his eight years in office, the only times he didn't men­tion "global imbal­ance" at all were August 2007, April 2005, and from Octo­ber 2004 to Jan­u­ary 2005.

Draghi con­tin­ued the tra­di­tion of ref­er­enc­ing "the pos­si­bil­ity of a dis­or­derly cor­rec­tion of global imbal­ances" in all of his press con­fer­ences from Novem­ber 2011 to Feb­ru­ary this year. The past meet­ing in March was the first time he didn't ref­er­ence it.

Axel Merk

Man­ager of the Merk Hard Cur­rency Fund, Asian Cur­rency Fund, Absolute Return Cur­rency Fund, and Cur­rency Enhanced U.S. Equity Fund, www.merkfunds.com

Axel Merk, Pres­i­dent & CIO of Merk Invest­ments, LLC, is an expert on hard money, macro trends and inter­na­tional invest­ing. He is con­sid­ered an author­ity on currencies.

The Merk Hard Cur­rency Fund (MERKX) seeks to profit from a rise in hard cur­ren­cies ver­sus the U.S. dol­lar. Hard cur­ren­cies are cur­ren­cies backed by sound mon­e­tary pol­icy; sound mon­e­tary pol­icy focuses on price stability.

The Merk Asian Cur­rency Fund (MEAFX) seeks to profit from a rise in Asian cur­ren­cies ver­sus the U.S. dol­lar. The Fund typ­i­cally invests in a bas­ket of Asian cur­ren­cies that may include, but are not lim­ited to, the cur­ren­cies of China, Hong Kong, Japan, India, Indone­sia, Malaysia, the Philip­pines, Sin­ga­pore, South Korea, Tai­wan and Thailand.

The Merk Absolute Return Cur­rency Fund (MABFX) seeks to gen­er­ate pos­i­tive absolute returns by invest­ing in cur­ren­cies. The Fund is a pure-play on cur­ren­cies, aim­ing to profit regard­less of the direc­tion of the U.S. dol­lar or tra­di­tional asset classes.

The Merk Cur­rency Enhanced U.S. Equity Fund (MUSFX) seeks to gen­er­ate total returns that exceed that of the S&P 500 Index. By employ­ing a cur­rency over­lay, the Merk Cur­rency Enhanced U.S. Equity Fund actively man­ages U.S. dol­lar and other cur­rency risk while con­cur­rently pro­vid­ing invest­ment expo­sure to the S&P 500.

The Funds may be appro­pri­ate for you if you are pur­su­ing a long-term goal with a cur­rency com­po­nent to your port­fo­lio; are will­ing to tol­er­ate the risks asso­ci­ated with invest­ments in for­eign cur­ren­cies; or are look­ing for a way to poten­tially mit­i­gate down­side risk in or profit from a sec­u­lar bear mar­ket. For more infor­ma­tion on the Funds and to down­load a prospec­tus, please visit www.merkfunds.com.

Investors should con­sider the invest­ment objec­tives, risks and charges and expenses of the Merk Funds care­fully before invest­ing. This and other infor­ma­tion is in the prospec­tus, a copy of which may be obtained by vis­it­ing the Funds' web­site at www.merkfunds.com or call­ing 866-MERK FUND. Please read the prospec­tus care­fully before you invest.

Since the Funds pri­mar­ily invest in for­eign cur­ren­cies, changes in cur­rency exchange rates affect the value of what the Funds own and the price of the Funds' shares. Invest­ing in for­eign instru­ments bears a greater risk than invest­ing in domes­tic instru­ments for rea­sons such as volatil­ity of cur­rency exchange rates and, in some cases, lim­ited geo­graphic focus, polit­i­cal and eco­nomic insta­bil­ity, emerg­ing mar­ket risk, and rel­a­tively illiq­uid mar­kets. The Funds are sub­ject to inter­est rate risk, which is the risk that debt secu­ri­ties in the Funds' port­fo­lio will decline in value because of increases in mar­ket inter­est rates. The Funds may also invest in deriv­a­tive secu­ri­ties, such as for– ward con­tracts, which can be volatile and involve var­i­ous types and degrees of risk. If the U.S. dol­lar fluc­tu­ates in value against cur­ren­cies the Funds are exposed to, your invest­ment may also fluc­tu­ate in value. The Merk Cur­rency Enhanced U.S. Equity Fund may invest in exchange traded funds ("ETFs"). Like stocks, ETFs are sub­ject to fluc­tu­a­tions in mar­ket value, may trade at prices above or below net asset value and are sub­ject to direct, as well as indi­rect fees and expenses. As a non-diversified fund, the Merk Hard Cur­rency Fund will be sub­ject to more invest­ment risk and poten­tial for volatil­ity than a diver­si­fied fund because its port­fo­lio may, at times, focus on a lim­ited num­ber of issuers. For a more com­plete dis­cus­sion of these and other Fund risks please refer to the Funds' prospectuses.

This report was pre­pared by Merk Invest­ments LLC, and reflects the cur­rent opin­ion of the authors. It is based upon sources and data believed to be accu­rate and reli­able. Opin­ions and forward-looking state­ments expressed are sub­ject to change with­out notice. This infor­ma­tion does not con­sti­tute invest­ment advice. Fore­side Fund Ser­vices, LLC, distributor.

Tags: Axel, Billions, Bond Market, Bond Prices, Business Days, Canadian Market, Cash Reserves, Central Banks, Current Account Deficit, ETF, ETFs, Eurozone Countries, Foreigners, Good Reason, Greenback, Guarantee Success, liquidity, Portfolios, Quality Considerations, Reserve Currency, Treasuries, Treasury Markets, Trillion, U S Treasury
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Is Popularity Ruining Indexing?

Tuesday, March 20th, 2012

by William Smead, Smead Cap­i­tal Management

We have been trav­el­ing around the world deliv­er­ing a talk to CFA Soci­eties on why pas­sive indexes beat most active equity funds. We start the talk with the fol­low­ing William Sharpe quote from 2002:

“Should every­one index every­thing? The answer is resound­ingly no. In fact, if every­one indexed, cap­i­tal mar­kets would cease to pro­vide the rel­a­tively effi­cient secu­rity prices that make index­ing an attrac­tive strat­egy for some investors. All the research under­taken by active man­agers keeps prices closer to val­ues,
enabling indexed investors to catch a free ride with­out pay­ing the costs. Thus there is a frag­ile equi­lib­rium in which some investors choose to index some or all of their money, while the rest con­tinue to search for mis­priced securities.

Should you index at least some of your port­fo­lio? This is up to you. I only sug­gest that you con­sider the option. In the long run this bor­ing approach can give you more time for more inter­est­ing activ­i­ties such as music, art, lit­er­a­ture, sports, and so on.”

Jason Zweig of the Wall Street Jour­nal wrote a blog last week titled, “Sim­ple Index Funds May Be Com­pli­cat­ing the Stock Mar­ket”. In it he explained how pas­sive invest­ments have risen to 33% of the money in equity mutual funds. He the­o­rizes that all these agnos­tic invest­ments might be adding to the volatil­ity and the high cor­re­la­tions in the marketplace:

“Recently, lead­ing invest­ing experts—including Rod­ney Sul­li­van, edi­tor of the Finan­cial Ana­lysts Jour­nal, con­sul­tant James Xiong of Morn­ingstar Invest­ment Man­age­ment and Jef­frey Wur­gler, a finance pro­fes­sor at New York University—have been warn­ing that index funds could desta­bi­lize the finan­cial markets.

The rise of trad­ing in index funds, these researchers say, is caus­ing stocks to move more tightly together than ever before—as if they “have joined a new school of fish,” as Prof. Wur­gler puts it. That is reduc­ing the power of diver­si­fi­ca­tion and could make booms and busts more likely and more extreme.

Unlike con­ven­tional funds run by highly paid stock-pickers who seek to buy the best secu­ri­ties and avoid the worst, index funds—including most exchange-traded funds, or ETFs—effectively buy and hold all the secu­ri­ties in a mar­ket bench­mark such as the Stan­dard & Poor’s 500-stock index.”

Let us unpack Sharpe’s the­ory, Zweig’s hypoth­e­sis and our man­i­festo on “Long Dura­tion Com­mon Stock Invest­ing”, to see if we can make sense out of today’s stock mar­ket environment.

William Sharpe was an effi­cient mar­ket believer in 2002. His beliefs are pred­i­cated on two ideas. First, “All the research under­taken by active man­agers keeps prices closer to val­ues, enabling indexed investors to catch a free ride with­out pay­ing the costs.” In his research on intrin­sic val­ues in Feb­ru­ary of 2009, Ben Inker at Grantham, Mayo and Van Otter­Loo (GMO) con­cluded that 75% of the intrin­sic value of a com­pany comes from cash flows start­ing 11 years from now and that 50% of the intrin­sic value is from cash flows that come more than 25 years from today. Since there is almost no long dura­tion equity research analy­sis done on Wall Street, the mar­ket can’t pos­si­bly be effi­cient. The stock mar­ket and its par­tic­i­pants have been com­pact­ing the dura­tion of their equity invest­ments con­stantly since the stock mar­ket topped in early 2000. Hold­ing peri­ods are down to his­tor­i­cally low lev­els on the NYSE, insti­tu­tions are heav­ily com­mit­ted to hedge funds with very high turnover and active equity fund man­agers have aver­age turnover around 100%. A man­ager with 50% turnover is con­sid­ered a low turnover manager!

Sec­ond, Sharpe was expect­ing that those who get paid to asset allo­cate would never get so heav­ily involved in index­ing as to ruin the goose that laid the inex­pen­sive and con­sis­tent “golden eggs”. Index­ing suc­cess is pred­i­cated on being a small minor­ity of the mar­ket­place. In effect, its pop­u­lar­ity is doom­ing the strat­egy and mak­ing the mar­ket even more inef­fi­cient than it was before! Between short-sighted active investors and agnos­tic index­ers dom­i­nat­ing the mar­ket, Zweig explains that you get very high cor­re­la­tions and extreme volatil­ity. The volatil­ity dri­ves poten­tial long dura­tion investors away from the marketplace.

“Con­sid­er­ing that index funds charge annual fees about one-10th of those levied by actively man­aged funds, it isn’t any won­der index­ing has become a money mag­net. A decade ago, 278 index mutual funds and 119 exchange-traded funds held $347 bil­lion, or about 16% of all assets in U.S. stock funds. Today, accord­ing to Morn­ingstar, 336 index funds and 1,148 ETFs hold $1.24 tril­lion, or fully one-third of all the money in U.S. stock funds.

That wor­ries some ana­lysts. “Mar­kets work best when peo­ple think and act inde­pen­dently, not all together,” Mr. Sul­li­van says. When investors add money to an index fund, it gen­er­ally will buy every secu­rity in the mar­ket that it tracks—hundreds, some­times thou­sands at a time, regard­less of price. When investors pull money out, the index fund has to sell across the board.”

We believe the solu­tion to these times is at the heart of our man­i­festo. You need to ana­lyze com­pa­nies with a spe­cial focus on char­ac­ter­is­tics which con­tribute to long dura­tion. We like wide moats, sus­tain­able high prof­itabil­ity, high free cash flow and strong bal­ance sheets. GMO likes low beta, low lever­age, high sus­tain­able prof­itabil­ity and low earn­ings volatil­ity. These are all fac­tors which con­tribute alpha over long stretches of time.

In our opin­ion, you either need to be a low turnover stock selec­tor or hire one to be your equity rep­re­sen­ta­tive. War­ren Buf­fett is quoted as say­ing, “The stock mar­ket serves as a relo­ca­tion cen­ter at which money is moved from the active to the patient.” The main attrac­tion to the S&P 500 Index is it has low man­age­ment fees in a mutual fund or ETF form and very low trad­ing costs due to turnover that aver­ages below 5% per year. Boston College’s Cen­ter for Retire­ment Research found that the aver­age US equity fund spent 1.44% per year on trad­ing costs. Add this to man­age­ment fees and oper­at­ing expenses in the mutual fund world and you need the equity man­ager to beat the S&P 500 Index by at least 2.5% per year just to keep up. We strive for turnover in the 15–25% range and seek minis­cule trad­ing costs.

Scarcity cre­ates value in eco­nom­ics. In our view, what is scarce today is an equity man­ager doing long-term/long dura­tion equity analy­sis and institutions/individual investors will­ing to employ them. Since 33% of the stock mar­ket is indexed and most of the other 67% works in very short ana­lytic time frames, we believe the mar­ket must be as inef­fi­cient as it has ever been. Time is the ally of the long-duration com­mon stock investor and we believe more so now, because index­ing is get­ting too pop­u­lar and invest­ing in short dura­tions is at epi­demic lev­els. We won­der what William Sharpe would say today.

***

The infor­ma­tion con­tained in this mis­sive rep­re­sents SCM’s opin­ions, and should not be con­strued as per­son­al­ized or indi­vid­u­al­ized invest­ment advice. Past per­for­mance is no guar­an­tee of future results. Some of the secu­ri­ties iden­ti­fied and described in this mis­sive are a sam­ple of issuers being cur­rently rec­om­mended for suit­able clients as of the date of this mis­sive and do not rep­re­sent all of the secu­ri­ties pur­chased or rec­om­mended for our clients. It should not be assumed that invest­ing in these secu­ri­ties was or will be prof­itable. A list of all rec­om­men­da­tions made by Smead Cap­i­tal Man­age­ment with in the past twelve month period is avail­able upon request.

Copy­right © Smead Cap­i­tal Management

Tags: Art Literature, Coul, Equity Funds, ETF, ETFs, Finance Professor, Financial Analysts Journal, Index Funds, Jason Zweig, Jeffrey Wurgler, Journal Consultant, Morningstar, Music Art, New York University, Passive Investments, School Of Fish, Security Prices, Smead, Traveling Around The World, Wall Street Journal, William Sharpe, Xiong
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Middle Age For The Middle Kingdom

Monday, March 19th, 2012

Fea­tured: GUGGENHEIM CHINA SMALL CAP ETF — Ticker: HAO / NYSE

China is aging and as it leaves its youth­ful days of high-energy growth behind, the mid­dle king­dom will set­tle into a more gen­teel, more com­fort­able middle-aged exis­tence. The impli­ca­tions for investors are many and require a re-think of your invest­ment strategy.

Middle-age has been a few years com­ing but the joint pains were espe­cially sharp this week. Speak­ing at the annual National People’s Con­gress meet­ing, Pre­mier Wen Jiabao low­ered China’s tar­get growth rate and said it would grad­u­ally reduce its depen­dence on capital-intensive growth in favor of strength­en­ing domes­tic con­sumer demand.

Mar­kets reacted instantly. The Shang­hai Shen­zen 300 Index fell nearly 3% and the iShares FTSE China 25 Index ETF (FXI/NYSE) fell more than 6% on the announce­ment. But beyond the instant, is this pol­icy shift really a bad thing? We don’t think so.

My vision of China, shaped by trav­els and by Edward Burtynsky’s hor­ri­fy­ing pho­tog­ra­phy, is one of dirty, heavy indus­try con­sum­ing moun­tains of resources – peo­ple, steel, oil – to pro­duce cheap baubles for export to the world. To have this present give way to a kinder future would be wonderful.

Nor is the present model sus­tain­able. The last decade of lop­sided trade rela­tions between China and the rest of the world were doomed to fail, espe­cially with demand from China’s biggest cus­tomers, Europe and the United States, falling in recent times and aus­ter­ity cuts as far as the horizon.

Then there are China’s inter­nal pres­sures: Eth­nic hatreds spark hin­ter­land riots that are fed by idle poverty; Urban hous­ing is in cri­sis, with a mod­est apart­ment in south China priced at about 45 times the aver­age salary (they joke that a peas­ant would need to have worked from the end of the Tang Dynasty in 907 AD to afford a Bei­jing apart­ment today); iPad and Dell PC assem­blers at Fox­conn rou­tinely use sui­cide as a bar­gain­ing chip. If China did noth­ing, how long would this pres­sure cooker remain intact?

Pre­mier Wen con­fronted these ten­sions. He announced higher min­i­mum wages in the big cities, a 20% increase in edu­ca­tion, health and wel­fare spend­ing, and allow­ing more rural folk to migrate to the cities. The boost in con­sumer spend­ing from these changes will help off­set the loss in demand else­where. He also com­mit­ted to keep­ing a tight rein on prop­erty prices by con­trol­ling spec­u­la­tion and by build­ing more pub­lic, sub­sidised housing.

The evo­lu­tion under­way in China is not unique. Early indus­trial Eng­land with its hell­ish fac­to­ries and impov­er­ished masses even­tu­ally emerged as a more diver­si­fied econ­omy pro­duc­ing more wealth for more of its peo­ple. Could China achieve the same over the next decade? DDB, the ad agency behind Volkswagen’s cute-kid-as-Darth-Vader ad, thinks so. It is mov­ing its cre­ative office to China.

What about for investors? China will still have heavy indus­tries but demand for their out­puts will fall over sev­eral years. And the export-oriented fac­to­ries churn­ing out every­thing from tele­phones to teddy bears will need to tar­get domes­tic con­sumers. Consumer-oriented sec­tors will ben­e­fit: Retail­ers; mak­ers of refrig­er­a­tors, cars and other durables; health-care and pharmaceuticals.

There are sev­eral China ETFs avail­able but few reflect this future China. The biggest ETF is the iShares FXI, with about $7 bil­lion in assets, hold­ing 26 large cap stocks with mar­ket caps of near $100 bil­lion. More than half the ETF by weight is in finan­cials and real estate – two areas of the Chi­nese mar­ket that are best avoided right now. Another 30% is in other large energy, min­ing and indus­trial firms.

For a more Chi­nese consumer-oriented ETF, con­sider instead the Guggen­heim China Small Cap ETF (HAO/NYSE). It holds 230 com­pa­nies and a quar­ter of its allo­ca­tion is to firms like retail­ers, hotels, and food and beer mak­ers. Another quar­ter is in indus­trial firms mak­ing trains, planes and auto­mo­biles. Its expo­sure to banks and real estate is a tol­er­a­ble 16%. Over­all, HAO offers a more diverse slice of the Chi­nese econ­omy and espe­cially the parts that will ben­e­fit from a stronger con­sumer. Other met­rics – div­i­dend yield, price-to-earnings and returns – are also pos­i­tive com­pared to FXI and others.

Aging is rarely pleas­ant but with an ETF like HAO, it can at least be some­what profitable.

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

Tags: Average Salary, Bargaining Chip, Dell Pc, Edward Burtynsky, ETF, ETFs, Fxi, Internal Pressures, Ipad, Ishares, Joint Pains, Kinder Future, Last Decade, Pc Assemblers, Policy Shift, Premier Wen Jiabao, Shenzen, South China, Steel Oil, Tang Dynasty, Target, Youthful Days
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Emerging Markets Radar (March 19, 2012)

Saturday, March 17th, 2012

Emerg­ing Mar­kets Radar (March 19, 2012)

Strengths

• Russ­ian indus­trial pro­duc­tion rose 6.5 per­cent in Feb­ru­ary com­pared with a year ear­lier, the fastest pace since Jan­u­ary 2011 and up from 3.8 per­cent in January.
• National Bank of Poland announced that M3 money sup­ply rose 12.6 per­cent year-over-year in Feb­ru­ary, after a 13.7 per­cent increase in January.
• China will con­sol­i­date rare earth com­pa­nies into two or three large-size enter­prises, Shang­hai Secu­ri­ties News reports, cit­ing Miao Wei, Min­is­ter of Indus­try and Infor­ma­tion Technology.
• China may resume nuclear plant approvals early this year, accord­ing to State Nuclear Power Tech­nol­ogy Corp. pres­i­dent Wang Binghua. China domes­tic coal prices and imports may surge as rail­way lines shut down for main­te­nance, accord­ing to Com­modor Research.
• China will allow exchanged-traded funds (ETFs) of Hong Kong shares to trade on the main­land exchanges “soon,” accord­ing to Hong Kong’s Sec­re­tary for Finan­cial Ser­vices and Trea­sury K.C. Chan.
• From March 1–9, China’s pas­sen­ger vehi­cle sales were 294,200 units, ris­ing 13 per­cent year-over-year and 5 per­cent month-over-month after adjust­ing the num­ber of work­ing days, accord­ing CICC.
• Singapore’s non-oil exports surged 30.5 per­cent year-over-year in Feb­ru­ary as elec­tron­ics and phar­ma­ceu­ti­cal ship­ments increased. The result was much higher than the median Bloomberg esti­mate of 16.2 percent.

Weak­nesses

• South African retail sales growth expanded at the slow­est pace in six months in Jan­u­ary as the high­est infla­tion rate in more than two years damped con­sumer spend­ing. Sales growth eased to 3.9 per­cent from 8.7 per­cent a month ear­lier, a Pretoria-based Sta­tis­tics South Africa said on its web­site this week. Infla­tion in South Africa was 6.3 per­cent in Jan­u­ary as elec­tric­ity, fuel and food prices climbed, lim­it­ing the room the cen­tral bank has to stim­u­late the econ­omy as Europe enters a recession.
• China’s for­eign direct invest­ment fell for the fourth month in a row in Feb­ru­ary as com­pa­nies reined in spend­ing amid a slow­down in the world’s second-biggest econ­omy and the pro­longed Euro­pean debt cri­sis. Invest­ment declined 0.9 per­cent to $7.73 bil­lion last month from a year ear­lier, fol­low­ing a 0.3 per­cent drop in Jan­u­ary, the Min­istry of Com­merce said in a state­ment this week.
• China’s Feb­ru­ary exports rose 18.4 per­cent, lower than the esti­mate of 31.1 per­cent, while imports rose 39.6 per­cent, higher than the esti­mate of 31.8 per­cent. How­ever, the largest trade deficit in the month was mainly due to sea­sonal fac­tors and won’t be sus­tained, Min­istry of Com­merce spokesman Shen Danyang said.
• Chi­nese pre­mier Wen Jiabao at a news con­fer­ence after the “Two Con­fer­ences” in Bei­jing strongly com­mented that the house prices are far from being rea­son­able, and stated the gov­ern­ment will main­tain its prop­erty curbs.
• Korea’s Feb­ru­ary unem­ploy­ment rate rose sur­pris­ingly to 3.7 per­cent from 3.2 per­cent in Jan­u­ary, above con­sen­sus of 3.2 per­cent. The main rea­son for the higher job­less rate was the increased labor force in the month, as col­lege stu­dents entered the labor market.

Oppor­tu­ni­ties

• Chile is said to spend more than $9 bil­lion on water treat­ment plants by 2017 as min­ing com­pa­nies boost pro­duc­tion, a report from Ray­mond Philippe, a Santiago-based direc­tor for the Cana­dian engi­neer­ing com­pany, Hatch Group, said this week.
• HSBC, Europe’s largest bank, is look­ing to buy a lender in Turkey. Given the size of HSBC, buy­ing a small bank would make lit­tle sense. HSBC would like “a mean­ing­ful invest­ment,” accord­ing to its CEO.
• Turkey will stop charg­ing spe­cial con­sump­tion taxes on car pur­chases, said Indus­try Min­is­ter Nihat Ergun.
• Turkey, with the biggest cur­rent account deficit after the U.S. and eco­nomic growth rival­ing China, is seek­ing to grow its pen­sion sys­tem as a means of sus­tain­ing eco­nomic growth with­out rely­ing on more volatile for­eign cap­i­tal inflows. The gov­ern­ment may dou­ble tax incen­tives for pen­sion con­tri­bu­tions this year.
• The merger between Youku and Tudou con­sol­i­dates China’s online video indus­try, which will ben­e­fit estab­lished inter­net play­ers such as Baidu and Sina. As the online video ad mar­ket grows explo­sively, those estab­lished plat­forms will com­pete rationally.

Threats

• India’s head­line infla­tion picked up for the first time in five months in Feb­ru­ary on higher food costs but another mea­sure of price pres­sures cooled, spark­ing mar­ket spec­u­la­tion that the cen­tral bank may sur­prise with an inter­est cut on Thurs­day. The whole­sale price index, India’s main gauge of infla­tion, edged up a faster-than-expected 6.95 per­cent from a year ear­lier in Feb­ru­ary after a spike in veg­etable prices fanned food inflation.
• With deter­mi­na­tion to restruc­ture its indus­try, China will allow its GDP growth to touch a lower low in the first and sec­ond quar­ters, but the mar­ket expects it to go higher after the first half of the year.

Tags: Canadian, Canadian Market, Cicc, Coal Prices, Commodor, Consumer Spending, Domestic Coal, ETF, ETFs, Food prices, Foreign Direct Investment, Inflation Rate, Minister Of Industry, Money Supply, National Bank Of Poland, Nuclear Plant, Nuclear Power Technology, Oil Exports, Railway Lines, Rare Earth, Research China, Retail Sales Growth, Russia, Shanghai Securities News, Technology Corp
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