U.S. Equity Market Radar (May 7, 2012)

Monday, May 7th, 2012

U.S. Equity Mar­ket Radar (May 7, 2012)

The S&P 500 Index declined 2.44 per­cent this week. Telecom­mu­ni­ca­tion ser­vices and util­i­ties out­per­formed as investors sought higher div­i­dend yields in the wake of higher mar­ket volatil­ity.  The S&P 500 suf­fered its worst weekly decline since Decem­ber as the mar­ket digested a slew of eco­nomic releases, which on aver­age came in slightly below expectations.

Strengths

• AT&T and Ver­i­zon led the telecom­mu­ni­ca­tion ser­vice sec­tor for a sec­ond week, as investors sought the rel­a­tive safety of mar­ket lead­ing div­i­dend yields.
• Util­i­ties also per­formed well dur­ing this “risk off’ week, par­tic­u­larly as the 10-year U.S. Trea­sury yield sank to just 1.88 percent.
• The defen­sive con­sumer sta­ples sec­tor out­per­formed the broader mar­ket with rel­a­tively small decline of 0.52 per­cent.  Whole Foods Mar­ket and Archer-Daniels gained 7.8 per­cent and 3.8 per­cent, respec­tively, dur­ing a chal­leng­ing trad­ing week.

Weak­nesses

• Notably, infor­ma­tion tech­nol­ogy trailed the S&P 500 Index this week by 131 basis points, and was the worst-performing sec­tor within the broad mar­ket. Accord­ingly, Apple declined by 6.3 per­cent over the last five days.
• Energy and Mate­ri­als lagged the mar­ket as the price of crude oil dropped below $100 a bar­rel and the Thomp­son Reuters/Jefferies Com­mod­ity Index fell by 2.7 per­cent this week on soft employ­ment data and eco­nomic growth con­cerns.  Dia­mond Off­shore Drilling fell 4.6 per­cent dur­ing the week.

Oppor­tu­nity

• Despite down­side volatil­ity dur­ing the week, the home­build­ing sub­sec­tor con­tin­ues to per­form well, hit­ting a new 52-week high, and fin­ish­ing the week rel­a­tively flat in a down market.

Threat

• The U.S. remains a bright spot in the global econ­omy and exter­nal shocks from Europe or Asia can’t be ruled out.

Tags: Archer Daniels, Broad Market, Commodity Index, Consumer Staples, Diamond Offshore Drilling, Dividend Yields, Downside Volatility, Economic Releases, Employment Data, External Shocks, Global Economy, Growth Concerns, Market Radar, Market Volatility, Price Of Crude Oil, Relative Safety, Telecommunication Service, Telecommunication Services, U S Treasury, Whole Foods Market
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Bill Gross: Investment Outlook (May 2012)

Wednesday, May 2nd, 2012

Tues­day Never Comes

May 2012

by William H. Gross, Co-Chief, PIMCO

- The cur­rent accel­er­a­tion of credit via cen­tral bank poli­cies will likely pro­duce a pos­i­tive rate of real eco­nomic growth this year for most devel­oped coun­tries, but the struc­tural dis­tor­tions brought about by zero bound inter­est rates will limit that growth and induce seri­ous risks in future years.

- Not sud­denly, but over time, grad­u­ally higher rates of infla­tion should be the result of QE poli­cies and zero bound yields that will likely con­tinue for years to come.

- Focus on secu­ri­ties with shorter dura­tions – bonds with matu­ri­ties in the five-year range and stocks pay­ing div­i­dends that offer 3%–4% yields. In addi­tion, real assets/commodities should occupy an increas­ing per­cent­age of portfolios.

The global econ­omy is float­ing on an ocean of credit, and a good thing too as our car­toon friend Wimpy reminds us. With­out it, he would be a hun­gry puppy by next Tues­day and nearly seven bil­lion world cit­i­zens would be worse off if barter, and not credit, was the oil that lubri­cated trade. Unlike Wimpy, early soci­eties func­tioned with­out an exchange of (money) or the promise to pay it back in the future (credit). Growth was lim­ited, how­ever, because sav­ings or invest­ment could not be incented prop­erly. Those that wanted to save for a rainy day had no means to express that cau­tion; bet­ter to con­sume a banana or a ham­burger today than to watch it rot and become worth­less on Tues­day. But money changed all of that and the abil­ity to bor­row and exchange it for repay­ment at some future date was the eco­nomic elixir of the ages. Shake­speare, with his admo­ni­tion to “nei­ther a bor­rower nor a lender be,” might have won a 17th cen­tury Pulitzer, but def­i­nitely not a Nobel Prize for economics.

Still, the use of credit never really kicked into high gear until the dis­cov­ery of frac­tional reserve bank­ing and the ulti­mate for­ma­tion of cen­tral banks to facil­i­tate and pro­tect its dis­burse­ment. Pic­ture a Wild, Wild West Bank in Yuma, Ari­zona back in 1901. It had a big safe where min­ers left their gold nuggets for safe keep­ing, but in order to become more than a depos­i­tory, the bank needed to issue notes and let­ters of credit in an amount greater than the gold in its vault. The­o­ret­i­cally there was some of the owner’s gold dust in there too, but who was count­ing as long as gold came in and gold went out and Yuma’s cit­i­zens thought that the bank’s notes were backed by tan­gi­ble evi­dence of wealth. Frac­tional reserve bank­ing was aborn­ing in the 20th cen­tury, sharp­shoot­ers and all.

Prob­lem was that many of those local banks with their indi­vid­ual cur­ren­cies and drafts went out of busi­ness, lead­ing to pan­ics and mild depres­sions through­out the grow­ing states, and so in 1913 the dol­lar became our sin­gle cur­rency, and the Fed­eral Reserve our offi­cial cen­tral bank. The Fed, with a cer­tain amount of gold cer­tifi­cates, would then extend credit to its mem­ber banks, which would then extend credit to busi­nesses, which would mag­i­cally pro­mote sav­ings, invest­ment and eco­nomic growth. No left­over ham­burg­ers on Tues­day for Wimpy – his tummy was grum­bling and by god, or by Fed, he was gonna get it NOW.

This process of credit and its cre­ation pow­ered global economies for the next cen­tury. It ben­e­fited not only con­sumers who wanted their burg­ers now, but lenders and investors who were will­ing to go hun­gry on Fri­day for the ben­e­fit of get­ting their money back with inter­est on Tues­day. Both sides expe­ri­enced a win/win exchange as the real econ­omy charged ahead, cre­at­ing jobs, tech­no­log­i­cal advances and the erad­i­ca­tion of dis­ease. What was not to like about credit? Noth­ing really, except much as the absence of it hin­dered ancient soci­eties, the excess of it now hob­bles mod­ern economies. Credit is the foun­da­tion of the wealth cre­ation process, but it can also be the cause of finan­cial insta­bil­ity and poten­tial wealth destruc­tion. Like nuclear energy, “atomic” credit or debt must be con­trolled if it is to ben­e­fit, as opposed to destroy.

And so the job of modern-day cen­tral bankers – Bernanke, King, Draghi and their global coun­ter­parts – is to decide how to con­trol a ben­e­fi­cial chain reac­tion with­out it get­ting out of hand. In many ways they are like their Wild, Wild West coun­ter­parts, try­ing to con­vince skep­ti­cal depos­i­tors that the gold will always be there. Yet, since 1971, when Nixon cratered Bret­ton Woods, there has been no explicit or even implicit gold back­ing. The U.S. and there­fore the world’s finance-based economies have been backed by an increas­ing amount of IOUs, which are sim­ply paper promises to cre­ate more paper when there is an old-fashioned 20th cen­tury run on the banks, or incred­i­bly enough – even when there is not. Lack­ing a dis­ci­plined parental exam­ple, the banks, invest­ment banks, money man­agers and hedge funds piled paper on top of paper as well, cre­at­ing deriv­a­tives and seem­ingly end­less chains of repos and rehy­poth­e­ca­tion of repos to amass a total amount of credit that lit­er­ally can­not be counted. Esti­mates sug­gest global credit in the finan­cial sec­tor exceeds $200 tril­lion, with devel­oped economies’ cen­tral banks hold­ing only $15 tril­lion in reserves or fig­u­ra­tive “gold dust.” If so, then the global bank­ing sys­tem is lev­ered at least thir­teen times. These num­bers don’t even count the amount of side bets or credit default swaps, which can’t be used as burger pay­ments, but which total $700–$800 tril­lion alone. Wimpy has financed so many Whop­pers that Tues­day can never come. Judg­ment day must always be around the cor­ner or after the next week­end. Wimpy can­not pay the tab, except with more and more credit cre­ation, as Euroland coun­tries are dis­cov­er­ing first hand.

Yet how much credit is too much credit and how is a ded­i­cated cen­tral banker to know? Part of the prob­lem is in clearly defin­ing what does or doesn’t fit the def­i­n­i­tion. There are the fam­i­lies of M’s – M1, M2 and the dis­banded M3 in the U.S. – the for­mer two of which the Fed now loosely uses to mon­i­tor a growth rate so as not to bring credit cre­ation to a boil. 21st cen­tury pri­va­teers, how­ever, proved there can be no accu­rate gauge of credit growth as long as banks and the shadow banks can cre­ate their own money at will. CDOs, CLOs and secu­ri­tized lend­ing that man­aged to skirt reg­u­la­tory stan­dards for bank loans by apply­ing 1%, 2% and 5% “hair­cuts” to secu­ri­tized assets made a mock­ery of sound bank­ing and ulti­mately cre­ated great risk for cen­tral bankers and their abil­ity to tem­per the excess of credit cre­ation. In 2008, cen­tral bankers never really knew how much debt was out there, and to be hon­est, they don’t know now.

Aus­trian school econ­o­mists might say “no mat­ter, for­get the count­ing – all a cen­tral banker has to do is observe the inter­est rate, the price of credit, to know whether things have got­ten out of hand.” And they may have had a point – even after 1971 and up to the mid-1990s, but then economies and the credit that was dri­ving them mor­phed into a uni­verse that the con­ser­v­a­tive Aus­tri­ans would not have rec­og­nized. With the dot­coms, the sub­primes and now the reflex­ive delev­er­ing of our finan­cial sys­tem, it is prac­ti­cally impos­si­ble to know what inter­est rate is applic­a­ble. With the QEs and LTROs reduc­ing real yields far below absolute zero, a cen­tral banker must wan­der aim­lessly in pol­icy space, won­der­ing how much credit to cre­ate, how many Trea­suries to buy, and how firm a twist to give the yield curve in order to allow Wimpy the chance for another burger and a side order of fries.

What they should know – and what the fol­low­ing chart, pro­vided by the always obser­vant Jim Bianco, shows – is that when QEI and QEII lapsed in recent years, stock prices declined by 10%–15% until mag­i­cally they came back to live another day. The same stunt­ing effect can be observed in the bond mar­ket when mea­sured by real as opposed to nom­i­nal inter­est rates. They go down with QEs and up in their absence.

Admit­tedly, Chart 1 shows only two real data points, which are dif­fi­cult for a Fed Chair­man or his staff to rely on, but com­mon sense under­lies the his­tor­i­cal obser­va­tion as well. With the Fed buy­ing nearly 70% of all five– to 30-year Trea­suries dur­ing Oper­a­tion Twist, and sim­i­larly large per­cent­age amounts of Trea­sury and Agency mortgage-backed issuance since the begin­ning of QEI in Decem­ber 2008, who will buy them now, if the Fed doesn’t?

The Fed appears to have a the­ory that is some­what incom­pre­hen­si­ble to me, stress­ing the “stock” of Trea­suries as opposed to the “flow.” Future flows and annual sup­plies of $1 tril­lion and more, the the­ory argues, will be gob­bled up by the mar­ket even with­out the Fed’s help, at cur­rent arti­fi­cially sup­pressed yields because the pri­vate market’s “stock” of Trea­suries has been depleted. Much like a wine cel­lar, I sup­pose, that is now nearly empty because pol­i­cy­mak­ers have been drink­ing the rare vin­tages, wine lovers will now be forced to restock their cel­lars to get a his­tor­i­cally com­fort­able inven­tory. Hmmm, being a beer drinker myself, I might oth­er­wise assume that appetites might switch due to higher prices (and lower yields). And if wine or bonds were man­dated to fill the cel­lar, then why not a for­eign wine or a for­eign bond? And too, I’m sure the Chi­nese in addi­tion to PIMCO clients would be will­ing at the mar­gin to change their pref­er­ences to real as opposed to finan­cial assets. More con­ser­v­a­tive investors might migrate to cash as the pre­ferred alter­na­tive, because the price of bonds or burg­ers was too high. Wimpy, in other words, might just go vegan if burg­ers aren’t cooked to taste.Because of QEs, the asso­ci­ated Twist, and sim­i­lar check writ­ing by the BOE, BOJ and ECB, sev­eral tril­lion dol­lars of what is aca­d­e­m­i­cally referred to as “base money,” and what Main Street cit­i­zens would rec­og­nize as “gold dust,” has been added to global cen­tral bank vaults. Rather than dug out of the ground, this credit has been cre­ated at the stroke of a pen or a touch of the key­board in today’s elec­tronic mon­e­tary sys­tem. How that is done is a topic for another day, but since the early 1900s, and espe­cially since 1971, it has been done so often that prices of goods and ser­vices are 400% of what they were when Pres­i­dent Nixon decided to pro­pel cen­tral bank­ing to another orbit. “We are all Key­ne­sians now,” he said back then, but he should have replaced Mr. Keynes with Mr. Burns, Miller, Vol­cker, Greenspan and Bernanke. We are all cen­tral bankers now, at least from the stand­point of endors­ing stim­u­la­tive poli­cies that per­mit Wimpy and his seven bil­lion coun­ter­parts to keep on eat­ing burg­ers, and their lenders, by the way, to keep on coin­ing profits.

Part pro­duc­tive, but increas­ingly destruc­tive, the cur­rent accel­er­a­tion of credit via cen­tral bank poli­cies will likely pro­duce a pos­i­tive rate of real eco­nomic growth this year for most devel­oped coun­tries, but the struc­tural dis­tor­tions brought about by zero bound inter­est rates will limit that growth as argued in pre­vi­ous Out­looks, and induce seri­ous risks in future years. In addi­tion, infla­tion should creep higher. Do not be mel­lowed by the affir­ma­tion of a 2% tar­get rate of infla­tion here in the U.S. or as tar­geted in six of the G-7 nations. Not sud­denly, but over time, grad­u­ally higher rates of infla­tion should be the result of QE poli­cies and zero bound yields that were ini­ti­ated in late 2008 and which will likely con­tinue for years to come. We are hooked on cheap credit just as Wimpy was hooked on Friday’s burg­ers. As I high­lighted last month in “The Great Escape,” bond and equity investors should focus on secu­ri­ties with shorter dura­tions – bonds with matu­ri­ties in the five-year range and stocks pay­ing div­i­dends that offer 3%–4% yields. In addi­tion, real assets/commodities should occupy an increas­ing per­cent­age of port­fo­lios. Wimpy would not be pleased by this change of diet nor by the cost and risk of burg­ers for deliv­ery next Tues­day. But for him, and for cen­tral bankers, the hope is that Tues­day never comes.

William H. Gross
Man­ag­ing Director

Tags: Admonition, Bank Policies, Bill Gross, Central Banks, Disbursement, Distortions, Fractional Reserve Banking, Future Years, Global Economy, Gross Co, Gross Investment, Hungry Puppy, Investment Outlook, Maturities, Nobel Prize For Economics, Qe, Real Assets, William H Gross, Wimpy, World Citizens
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Hugh Hendry: Investment Outlook (April 2012)

Monday, April 30th, 2012

Hugh Hendry is back with a bang after a two year hia­tus with what so many have been clam­or­ing for, for so long — another must read let­ter from one of the true (if com­pletely unsung) vision­ary investors of our time: "I have not writ­ten to you at any great length since the win­ter of 2010. This is largely because not much has hap­pened to change our views. We still see the global econ­omy as grotesquely dis­torted by the pres­ence of fixed exchange rates, the unrav­el­ing of which is cre­at­ing finan­cial anar­chy, just as it did in the 1920s and 1930s. Back then the rel­e­vant fixes were around the gold stan­dard. Today it is the dual fixed pric­ing regimes of the euro coun­tries and of the dollar/renminbi peg."

In the let­ter the most sur­pris­ing insight from the per­pet­ual con­trar­ian is his almost pre­dictable con­trary view of the dom­i­nant invest­ing meme at the moment. To wit: "We are, as a result, long the debt sad­dled west and short the vastly over vaunted and over owned BRICs." More on this: "There is a near con­sen­sus that China will sup­plant Amer­ica this decade. We do not believe this. We are more bull­ish on US growth than most. The momen­tous nature of recent advances in shale oil and gas extrac­tion and America's accep­tance of the unpleas­ant­ness of debt and labour price restruc­tur­ing looks to us as if it is cre­at­ing yet another his­toric turn­ing point. By embrac­ing his inad­e­qua­cies and leap­ing on his luck, the strong man may have finally bro­ken the binds that had pre­vi­ously held him back. We are also more pes­simistic on Chi­nese growth than ever. This makes us bear­ish on most Asian stocks, bear­ish on indus­trial com­mod­ity prices, inter­ested in some US stocks, a seller of high vari­ance equi­ties and deeply con­cerned that Japan could become the focal point of the next global leg down. On the plus side we also believe that we are much closer than before to the begin­ning of a bull mar­ket of per­haps 1982, if not 1932, pro­por­tions. We just need the last shoe to drop."

We will let read­ers combs through the nar­ra­tive that shapes Hendry's most recent out­look, although one chart worth point­ing out is The Eclec­tica boss' visual sum­mary of the "New Eco­nomic Order" which presents pre­cisely the ten­u­ous rela­tion­ship between the Fed and the PBOC we have been decry­ing for so long, and which so many com­men­ta­tors (ooh, ooh, the PBOC is eas­ing any minute now... oh wait, it isn't) fail to grasp:

Yet one thing we do want to point out is how dif­fer­ent com­pared to your run off the mill 2 and 20 rent col­lec­tor is the Eclec­tica M.O. when it comes to gen­er­at­ing Alpha (as opposed to every­one else's lev­ered beta):

As you know, I have a pro­cliv­ity to make money in a bear mar­ket. The Fund's ten-year NAV pro­gres­sion demon­strates this sur­vivor­ship bias; when bad things have hap­pened, we have made money. We are very robust. Last year was no excep­tion. Despite the chal­lenges con­fronting spec­u­la­tors, I am much relieved that we suc­ceeded in mak­ing 12% in a rather dis­ci­plined man­ner, and the Fund has now posted a CAGR of almost 10% for the last nine years.

Maybe that was the easy bit. The ques­tion now is just how we can make money in the tough busi­ness of global macro invest­ing this year. As I am sure you by now know, I am noth­ing but a wor­rier. I have, I think, a soul mate in the pro­lific but often mis­un­der­stood Ital­ian soc­cer player Pippo Inza­ghi, the sec­ond high­est scorer in all Euro­pean club com­pe­ti­tions. He has 70 goals behind him but he recently noted that, “the ten­sion is always the same...I hoped to become less agi­tated with time, but this is also my strength”. I sus­pect he would have made a fine macro manager.

I meet a lot of inquis­i­tive and extremely intel­li­gent peo­ple in this busi­ness and I have come to think that maybe this is some­thing of a prob­lem. Per­haps they are just too smart. Per­haps they just try too hard. Rightly or wrongly, the high­est return on intel­lec­tual cap­i­tal of any endeav­our in the world today comes from the man­age­ment of other people’s money. So it is entirely ratio­nal (espe­cially if you have never met a hedge fund man­ager) to assume the indus­try attracts the bright­est, smartest minds. The beau­ti­ful mind, if you will. But I am not aim­ing to out­smart George, Stan, Julian, Bruce or the oth­ers. I do not think it is log­i­cal to try and out­smart the smartest peo­ple. Instead, my weapons are irony and para­dox. The joy of life is partly in the strange and unex­pected. It is in the con­stant excla­ma­tion "Who would have thought it?"

Why did ten year trea­suries yield 14% under the vice like grip of iron-man Volker but yield just 1.8% under the book­ish and most def­i­nitely Weimar-like Bernanke? Why does France in 2012 flirt with the notion of elect­ing a social­ist pres­i­dent intent on reduc­ing the retire­ment age, impos­ing a top rate of tax of 75% and increas­ing the size of the pub­lic sec­tor? Why do we hang on the every word of elected politi­cians when Luxembourg’s prime min­is­ter Jean Claude Junker openly admits, "When it becomes seri­ous, you have to lie"?

You can­not make stuff like this up. It is sim­ply too absurd.

That is per­haps a long way of say­ing that exis­ten­tial­ism is alive and well in the 21st cen­tury. For, if the last ten years have taught me any­thing, it must be that the French philoso­pher Albert Camus, in his search for an under­stand­ing of the prin­ci­pals of ethics that can shape and form our behav­iour, may have sur­rep­ti­tiously pro­vided us with three basic prin­ci­ples for macro invest­ing. I am per­haps doing him a gross injus­tice, but I would sum­marise as fol­lows: God is dead, life is absurd and there are no rules. In other words, you are on your own and you must take own­er­ship of your own destiny.

For me this has always meant being detached from the sell-side com­mu­nity. It is not a ques­tion of respect, it is just that I pre­fer not to engage in their per­pet­ual dia­logue of deter­min­ing where the “flow" is. I can­not be reached by tele­phone. I sus­pect that I am one of the few CIOs who does not main­tain daily cor­re­spon­dence with invest­ment bankers and their spe­cial­ist hedge fund sales teams. Not one buddy, not one phone call, not one instant mes­sage. I am not seek­ing that kind of "edge.” Eclec­tica occu­pies an area out­side the accepted belief system.

I attempt to cul­ti­vate my own insights and to recog­nise the pre­car­i­ous uncer­tainty of global macro trends. I attempt to observe such things first hand through my exten­sive travel (I promise no more YouTube videos), and seek to under­stand their sig­nif­i­cance by inves­ti­gat­ing how pre­vi­ous soci­eties coped under sim­i­lar cir­cum­stances. But first and fore­most, I am always pre­oc­cu­pied with the notion that I just do not have the answer. I am not blessed with the notion of cer­tainty. Some­one once said we should think of the world as a sen­tence with no gram­mar. If we do I see my job as putting in the punc­tu­a­tion. But above all, my job is to make money.

In keep­ing with this theme, I want define the three ingre­di­ents that I believe make for an out­stand­ing macro hedge fund man­ager. These are, in no strin­gent order:

1. Suc­cess­ful but con­tentious macro risk posturing.

2. The need to choose the asset class offer­ing the high­est prob­a­bil­ity of pay­out should the con­vic­tion hold true whilst offer­ing an asym­met­ric loss pro­file should the orig­i­nal premise prove unfounded

3. A best in class risk tech­nique that stop losses the nar­ra­tive and responds early with loss mit­i­ga­tion pro­ce­dures (i.e. a method of stay­ing sol­vent, ratio­nal and dis­ci­plined under pressure).

I have always fig­ured that the first is the real key. That suc­cess was sim­ply a mat­ter of con­tentious macro pos­tur­ing. In other words, going long very rich risk pre­mium or buy­ing cheap stuff. It is my asser­tion that what makes a great fund man­ager first and fore­most is the abil­ity to estab­lish a con­tentious premise out­side the exist­ing belief sys­tem and have it go on to become adopted by the broader finan­cial com­mu­nity. Bruce Kovner expressed the idea more elo­quently when he said, “I have the abil­ity to imag­ine con­fig­u­ra­tions of the world dif­fer­ent from today and really believe it can hap­pen. I can imagine...that the dol­lar can fall to 100 yen”. I am sure you are nod­ding in agree­ment, except Bruce was say­ing this when the USDJPY was well over 200, not today's rate of 80!

That is the kind of guy I want to be when I grow up. Recall that I have the kind of imag­i­na­tion that can con­ceive of the yen trad­ing closer to 60. Sim­i­larly, if we look back and rem­i­nisce about pre­vi­ous years, the Fund's 50% return in 2003 was derived from a legit­i­mate but cer­tainly con­tentious view that China's WTO entry was set to boost the cycli­cal "old" econ­omy of the West and that fiat hyper-management of the finan­cial econ­omy could pro­pel gold into a super bull mar­ket. To think these views were once con­tentious; plus ça change!

Who would'a thunk it: one just needs some imag­i­na­tion and cre­ativ­ity, the abil­ity to visu­al­ize that which most of the other ones cant or are too lazy to do it, and just wait as the bizarro mar­ket takes over and makes the impos­si­ble not only prob­a­ble, but con­ven­tion­ally accepted by the herd.

...

And a seg­ment that all the Whit­ney Tilsons of the world should read:

I fear that our no longer small com­mu­nity has been com­pro­mised. Funds are neglect­ing their hard port­fo­lio stop lim­its. Last year was gen­er­ally very tough for long/short strate­gies and I com­mis­er­ate with all con­cerned. But last year wit­nessed too many world class funds lose over 15% in the space of just two months. Of course today they are cel­e­brated once again for mak­ing dou­ble digit returns in the quar­ter just ended yet they still lan­guish below high water marks and their Sharpe ratios are busted.

You could prob­a­bly live with that if you are a pen­sion scheme or a large, sophis­ti­cated fund-of-fund because you have a global macro sub-sector that is typ­i­cally long gamma (just look at our credit tail fund's 46% gain last year). The unfor­tu­nate thing is this group exer­cised its stop losses some­where between 2009 and 2010. That is to say, they hon­oured the pact they had with clients. They adhered to the terms of their risk bud­get. I fear that owing to this nasty expe­ri­ence, today no one in macro is run­ning much risk. I sus­pect daily VaR bud­gets are anchored at 50 bps or less. That is to say, I fear the finan­cial world is in dan­ger of har­vest­ing a mono­cul­ture of fund returns that could prove less than robust should the global econ­omy suf­fer another defla­tion­ary reversal...

Read the full let­ter below:

April 2012 TEF Commentary

Tags: 1920s, 1930s, Asian Stocks, Chinese Growth, Commodity Prices, Contrary View, Euro Countries, Fixed Exchange Rates, Focal Point, Gas Extraction, Global Economy, Hiatus, Hugh Hendry, Inadequacies, Industrial Commodity, Investment Outlook, Shale Oil, Strong Man, Variance, Visionary Investors
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U.S. Equity Market Radar (April 30, 2012)

Sunday, April 29th, 2012

U.S. Equity Mar­ket Radar (April 30, 2012)

The S&P 500 Index rose 1.80 per­cent this week con­tin­u­ing the bounce-back that began last week. Tele­com ser­vices was the best-performing sec­tor this week along with con­sumer dis­cre­tion and infor­ma­tion tech­nol­ogy. It was a very busy week for quar­terly earn­ings reports and so far this earn­ings sea­son results have been strong.

Strengths

• AT&T and Ver­i­zon pow­ered the tele­com ser­vice sec­tor higher as both were strong this week on the back of better-than-expected earn­ings, dri­ven by an increase in wire­less data sales.
• The con­sumer dis­cre­tion sec­tor was dri­ven by online retail­ers, Expe­dia, Amazon.com and Priceline.com. Home­builders such as Pul­te­Group, Lennar and DR Hor­ton were all up more than 7 per­cent this week.
• Apple was also a notable per­former this week, jump­ing by more than five per­cent on very strong first quar­ter results.

Weak­nesses

• The con­sumer sta­ples sec­tor was the worst per­former and the only sec­tor to close lower for the week. Kel­logg, Safe­way and Wal-Mart were all down more than five percent.
• Net­flix was the worst per­former in the S&P 500 this week as the com­pany pro­jected a slow­down in U.S. sub­scriber growth.
• Other weak per­form­ers for the week included Big Lots, Repub­lic Ser­vices and MetroPCS.

Oppor­tu­nity

• We are still in the mid­dle of earn­ings sea­son with key reports due from numer­ous bench­mark heavy­weights, includ­ing Pfizer, Mas­ter­card and All­state. Results have been gen­er­ally bet­ter than expected and, once estab­lished, this trend is likely to continue.

Threat

• The U.S. remains a bright spot in the global econ­omy but exter­nal shocks can’t be ruled out.

Tags: Amazon, Big Lots, Bounce Back, Consumer Staples, Dr Horton, Earnings Season, External Shocks, Global Economy, Heavyweights, Homebuilders, Lennar, Market Radar, Netflix, Priceline, Quarterly Earnings Reports, Republic Services, Subscriber Growth, Telecom Service, Telecom Services, Wal Mart
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Is it 2010 and 2011 All Over Again?

Thursday, April 26th, 2012

Fol­low­ing a string of weaker than expected eco­nomic reports over the last few weeks and today's much larger than expected drop in Durable Goods Orders, investors are increas­ingly ask­ing if the mar­ket is set­ting itself up for a repeat of 2010 and 2011.  In the chart below, we high­light the annual per­for­mance of the S&P 500 so far this year, as well as in 2010 and 2011.  As shown in the chart, in both 2010 and 2011 the S&P 500 ral­lied in the first four months of the year.

In 2010, the S&P 500 was up 9.2% when it reached its first half peak on 4/23.  From there, the index dropped sharply and was down as much as 10% YTD before ral­ly­ing when the Fed stepped in with QE2.  In 2011, we saw a sim­i­lar pat­tern.  When the S&P 500 reached its first half peak on April 29th, the index was up 8.4% on the year.  From there, it was a down­ward slide as the index fell roughly 20% through Octo­ber.  Then late in the year, the mar­ket once again ral­lied when the Sum­mer ended and the Fed stepped in with 'Oper­a­tion Twist.'

This year, the mar­ket finds itself in a sim­i­lar posi­tion as the month of April comes to a close.  At its peak on 4/2, the S&P 500 was up 12.8% on the year, but it has since seen a minor pull­back.  This pull­back cou­pled with recent weak­ness in eco­nomic data and the on-going Euro­pean debt cri­sis has investors wor­ried that this could be a long hard Summer.

Will 2012 turn out a lot like last year?  Only time will tell, but while there are some sim­i­lar­i­ties between now and then, there are also some key dif­fer­ences.  For starters, the econ­omy is at a higher level now than it was then.   Addi­tion­ally, while most global Cen­tral Banks had a bias towards tight­en­ing early last year, this year the bias is towards eas­ing.  Finally, last year's peak in the mar­ket and eco­nomic activ­ity came just weeks after the earth­quake in Japan.  As we noted back then, when the world's third largest econ­omy essen­tially grinds to a halt, the global econ­omy will feel an impact.

Tags: Amp, Bias, Central Banks, Debt Crisis, Downward Slide, Durable Goods Orders, Earthquake In Japan, Economic Activity, Economic Data, Economic Reports, Four Months, Global Economy, Half Peak, Investors, Month Of April, Months Of The Year, Pullback, Qe2, Starters, Ytd
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The Day Austerity Died (Tchir)

Tuesday, April 24th, 2012

by Peter Tchir, TF Mar­ket Advisors

Aus­ter­ity is dead! Long live Spending!

Futures are up, Ital­ian and Span­ish bonds are up, CDS spreads on them are at least 10 bps tighter, and MAIN is 3 bps tighter on the day (though I have this feel­ing I bet­ter type fast as we are start­ing to fade off the best levels).

Lots of lit­tle things seem to be con­tribut­ing to the strength, TXU earn­ings, no eco­nomic data, auc­tions that raised the required money, etc., but there does also seem to be a belief that Ger­many finally “gets it”. That Ger­many is finally going to relent on their demands for austerity.

The first ques­tion is “what is defined as aus­ter­ity?” Pro­grams that are pro­vid­ing money today, that is quickly re-circulated into the econ­omy because it is pay­ing for peo­ple to live should not be cut – that is bad aus­ter­ity. Rais­ing taxes in gen­eral is prob­a­bly bad aus­ter­ity, but what about actu­ally col­lect­ing taxes on all those who have avoided pay­ing what they owe? Plans to reduce long term ben­e­fits must go for­ward, min­i­mal cur­rent cost to the econ­omy, but nec­es­sary for any long term solu­tion. So while “aus­ter­ity” hasn’t worked, it is not all bad, and some forms need to be main­tained to have any hope that the sit­u­a­tion can be turned around in the future.

The sec­ond, and more impor­tant ques­tion, is “why does any sane per­son think spend­ing for growth will work?” Just pause for 1 moment. How were these mas­sive deficits built up? Was all the spend­ing friv­o­lous? I don’t think so. A lot of spend­ing was meant to tar­get growth in cer­tain areas. It is just very dif­fi­cult to achieve. If spend­ing to get growth was so easy in a global econ­omy, the U.S., the cur­rent king of spend­ing, would have Chi­nese like GDP growth. It is not that easy to spend your way to growth. I’m sure at some level, Solyn­dra received money because there was a real belief some­where that it was a good invest­ment for growth. GM might be used as an exam­ple, but I’m not con­vinced that the gov­ern­ment spend­ing did any­thing more than pri­vate cap­i­tal would have done in the wake of a real bank­ruptcy. The excite­ment over “spend­ing for growth” is almost mind-boggling, because it basi­cally goes against a decade of his­tory show­ing the inabil­ity of gov­ern­ments to spend and achieve real growth. But, there is one part that does make sense, at least from a Wall Street perspective.

So the final ques­tion is, “who will finance all that spend­ing?” Ahhh, the real rea­son Wall Street is enthu­si­as­tic about spend­ing for growth. The only way a spend­ing for growth cam­paign can begin, is with another mas­sive round of bal­ance sheet expan­sion by cen­tral banks. That has been great for banks and wall street, while less clear what it has done for the econ­omy, or any­one with­out a sig­nif­i­cant por­tion of their wealth in stocks. If Spain announced a big new spend­ing cam­paign, would any­one really believe it would work? What would they do? Build more homes to get con­struc­tion going? How would that help when an unpopped real estate bub­ble is part of the prob­lem (actu­ally the bub­ble has burst, it just hasn’t been rec­og­nized on banks’ and cajas’ bal­ance sheets). Would investors who aren’t excited about lend­ing 5 year money at 4.75% sud­denly line up to buy all this debt think­ing the new spend­ing ini­tia­tives (which increase debt in the short term) will really work? I don’t think so. Buy­ing new debt in an envi­ron­ment where coun­tries feel free to spend and run deficits because aus­ter­ity doesn’t work, will only frighten pri­vate cap­i­tal. So the cen­tral banks of the world will have to step up again and pro­vide the fund­ing. I don’t think that is a good thing, but can see why some do, and can really see why some of those push­ing the most for a return to debt issuance and spend­ing and cen­tral bank inter­ven­tion would want it – because they ben­e­fit, not because it will work.

The real­ity is that spend­ing won’t solve any­thing. It will grow debt faster than the spend­ing can improve the econ­omy. Stop­ping longer term aus­ter­ity pro­grams will make the future debt to GDP ratios look even more hor­rific. There will ulti­mately need to restruc­tur­ing on a mas­sive scale.

It is no co-incidence that more and more sov­er­eign debt is being funded by insti­tu­tions in that coun­try. It is specif­i­cally to make leav­ing the Euro eas­ier. An Ital­ian pen­sion plan for exam­ple has both its assets and its lia­bil­i­ties in Italy. A con­ver­sion back to Lire is man­age­able in a sit­u­a­tion like that. Yes, the pen­sion plan’s rede­nom­i­nated Ital­ian Lire bonds may trade down because of the deval­u­a­tion, but their pen­sion oblig­a­tions would also be rede­nom­i­nated at the same time, off­set­ting a lot, if not all of the pain. The same is true in the bank­ing sec­tor. Cor­po­ra­tions won’t have that lux­ury as many are global, but it may explain why Ital­ian and Span­ish com­pa­nies have been busy issu­ing debt. So return­ing to tra­di­tional cur­ren­cies has the least impact on the coun­try and the Euro­zone if the debt is largely held inter­nally. That is the direc­tion the coun­tries and the ECB have been mov­ing, so don’t ignore this as a more likely real solution.

Debt restruc­tur­ing in terms of coupon reduc­tion, notional reduc­tion, and matu­rity exten­sion are all real pos­si­bil­i­ties too. If coun­tries learned any­thing from Greece, it is that by wait­ing too long, and accept­ing more Troika money than the pri­vate sec­tor wrote-off, the prob­lem doesn’t go away. Restruc­tur­ing early and harshly is far bet­ter than wait­ing and doing it in bits and pieces, and it has to affect ALL cred­i­tors. One rea­son that the ECB hasn’t resumed its SMP just yet is that coun­tries aren’t sure how much they want to owe the ECB. The ECB has proven itself to be an unhelp­ful part­ner in restruc­tur­ing. Watch what the ECB does (or doesn’t do) and ask your­self why.

So “Aus­ter­ity Now” may be over, but killing some­thing that didn’t work, isn’t the same as solv­ing the prob­lem. Going back to the norm that caused the prob­lem in the first place, hardly seems like a solu­tion either. Cur­rency rever­sion and/or debt restruc­tur­ing will be the ulti­mate end-game.

We get a del­uge of hous­ing data out this morn­ing. I expect it to dis­ap­point, but at this stage I’m not sure another hous­ing dis­ap­point­ment does any­thing for the mar­ket. It would merely con­firm what is becom­ing a con­sen­sus view – that the actual weather actu­ally played a role in mak­ing the win­ter num­bers look bet­ter than they might oth­er­wise have been.

Good luck with the rest of the day, though I sus­pect that once Europe goes home we will do noth­ing but watch every move in AAPL like we did yes­ter­day after­noon. In the mean­time I hope I can get the Don Maclean Amer­i­can Pie song out of my head on “the day aus­ter­ity died”….

Copy­right © TF Mar­ket Advisors

Tags: Auctions, Austerity Programs, Belief That, Bonds, Bps, Current, Earnings, Economic Data, Futures, GDP, GDP Growth, Global Economy, Gm, Long Term Solution, Money, Nbsp, Sane Person, Taxes, Tf, Txu
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Is Capitalism Dead or Simply Dying?

Thursday, April 19th, 2012

Noted finan­cial author Richard Dun­can says Cap­i­tal­ism is Dead, Credit New King.

The world needs to clue in to changes to its eco­nomic sys­tem, includ­ing the death of cap­i­tal­ism, accord­ing to noted finan­cial author Richard Dun­can, who warns that attempts to turn back the clock on our credit-driven economies could be cataclysmic

Rec­og­niz­ing that the world oper­ates on a dif­fer­ent set of rules from the laissez-faire cap­i­tal­ism of the 19th cen­tury is among the key argu­ments in Duncan’s 2012 book, “The New Depres­sion: The Break­down of the Paper Money Economy.”

Stuck with ‘Creditism’

Dun­can sees the global econ­omy as hav­ing under­gone a fun­da­men­tal trans­for­ma­tion dur­ing the past 43 years. Since changes in 1968 that freed the Fed­eral Reserve from hold­ing phys­i­cal gold in reserve against dol­lars in cir­cu­la­tion, total global credit has expanded 50 times, or from about $1 tril­lion to $50 tril­lion in 2007.

Over that period, credit cre­ation and con­sump­tion, or what Dun­can calls “cred­itism,” took hold as the growth dynamic behind the global econ­omy, dis­plac­ing cap­i­tal­ism, which he says relied upon sound money, hard work and cap­i­tal accumulation.

Attempts to break the global economy’s reliance on credit cre­ation as a dri­ver and reboot back to ear­lier ways won’t work, said Dun­can, who sees “sound money” pol­icy rec­om­men­da­tions as a recipe for disaster.

Dun­can believes that true cap­i­tal­ism died in 1914, when nations across Europe aban­doned gold-backed cur­ren­cies, run­ning up huge deficits in prepa­ra­tion for what would come to be known as the Great War.

“I’m rec­om­mend­ing mak­ing use of this new eco­nomic sys­tem. Bor­row money at the gov­ern­ment level at very low inter­est rates and then invest that money and change our world for the bet­ter.” Dun­can said.

Build­ing a national solar-energy grid that could tap the arid land­scapes of Nevada are among Duncan’s recommendations.

Dun­can said he first out­lined his think­ing on government-led invest­ment in a 2008 book. On speak­ing tours, he encoun­tered the “great­est push-back” from free-market, lib­er­tar­ian thinkers who are skep­ti­cal of gov­ern­ment involve­ment in the economy.

He says many lib­er­tar­i­ans “are with me along through the argu­ment” on causes of the global cri­sis, but that they tend to be “very sur­prised” by his con­clu­sion that part of the solu­tion requires gov­ern­ments to spend more — not less.

Mon­e­tary Madness

Dun­can is yet another author who pre­dicted a finan­cial cri­sis but whose solu­tions can only be described as mon­e­tary madness.

"Glut­ted with excess indus­trial capac­ity and a bank­ing sys­tem laden with mas­sive loans that will never be paid back, China faces dif­fi­cult deci­sions much as Japan did" says Duncan.

Indeed!

Then like an eco­nomic mad­man, Dun­can wants the US gov­ern­ment to under­take mas­sive infra­struc­ture projects just like the ones that bank­rupted Japan and China's State-Owned-Enterprises (SOEs).

Obama's Excur­sions Into Clean Energy

Look at Obama's back­ing of Green Energy com­pa­nies Ener1, Solyn­dra Inc., and Bea­con Power, all three now bank­rupt as noted in Another Obama-Backed Green Energy Com­pany Goes Bank­rupt.

Solar Energy Mad­ness in Europe

In an effort to spur solar energy in France, Ger­many, Spain and other Euro­pean coun­tries, bureau­cratic dunces decided to pay as much as 10 times mar­ket rates for those sup­ply­ing energy to the power grid.

In response, farm­ers in France have started build­ing "barns" that serve no other pur­pose than a place to put solar pan­els. Super­mar­kets put solar pan­els on their roofs and unused sec­tions of park­ing lots.

It has been a boom to solar panel mak­ers (China), but it is cost­ing the French power com­pany Elec­tricite de France SA more than a bil­lion euros ($1.3 bil­lion) a year to meet gov­ern­ment man­dated pledges to accept solar energy from those sup­ply­ing the grid.

At the end of 2010, EDF received 3,000 appli­ca­tions a day to con­nect pan­els to the grid. In 2008, the num­ber of appli­ca­tions was 7,100 for the entire year.

The results should have been easy to pre­dict in advance, but you can never explain any­thing to eco­nomic illit­er­ates inter­fer­ing in the free mar­kets hop­ing to make things bet­ter. They never do.

For more details, please con­sider EDF’s Solar ‘Time Bomb’ Will Tick On After France Pops Bubble

Is Cap­i­tal­ism Dead?

If cap­i­tal­ism is dead, it is because social­ists, fas­cists, bureau­cratic fools, and central-planner advo­cates like Dun­can destroyed it via fool­ish pro­pos­als to improve on it.

The idea that gov­ern­ments can invest wisely in tech­nol­ogy, at rea­son­able costs, and the free mar­ket can­not is down­right absurd as the US, Japan, China, and Europe have proven in spades. In short, Dun­can has lost his mind.

Mike "Mish" Shedlock

http://globaleconomicanalysis.blogspot.com

Tags: Arid Landscapes, Capital Accumulation, Credit Creation, Driven Economies, Economic System, Energy Grid, Financial Author, Fundamental Transformation, Global Credit, Global Economy, Government Level, Laissez Faire Capitalism, Low Interest Rates, Money Economy, Money Policy, Paper Money, physical gold, Policy Recommendations, Richard Duncan, Sound Money
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Q2 Markets: Don’t Expect Smooth Sailing

Wednesday, April 18th, 2012

by Russ Koes­terich, iShares

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

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

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

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

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

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

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

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

Source: Bloomberg

The author is long LQD and IDV

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

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

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

Past per­for­mance does not guar­an­tee future results.

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

Friday, April 13th, 2012

by Axel Merk, Merk Funds

April 10, 2012

The global econ­omy is heal­ing, so we are told. Yet, the moment the Fed­eral Reserve (Fed) indi­cates just that – and thus imply­ing no addi­tional stim­u­lus may be war­ranted – the mar­kets appear to throw a tantrum. In the process, the U.S. dol­lar has enjoyed what may be a tem­po­rary lift. To make sense of the recent tur­moil, let’s look at the dri­vers of this “recov­ery” and poten­tial impli­ca­tions for the U.S. dol­lar, gold, bonds and the stock mar­ket.

In our assess­ment, what we see unfold­ing is the lat­est chap­ter in the tug of war between infla­tion­ary and defla­tion­ary forces. Dur­ing the “goldilocks” econ­omy of the last decade, investors lev­ered them­selves up. Home­own­ers treated their homes as if they were ATMs; banks set up off-balance sheet Spe­cial Invest­ment Vehi­cles (SIVs); gov­ern­ments engag­ing in arrange­ments to get cheap loans that may cost future gen­er­a­tions dearly. Cumu­la­tively, it was an amaz­ing money gen­er­a­tion process; yet, cen­tral banks remained on the side­lines, as infla­tion – accord­ing to the met­rics focused on — appeared con­tained. Indeed, we have argued in the past that cen­tral banks lost con­trol of the money cre­ation process, as they could not keep up with the plethora of “finan­cial inno­va­tion” that jus­ti­fied greater lever­age. It was only a mat­ter of time before the world no longer appeared quite so risk-free. Ratio­nal investors thus reduced their expo­sure: de-levered. When de-leveraging spreads, how­ever, mas­sive defla­tion­ary forces may be put in motion. The finan­cial sys­tem itself was at risk, as insti­tu­tions did not hold suf­fi­ciently liq­uid assets to de-lever in an orderly way. With­out inter­ven­tion, defla­tion­ary forces might have thrown the global econ­omy into a depression.

The trou­ble occurs when the money cre­ation process takes on a life of its own, because the money destruc­tion process is rather dif­fi­cult to stop. How­ever, it hasn’t stopped pol­icy mak­ers from try­ing: in an effort to fight what may have been a dis­or­derly col­lapse of the finan­cial sys­tem, unprece­dented mon­e­tary and fis­cal ini­tia­tives were under­taken to stem against mar­ket forces. Tril­lion dol­lar deficits, tril­lions in secu­ri­ties pur­chased by the Fed with money cre­ated out of thin air (when the Fed buys secu­ri­ties, it merely cred­its the account of the bank with an account­ing entry – while no phys­i­cal dol­lar bills are printed, many – includ­ing us – refer to this process as the print­ing of money).

Will it work? The Fed thinks it might. But nobody really knows. We do know that a depres­sion works in remov­ing the excesses of a bub­ble. How­ever, the cost of a depres­sion may be severe, both in social and mon­e­tary terms. Crit­ics of the “let ‘em fail” argu­ment say that busi­nesses and jobs beyond those that have engaged in bad deci­sions will be caught by con­ta­gion effects and may ulti­mately be bound to fail too. Fed Chair Bernanke, a stu­dent of the Great Depres­sion, fre­quently warns against repeat­ing the pol­icy mis­takes of that era. So does the refla­tion­ary argu­ment work, i.e. does print­ing and spend­ing money help bring an econ­omy back from the brink of dis­as­ter? We can­not find an exam­ple in his­tory where it has. As Bernanke points out, pol­icy mak­ers have learned a great deal by study­ing crises of the past. Our reser­va­tion comes from the fol­low­ing obser­va­tion: cen­tral bankers at any time have always been con­sid­ered amongst the smartest of their era, yet – with hind­sight – they may have engaged in ter­ri­ble mis­takes. While we cer­tainly wish that Bernanke is right, we nonethe­less main­tain a degree of skep­ti­cism and believe it is any investor’s duty to take the risk that the world does not evolve the way he envi­sions into account. Our pol­icy mak­ers also might be well served to be more hum­ble, as they are putting the world’s sav­ings at risk.

Yet, the rea­son cen­tral bankers are bold, not hum­ble, is because they fear hes­i­ta­tion will lead to defla­tion­ary forces tak­ing the upper hand yet again. Bernanke’s con­tention, that one of the biggest mis­takes dur­ing the Great Depres­sion was to tighten mon­e­tary pol­icy too early, stems from that fear. In its recently released min­utes, the Fed­eral Reserve Open Mar­ket Com­mit­tee (FOMC) placed that fear in today’s con­text: “While recent employ­ment data had been encour­ag­ing, a num­ber of mem­bers per­ceived a non neg­li­gi­ble risk that improve­ments in employ­ment could dimin­ish as the year pro­gressed, as had occurred in 2010 and 2011, and saw this risk as rein­forc­ing the case for leav­ing the for­ward guid­ance unchanged at this meet­ing."

In our view, the rea­son why the Fed is com­mit­ted to keep­ing rates low until the end of 2014 is pre­cisely because the Fed does not want to be per­ceived as tight­en­ing too early. Why the end of 2014? Well, because it’s not today or tomor­row. We believe nobody – not even at the Fed – knows whether the end of 2014 is the right date. The prob­lem with that pol­icy will be when the mar­ket no longer buys it. The mar­ket just needs to see one mem­ber of the FOMC turn more hawk­ish, as a result of improv­ing eco­nomic data, to inter­pret that we may be start­ing down the road of mon­e­tary tight­en­ing. Yet, if the mar­ket thinks the Fed may tighten, defla­tion­ary forces take over, pos­si­bly unrav­el­ing all the “hard work” the Fed has done.

Will tight­en­ing ever be bear­able for the econ­omy again? U.S. finan­cial insti­tu­tions are in a stronger posi­tion than they were in 2008. Con­versely, gov­ern­ments around the world – not just the U.S. gov­ern­ment – are in far weaker posi­tions, given the large amounts of debt they have incurred, in an effort to man­age the finan­cial cri­sis. Many con­sumers have down­sized (read: lost their homes / filed for bank­ruptcy), but there con­tin­ues to be down­ward pres­sure on the hous­ing mar­ket, as mil­lions of homes remain in the fore­clo­sure process and are only slowly mak­ing it to the mar­ket. Bernanke may have cho­sen the end of 2014 as the ear­li­est time to raise rates because it rep­re­sents a date when the hous­ing mar­ket may have freed itself from much of the fore­clo­sure pipeline. Indeed, Fed research sug­gests that res­i­den­tial con­struc­tion won’t fully recover until 2014. We don’t think that is a coin­ci­dence. To Bernanke, a thriv­ing home mar­ket appears to be key to a healthy con­sumer and thus a healthy and sus­tain­able recov­ery in con­sumer spending.

Tying mon­e­tary pol­icy to the cal­en­dar has cre­ated alarm with eco­nomic “hawks” – not just the Fed itself, with the lone hawk­ish vot­ing FOMC mem­ber, Rich­mond Fed Pres­i­dent Jeff Lacker, openly dis­sent­ing. But if one fol­lows Bernanke’s line of think­ing, what’s the alter­na­tive? The alter­na­tive would be to firmly err on the side of infla­tion, as the Fed thinks infla­tion is the one prob­lem it knows how to fight. Except that a cen­tral bank must never com­mu­ni­cate that it wants to induce infla­tion, as it may derail the mar­kets. So the 2nd best option, from Bernanke’s point of view, may be to com­mit to keep­ing rates low until the end of 2014; the “risk” that the econ­omy might per­form bet­ter than expected (and thus ear­lier tight­en­ing war­ranted) appears to be shoved aside. Just to make sure the mar­kets behave, the Fed also intro­duced an infla­tion tar­get, assur­ing the mar­kets not to worry, all will be fine on the infla­tion front.

Unfor­tu­nately, we don’t think Bernanke’s plan will work. The rea­son is that infla­tion may not be as eas­ily fought as Bernanke thinks. The extra­or­di­nary poli­cies that have been pur­sued have not only planted the seeds of infla­tion, but have re-introduced lever­age into the sys­tem. While Bernanke claims he can raise rates in 15 min­utes, we believe there is sim­ply too much lever­age in the econ­omy to raise rates as much as for­mer Fed Chair Paul Vol­cker did in the early 1980s to con­vince the mar­kets the Fed is seri­ous about infla­tion. Given the increased inter­est rate sen­si­tiv­ity of the econ­omy, much less tight­en­ing would likely be nec­es­sary. We are not as opti­mistic as many cur­rent and for­mer Fed offi­cials that it will be pos­si­ble to engi­neer a sus­tain­able eco­nomic growth while adher­ing to the Fed’s infla­tion tar­get. The Fed is ulti­mately respon­si­ble for infla­tion; how­ever, we have also learned that the mod­ern Fed is unlikely to risk severe eco­nomic hard­ship to achieve its price sta­bil­ity mandate.

What does it all mean for the mar­kets? Defla­tion­ary forces have favored the U.S. dol­lar and been a neg­a­tive for gold. As indi­cated, how­ever, we don't think the Fed will sit by idly as the mar­kets price in tight­en­ing before the econ­omy is “ready”. As such, a flight into the dol­lar out of gold might be an oppor­tu­nity to diver­sify out of the dol­lar into a bas­ket of hard cur­ren­cies, includ­ing gold. With regard to the bond mar­ket, we are rather con­cerned that the long end of the yield curve has been extra­or­di­nar­ily well behaved until just a few weeks ago. The rea­son for our con­cern is that peri­ods of low volatil­ity in any asset class usu­ally means that money has entered the space that might leave on short notice: we call it fast money chas­ing yields. We don’t need a cri­sis for investors to run for the hills in the bond mar­ket; we may just need a return to more nor­mal lev­els of volatil­ity. As such, investors may want to con­sider keep­ing inter­est risk low, i.e. stay­ing on the short-end of the yield curve, both in U.S. dol­lars and other cur­ren­cies. With regard to the stock mar­ket, it may do well should the Fed think of another round of eas­ing, but let’s keep in mind that the stock mar­ket has had a tremen­dous rally in recent months.

If investors con­sider invest­ing in the stock mar­ket because of the Fed’s mon­e­tary pol­icy, why not express that same view in the cur­rency mar­ket? After all, cur­ren­cies – when no lever­age is employed – are his­tor­i­cally less volatile than domes­tic (or inter­na­tional) equi­ties. Cur­ren­cies may give investors the oppor­tu­nity to take advan­tage of the risks and oppor­tu­ni­ties pro­vided by our pol­icy mak­ers with­out tak­ing on the equity risk.

Please sub­scribe to Merk Insights by click­ing here to be informed as we ana­lyze the global dynam­ics play­ing out. 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 ET / 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.

Tags: Central Banks, Cheap Loans, Deflationary Forces, Dollar Gold, Financial Innovation, Future Generations, Global Economy, Gold Bonds, Goldilocks Economy, Investment Vehicles, Last Decade, Liquid Assets, Matter Of Time, Money Creation, Plethora, Rational Investors, Sidelines, Stimulus, Tantrum, Tug Of War
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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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Bill Gross: Investment Outlook (April 2012)

Tuesday, March 27th, 2012

The Great Escape:
Deliv­er­ing in a Delev­er­ing World

by William H. Gross, PIMCO

April 2012

• When inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed, the momen­tum begins to shift, not nec­es­sar­ily sud­denly, but grad­u­ally – yields mov­ing mildly higher and spreads sta­bi­liz­ing or mov­ing slightly wider.
• In such a mildly reflat­ing world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Trea­sury bills, then you must take risk in some form.
• We favor high qual­ity, shorter dura­tion and inflation-protected bonds; div­i­dend pay­ing stocks with a pref­er­ence for devel­op­ing over devel­oped mar­kets; and inflation-sensitive, supply-constrained com­mod­ity products.

About six months ago, I only half in jest told Mohamed that my tomb­stone would read, “Bill Gross, RIP, He didn’t own ‘Trea­suries’.” Now, of course, the days are get­ting longer and as they say in golf, it is bet­ter to be above – as opposed to below – the grass. And it is bet­ter as well, to be deliv­er­ing alpha as opposed to delev­er­ing in the bond mar­ket or global econ­omy. The best way to visu­al­ize suc­cess­ful deliv­er­ing is to rec­og­nize that investors are locked up in a finan­cially repres­sive envi­ron­ment that reduces future returns for all finan­cial assets. Break­ing out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.

The term delev­er­ing implies a period of prior lever­age, and lever­age there has been. Whether you date it from the begin­ning of frac­tional reserve and cen­tral bank­ing in the early 20th cen­tury, the debase­ment of gold in the 1930s, or the ini­ti­a­tion of Bret­ton Woods and the coör­di­nated dol­lar and gold stan­dard that fol­lowed for nearly three decades after WWII, the trend towards finan­cial lever­age has been ever upward. The aban­don­ment of gold and embrace­ment of dol­lar based credit by Nixon in the early 1970s was cer­tainly a lever­ag­ing land­mark as was the dereg­u­la­tion of Glass-Steagall by a Demo­c­ra­tic Clin­ton admin­is­tra­tion in the late 1990s, and else­where glob­ally. And almost always, the pri­vate sec­tor was more than will­ing to play the game, invent­ing new forms of credit, loosely known as deriv­a­tives, which avoided the con­cept of con­ser­v­a­tive reserve bank­ing alto­gether. Although there were acci­dents along the way such as the S&L cri­sis, Con­ti­nen­tal Bank, LTCM, Mex­ico, Asia in the late 1990s, the Dot-coms, and ulti­mately global sub­prime own­er­ship, finan­cial insti­tu­tions and mar­ket par­tic­i­pants learned that pol­i­cy­mak­ers would sup­port the sys­tem, and most indi­vid­ual par­tic­i­pants, by extend­ing credit, low­er­ing inter­est rates, expand­ing deficits, and dereg­u­lat­ing in order to keep economies tick­ing. Impor­tantly, this com­bined fis­cal and mon­e­tary lever­age pro­duced out­sized returns that exceeded the abil­ity of real economies to cre­ate wealth. Stocks for the Long Run was the almost uni­ver­sally accepted mantra, but it was really a period – for most of the last half cen­tury – of “Finan­cial Assets for the Long Run” – and your house was included by the way in that cat­e­gory of finan­cial assets even though it was just a pile of sticks and stones. If it always went up in price and you could bor­row against it, it was a finan­cial asset. Secu­ri­ti­za­tion ruled supreme, if not subprime.

As nom­i­nal and real inter­est rates came down, down, down and credit spreads were com­pressed through pol­icy sup­port and secu­ri­ti­za­tion, then asset prices mag­i­cally ascended. PE ratios rose, bond prices for 30-year Trea­suries dou­bled, real estate thrived, and any­thing that could be lev­ered did well because the global econ­omy and its finan­cial mar­kets were being lev­ered and lev­ered consistently.

And then sud­denly in 2008, it stopped and reversed. Lever­age appeared to reach its lim­its with sub­primes, and then with banks and invest­ment banks, and then with coun­tries them­selves. The game as we all have known it appears to be over, or at least sub­stan­tially changed – mov­ing for the moment from pri­vate to pub­lic bal­ance sheets, but even there fac­ing investor and polit­i­cal lim­its. Actu­ally global finan­cial mar­kets are only selec­tively delev­er­ing. What delev­er­ing there is, is most vis­i­ble with house­hold bal­ance sheets in the U.S. and Euroland periph­eral sov­er­eigns like Greece. The delev­er­ing is also rel­a­tively hid­den in the recap­i­tal­iza­tion of banks and their looka­likes. Increas­ing cap­i­tal, in addi­tion to hair­cut­ting and defaults are a form of delever­ag­ing that is long term healthy, if short term growth restric­tive. On the whole, how­ever, because of mas­sive QEs and LTROS in the tril­lions of dol­lars, our credit based, lever­age depen­dent finan­cial sys­tem is actu­ally lever­age expand­ing, although only mildly and sys­tem­i­cally less threat­en­ing than before, at least from the stand­point of a growth rate. The total amount of debt how­ever is daunt­ing and con­tin­ued credit expan­sion will pro­duce accel­er­at­ing global infla­tion and slower growth in PIMCO’s most likely outcome.

How do we deliver in this New Nor­mal world that levers much more slowly in total, and can delever sharply in selec­tive sec­tors and coun­tries? Look at it this way rather sim­plis­ti­cally. Dur­ing the Great Lever­ag­ing of the past 30 years, it was finan­cial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more lev­ered those flows, then the bet­ter they did. That is because, as I’ve just his­tor­i­cally out­lined, future cash flows are dis­counted by an inter­est rate and a risk spread, and as yields came down and spreads com­pressed, the greater return came from the longest and most lev­ered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the abil­ity of global economies to con­sis­tently repli­cate them. Finan­cial assets rel­a­tive to real assets out­per­form in such a world as wealth is brought for­ward and stolen from future years if real growth can­not repli­cate his­tor­i­cal total returns.

To put it even more sim­ply, finan­cial assets with long inter­est rate and spread dura­tions were win­ners: long matu­rity bonds, stocks, real estate with rental streams and cap rates that could be com­pressed. Com­modi­ties were on the rel­a­tive los­ing end although infla­tion took them up as well. That’s not to say that an oil com­pany with reserves in the ground didn’t do well, but the oil for imme­di­ate deliv­ery that couldn’t ben­e­fit from an expan­sion of P/Es and a com­pres­sion of risk spreads – well, not so well. And so com­modi­ties lagged finan­cial asset returns. Our num­bers show 1, 5 and 20-year his­to­ries of finan­cial assets out­per­form­ing com­modi­ties by 15% for the most recent 12 months and 2% annu­ally for the past 20 years.

This out­per­for­mance by finan­cial as opposed to real assets is a result of the long jour­ney and ulti­mate des­ti­na­tion of credit expan­sion that I’ve just out­lined, result­ing in neg­a­tive real inter­est rates and nar­row credit and equity risk pre­mi­ums; a state of finan­cial repres­sion as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie star­ing Steve McQueen called The Great Escape where Amer­i­can pris­on­ers of war were con­fined to a POW camp inside Ger­many in 1943. The liv­ing con­di­tions were OK, much like today’s finan­cial mar­kets, but cer­tainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and Amer­i­can offi­cers to try to escape and get back to the old nor­mal. They inge­niously dug escape tun­nels and even­tu­ally escaped. It was a real life story in addi­tion to its Hol­ly­wood fla­vor. Sim­i­larly though it is your duty to try to escape today’s repres­sion. Your liv­ing con­di­tions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover lia­bil­i­ties. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this finan­cial repres­sive world.

What hap­pens when we flip the sce­nario or per­haps reach the point at which inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed? The momen­tum we would sug­gest begins to shift: not nec­es­sar­ily sud­denly or swiftly as fat­ter tail bimodal dis­tri­b­u­tions might warn, but grad­u­ally – yields mov­ing mildly higher, spreads sta­bi­liz­ing or mov­ing slightly wider. In such a mildly reflat­ing world where infla­tion itself remains above 2% and in most cases moves higher, deliv­er­ing double-digit or even 7–8% total returns from bonds, stocks and real estate becomes prob­lem­atic and cer­tainly much more dif­fi­cult. Real growth as opposed to finan­cial wiz­ardry becomes pre­dom­i­nant, yet that growth is stressed by exces­sive fis­cal deficits and high debt/GDP lev­els. Com­modi­ties and real assets become ascen­dant, cer­tainly in rel­a­tive terms, as we by neces­sity delever or lever less. As well, finan­cial assets can­not be ele­vated by zero based inter­est rate or other tried but now tired pol­icy maneu­vers that bring future wealth for­ward. Cur­rent prices in other words have squeezed all of the risk and inter­est rate pre­mi­ums from future cash flows, and now finan­cial mar­kets are left with real growth, which itself expe­ri­ences a slower new nor­mal because of less finan­cial leverage.

That is not to say that infla­tion can­not con­tinue to ele­vate finan­cial assets which can adjust to infla­tion over time – stocks being the prime exam­ple. They can, and there will be rel­a­tive win­ners in this con­text, but the abil­ity of an investor to earn returns well in excess of infla­tion or well in excess of nom­i­nal GDP is lim­ited. Total return as a super­charged bond strat­egy is fad­ing. Stocks with a 6.6% real Jeremy Siegel con­stant are fad­ing. Lev­ered hedge strate­gies based on spread and yield com­pres­sion are fad­ing. As we delever, it will be hard to deliver what you have been used to.

Still there is a place for all stan­dard asset classes even though betas will be lower. Should you desert bonds sim­ply because they may return 4% as opposed to 10%? I hope not. PIMCO’s poten­tial alpha gen­er­a­tion and the sta­bil­ity of bonds remain crit­i­cal com­po­nents of an invest­ment portfolio.

In sum­mary, what has the poten­tial to deliver the most return with the least amount of risk and high­est infor­ma­tion ratios? Log­i­cally, (1) Real as opposed to finan­cial assets – com­modi­ties, land, build­ings, machines, and knowl­edge inher­ent in an edu­cated labor force. (2) Finan­cial assets with shorter spread and inter­est rate dura­tions because they are more defen­sive. (3) Finan­cial assets for enti­ties with rel­a­tively strong bal­ance sheets that are exposed to higher real growth, for which devel­op­ing vs. devel­oped nations should dom­i­nate. (4) Finan­cial or real assets that ben­e­fit from favor­able pol­icy thrusts from both mon­e­tary and fis­cal author­i­ties. (5) Finan­cial or real assets which are not bur­dened by exces­sive debt and sub­ject to future haircuts.

In plain speak –

For bond mar­kets: favor higher qual­ity, shorter dura­tion and infla­tion pro­tected assets.

For stocks: favor devel­op­ing vs. devel­oped. Favor shorter dura­tions here too, which means con­sis­tent div­i­dend pay­ing as opposed to growth stocks.

For com­modi­ties: favor infla­tion sen­si­tive, sup­ply con­strained products.

And for all asset cat­e­gories, be wary of lev­ered hedge strate­gies that promise double-digit returns that are dif­fi­cult in a delev­er­ing world.

With regard to all of these broad asset cat­e­gories, an investor in finan­cial mar­kets should not go too far on this defen­sive, as opposed to offen­sively ori­ented sce­nario. Unless you want to earn an infla­tion adjusted return of minus 2–3% as offered by Trea­sury bills, then you must take risk in some form. You must try to max­i­mize risk adjusted carry – what we call “safe spread.”

“Safe carry” is an essen­tial ele­ment of cap­i­tal­ism – that is investors earn­ing some­thing more than a Trea­sury bill. If and when we can­not, then the sys­tem implodes – espe­cially one with exces­sive lever­age. Paul Vol­cker suc­cess­fully redi­rected the U.S. econ­omy from 1979–1981 dur­ing which investors earned less return than a Trea­sury bill, but that could only go on for sev­eral years and occurred in a much less lev­ered finan­cial sys­tem. Vol­cker had it eas­ier than Bernanke/King/Draghi have it today. Is a sys­temic implo­sion still pos­si­ble in 2012 as opposed to 2008? It is, but we will likely face much more mon­e­tary and credit infla­tion before the bal­loon pops. Until then, you should bud­get for “safe carry” to help pay your bills. The bunker port­fo­lio lies fur­ther ahead.

Two addi­tional con­sid­er­a­tions. In a highly lev­ered world, grad­ual rever­sals are not nec­es­sar­ily the high prob­a­ble out­come that a nor­mal bell-shaped curve would sug­gest. Pol­icy mis­takes – too much money cre­ation, too much fis­cal belt-tightening, geopo­lit­i­cal con­flicts and war, geopo­lit­i­cal dis­agree­ments and dis­in­te­gra­tion of mon­e­tary and fis­cal unions – all of these and more lead to poten­tial bimodal dis­tri­b­u­tions – fat left and right tail out­comes that can inflate or deflate asset mar­kets and real eco­nomic growth. If you are a ratio­nal investor you should con­sider hedg­ing our most prob­a­ble inflationary/low growth out­come – what we call a “C-“ sce­nario – by buy­ing hedges for fat­ter tailed pos­si­bil­i­ties. It will cost you some­thing – and hedg­ing in a low return world is harder to buy than when the cot­ton is high and the liv­ing is easy. But you should do it in amounts that hedge against prin­ci­pal down­sides and allow for prin­ci­pal upsides in bimodal out­comes, the lat­ter per­haps being epit­o­mized by equity mar­kets 10–15% returns in the first 80 days of 2012.

And sec­ondly, be mind­ful of invest­ment man­age­ment expenses. Whoops, I’m not sup­posed to say that, but I will. Be sure you’re get­ting value for your expense dol­lars. We of course – per­haps like many other firms would say, “We’re Num­ber One.” Not always, not for me in the sum­mer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are cer­tainly a #1 seed – with aspi­ra­tions as always to be your #1 Champion.

William H. Gross
Man­ag­ing Director

“Safe Spread” also known as “Safe Carry” is defined as sec­tors that we believe are most likely to with­stand the vicis­si­tudes of a wide range of pos­si­ble eco­nomic sce­nar­ios. All invest­ments con­tain risk and may lose value.
Past per­for­mance is not a guar­an­tee or a reli­able indi­ca­tor of future results. Invest­ing in the bond mar­ket is sub­ject to cer­tain risks includ­ing mar­ket, interest-rate, issuer, credit, and infla­tion risk. Equi­ties may decline in value due to both real and per­ceived gen­eral mar­ket, eco­nomic, and indus­try con­di­tions. Com­modi­ties con­tain height­ened risk includ­ing mar­ket, polit­i­cal, reg­u­la­tory, and nat­ural con­di­tions, and may not be suit­able for all investors. Invest­ing in for­eign denom­i­nated and/or domi­ciled secu­ri­ties may involve height­ened risk due to cur­rency fluc­tu­a­tions, and eco­nomic and polit­i­cal risks, which may be enhanced in emerg­ing mar­kets. Sov­er­eign secu­ri­ties are gen­er­ally backed by the issu­ing gov­ern­ment, oblig­a­tions of U.S. Gov­ern­ment agen­cies and author­i­ties are sup­ported by vary­ing degrees but are gen­er­ally not backed by the full faith of the U.S. Gov­ern­ment; port­fo­lios that invest in such secu­ri­ties are not guar­an­teed and will fluc­tu­ate in value. Inflation-linked bonds (ILBs) issued by a gov­ern­ment are fixed-income secu­ri­ties whose prin­ci­pal value is peri­od­i­cally adjusted accord­ing to the rate of infla­tion; ILBs decline in value when real inter­est rates rise. Tail risk hedg­ing may involve enter­ing into finan­cial deriv­a­tives that are expected to increase in value dur­ing the occur­rence of tail events. Invest­ing in a tail event instru­ment could lose all or a por­tion of its value even in a period of severe mar­ket stress. A tail event is unpre­dictable; there­fore, invest­ments in instru­ments tied to the occur­rence of a tail event are spec­u­la­tive. Deriv­a­tives may involve cer­tain costs and risks such as liq­uid­ity, inter­est rate, mar­ket, credit, man­age­ment and the risk that a posi­tion could not be closed when most advan­ta­geous. Invest­ing in deriv­a­tives could lose more than the amount invested. There is no guar­an­tee that these invest­ment strate­gies will work under all mar­ket con­di­tions or are suit­able for all investors and each investor should eval­u­ate their abil­ity to invest long-term, espe­cially dur­ing peri­ods of down­turn in the mar­ket. An investor should con­sult their finan­cial advi­sor prior to mak­ing an invest­ment decision.

This mate­r­ial con­tains the cur­rent opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial is dis­trib­uted for infor­ma­tional pur­poses only. Fore­casts, esti­mates, and cer­tain infor­ma­tion con­tained herein are based upon pro­pri­etary research and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. No part of this arti­cle may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion of Pacific Invest­ment Man­age­ment Com­pany LLC. ©2012, PIMCO.

Tags: Bill Gross, Bond Market, Bretton Woods, Central Banking, Commodities, Commodity, Commodity Products, Debasement, Dividend Paying Stocks, Financial Assets, Financial Leverage, Future Returns, Global Economy, Gold Standard, Great Escape, Gross Investment, Inflation Protected Bonds, Investment Outlook, PIMCO, Three Decades, Treasury Bills, William H Gross
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A False Sense of Security (Hussman)

Sunday, March 25th, 2012

"The world econ­omy has stepped back from the brink and we have causes to be a lit­tle bit more opti­mistic. But opti­mism should not give us a sense of com­fort and cer­tainly should not lull us into a false sense of security."

IMF Man­ag­ing Direc­tor Chris­tine Lagarde, March 17, 2012

As we exam­ine the present evi­dence relat­ing to both the finan­cial mar­kets and the global econ­omy, the aspect that strikes us most is the extent to which Wall Street con­tin­ues to empha­size super­fi­cially pos­i­tive data in pref­er­ence for deeper analy­sis, to extrap­o­late short-term dis­tor­tions as if they were long-term trends, and to mis­con­strue freshly printed wall­pa­per and thin sup­port­ing ice as if they were solid walls and floors.

Two propo­si­tions we heard last week were char­ac­ter­is­tic of this false sense of secu­rity. One was a remark by an ana­lyst that stocks were in a "sec­u­lar bull mar­ket" here. The other was a Wall Street "fac­toid" being passed around, sug­gest­ing that the "equity risk pre­mium" on stocks has never been higher.

Let's address these in turn. When peo­ple talk about bull and bear mar­kets, they often use the terms "cycli­cal" and "sec­u­lar." One cycli­cal bull and one cycli­cal bear mar­ket com­prise the nor­mal garden-variety mar­ket cycle of about 5 years in dura­tion (though with quite a bit of vari­a­tion around that norm, see "notes on sec­u­lar and cycli­cal mar­kets" in Hang­ing Around, Hop­ing to Get Lucky ). Tak­ing very broad aver­ages, a cycli­cal bull mar­ket lasts about 3.75 years, aver­ag­ing a trough-to-peak gain of about 150%, and a cycli­cal bear mar­ket lasts about 1.25 years, aver­ag­ing a decline of just over 30% from peak-to-trough. If you do the com­pound­ing, you'll observe that the typ­i­cal bear mar­ket wipes out more than half of the pre­ced­ing bull mar­ket gain.

How­ever, those aver­ages mask an addi­tional source of vari­a­tion, which depends on "sec­u­lar" con­di­tions. If you exam­ine mar­ket his­tory as far back as the late-1800's, you'll find that mar­ket val­u­a­tions have moved in broad advanc­ing and declin­ing phases, with each phase last­ing about 17–18 years in dura­tion (that still should be treated only as a ten­dency, and there's no rea­son I know for treat­ing it as a magic num­ber). As an exam­ple, stocks moved from extremely low val­u­a­tions in 1947 to quite rich val­u­a­tions by 1965, pro­duc­ing a long "sec­u­lar" bull mar­ket where each suc­ces­sive cycli­cal bull mar­ket topped out at higher and higher val­u­a­tion mul­ti­ples. In con­trast, from 1965 to 1982, val­u­a­tion mul­ti­ples went through a long con­trac­tion, where each suc­ces­sive cycli­cal bear mar­ket bot­tomed out at lower and lower val­u­a­tion multiples.

The effect of these longer val­u­a­tion "waves" is this: dur­ing long sec­u­lar bull phases, the cycli­cal bull mar­kets tend to be longer and more reward­ing, and the cycli­cal bear mar­kets tend to be shorter and less dam­ag­ing. In sec­u­lar bulls, the mar­ket is run­ning with the wind at its back. The sec­u­lar bull mar­ket period from 1982 through 2000 was a good exam­ple of this tendency.

In con­trast, dur­ing long sec­u­lar bear phases, the cycli­cal bull mar­kets tend to be shorter and less reward­ing, while the cycli­cal bear mar­kets tend to be longer and more vio­lent. In sec­u­lar bears, the mar­ket is swim­ming against the tide. The sec­u­lar bear period that began in 2000 has been a good exam­ple of this tendency.

As Nau­tilus Cap­i­tal observes, the aver­age cycli­cal bull mar­ket in a sec­u­lar bear mar­ket period has pro­duced an aver­age gain of only about 85%, last­ing less than 3 years on aver­age. In con­trast, the aver­age cycli­cal bear in a sec­u­lar bear has been unusu­ally vio­lent, aver­ag­ing a 39% loss over a span of about a year and a half. Com­pound the two, and that's enough dam­age to drag the cumu­la­tive full-cycle return down to just 13%, on average.

Need­less to say, the asser­tion that stocks are in a "sec­u­lar" bull mar­ket is really an asser­tion that investors can let down their guard, in the sense that down­turns are likely to be muted and advances will be extended. But from our stand­point, if you're going to pick a sec­u­lar team, it would be best to have reli­able data to back up the choice.

So what dis­tin­guishes a sec­u­lar bull from a sec­u­lar bear? Val­u­a­tions. Not just any val­u­a­tion mea­sure how­ever — it's impor­tant to demon­strate that the val­u­a­tion mea­sure you choose actu­ally has a strong and demon­stra­ble long-term rela­tion­ship with sub­se­quent mar­ket returns (which is where Wall Street's disin­gen­u­ous use of toy mod­els like sim­ple price-to-forward earn­ings mul­ti­ples and the "Fed Model" makes us nearly apoplectic).

Below, I've anno­tated our usual val­u­a­tion chart to pro­vide a bet­ter sense of what dri­ves the long "sec­u­lar" move­ments in the stock mar­ket. The chart uses our stan­dard val­u­a­tion method­ol­ogy to esti­mate prospec­tive mar­ket returns.

It should be quickly evi­dent that sec­u­lar bull mar­kets don't sim­ply come out of the blue. They emerge pre­cisely because stocks become priced to achieve extra­or­di­nar­ily high long-term returns. Both the 1947–1965 sec­u­lar bull and the 1982–2000 sec­u­lar bull began at points where stocks were priced to achieve 10-year returns of close to 20% annu­ally. In con­trast, the 1965–1982 sec­u­lar bear began with prospec­tive 10-year returns of just 5.9% (though slightly higher than the 4.4% yield on Trea­sury bonds at the time), and of course, the sec­u­lar bear that began in 2000 emerged from bub­ble val­u­a­tions, where we pro­jected neg­a­tive 10-year total returns at the time.

It seems to be an arti­cle of faith among some ana­lysts that the 2009 low rep­re­sented the start of a new sec­u­lar bull mar­ket, but two fea­tures are note­wor­thy. The first is that the val­u­a­tion achieved in 2009 was nowhere near the val­u­a­tion that typ­i­cally ush­ers in a new sec­u­lar bull mar­ket. The sec­ond is that the brief under­val­u­a­tion we observed in 2009 was quickly elim­i­nated. At present, we project total returns for the S&P 500 of just over 4% annu­ally over the com­ing decade. This is even worse than the val­u­a­tion where the 1965–1982 sec­u­lar bear started (though cer­tainly less extreme than the 2000 peak). Though inter­est rates are lower today than in the 1965–1982 period, sat­is­fac­tory returns from present lev­els will require investors to sus­tain rich val­u­a­tions indefinitely.

Again, it's worth empha­siz­ing that our stan­dard val­u­a­tion meth­ods are (and have remained) well-correlated with sub­se­quent mar­ket returns — a very basic cri­te­rion that is painfully lack­ing among many pop­u­lar val­u­a­tion mea­sures such as the Fed Model. It strikes me as absolutely bizarre that so many Wall Street "pro­fes­sion­als" offer up the Fed Model and the "for­ward oper­at­ing earn­ings times arbi­trary mul­ti­ple" approach so freely, when it takes noth­ing but some data and a few hours of effort to demon­strate that those approaches are nearly worth­less (see for exam­ple the August 20, 2007 com­ment Long Term Evi­dence on the Fed Model and For­ward Oper­at­ing P/E Ratios — not that many ana­lysts agreed with our val­u­a­tion con­cerns at that point either).

A related asser­tion we've heard a lot lately is that "the equity risk pre­mium on stocks has never been higher." In the finance lit­er­a­ture, the "equity risk pre­mium" is essen­tially the return that stocks are priced to achieve, in excess of the risk-free inter­est rate. Of course, these esti­mates vary wildly depend­ing on the method you use (many com­mon ones which, again, have vir­tu­ally no cor­re­la­tion with actual sub­se­quent returns). A few pop­u­lar meth­ods include 1) the Fed Model (for­ward oper­at­ing earn­ings yield minus the 10-year Trea­sury yield); 2) div­i­dend yield plus pro­jected earn­ings growth, minus the 10-year Trea­sury yield; 3) his­tor­i­cal stock returns minus the 10-year Trea­sury yield, which is a par­tic­u­larly mis­lead­ing mea­sure of the returns stocks are priced to achieve in the future, or; 4) any of the above using the pre­vail­ing T-bill yield instead of 10-year yields.

Among the prob­lems with these typ­i­cal approaches is that stocks are not 3-month or 10-year instru­ments, but have a dura­tion that is essen­tially the inverse of the div­i­dend yield (so at present, the dura­tion of stocks is roughly 50 years, com­pared with a 10-year Trea­sury, which has a dura­tion closer to 7 years). So the appro­pri­ate "risk free" return in these esti­mates should really be either a Trea­sury yield of equiv­a­lent matu­rity — none which are avail­able, or at least an esti­mate of the aver­age expected short-term risk free rate expected over the same hori­zon. Need­less to say, esti­mates of the equity risk pre­mium get a false ben­e­fit if you use today's unusu­ally sup­pressed, short-duration risk-free rates.

The larger dif­fi­culty is the esti­mate of the prospec­tive return on stocks. If you want to use a 10-year Trea­sury yield as a bench­mark, you would also want to use a 10-year pro­jected return for the S&P 500. On that note, and using reli­able val­u­a­tion meth­ods (see above), the dif­fer­ence between the expected 10-year total return on stocks and the 10-year Trea­sury yield is presently less than 2% (nominal).

How does this com­pare his­tor­i­cally? It's notable that the esti­mated equity risk pre­mium was severely neg­a­tive dur­ing the late-1990's mar­ket bub­ble. Not sur­pris­ingly, stocks have per­formed ter­ri­bly ver­sus risk-free Trea­suries as a result. Exclud­ing bubble-era data, we esti­mate that the nor­mal his­tor­i­cal equity risk pre­mium (on a 10-year hori­zon) has been just over 6%, reach­ing 17% in the late-1940's as a sec­u­lar bull mar­ket was begin­ning, and hold­ing in the 5–9% range even dur­ing the high-inflation 1970's. Includ­ing the late-1990's bub­ble period in the cal­cu­la­tion brings the aver­age down to just over 4.5%.

When has the equity risk pre­mium been as low as it is today? Prior to the late-1990's bub­ble period, the esti­mated equity risk pre­mium has been below 2% only dur­ing the two-year period lead­ing up to the 1929 peak, between 1968–1972 (when the equity risk pre­mium finally nor­mal­ized as a result of the 1973–1974 mar­ket plunge), and briefly in 1987, before the mar­ket crash of that year. We know how each of these peri­ods ended. The only real vari­a­tion is in how long the pre­ced­ing over­val­u­a­tion was sustained.

Profit mar­gins and a false sense of security

One of the aspects of the mar­ket that is most likely to con­fuse investors here is the wide range of opin­ions about val­u­a­tion, with some ana­lysts argu­ing that stocks are cheap or fairly val­ued, and oth­ers — includ­ing Jeremy Grantham, Albert Edwards, and of course us — argu­ing that val­u­a­tions are very rich.

The fol­low­ing chart may help to bridge that gulf. Essen­tially, ana­lysts who view stocks as "cheap" here are invari­ably bas­ing that con­clu­sion on cur­rent and year-ahead fore­casts for earn­ings. In con­trast, ana­lysts who view stocks as richly val­ued are typ­i­cally those who view stocks as a claim not on this years' or next years' earn­ings, but instead are a claim on a long-term stream of deliv­er­able cash flows. Sim­ply put, there is presently a mas­sive dif­fer­ence between short-horizon earn­ings mea­sures and longer-term, nor­mal­ized earn­ings measures.

What's going on here is that profit mar­gins have never been wider in his­tory. But profit mar­gins are also highly cycli­cal over time. The wide mar­gins at present are partly the result of deficit spend­ing amount­ing to more than 8% of GDP — where gov­ern­ment trans­fer pay­ments are still hold­ing up nearly 20% of total con­sumer spend­ing, and partly the result of for­eign labor out­sourc­ing (directly, and also indi­rectly through imported inter­me­di­ate goods) which has held down wage and salary pay­outs. Indeed, the ratio of cor­po­rate prof­its to GDP is now close to 70% above its long-term norm.

Now, if you look at the red line (right scale, inverted), you'll notice that unusu­ally high profit shares are invari­ably cor­re­lated with unusu­ally low growth in cor­po­rate prof­its over the fol­low­ing 5-year period. Thanks to con­tin­u­ing deficits and extra­or­di­nary mon­e­tary inter­ven­tions, this effect has been largely post­poned in recent years, allow­ing prof­its to expand to present extremes. We are not argu­ing that profit mar­gins nec­es­sar­ily have to decline over the near-term, and our con­cerns don't rest on the assump­tion that they will. It is suf­fi­cient to rec­og­nize that the bulk of the value of any stock is not in the early years of earn­ings, but in the long tail of future cash flows — espe­cially if pay­outs are low. Stocks are essen­tially 50-year instru­ments here in terms of the cash flows that are rel­e­vant to their val­u­a­tion. There are a lot of fac­tors and quiet math that affect the P/E mul­ti­ple that can be appro­pri­ately applied to earn­ings. Slap­ping an arbi­trary mul­ti­ple onto ele­vated earn­ings reflect­ing extra­or­di­nar­ily inflated profit mar­gins ignores all of it.

The upshot is that if investors are will­ing to believe (with­out the use of off-label hal­lu­cino­gens) that cur­rent profit mar­gins are the new nor­mal, and will be sus­tained indef­i­nitely, then Wall Street's val­u­a­tions based on cur­rent and for­ward earn­ings esti­mates can be taken at face value. This assump­tion of a per­ma­nently high plateau in profit mar­gins is qui­etly embed­ded into every dis­cus­sion of "for­ward earn­ings" here.

As a side note, ana­lysts con­tinue bemoan the "inex­plic­a­ble" gap between the eco­nomic malaise of "Main Street" and the opti­mism of Wall Street. Com­pare the pre­vi­ous graph to the one below, which shows how the "Mup­pets" are doing (and peo­ple won­der why I'm cyn­i­cal about cor­po­rate cul­ture). An econ­omy that is this far out of bal­ance is one that is unlikely to avoid top­pling over to some extent. Cap­i­tal­ism and free mar­kets work, and Amer­ica remains the most cre­ative and inno­v­a­tive nation on the planet, but until pol­icy mak­ers and reg­u­la­tors wake up, it will be impos­si­ble to escape the long-term con­se­quences of dis­torted mar­kets, reck­less bubble-seeking Fed Chair­men, repres­sively low inter­est rates that penal­ize sav­ing and lower the bar for pro­duc­tive invest­ment, a self-serving finan­cial sys­tem, and bailouts that remove all con­se­quences for mis­al­lo­cat­ing cap­i­tal that could oth­er­wise cre­ate jobs and raise liv­ing standards.

The iron law of equilibrium

A final obser­va­tion. We con­tinue to hear end­less vari­a­tions of this com­ment — "The Fed is cre­at­ing huge amounts of money, and all of that money has to go somewhere."

Actu­ally no, it does not. The iron law of equi­lib­rium is that once a secu­rity is issued — whether that piece of paper is a share of stock, a bond cer­tifi­cate, or a dol­lar bill — that secu­rity has to be held by some­one in exactly that form, and in no other form, until it is retired. If IBM issues one share of stock, that share of stock can change hands between any num­ber of peo­ple, but some­one has to hold that share until it is retired. If the Fed cre­ates a dol­lar of base money, that base money can change hands between any num­ber of peo­ple, but some­one has to hold that dol­lar until it is retired. There is no "get­ting out" of cash and into stocks in aggre­gate. There is only an exchange of own­er­ship between exist­ing pieces of paper that will each con­tinue to exist until each is retired.

So the proper ques­tion isn't where all of these pieces of paper will go — they still have to be held by some­one exactly as they are. They may change hands, but in equi­lib­rium, they don't go any­where. They can't go any­where in aggre­gate. The only real ques­tion is this: how low do you have to drive the returns on all other com­pet­ing assets until the "some­one" hold­ing that dol­lar bill has no incen­tive to try to trade it for some other piece of paper? This, pre­cisely this, and only this, is what the Fed is manip­u­lat­ing with its mas­sive inter­ven­tions. By cre­at­ing enor­mous amounts of paper, and hoard­ing higher dura­tion secu­ri­ties like Trea­sury secu­ri­ties, the Fed is try­ing to force investors into risky assets until the prospec­tive returns on all com­pet­ing assets are dri­ven so low that investors and banks hold­ing cash are will­ing to just sit on it. In short, the Fed has focused its efforts on cre­at­ing a bub­ble in risky assets, on the mis­guided, semi-psychotic, and empir­i­cally dis­prov­able notion that this will make peo­ple feel wealth­ier and get them to spend and bor­row — despite the fact that their incomes can't sup­port it with­out mas­sive gov­ern­ment trans­fer payments.

Aside from peri­odic jolts of enthu­si­asm that release some amount of pent-up demand for a few months at a time, what this pol­icy has actu­ally pro­duced is near-zero prospec­tive returns on nearly every class of assets. These assets will now go on to actu­ally achieve tepid returns for an extended period of time, pro­vided that things work out well, and a col­lapse in the prices of risky assets if investors ever get the incli­na­tion to demand a nor­mal return as com­pen­sa­tion for the risk they are taking.

Mar­ket Climate

The Mar­ket Cli­mate for stocks remains char­ac­ter­ized by an unusu­ally hos­tile set of indi­ca­tor syn­dromes, most notably, an "over­val­ued, over­bought, over­bull­ish, rising-yields" syn­drome that has his­tor­i­cally been unfa­vor­able for stocks regard­less of pre­vail­ing Fed pol­icy or trend-following indi­ca­tors. Even in recent years, the effect of Fed pol­icy and other inter­ven­tions has been evi­dent after sig­nif­i­cant mar­ket weak­ness (essen­tially lim­it­ing the fol­low through and help­ing to re-establish rich val­u­a­tions), but those inter­ven­tions have not pre­vented the weak­ness itself — not in 2007–2009, not in 2010, and not in 2011. Our pri­mary risk esti­mates are now in the worst 0.5% of what we observe in his­tor­i­cal data. We have increas­ingly used the word "warn­ing" in our weekly com­ments for that rea­son. Strate­gic Growth and Strate­gic Inter­na­tional remain fully hedged. Strate­gic Div­i­dend Value is hedged at 50% of the value of stocks held by the Fund, which is its most tightly hedged stance. Strate­gic Total Return main­tains a gen­er­ally con­ser­v­a­tive stance as well, with a dura­tion of just under 3 years in Trea­suries, and about 5% of assets allo­cated between pre­cious met­als shares, util­ity shares, and for­eign cur­ren­cies. I strongly expect that we will have sig­nif­i­cantly bet­ter oppor­tu­ni­ties to accept finan­cial risk in expec­ta­tion of return than the near-zero prospects the Fed­eral Reserve has forced upon investors at present.

Mean­while, our eco­nomic con­cerns per­sist, as detailed last week and in prior com­ments. Despite a low-level rebound in var­i­ous coin­ci­dent mea­sures, we con­tinue to observe gen­eral weak­ness in the most infor­ma­tive lead­ing mea­sures (as we saw again in data from Europe and China last week as well). Based on the typ­i­cal lead-time of these mea­sures, we are now in a win­dow where we would expect dete­ri­o­rat­ing coin­ci­dent data over the com­ing 2–3 months. As I've noted in prior com­ments, to the extent that we observe eco­nomic data com­ing in bet­ter than expected dur­ing this win­dow, the inferred state of the econ­omy is likely to improve, and we would then be able to sus­pend our reces­sion con­cerns. Regard­less, it's impor­tant to rec­og­nize that our defen­sive­ness about the stock mar­ket here is dis­tinct from those eco­nomic con­cerns, and our risk esti­mates would remain quite high (based on fac­tors includ­ing the pre­vail­ing over­val­ued, over­bought, over­bull­ish, rising-yields syn­drome), even if we were to zero out our reces­sion concerns.

Tags: Bear Market, Bear Markets, Bull And Bear, Christine Lagarde, Distortions, Equity Risk Premium, False Sense Of Security, Financial Markets, Garden Variety, Global Economy, Hussman, Imf, Market History, Market Valuations, Secular Bull Market, Sense Of Security, Source Of Variation, Term Trends, Trough, World Economy
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Emerging Markets Radar (March 26, 2012)

Sunday, March 25th, 2012

Emerg­ing Mar­kets Radar (March 26, 2012)

Strengths

• China has cut the required reserve ratio (RRR) for 379 branches of the Agri­cul­ture Bank of China to boost rural area loan vol­umes, sig­nal­ing fine-tuning mon­e­tary eas­ing. The mar­ket is cur­rently expect­ing fur­ther RRR cuts for all the banks this year.
• China has raised gaso­line and diesel prices by 7 per­cent and 7.76 per­cent, respec­tively. After the increase, the down­stream refin­ery busi­ness is closer to breakeven.
• Singapore’s Con­sumer Price Index (CPI) rose 4.6 per­cent in Feb­ru­ary, unex­pect­edly slow­ing as com­mu­ni­ca­tion costs fell in the city state. In Malaysia, con­sumer prices also slowed, ris­ing 2.2 per­cent year-over-year in Feb­ru­ary, down from 2.7 per­cent in Jan­u­ary and well below the mar­ket esti­mate of 2.5 per­cent. The key rea­son for the decline in infla­tion was a drop in food price inflation.
• The Philip­pines’ bud­get deficit nar­rowed to 15.9 bil­lion pesos ($370 mil­lion) in Jan­u­ary from 101.5 bil­lion pesos the pre­vi­ous month. In Thai­land, the Bank of Thai­land left its bench­mark rate at 3 per­cent, paus­ing after two recent reduc­tions. The result was widely expected.
• Nouriel Roubini turned more pos­i­tive on Colom­bia, revis­ing his 2012 and 2013 growth fore­casts to 5 and 4.5 per­cent, respec­tively, cit­ing a dis­si­pa­tion of down­side risk from the global econ­omy and a cool-down in domes­tic eco­nomic activity.
• The Brazil­ian labor mar­ket is show­ing that con­di­tions are get­ting bet­ter for con­sumers. Although the Feb­ru­ary unem­ploy­ment rate inched up to 5.7 per­cent from 5.5 per­cent in Jan­u­ary and 4.7 per­cent in Decem­ber, after strip­ping out sea­son­al­ity, the unem­ploy­ment rate remained at the series' record low of 5.6 per­cent for the fourth con­sec­u­tive month. Employ­ment grew 0.6 per­cent month-over-month (while the num­ber of unem­ployed work­ers dropped by 0.5 per­cent), which cou­pled with the 0.7 per­cent increase in real wages, pushed the real wage bill up by 1.3 per­cent month-over-month or by 17 per­cent in annu­al­ized terms.
• The num­ber of peo­ple employed in South Africa’s for­mal sec­tor inched up 0.3 per­cent in the fourth quar­ter of 2011, with the man­u­fac­tur­ing sec­tor pri­mar­ily adding the jobs. Employ­ment rose by 23,000 peo­ple dur­ing the last quar­ter of 2011, to 8.381 mil­lion, and was up 1.6 per­cent on a year-over-year basis, Sta­tis­tics South Africa said.

Weak­nesses

• HSBC March China Flash Pur­chas­ing Man­agers’ Index (PMI) was 48.1, down 1.5 from February’s 49.6, indi­cat­ing indus­trial activ­i­ties are fur­ther con­tract­ing, par­tic­u­larly in export-oriented manufacturers.
• Bloomberg news reports today that CBRC said China banks mis­clas­si­fied RMB1.8 tril­lion (20 per­cent) of local gov­ern­ment loans as fully-cash-flow-covered due to the inclu­sion of gov­ern­ment sub­si­dies. CICC bank ana­lysts will check whether CBRC peo­ple have said this or not, but bank ana­lyst Mao Jun­hua does not believe the 1.8 tril­lion num­ber is correct.
• Lend­ing by China’s four biggest banks was less than RMB 50 bil­lion from March 1 to 15, the Eco­nomic Infor­ma­tion Daily reports.
• BCA research reported recently that India’s cap­i­tal rationing is deter­ring growth, and pre­dicts a finan­cial crunch in 2012, which will ham­string much-needed cap­i­tal spend­ing. The firm sus­pects that India’s poten­tial growth rate is declin­ing because of slow­ing pro­duc­tiv­ity gains, which in turn are due to lower sav­ings and invest­ment rates.

Oppor­tu­ni­ties

• The South African rand gained for the first time in four days on Fri­day, trim­ming its worst weekly loss in six weeks, before data fore­cast to show U.S. sales of new homes rose last month, damp­en­ing demand for the dol­lar as a haven.
• Fol­low­ing a severe con­trac­tion in the fourth quar­ter of 2011, Thai­land is in the midst of a solid rebound that should bring back a growth trend by the end of the year with a 5.3 per­cent annual expan­sion, Nouriel Roubini said this week.
• Ver­bal inter­ven­tion from gov­ern­ments to bring down the price of crude has increased, in addi­tion to rumors of an agree­ment between the U.S. and the U.K. to tap into strate­gic reserves. In fact, France has offi­cially said that it and other indus­tri­al­ized nations are con­sid­er­ing a strate­gic reserves release. Fur­ther­more, Saudi Ara­bia has called present prices “unjus­ti­fied,” cit­ing a global sup­ply sur­plus of 1–2 mil­lion bar­rels per day, sig­nal­ing that it is pre­pared to increase pro­duc­tion by 25 per­cent to bring prices down if needed.
• Indonesia’s stock mar­ket has lagged its peers this year, pri­mar­ily due to the over­hang of ris­ing infla­tion risk. This is the result of the removal of gov­ern­ment sub­si­dies in fuel and power prices, and wage increases this year. How­ever, the dri­vers of the econ­omy in Indone­sia (i.e., ris­ing for­eign direct invest­ment, infra­struc­ture con­struc­tion, and ris­ing mid­dle class con­sump­tion) are intact and, there­fore, the stock mar­ket appears to be a long-term play.

Threats

• The Chi­nese econ­omy is still in the process of a soft land­ing, which may cause uncer­tain­ties for the economy.
• Poland’s shale gas reserves are about one-tenth the size of pre­vi­ous esti­mates, a gov­ern­ment report showed this week, dent­ing hopes for an energy source that could play a key role in wean­ing Europe off Russ­ian gas. The long-awaited study esti­mated Poland's recov­er­able shale reserves at 346 to 768 bil­lion cubic meters, far less than the pre­vi­ous esti­mate of 5.3 tril­lion from the U.S. Energy Infor­ma­tion Association.
• South Africa’s for­eign affairs min­istry said it is reduc­ing Iran oil imports, as its largest sup­plier of crude oil faces inter­na­tional sanc­tions. The indus­try awaits fur­ther detail, as a national oil indus­try group said it hadn’t been informed of the plan.

Tags: Agriculture, Agriculture Bank Of China, Bank Of China, Bank Of Thailand, Benchmark Rate, Brazil, Budget Deficit, Communication Costs, Consumer Price Index, Diesel Prices, Downside Risk, Food Price, Global Economy, Growth Forecasts, Index Cpi, Price Inflation, Reserve Ratio, Rrr, Rural Area, Russia, Seasonality, Unemployed Workers, Unemployment Rate
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Biderman: Where Are We Headed as a Global Economy?

Tuesday, March 20th, 2012

“Where are we headed as a global econ­omy?” is a ques­tion most of us worry about. My best guess is that over time – in years not months – gov­ern­ments will wither away and the under­ly­ing global econ­omy will grow and prosper.

How I get there starts with where we are right now. And right now, there are enor­mous head­winds fac­ing us. The head­winds all have a com­mon theme however.

The gov­ern­ments of the United States, Europe and Japan cur­rently owe tril­lions of dol­lars that it will not be able to pay. Part of the un-payable debt is due to the print­ing of close to $10 tril­lion of paper the cen­tral banks hope and pray will be con­sid­ered money by their publics. The rest of the un-payable debt is due to promises about future ben­e­fits made by these gov­ern­ments to pla­cate their citizens.

That rot­ten mess sits on top of a global expan­sion of the abil­ity to pro­duce goods and ser­vices wanted and needed by the emerg­ing world. The truly amaz­ing fun­da­men­tal real­ity not under­stood by most is that more peo­ple as a per­cent­age of this plan­ets pop­u­la­tion have achieved calo­rie suf­fi­ciency in the past decade than ever before. That is worth repeat­ing, more peo­ple as a per­cent­age of this plan­ets pop­u­la­tion are no longer calo­rie insuf­fi­cient than ever before. Calo­rie insuf­fi­cient is a nice way of say­ing starv­ing to death.

Look at Asia. Broad­band has cre­ated the pos­si­bil­ity of a global econ­omy. With broad­band Asian fac­to­ries can be the low cost pro­ducer for the world. Yes, the loss of man­u­fac­tur­ing jobs to Asia costs the devel­oped world jobs, but con­sider how many peo­ple have stopped starv­ing as a result.

I am not say­ing that star­va­tion is no longer an issue, I still con­tribute monthly to the Global Hunger Project, but what I am say­ing is that broad­band is the com­mu­ni­ca­tion tech­nol­ogy break­through that is the best tool ever devel­oped to fight starvation.

To sum­ma­rize where we are right now is we have a vibrant global econ­omy being sti­fled by bad gov­ern­ments in the US, Europe and Japan. Maybe the solu­tion is sim­ply remov­ing all those gov­ern­ments and let­ting the rest of the global econ­omy alone?

Do you know who would be most opposed to such a solu­tion? My guess is the gov­ern­ments and those who are being paid by the gov­ern­ment whether in salaries and ben­e­fits; as well as all the spe­cial inter­est group parasites.

Let me be emphatic that I am not advo­cat­ing any sort of phys­i­cal or even non-physical violence.

A buddy who read this in draft form sug­gested we need gov­ern­ment to act as a mon­i­tor and ref­eree to keep the bad guys under con­trol. Maybe we do. But does it have to be called gov­ern­ment or could social media take on being the ref­eree and mon­i­tor for the globe?

By the way, Happy Anniver­sary my dar­ling Virginia.

Charles Bider­man
Pres­i­dent & CEO TrimTabs Invest­ment Research
Port­fo­lio Man­ager, TrimTabs Float Shrink ETF (TTFS)

Tags: Asian Factories, Best Guess, Central Banks, Communication Technology, Fundamental Reality, Global Economy, Global Expansion, Global Hunger, Governmen, Governments, Headwinds, Hunger Project, Manufacturing Jobs, Planets, Promises, Starvation, Starving To Death, Sufficiency, Technology Breakthrough, Trillion, Trillions
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Cyclical Outlook: Navigating the Hurricane of Global Deleveraging (PIMCO)

Friday, March 16th, 2012

by Saumil H. Parikh, PIMCO

• We expect the euro­zone econ­omy to expe­ri­ence a reces­sion in 2012 on the back of con­tin­u­ing pro-cyclical fis­cal aus­ter­ity measures.
• We expect 2012 to be the year in which the res­i­den­tial con­struc­tion sec­tor begins to grad­u­ally con­tribute to U.S. eco­nomic growth after a long and painful five-year hiatus.
• Major emerg­ing mar­ket economies are strug­gling with domes­tic over-investment, ris­ing income inequal­i­ties and infla­tion risks. There­fore, PIMCO expects major emerg­ing mar­ket economies to be less of a global engine of growth in 2012–13.

The global econ­omy finds itself sail­ing through calmer waters and clearer skies this quar­ter. Most finan­cial asset prices have improved sub­stan­tially in recent months. Liq­uid­ity con­di­tions across mar­kets have eased. Forced bal­ance sheet delever­ag­ing has slowed, and as a result, global eco­nomic growth has found a foot­ing of sorts com­pared to last quarter.

The recent improve­ment in liq­uid­ity con­di­tions and finan­cial asset prices in Europe on the back of two Long-Term Repo Oper­a­tions (LTROs) car­ried out by the Euro­pean Cen­tral Bank (ECB) in early Decem­ber and early March is of great impor­tance to the evolv­ing nature of PIMCO’s cycli­cal eco­nomic out­look. These oper­a­tions have suc­ceeded in pro­vid­ing highly at-risk Euro­pean finan­cial insti­tu­tions with nearly a tril­lion euros in much needed financ­ing to meet accel­er­at­ing deposit flight, pay bond redemp­tions, secure longer-term fund­ing and address asset-liability mis­matches. Addi­tion­ally, they have also dri­ven pos­i­tive spillover effects for cer­tain sov­er­eign bond mar­kets (in par­tic­u­lar Italy and Spain). In turn, this has slowed down the vicious Euro­pean delever­ag­ing feed­back loop that was threat­en­ing the global eco­nomic out­look com­ing into 2012.

But the crit­i­cal ques­tion for the year ahead is whether the ECB has done enough to halt and reverse delever­ag­ing and change the course of the euro­zone and global eco­nomic out­look on a sus­tain­able basis? That is, is the global econ­omy in the eye of the hur­ri­cane or has the hur­ri­cane passed over completely?

At PIMCO, we rec­og­nize the dynam­ics of eco­nomic and bal­ance sheet heal­ing but remain con­cerned that, in some key areas, they have not yet reached crit­i­cal mass. This is par­tic­u­larly the case in Europe, where ECB liq­uid­ity pro­vi­sions are nec­es­sary, but insuf­fi­cient to deal with the twin under­ly­ing prob­lems of too lit­tle growth and too much debt.

Eurozone’s Chal­lenges Continue

In our view, it is still too early to give the all clear sign for the euro­zone out­look. The fun­da­men­tal prob­lem fac­ing the euro­zone remains one of uneven com­pet­i­tive­ness, cur­rency rigid­ity and the lack of a coör­di­nated vision shared between mon­e­tary and fis­cal pol­icy institutions.

We expect the euro­zone econ­omy to expe­ri­ence a reces­sion in 2012 on the back of con­tin­u­ing pro-cyclical fis­cal aus­ter­ity mea­sures, which will make euro­zone sov­er­eign risk indi­ca­tors cycli­cally worse before they are given a chance to get sec­u­larly better.

This raises the specter of more down­grades, fur­ther destruc­tion of demand for euro­zone debt and the need to fur­ther delever­age bal­ance sheets in the com­ing months and quar­ters. Spain has already raised its hand, demand­ing per­mis­sion to run higher fis­cal deficits than promised just a few months ago. The sit­u­a­tion in Greece remains crit­i­cal, and, along with Por­tu­gal, high­lights the inad­e­quacy of liq­uid­ity pro­vi­sions to cure real sol­vency prob­lems once debt dynam­ics move beyond the point of no return.

The future sol­vency of euro­zone sov­er­eigns can only be improved via the real­iza­tion of much higher nom­i­nal growth and the reduc­tion in sov­er­eign bor­row­ing costs which will require a lender of last resort. Rates need to drop to a level low enough to make debt bur­dens sus­tain­able even at eco­nomic growth rates below the eurozone’s full poten­tial. Nei­ther of these sol­vency improv­ing options are being offered to the trou­bled euro­zone economies today.

As a result of our expec­ta­tions for a euro­zone reces­sion, ris­ing polit­i­cal risks across impor­tant coun­tries and also the lack of crit­i­cal sol­vency con­di­tions, we believe the delever­ag­ing feed­back loop in Europe will remain in place and will con­tinue to be the defin­ing cen­tral fea­ture of the global cycli­cal eco­nomic out­look. Like we said in Decem­ber, as goes the euro­zone delever­ag­ing, so goes the global econ­omy over the next six to 12 months.

U.S. Eco­nomic Growth Prospects

While the strug­gling euro­zone econ­omy will likely pre­vent the U.S. from achiev­ing above-trend growth, some sec­tors of the U.S. econ­omy have gen­uinely improved and are re-emerging from sec­u­lar lows. This is clear in auto­mo­bile out­put and more gen­er­ally in man­u­fac­tur­ing. One impor­tant inflec­tion point in the story of U.S. delever­ag­ing is the flat­ten­ing out and rever­sal of the neg­a­tive con­tri­bu­tion of res­i­den­tial con­struc­tion to over­all eco­nomic growth. We expect 2012 to be the year in which the res­i­den­tial con­struc­tion sec­tor begins to grad­u­ally con­tribute to U.S. eco­nomic growth after a long and painful five-year hia­tus. While we don’t expect the total con­tri­bu­tion from this sec­tor to be large (῀0.3%-0.4%), it does set the stage for a poten­tial multi-year recov­ery in res­i­den­tial con­struc­tion that we expect will even­tu­ally see a return to bal­ance between house­hold for­ma­tion rates and new con­struc­tion. This will add jobs and cre­ate income for many Amer­i­can work­ers that have endured a long depres­sion in the sec­tor. This is great news.

Another pos­i­tive for the U.S. econ­omy in 2012 is the nascent revival of avail­abil­ity of con­sumer credit. In recent months, this has become most clearly evi­dent in the areas of stu­dent loans and also auto­mo­bile financ­ing. The lat­ter was a crit­i­cal com­po­nent in the recov­ery of auto­mo­bile sales to a 15 mil­lion annu­al­ized sales rate in Feb­ru­ary 2012 (a level of activ­ity not seen in the sec­tor since March of 2008) accord­ing to the U.S. Depart­ment of Com­merce.
An impor­tant ques­tion, how­ever, is whether this recov­ery in con­sumer credit avail­abil­ity will fil­ter deep enough and wide enough in the house­hold sec­tor to allow for a sus­tained and con­tin­ued drop in the U.S. house­hold sav­ings rate, which will be needed to sus­tain cycli­cal U.S. eco­nomic growth in the face of a weak­en­ing out­look for fis­cal stim­u­lus and exports. The poten­tial cer­tainly exists and will be strength­ened sig­nif­i­cantly if cur­rent improve­ments in employ­ment and income can be sus­tained into 2013.

Emerg­ing Mar­ket Slowdown

Europe and the emerg­ing mar­kets are very impor­tant des­ti­na­tions for U.S. exports. Brazil, Rus­sia, India, China and Mex­ico, in total, are the largest mar­ket for U.S. exports, fol­lowed by Canada, fol­lowed closely by Europe. While we believe Europe is almost cer­tainly going to encounter a reces­sion in 2012, recent evi­dence from the major emerg­ing mar­ket coun­tries sug­gests that there is a sig­nif­i­cant cycli­cal slow­down under­way there as well, espe­cially in China, Brazil and India.
Our cycli­cal out­look for the major emerg­ing mar­kets is for growth to set­tle at the sector’s full poten­tial, with risks of under-shooting due to poli­cies designed to oppor­tunis­ti­cally con­tain infla­tion. Emerg­ing mar­ket economies have played an out­sized role in the global eco­nomic recov­ery since 2008.

Because of much bet­ter ini­tial con­di­tions, and also greater pol­icy effec­tive­ness, fis­cal and mon­e­tary stim­u­la­tion of major emerg­ing mar­ket economies pro­vided impor­tant exter­nal demand for both U.S. and Euro­pean com­mod­ity and cap­i­tal goods exports dur­ing frag­ile peri­ods of post-crisis growth. But, we expect this exter­nal demand source to wane dur­ing 2012.

Major emerg­ing mar­ket economies are strug­gling with domes­tic over-investment, ris­ing income inequal­i­ties and infla­tion risks. There­fore, PIMCO expects major emerg­ing mar­ket economies to be less of a global engine of growth in 2012–13.

Poten­tial Grey Swans

Finally, there are three grey swans on the cycli­cal horizon.

The U.S. elec­tions in Novem­ber will be crit­i­cal in deter­min­ing the shape of U.S. fis­cal pol­icy going into 2013 and beyond. As is well known by now, the U.S. econ­omy faces a “fis­cal cliff” in Jan­u­ary of next year, when tax stim­u­lus and gov­ern­ment spend­ing worth approx­i­mately 3.5% of GDP are sched­uled to be cut. Even if the new pres­i­dent and incom­ing con­gress are able to avoid the debil­i­tat­ing fis­cal con­trac­tion in 2013, the risk remains that as we approach the “fis­cal cliff,” polit­i­cal the­atrics and uncer­tainty regard­ing the out­come will hin­der con­fi­dence and ani­mal spir­its as they did before the debt ceil­ing debate of 2011.

There are also pres­i­den­tial elec­tions in France, a coun­try that is key to resolv­ing the Euro­pean debt cri­sis. We will be fol­low­ing devel­op­ments there closely, with par­tic­u­lar focus on their poten­tial impact on the French pol­icy stance, Franco–

Ger­man col­lab­o­ra­tion and the out­look for Europe.

It is the third swan that dis­turbs us most. The qui­etly ris­ing ten­sions in the Mid­dle East between Israel and Iran must be addressed by global lead­ers in a uni­fied man­ner before long. The exis­tence of known unknowns is exert­ing unwel­come pres­sure on oil prices at a time when the global econ­omy is only begin­ning to sta­bi­lize and grow out of vicious sec­u­lar delever­ag­ing process. Any global com­pla­cency on this front will quickly embed itself in oil prices, which in turn will ren­der our best cycli­cal fore­casts use­less dur­ing a time in which vis­i­bil­ity is already poor on all points across the horizon.

While we are sail­ing through calmer seas and clearer skies this quar­ter, the hori­zon in most direc­tions remains grey and vis­i­bil­ity remains very poor. A sus­tain­able res­o­lu­tion to the euro­zone sov­er­eign cri­sis, con­tin­ued gains in U.S. employ­ment and con­sump­tion and a peace­ful res­o­lu­tion to Mid­dle East ten­sions are all nec­es­sary before we can declare sec­u­lar smooth sail­ing ahead.

Tags: Asset Liability, Asset Prices, Austerity Measures, Bond Markets, Brazil, Canadian Market, Construction Sector, Critical Question, Emerging Market Economies, Feedback Loop, Financial Asset, Fiscal Austerity, Global Economic Growth, Global Economic Outlook, Global Economy, Income Inequalities, Inflation Risks, Liquidity Conditions, Outlo, Parikh, PIMCO, Russia, Spillover Effects
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Systemic Risk, Multiple Equilibria and Market Dynamics – What You Need to Know and Why

Thursday, March 15th, 2012

• ​ In assess­ing the pos­si­bil­ity, dura­tion and impact of sys­temic risk fac­tors, we need to ana­lyze the inter­ac­tion of expec­ta­tions with mar­ket (endoge­nous) and pol­icy (exoge­nous) cir­cuit breakers.
• In the cur­rent envi­ron­ment, the preva­lence of some sub­jec­tive bimodal expec­ta­tion dis­tri­b­u­tions (e.g. Europe related) speaks to the mul­ti­ple equi­lib­rium fea­tures of sov­er­eign debt markets.
• Mul­ti­ple equi­lib­ria give rise to a range of sce­nar­ios, each quite dif­fer­ent and each with its own dis­tri­b­u­tion of returns, risks, cor­re­la­tions, and mar­ket functioning.
• In today's global con­text, investors (as well as pol­icy mak­ers, researchers and opin­ion lead­ers) need to sup­ple­ment their analy­ses of fun­da­men­tals, his­toric risk pre­mia, cor­re­la­tions and rel­a­tive value with a clearer delin­eation of the expec­ta­tion for­ma­tion process itself.

​Intro­duc­tion
Finan­cial mar­kets are sub­ject to peri­odic bouts of sys­temic risk that affect their func­tion­ing and sta­bil­ity, as well as invest­ment returns and volatil­ity. Sev­eral ele­ments of invest­ment strat­egy – includ­ing asset allo­ca­tion, liq­uid­ity man­age­ment, risk mit­i­ga­tion and, in cer­tain cases, even the design of bench­marks and guide­lines – can be affected by this real­ity. Accord­ingly, and par­tic­u­larly given the ongo­ing re-alignment of the global econ­omy and mar­kets, it is impor­tant to have a han­dle on the under­ly­ing dynam­ics. To this end, in this paper we ana­lyze those asso­ci­ated with sud­den shifts in expec­ta­tions. It explains how they can morph into par­tic­u­larly dis­rup­tive mul­ti­ple equi­lib­ria dynam­ics, and it points to pos­si­ble impli­ca­tions for mar­ket out­comes, mar­ket equi­lib­ria and pol­icy responses.

The Con­text
Ear­lier work in eco­nom­ics on sig­nal­ing and screen­ing, includ­ing by one of the authors of this arti­cle (Mike Spence), sheds impor­tant light on issues that are of cur­rent inter­est to mar­kets and investors. Specif­i­cally, a sig­nif­i­cant sub­set of mul­ti­ple equi­lib­rium mar­ket struc­tures – the ones that are most rel­e­vant to finan­cial mar­kets and to their inter­ac­tions with the real econ­omy – are those in which expec­ta­tions have two char­ac­ter­is­tics: First, the expec­ta­tions are endoge­nous – i.e., they are deter­mined as part of the process of reach­ing equi­lib­rium out­comes in the mar­ket. Sec­ond, they exert a sub­stan­tial influ­ence on behav­ior and hence on the mar­ket out­comes that are inher­ently linked with the expec­ta­tions themselves.

The inter­ac­tions of these two fac­tors are crit­i­cal. Indeed, if they are mis­un­der­stood, they can eas­ily result in inap­pro­pri­ate analy­ses, invest­ment deci­sions and risk man­age­ment. They also can lead to mis­guided pol­icy reactions.

If just the first char­ac­ter­is­tic is present, mar­kets are in equi­lib­rium when expec­ta­tions are accu­rate. How­ever, if both are present, then expec­ta­tions aren’t best described as accu­rate but rather self-confirming in a ser­ial man­ner; and the sequence of local equi­lib­ria need not lead to a global equi­lib­rium. Con­se­quently, it is this kind of struc­ture that has mul­ti­ple equi­lib­ria and hence the poten­tial sud­den shifts in both expec­ta­tions and equi­lib­rium mar­ket outcomes.

For finan­cial mar­kets, bal­ance sheets and the real econ­omy, the endo­gene­ity of expec­ta­tions is always part of the struc­ture. But shifts in expec­ta­tions and asset val­ues need not always cause pow­er­ful feed­back effects on investor behav­ior and/or the real econ­omy. They do when a slight ini­tial per­tur­ba­tion in expec­ta­tions is ampli­fied into a rapid, non-mean-reverting shift to a very dif­fer­ent set of outcomes.

In assess­ing sys­temic risk, we there­fore need to look for the con­di­tions where there are sub­stan­tial feed­back effects and where mar­ket or pol­icy cir­cuit break­ers are either miss­ing, incom­plete or uncertain.

Sig­nal­ing as an Exam­ple of a Mul­ti­ple Equi­lib­rium Struc­ture
Sig­nal­ing occurs in mar­ket envi­ron­ments in which there are both infor­ma­tional gaps and infor­ma­tional asym­me­tries between the buy­ers and sell­ers. That is, there is some attribute of the prod­uct or ser­vice about which one side knows more than the other.

Asym­met­ri­cal infor­ma­tion con­di­tions are quite com­mon. They occur in labor, finan­cial and insur­ance mar­kets, and in many more places. As an exam­ple, in insur­ance mar­kets, the observ­abil­ity gap is vari­a­tion in risk across the enti­ties seek­ing to buy insur­ance. This phe­nom­e­non is called adverse selec­tion. It leads to sub-optimal out­comes and mar­ket failures.

Incom­plete infor­ma­tion and the inabil­ity to dis­tin­guish cause a loss of prod­uct dif­fer­en­ti­a­tion. Sell­ers try to recover the dif­fer­en­ti­a­tion through sig­nal­ing. For buy­ers, sig­nals are vis­i­ble attrib­utes that sell­ers can acquire at a cost that, in turn, trans­mits infor­ma­tion to buy­ers. Sig­nals that sur­vive and con­tain infor­ma­tion in equi­lib­rium have the prop­erty that their costs are neg­a­tively cor­re­lated with the invis­i­ble, val­ued attribute. If that con­di­tion is absent, the hypo­thet­i­cal sig­nal­ing behav­ior of sell­ers will not be cor­re­lated with the under­ly­ing attribute. Sub­se­quent mar­ket out­comes will reflect that, and the sig­nal then loses its infor­ma­tional con­tent and falls into dis­use and out of the mar­ket equi­lib­rium deter­mi­na­tion mechanisms.

Sig­nal­ing has the two prop­er­ties described above: Expec­ta­tions are endoge­nous; and they exert a pow­er­ful influ­ence on both incen­tives and choices made by sell­ers. Sig­nal­ing mod­els have mul­ti­ple equi­lib­ria, in each of which the expec­ta­tions are self-fulfilling.

In the cur­rent envi­ron­ment of large cor­re­lated global macro risks, we nat­u­rally tend to think mainly of dan­ger­ous equi­lib­rium shifts – away from good ones and toward unfa­vor­able bad ones that are also poten­tially unsta­ble in that one bad equi­lib­rium gives way to even worse ones in a ser­ial fash­ion. But, impor­tantly, it can go the other way too.

Yes, you can get stuck in a “bad” equi­lib­rium. For exam­ple, in the devel­op­ing coun­try con­text in the early stages of devel­op­ment, there is an equi­lib­rium in which there is rel­a­tively lit­tle growth and sub­op­ti­mal invest­ment – a bad equi­lib­rium if you like. Any shock, endoge­nous or exoge­nous, car­ries a high risk of tip­ping the coun­try into an even worse equi­lib­rium. In such cir­cum­stances, the lead­er­ship and reform chal­lenge is to shift the expec­ta­tions and hence the under­ly­ing invest­ment dynam­ics to a dif­fer­ent and much more pos­i­tive equi­lib­rium. And it is here that a series of pos­i­tive equi­lib­ri­ums can impose them­selves, with sig­nif­i­cant impli­ca­tions for invest­ment returns.

Ordi­nary Mar­ket Dynam­ics: Momen­tum and Value Invest­ing
Finan­cial mar­kets have endoge­nous expec­ta­tions. Investors know that expec­ta­tions and prices can drift away from fun­da­men­tals, with a dynamic dri­ven largely by the self-referential nature of the expec­ta­tions. But there are limits.

In “nor­mal” con­di­tions, the feed­back effects of asset price move­ments on the bal­ance sheets of finan­cial and other insti­tu­tions (and of house­holds) are not that large; and the wealth effect on activ­i­ties in the real econ­omy is small as a result. More­over, arbi­trage flows are sub­ject to rel­a­tively low liq­uid­ity and risk premia.

So while a set of investors may base their choices on momen­tum and charts, oth­ers counter by bas­ing their deci­sions more on devi­a­tions of mar­ket prices from some assess­ment of fun­da­men­tal val­ues, either short– or long-term. Trad­ing fre­quency varies, as does the degree of dynamic port­fo­lio real­lo­ca­tions and the pre­mium that can be col­lected for sell­ing volatil­ity in dif­fer­ent mar­ket segments.

Gen­er­ally investors know that at least short term returns are deter­mined in part by other investors’ expec­ta­tions, but longer-term val­u­a­tions will revert to lev­els war­ranted by the under­ly­ing fun­da­men­tals. As cer­tain traders cause mar­kets to move away from fun­da­men­tal val­ues (a mini bub­ble), the devi­a­tions become larger rel­a­tive to the dis­tri­b­u­tion of under­ly­ing value esti­mates. This entices value investors to move against the trends, thus caus­ing a shift in the mar­ket dynam­ics back toward the cen­tral part of the fun­da­men­tal value distribution.

Depend­ing on the size and respon­sive­ness of assets man­aged by each class of investor, the devi­a­tion from fun­da­men­tal val­ues can per­sist for awhile, but it gets pulled back. This can be thought of as a rel­a­tively harm­less form of fluc­tu­at­ing mul­ti­ple equi­lib­rium. And it tends to give rise to attrac­tive pre­mi­ums that investors can cap­ture by sell­ing volatil­ity, either directly in a range of mar­kets (e.g., inter­est rates, credit, equi­ties, com­modi­ties and for­eign exchange) or indi­rectly and less com­pre­hen­sively through cer­tain asset classes (e.g., mort­gages, cor­po­rate bonds, and emerg­ing mar­kets’ local rates, credit and equities).

In this rather com­mon dynamic, the devi­a­tions are gen­er­ally mean revert­ing as expec­ta­tions shifts do not sub­stan­tially affect fun­da­men­tal val­ues. This is not the case when, crit­i­cally, feed­back effects are large and the val­u­a­tion anchor morphs into a mov­ing target.

For exam­ple, in the after­math of the 2008 cri­sis, the real econ­omy headed down a highly cor­re­lated down­ward spi­ral along with the finan­cial mar­kets. Lever­age caused a sub­stan­tial part of the prob­lem, as did pro-cyclical behav­ior on the part of mar­kets and investors. The result was a sig­nif­i­cant, across the board repric­ing of mar­kets, along with “atyp­i­cal” devel­op­ments in mar­ket cor­re­la­tions and the range of risk pre­mia (includ­ing the liq­uid­ity pre­mium). As a result, ini­tial changes in asset val­ues that in an unlever­aged world would not have pro­duced large real econ­omy effects caused sub­stan­tial bal­ance sheet dam­age in the highly lev­ered finan­cial and house­hold sec­tors. This led to large neg­a­tive real-economy feed­back effects and declin­ing fun­da­men­tal val­ues. It wasn’t clear what the anchor was, or if there was one. That kind of struc­ture can implode; and it would have were it not for dra­matic and unprece­dented inter­ven­tion on the part of pol­icy mak­ers who aggres­sively sub­sti­tuted pub­lic bal­ance sheets for rapidly implod­ing pri­vate ones.

The small feed­back con­di­tion that we asso­ciate with nor­mal sta­ble mar­ket con­di­tions was arguably also not what we saw last year in the Euro­pean sov­er­eign debt mar­kets. Then, a yield run up in Italy or Spain threat­ened to shift the trio of mar­ket, polit­i­cal and pol­icy incen­tives in such a way that it would have a major effect on credit qual­ity. This had occurred already in Greece. More on this later.

Bank Runs
Mul­ti­ple equi­lib­rium struc­tures are not new. His­tory is full of exam­ples where, absent effec­tive pol­icy cir­cuit break­ers, mar­ket real­i­ties devi­ated con­sid­er­ably from fun­da­men­tals, and did so in a sequen­tial and increas­ingly dis­or­derly fashion.

Con­sider the case of the bank­ing sec­tor. The nor­mal lev­ered con­fig­u­ra­tion of banks (in a nar­row sense, these are asso­ci­ated pri­mar­ily with their matu­rity trans­for­ma­tion as short term liq­uid lia­bil­i­ties fund longer-term and less liq­uid assets) is key to their role in fund­ing pro­duc­tive invest­ments in an econ­omy. But it also makes them vul­ner­a­ble to losses of con­fi­dence – a sit­u­a­tion that was mas­sively accen­tu­ated in the run up to the global finan­cial cri­sis by prop activ­i­ties and off bal­ance sheet struc­tured invest­ment vehi­cles (SIVs) and other shadow bank­ing activities.

Some­times the change in oper­at­ing par­a­digm is real, in the sense that the assets suf­fer some kind of per­ma­nent impair­ment result­ing in neg­a­tive equity. At some point depos­i­tors and cred­i­tors notice and a race for the exit starts. But as often observed, you do not need such a sol­vency shock to start a bank run. Just the per­cep­tion of such a risk will do. Why? Because it is self-fulfilling absent gov­ern­ment and cen­tral bank inter­ven­tion. In such sit­u­a­tions, sol­vency itself becomes endogenous.

Extreme bank runs are uncom­mon these days because gov­ern­ments guar­an­tee deposits and cen­tral banks can and do move quickly to mon­e­tize the asset side of a sol­vent bank fast enough to keep it in busi­ness, even if the deposit run con­tin­ues for some time, or if short term pri­vate financ­ing in the mar­ket is cut off. Even­tu­ally the deposit run reverses, bor­row­ing capac­ity returns, and the orig­i­nal equi­lib­rium is restored.

The Inter­net Bub­ble of 2000–2001
The inter­net bub­ble of some 10 years ago is an inter­est­ing and slightly dif­fer­ent case. Val­u­a­tions of infor­ma­tional tech­nol­ogy assets (pub­licly traded and not) got dis­con­nected from real­ity, and had some of the char­ac­ter­is­tics of mini-bubbles described above. But the devi­a­tions from fun­da­men­tal value were quite extreme.

The value investor mar­ket cor­rec­tion was delayed by the new­ness of the tech­nolo­gies and the tem­po­rary absence of rel­e­vant data to con­strain the expec­ta­tions. In this data-free envi­ron­ment, nar­ra­tives, uncon­strained by rel­e­vant expe­ri­ence (there wasn’t any), dom­i­nated, usu­ally with a rev­o­lu­tion­ary, dis­rup­tive tech­nol­ogy fla­vor. How­ever, the data-free con­di­tion was not per­ma­nent. Even­tu­ally it became clear that, at least in the short term, fore­casts of growth, rel­e­vance, rev­enues and earn­ings were way too opti­mistic. The mar­kets expe­ri­enced a major down­ward reset, with real econ­omy effects that were large enough to cause a recession.

With hind­sight, it seems fairly clear that the mar­ket dis­tor­tions were not caused by an inac­cu­rate spec­i­fi­ca­tion of the ulti­mate impact of the tech­nol­ogy. Instead, it was the sub­stan­tial over­es­ti­mate of the speed with which these new tech­nolo­gies would affect pro­duc­tiv­ity, soci­ety and the global economy.

There are a vari­ety of ways to describe this. Essen­tially, the value-investing anchor was present but much delayed. There were value and activist investors who were skep­tics but, in the early stages, either they were less numer­ous in terms of con­trol over assets or less cer­tain of their views – hence the delay in responding.

The inter­net bub­ble was suf­fi­ciently large that it did, via the wealth effect, pro­duce a shift in the tra­jec­tory of the real econ­omy. For a while this effect was pos­i­tive and rein­forc­ing. But when expec­ta­tions shifted and val­u­a­tions reset, the reverse occurred and the real econ­omy dipped to the point that the cen­tral bank opted for low inter­est rates to cush­ion the reces­sion­ary effect.

Stand­ing back from these spe­cific two cases for a moment, some­thing is clear. In both, there were mul­ti­ple equi­lib­ria affect­ing mar­ket activ­ity, pol­icy anchors and cir­cuit break­ers; and they ended up oper­at­ing with vary­ing speed and certitude.

Sov­er­eign Debt and the Euro­zone
Olivier Blan­chard, the chief econ­o­mist at the IMF, observed in his 2011 end-of-year remarks: “… post the 2008-09 cri­sis, the world econ­omy is preg­nant with mul­ti­ple equi­lib­ria – self-fulfilling out­comes of pes­simism or opti­mism, with major macro­eco­nomic impli­ca­tions.”

Con­sider the case of Italy last year. In May, Ital­ian bond yields were rel­a­tively sta­ble and well behaved. By August and again in Novem­ber onward, unprece­dented volatil­ity drove them to dan­ger­ously high lev­els – enough to raise legit­i­mate con­cern about the risk of a debt insol­vency sequence.

With yields in the 6% to 7% range and the prospect that they might remain high as matur­ing low cost debt was increas­ingly refi­nanced via high cost debt, there was a mate­r­ial risk of a shift in expec­ta­tions – not just on the mar­ket side, but also on pol­icy incen­tives. The inter­ac­tions of these expec­ta­tions, includ­ing through feed­back mech­a­nisms, trans­lated into mount­ing pres­sures on credit qual­ity, yields, growth and poli­cies. They also had social and polit­i­cal effects. And as the Ital­ian stock mar­ket lost a third of its value, the wealth effect kicked in, help­ing to push Italy’s econ­omy toward neg­a­tive growth and debt defla­tion.

Sov­er­eign debt in this con­text assumes the struc­tural char­ac­ter­is­tics of mul­ti­ple equi­lib­ria. The “credit risk” is endoge­nous. Per­ceived risk affects investor behav­ior, mar­ket prices, the incen­tives of gov­ern­ments and hence credit risk.
What are the cir­cuit break­ers or anchors in a sit­u­a­tion like this? One para­me­ter is the level of sov­er­eign debt. Italy’s pub­lic debt-to-GDP is sec­ond only to Japan among the G-7 economies. That makes the cost of a rise in yields con­sid­er­able.
In the low lever­age case, you could argue that the anchor is the rel­a­tively low cost to the pub­lic finances of a rise in yields, break­ing the feed­back effect on credit risk. In that case, value investors respond to yield increases by increas­ing expo­sures and bring­ing the yields back down. Higher debt flows do the oppo­site: They change the incen­tive struc­ture and amplify the feed­back effect.
Sec­ond, with respect to a sud­den shift in equi­lib­rium, antic­i­pated pol­icy responses mat­ter. In the Ital­ian case, an aggres­sive assault on tax eva­sion, mea­sures to lib­er­al­ize labor mar­kets and lift growth, and to dial back the para­me­ters that deter­mine non-debt pub­lic lia­bil­i­ties like pen­sions, with enough lead­er­ship to over­come the burden-sharing iner­tial forces that are present in any polit­i­cal sys­tem, would clearly reduce (though not elim­i­nate) the risk. By con­trast, prior to the arrival of the tech­no­cratic gov­ern­ment under the lead­er­ship of Prime Min­is­ter Mario Monti, Italy had a gov­ern­ment that was dis­tracted, per­haps not fully aware of the risks, and los­ing pop­u­lar sup­port (as well as that of Euro­pean part­ners). Even if it had attempted the kind of reform pro­gram that would have made a dif­fer­ence, there was height­ened risk that prob­a­bly tipped the mar­kets toward the new equi­lib­rium.
With a change in gov­ern­ment and in pol­icy approach, includ­ing mean­ing­ful sup­port from the ECB via the long-term refi­nanc­ing oper­a­tions (LTROs), Italy had the abil­ity to inter­rupt the neg­a­tive mul­ti­ple equi­lib­rium dynam­ics at the end of 2011/beginning of 2012, thus low­er­ing its bor­row­ing costs. That was not the case for Greece, where the ini­tial eco­nomic and finan­cial con­di­tions were con­sid­er­ably worse, there are legit­i­mate ques­tions about the polit­i­cal will to imple­ment and sus­tain the reform process, and Euro­pean part­ners and the IMF appear much more skep­ti­cal and hes­i­tant.
The gen­eral aware­ness of the seri­ous­ness of the prob­lem has risen sub­stan­tially, but the issue of who across var­i­ous parts of the econ­omy and exter­nally should bear the real costs of restor­ing fis­cal bal­ance and growth momen­tum remains. Even with the recent debt restruc­tur­ing oper­a­tions, or PSI (for pri­vate sec­tor involve­ment), mar­kets are pric­ing remain­ing unal­lo­cated cap­i­tal losses that act as an imped­i­ment to sol­vency, growth and employ­ment. As a result, fresh cap­i­tal is largely refus­ing to engage notwith­stand­ing yields that remain high.
It is impor­tant to stress the com­ple­men­tary poten­tial cir­cuit break­ers formed by the exter­nal pol­icy response – namely, the scale and scope of inter­ven­tion from the ECB, EU and IMF (the “troika”) in the sov­er­eign debt mar­kets expe­ri­enc­ing ris­ing yields that threaten the effec­tive­ness of and com­mit­ment to reform mea­sures.
These enti­ties’ inter­ven­tions can and in some cases have suc­ceeded to sta­bi­lize yields, buy­ing time for the reform process to work. This is the case for the pow­er­ful LTROs.
By pro­vid­ing “unlim­ited liq­uid­ity” to banks on truly excep­tional terms (1%, three-year matu­ri­ties, and relaxed col­lat­eral require­ments), the ECB has been instru­men­tal in eas­ing forced de-leveraging, min­i­miz­ing the risk of dis­or­derly deposit out­flows, and pre­vent­ing highly dis­rup­tive bank runs and pay­ments prob­lems. Some of that inter­ven­tion also spilled over to sov­er­eign debt mar­kets.
But thus far, the ECB and the euro­zone core have been unwill­ing to make uncon­di­tional com­mit­ments to inter­vene directly in the sov­er­eign debt mar­kets of Italy and Spain to sta­bi­lize yields. This reluc­tance is under­stand­able and is prob­a­bly due to con­cern about what might be called polit­i­cal or pol­icy moral haz­ard: The con­cern is that such a com­mit­ment, while reduc­ing the like­li­hood of the unat­trac­tive equi­lib­rium, other things equal, might also reduce the incen­tive for reform by politi­cians and cit­i­zens. Since such reform is acknowl­edged to be essen­tial to restor­ing sta­bil­ity in the euro­zone, depend­ing on which effect is larger, the inter­ven­tion could be self-defeating.
Many knowl­edge­able observers believe that the inten­tion in the euro­zone core is to inter­vene, pro­vided the reform process is seri­ous and mak­ing head­way, but not to announce this inten­tion in order to mit­i­gate the moral haz­ard prob­lem. The prob­lem then becomes the bal­ance between proac­tive and reac­tive mea­sures, as well as the abil­ity to crowd in the pri­vate sec­tor.
A sim­i­lar kind of polit­i­cal moral haz­ard may have moti­vated Ger­man Chan­cel­lor Angela Merkel’s deci­sion to insist on a par­al­lel process of fis­cal reform, in spite of the fact that such a process bur­dens a polit­i­cal con­struct that is already chal­lenged by the process of restor­ing order in the periph­ery. The the­ory being that, in the sequen­tial ver­sion, if and when things are sta­bi­lized, the incen­tive to do the insti­tu­tional reform declines among politi­cians and elec­torates. It is a com­plex situation.

The USA and Japan
If this analy­sis is cor­rect, then as the U.S. runs up its sov­er­eign debt over time, there will be a grad­ual increase in the risk of a sud­den shift in sentiment/expectations. Down the road, this could lead to an increase in yields and hence reduce fis­cal space and pol­icy flex­i­bil­ity. Polit­i­cal grid­lock adds to this risk by low­er­ing the per­ceived capac­ity to engage in cor­rec­tive medium-term action on a timely basis, or to cred­i­bly com­mit to a multi-year term plan for fis­cal sta­bi­liza­tion and growth.
If expec­ta­tions start to dete­ri­o­rate on U.S. sov­er­eign debt, there is no plau­si­ble exter­nal cir­cuit breaker. It has to come from within the coun­try. And the only plau­si­ble anchor to pull it back would be strong, dis­ci­plined, multi-year pol­icy response that tar­gets, impor­tantly, both lower debt and higher growth. The longer it is delayed, the more expen­sive and riskier it becomes. While the lever­age is prob­a­bly not yet high enough to make the cur­rent equi­lib­rium unsta­ble, the return of the threat of a tech­ni­cal default in late 2012 or early 2013 could move the risks for­ward in time.
The U.S. Econ­omy in the Decade Prior to the Cri­sis of 2008
The U.S. econ­omy prior to the cri­sis was run­ning with excess con­sump­tion, defi­cient pub­lic sec­tor invest­ment, gov­ern­ment dis-saving, and a cur­rent account deficit reflect­ing a short­fall of sav­ing rel­a­tive to gross invest­ment. In short, the econ­omy was invest­ing too lit­tle to sus­tain growth and sav­ing even less.
Unlike other major devel­oped economies, the U.S. ran a bilat­eral cur­rent account deficit with respect to almost every major coun­try. Income and wealth dis­tri­b­u­tion con­tin­ued to dete­ri­o­rate, and net employ­ment cre­ation in the trad­able side was neg­a­tive with espe­cially large declines for the middle-income groups. The non-tradable side of the econ­omy absorbed the incre­men­tal labor force with big increases in gov­ern­ment and health care and a boost from excess con­sump­tion, espe­cially in the labor inten­sive sec­tors, retail­ing, hos­pi­tal­ity and con­struc­tion.
Both the struc­tural imbal­ances and the accu­mu­la­tion of pub­lic and pri­vate debt should have raised ques­tions among pol­icy mak­ers and investors about the sus­tain­abil­ity of the growth pat­tern over the medium-term, espe­cially in the non-tradable sec­tor, as well as about the polit­i­cal econ­omy and dis­tri­b­u­tional effects. But all of this is with the ben­e­fit of hind­sight. Too many were insuf­fi­ciently atten­tive to the pow­er­ful sec­u­lar tech­no­log­i­cal and global eco­nomic forces oper­at­ing on the econ­omy, overly san­guine about the sus­tain­abil­ity of the growth pat­tern, and unable to accu­rately assess the ris­ing sys­temic risks. As a result, on a rather large scale, the mar­ket and pol­icy cir­cuit break­ers failed to oper­ate, and even­tu­ally the equi­lib­rium shifted sud­denly and vio­lently.
The cri­sis of 2008 wasn’t so much a 100 year storm but rather an acci­dent wait­ing to hap­pen. It is true that fail­ures of reg­u­la­tion and risk assess­ment played impor­tant enabling roles. But the under­ly­ing prob­lem was in large part a sys­tem­atic pat­tern of unsus­tain­able intertem­po­ral choices, reflected in lever­age, debt and a sense of unlim­ited credit enti­tle­ment. This led to a dynamic in both the real econ­omy and the mar­kets that con­sti­tuted an increas­ingly unsta­ble equi­lib­rium. It broke in 2008, and we are in the some­what lengthy process of shift­ing to a dif­fer­ent equi­lib­rium, what PIMCO labeled back in May 2009 the bumpy jour­ney to a new des­ti­na­tion (or a “new nor­mal”).
Assess­ing non-cyclical macro sys­temic risk is com­plex: Accu­rately gaug­ing the like­li­hood of an equi­lib­rium shift is hard, and as a result, the anchors that pre­vent major devi­a­tions from real­is­tic sus­tain­able long run value cre­ation are not nec­es­sar­ily present. But one les­son for pol­icy mak­ers and investors seems clear: It is unwise to assume sta­bil­ity and sus­tain­abil­ity when under­ly­ing fun­da­men­tals are weak­en­ing.
Tip­ping Points
It is not enough for investors and pol­i­cy­mak­ers to rec­og­nize the fuel for mul­ti­ple equi­lib­ria dynam­ics. There is also the ques­tion of the spark, or what is known as tip­ping points.
Tip­ping points are shifts in the equi­lib­rium when either fun­da­men­tals or expec­ta­tions change course and then are legit­imized by sub­se­quent devel­op­ments. Often they occur quite sud­denly, with accel­er­a­tions com­ing from tech­ni­cal fac­tors. The exact tim­ing is noto­ri­ously dif­fi­cult to pre­dict, rais­ing the chal­lenges for how mar­kets, investors and poli­cies should react and internalize/price this non-linearity.
From recent expe­ri­ence, ques­tion marks or chang­ing views about pol­icy responses increase the like­li­hood of an equi­lib­rium shift by oper­at­ing directly on the expec­ta­tions. New data can have the same effect. Also, obser­va­tion of mar­ket dynam­ics sug­gest that there are nar­ra­tives and sto­ries that affect investor behav­ior, and that when these nar­ra­tives change, expec­ta­tions and pric­ing dynam­ics can shift too.
But even for con­trar­i­ans who detect the struc­tural con­di­tions early, pre­dict­ing the tim­ing has proved elu­sive, and the dura­tion of the con­trar­ian bet can be uncom­fort­ably long. Gen­er­ally, most schol­ars and ana­lysts have con­cluded that it is impos­si­ble to pre­dict the tim­ing of an equi­lib­rium shift even when the ingre­di­ents that cre­ate the ris­ing poten­tial insta­bil­ity and the pos­si­bil­ity of mul­ti­ple equi­lib­ria are present. The ana­logue in the sci­ences are sys­tems that are called “crit­i­cal states” whose move­ments behave accord­ing to fat-tailed power law dis­tri­b­u­tions.
Bimodal Dis­tri­b­u­tions, Mul­ti­ple Equi­lib­ria and Invest­ment Strat­egy
In the cur­rent envi­ron­ment, the preva­lence of some sub­jec­tive bimodal dis­tri­b­u­tions on the part of investors can be viewed as a reflec­tion of the mul­ti­ple equi­lib­rium fea­tures of a num­ber of sov­er­eign debt mar­kets. This is espe­cially the case in Europe where investors are torn between the prospects for frag­men­ta­tion (reflect­ing both default and exit risks asso­ci­ated with the weak­est euro­zone periph­er­als) and recov­ery (dri­ven by the core’s com­mit­ment to “refound­ing” the euro­zone and the periphery’s adjust­ment efforts). Here the ram­i­fi­ca­tions of a sud­den equi­lib­rium shift, good or bad, go well beyond the sov­er­eign debt mar­kets them­selves, radi­at­ing out to the entire global econ­omy.
Mul­ti­ple equi­lib­ria give rise to two or more sce­nar­ios, each quite dif­fer­ent and each with its own dis­tri­b­u­tion of out­comes, cor­re­la­tions, mar­ket func­tion­ing and returns. Investors – and espe­cially long-term investors in both finan­cial and phys­i­cal assets – are faced with the need to assess the rel­a­tive like­li­hood of the sce­nar­ios, and then take a weighted aver­age of usu­ally two rather more nor­mal look­ing dis­tri­b­u­tions to end up with the bi-modal one. Whether it is in fact bimodal or not depends on the weights. Extreme opti­mism or pes­simism will elim­i­nate the bimodal fea­ture.
This sug­gests that the tip­ping point can be crossed when the rel­a­tive weight given to the non-status quo sce­nario starts to rise for a sub­set of investors. There is some emerg­ing evi­dence that the short-term cor­re­la­tions, across and within asset classes, start to rise before a pos­si­ble equi­lib­rium shift. But that does not imply that the shift will occur. And when the cor­re­la­tions rise, the cost of the tail risk hedges also tends to rise.
Boldly bet­ting on one or the other of the sce­nar­ios – i.e., either an extreme risk-off or risk-on pos­ture – requires a very high level of con­vic­tion and foun­da­tion in an inher­ently “unusu­ally uncer­tain” con­text. Sim­i­larly, posi­tion­ing for the aver­age of the two modes means that investors end up in the mud­dled mid­dle – a “carry-laden” port­fo­lio posi­tion­ing that pays off only if the unsus­tain­able is sus­tained.
A bet­ter approach revolves around the early detec­tion of the struc­tural bases for mul­ti­ple equi­lib­ria accom­pa­nied by rel­a­tive low cost tail-risk hedges. Absent that, for many investors, sit­ting on the side­lines and accept­ing low cash returns (and, in today’s policy-induced finan­cial repres­sion envi­ron­ment, neg­a­tive real rates) until the bimodal fea­tures are resolved is under­stand­able. How to do that used to be via a bas­ket of “risk-free” assets; but with sov­er­eign debt risk in the major economies on the rise, the menu of “risk-free” assets is being reduced, and yields on what remains have con­verged to very low nom­i­nal lev­els.
Con­clu­sions
With too many advanced economies con­fronting the twin dilemma of too much debt and too lit­tle growth, and with sys­tem­i­cally impor­tant emerg­ing coun­tries nav­i­gat­ing the tricky middle-income devel­op­men­tal tran­si­tion, today’s global econ­omy poses unusual chal­lenges for tra­di­tional con­cepts of asset allo­ca­tion and risk man­age­ment. It is also slowly influ­enc­ing the way that cer­tain investors are think­ing about cor­re­la­tions, volatil­ity, guide­lines and bench­marks.
These changes can be par­tic­u­larly pro­nounced in sit­u­a­tions where mar­kets tran­si­tion from a mean-reverting par­a­digm to one of mul­ti­ple equi­lib­ria and path depen­dency. This is the world in which expec­ta­tions can and do play a major role in eco­nomic and mar­ket out­comes.
On the neg­a­tive side, the global econ­omy saw this dra­mat­i­cally back in 2008-09, and Europe has been expe­ri­enc­ing it more recently. More­over, it fea­tured in many of the his­toric bub­bles and bank runs that are still the sub­ject of analy­sis and fas­ci­na­tion. On the pos­i­tive end, it has char­ac­ter­ized the ben­e­fi­cial break­out phase in sev­eral emerg­ing economies. We also saw it in the reac­tions of mar­kets to cir­cuit break­ers imposed by deci­sive pol­icy actions on the part of sev­eral coun­tries in 2009.
In such cases, suc­cess­ful investors (as well as pol­icy mak­ers, researchers and opin­ion lead­ers) have to extend well beyond their under­stand­ing of fun­da­men­tals, his­toric risk pre­mia, cor­re­la­tions and rel­a­tive value. They have no alter­na­tive but to also try to under­stand the expec­ta­tion for­ma­tion process itself, includ­ing agent sig­nal­ing and feed­back loops incor­po­rat­ing eco­nomic out­comes and incen­tive struc­tures. With­out such under­stand­ing, it becomes even harder to con­tin­u­ously suc­ceed in meet­ing objec­tives – espe­cially in a world that will con­tinue to de-lever and where pol­icy mak­ers are still in full exper­i­men­ta­tion mode.
Both the­ory and the expe­ri­ence of the last few years sug­gest that investors must also enhance their analy­sis of pol­icy mak­ers’ reac­tion func­tion. Indeed, this is an impor­tant input into assess­ments of cor­re­la­tions, volatil­ity, returns and risk.
For pol­icy, this points to a need for a bet­ter design and use of ex ante and ex post cir­cuit break­ers. The for­mer pre­vent the evo­lu­tion of struc­tures that amplify the feed­back loops. The lat­ter are designed to break the ser­ial con­t­a­m­i­na­tion of expec­ta­tions, the real econ­omy and mar­ket link­ages, thereby inter­rupt­ing the often dis­rup­tive dynamic that leads to a sequence of bad equilibria.

A "risk free" asset refers to an asset which in the­ory has a cer­tain future return. U.S. Trea­suries are typ­i­cally per­ceived to be the "risk free" asset because they are backed by the U.S. gov­ern­ment. All invest­ments con­tain risk and may lose value.
Invest­ing in the bond mar­ket is sub­ject to cer­tain risks includ­ing mar­ket, interest-rate, issuer, credit, and infla­tion risk. Equi­ties may decline in value due to both real and per­ceived gen­eral mar­ket, eco­nomic, and indus­try con­di­tions. Invest­ing in for­eign denom­i­nated and/or domi­ciled secu­ri­ties may involve height­ened risk due to cur­rency fluc­tu­a­tions, and eco­nomic and polit­i­cal risks, which may be enhanced in emerg­ing mar­kets. Sov­er­eign secu­ri­ties are gen­er­ally backed by the issu­ing gov­ern­ment, oblig­a­tions of U.S. Gov­ern­ment agen­cies and author­i­ties are sup­ported by vary­ing degrees but are gen­er­ally not backed by the full faith of the U.S. Gov­ern­ment; port­fo­lios that invest in such secu­ri­ties are not guar­an­teed and will fluc­tu­ate in value. Mort­gage and asset-backed secu­ri­ties may be sen­si­tive to changes in inter­est rates, sub­ject to early repay­ment risk, and while gen­er­ally sup­ported by a gov­ern­ment, government-agency or pri­vate guar­an­tor there is no assur­ance that the guar­an­tor will meet its oblig­a­tions. Tail risk hedg­ing may involve enter­ing into finan­cial deriv­a­tives that are expected to increase in value dur­ing the occur­rence of tail events. Invest­ing in a tail event instru­ment could lose all or a por­tion of its value even in a period of severe mar­ket stress. A tail event is unpre­dictable; there­fore, invest­ments in instru­ments tied to the occur­rence of a tail event are spec­u­la­tive. Deriv­a­tives may involve cer­tain costs and risks such as liq­uid­ity, inter­est rate, mar­ket, credit, man­age­ment and the risk that a posi­tion could not be closed when most advan­ta­geous. Invest­ing in deriv­a­tives could lose more than the amount invested.
This mate­r­ial con­tains the opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial is dis­trib­uted for infor­ma­tional pur­poses only and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. No part of this mate­r­ial may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion. ©2012, PIMCO.

Tags: Asset Allocation, Circuit Breakers, Debt Markets, Delineation, Global Context, Global Economy, Investment Returns, Liquidity Management, Management Risk, Market Dynamics, Market Equilibria, Market Outcomes, Mike Spence, Periodic Bouts, Policy Responses, Relative Value, Risk Mitigation, Risk Premia, Sovereign Debt, Sudden Shifts
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Understanding the New Price of Oil (Martenson)

Wednesday, March 14th, 2012

by Gre­gor Mac­don­ald via Chris Marten­son

Under­stand­ing The New Price Of Oil

In the Spring of 2011, when Libyan oil pro­duc­tion — over 1 mil­lion bar­rels a day (mpd) — was sud­denly taken offline, the world received its first real-time test of the global pric­ing sys­tem for oil since the crash lows of 2009.

Oil prices, already at the $85 level for WTIC, bolted above $100, and even­tu­ally hit a high near $115 over the fol­low­ing two months.

More impor­tantly, how­ever, is that — save for a brief eight week period in the autumn — oil prices have stub­bornly remained over the $85 pre-Libya level ever since. Even as the debt cri­sis in Europe has flared.

As usual, the main­stream view on the world’s abil­ity to make up for the loss has been wrong. How could the removal of “only” 1.3% of total global pro­duc­tion affect the oil price in any pro­longed way?, was the uni­ver­sal view of “experts.”

Answer­ing that ques­tion requires that we mod­ern­ize, effec­tively, our under­stand­ing of how oil's numer­ous price dis­cov­ery mech­a­nisms now oper­ate. The past decade has seen a num­ber of enor­mous shifts, not only in sup­ply and demand, but in mar­ket per­cep­tions about spare capac­ity. All these were very much at play last year.

And, they are at play right now as oil prices rise once again as the global econ­omy tries to strengthen.

The Sub­or­di­na­tion of Cushing

Through the dom­i­nant force of its own demand, the US econ­omy largely con­trolled the oil price for many decades. For years, it was com­mon prac­tice there­fore to gauge world demand through the weekly updates to oil stor­age at Cush­ing, Okla­homa as well as total oil stor­age in the United States. If the US was demand­ing more oil from the global mar­ket, and thus either not adding to oil inven­to­ries or draw­ing them down, then a sig­nal was given, point­ing to future oil price strength.

But this dynamic began to break down com­ing into 2005–2007. That was the period when US oil demand — because of ris­ing prices — began its cur­rent decline. Now that US oil demand is down over 12% from its mid-decade peak, the fluc­tu­a­tion of oil inven­to­ries in the US no longer drive prices.

The chart below shows that US inven­to­ries have been on an upward trend since 2005, and are now near decadal highs above 300 mil­lion bar­rels even though oil prices are back above $100:

What we're now see­ing is that US inven­to­ries and US demand are now sub­or­di­nate to numer­ous other fac­tors, rang­ing from emerg­ing mar­ket demand, to mar­ket per­cep­tion of spare capacity.

Lessons of Libya

A use­ful fact learned dur­ing last year's Libyan civil war is that Saudi Ara­bia does not nec­es­sar­ily posses the 2–3 mbpd of spare capac­ity which most have assumed for years. More­over, Saudi Ara­bia ceded the posi­tion of top world oil pro­ducer to Rus­sia over 5 years ago in 2006. Indeed, Saudi Ara­bia made no pro­duc­tion response to the loss of Libyan oil last spring. Pro­duc­ing near 9 mbpd, it was only by June that Saudi pro­duc­tion was lifted by 600 thou­sand bar­rels a day (kbpd). That is a hefty pro­duc­tion increase to be sure, but it raised ques­tions as to how quickly spare capac­ity in the world can be brought online.

By the time Saudi Ara­bia had lifted pro­duc­tion, the OECD coun­tries led by the IEA in Paris had already decided to release oil from offi­cial inven­to­ries. But this, too, did lit­tle to calm oil prices — and as I pointed out last June, only cre­ated fur­ther prob­lems. In The Dark Side of the OECD Oil Inven­tory Release, I explained that, by low­er­ing OECD inven­to­ries, the mar­ket would cor­rectly deduce that safety buffers had been reduced fur­ther. Com­bined with the Saudi increase in pro­duc­tion, this only reduced spare capac­ity further.

The result was even stronger prices as WTIC ran back to $100 (until all global mar­kets floun­dered on a flare-up in the EU finan­cial cri­sis). Indeed, it is no longer US inven­to­ries of crude oil but the fluc­tu­a­tions in the emer­gency cush­ion of all inven­to­ries in the OECD (of which the US is part) that is now the more impor­tant fac­tor in oil prices:

The loss of Libyan pro­duc­tion caused a dra­matic draw­down of OECD total oil stocks, which were already in a down­ward trend start­ing the pre­vi­ous sum­mer in 2010. OECD inven­to­ries fell on both an absolute basis and on a com­par­a­tive basis to the trail­ing 5 Year Aver­age as the above chart shows. Tak­ing these inven­to­ries from a high of 2800 mb to 2600 mb only 6 months later, com­bined with unrest across the entire Mid­dle East, was more than enough sup­port to boost WTIC oil prices from $85 to above $100 last spring. Addi­tion­ally, as we can see in the chart, the decline in OECD oil inven­to­ries was main­tained into the end of 2011.

These are impor­tant con­di­tions to con­sider when try­ing to under­stand how oil prices now, in early 2012, are once again on the rise.

The Decline of Spare Pro­duc­tion Capacity

The lat­est global pro­duc­tion data shows that Saudi Ara­bia was pro­duc­ing 9.4 mbpd on aver­age dur­ing 2011, an increase of 500 kbpd over 2010. To accom­plish this, The Saudis had to increase pro­duc­tion from 9 mbpd in 1H 2011 to 9.8 mbpd dur­ing 2H of 2011. But para­dox­i­cally, this pro­duc­tion increase has only made the global oil mar­ket even tighter, as spare capac­ity shrinks further.

Let's recall that nearly 60% of global oil sup­ply comes from out­side of OPEC from coun­tries like the US, Canada, Brazil, Mex­ico, China, Aus­tralia, and the big producer—Russia. There is no spare capac­ity in this non-OPEC group­ing and there hasn’t been for years. Sure, there is oil to be devel­oped in non-OPEC coun­tries; but that is not pro­duc­tion capac­ity (mean­ing it is not sup­ply that can be brought online quickly).

More­over, Rus­sia, the coun­try that single-handedly saved non-OPEC pro­duc­tion from going into steep decline, mas­sively increased its con­tri­bu­tion to world sup­ply in 2002. But in the past two years, it has seen its pro­duc­tion growth taper off and flat­ten, to just shy of 10 mbpd.

That leaves the oil mar­ket, tasked with the job of pric­ing, to fig­ure out the ongo­ing mys­tery that is the "true" spare pro­duc­tion capac­ity in OPEC. That it took 4–5 months for Saudi Ara­bia to increase pro­duc­tion is a con­cern. Such delays should seri­ously give pause to those ana­lysts who’ve regur­gi­tated the belief over years that Saudi has 2–3 mbpd that can be brought on quickly.

Although EIA Wash­ing­ton cur­rently judges OPEC spare capac­ity to be higher than dur­ing the lows of 2003–2008, it's his­toric fig­ures show that spare capac­ity has been declin­ing since a 2009 high.

More­over, the fail­ure of non-OPEC pro­duc­tion to increase within last decade counts as a true sur­prise to the global oil mar­ket. The faith in non-OPEC sup­ply over the last decade helped to keep prices sub­dued, until that faith was shat­tered by 2007's wild spike.

The prob­lem now is that the oil mar­ket has been re-educated. Faith in the non-OPEC coun­tries' abil­ity to increase sup­ply is no more. Mean­while, the great decel­er­a­tion in Russ­ian oil sup­ply growth, has spooked the mar­ket. Com­bined, a mar­ket with 74 mbpd of pro­duc­tion and a the­o­ret­i­cal spare capac­ity of 3 mbpd sim­ply cre­ates too much uncertainty.

And con­sider this: the amount of total spare capac­ity is now equal to the 3 mbpd of demand that’s been taken offline in Europe, Japan, and the United States over the past 7 years, as oil prices have risen from $40 to the $100 level. Thus the oil mar­ket has quite cor­rectly rationed sup­ply, at higher prices. If prices were to fall to $50 or $60, the world’s lost demand could be rebuilt rather quickly.

Killing dis­cre­tionary demand is now the proper func­tion of the oil mar­ket in an age of flat sup­ply growth.

Quan­ti­ta­tive Eas­ing and Granger Causality

We should also remem­ber that the global econ­omy would be mired in a text­book defla­tion­ary depres­sion were it not for the con­tin­ual and gar­gan­tuan US$ tril­lions that have been pro­vided by cen­tral banks since 2008.

Early 2009 saw oil prices slip briefly below $40. But, of course, that's the price level appro­pri­ate to a world dur­ing an indus­trial crash — with reduced ship­ping, halted economies, and dis­lo­cated con­sumer demand. The world can have those prices again, if it chooses. But it must also be will­ing to accept a global reces­sion to achieve such low oil prices.

Thus, there is a mis­con­cep­tion that cur­rency debase­ment is the main dri­ver of oil prices. How­ever, given the new sup­ply real­i­ties, that sim­ply isn't true any longer.

The chart below is help­ful in explain­ing why. There is no ques­tion that com­ing out of 2000, the decline of the US Dol­lar as expressed by the USD Index was a true com­po­nent of the ris­ing oil price. Dur­ing that period, as the USD was falling, global oil sup­ply was still increas­ing. The descent of the US Dol­lar was unques­tion­ably part of the repric­ing process, as the USD Index fell from a high of 120.00 in 2002 to 80.00 in 2005:

But see how the most fero­cious part of oil’s price advance started to unfold after 2005, when, as the USD con­tin­ued falling, the global sup­ply of oil stopped grow­ing.

If we think of this com­pre­hen­sively, we have to con­clude that the debase­ment of cur­ren­cies is no longer the pri­mary fac­tor in the price of oil on a val­u­a­tion basis. Rather, it is that quan­ti­ta­tive eas­ing pre­vents a defla­tion­ary indus­trial col­lapse, thus keep­ing the global econ­omy alive and able to con­sume more energy.

We can there­fore say that in our post-credit bub­ble col­lapse era, and with global oil sup­ply now flat, that quan­ti­ta­tive eas­ing causes higher oil prices (through Granger causal­ity). It keeps economies from col­laps­ing (for now) and thus brings demand up against very tight sup­ply. As we can see from the chart above, the USD Index has for 3 years now been bounc­ing off the bot­tom it first reached in 2008. In a way, this is help­ful because it brings to light the new dom­i­nant fac­tor in global oil prices: supply.

Sup­ply is now Primary

Sup­ply, and the recog­ni­tion of sup­ply, are now the dom­i­nant fac­tor in the oil price. A point so obvi­ous, it hardly seems worth mak­ing. How­ever, the devel­oped world is still largely oper­at­ing on the clas­si­cal eco­nomic view that higher prices will make new oil resources available.

That is true. But, it’s just not true in the way most anticipate.

While higher prices have brought on new sup­ply, these resources have been slow to develop, are more dif­fi­cult to extract, and gen­er­ally flow at lower rates of pro­duc­tion. As the older oil fields of the world decline, the price of oil must reflect the eco­nom­ics of this new tranche of oil resources. There are no vast, new sup­plies of oil that will come online in 2013, 2014, and 2015 at the scale to negate exist­ing global declines.

Dur­ing the entire time that global oil sup­ply has been held at a ceil­ing of 74 mbpd, since 2005, a lot of new pro­duc­tion in the Amer­i­cas and Africa espe­cially has come online. But it has not not enough to increase total world sup­ply. And the price of oil has finally started to price in that new reality.

Here Comes Volatil­ity in Oil Prices

The pric­ing dynamic dis­cussed above is accen­tu­ated by the cri­sis cycle: the repet­i­tive oscil­la­tion between acute and chronic phases of the ongo­ing debt cri­sis, mit­i­gated by cen­tral bank refla­tion­ary policies.

In Part II: Get Ready for Oil Price Volatil­ity to Kill the 'Recov­ery', we fore­cast how today's pro­tractly high recent oil prices are already send­ing a sig­nal that a new hit to global demand is underway.

Gen­er­ally, it appears that the oil price is mak­ing its move too early in the year — which will likely serve as a sucker punch to the frag­ile world econ­omy — thus mak­ing spec­tac­u­larly high prices before year end less likely, and a sharp mar­ket cor­rec­tion and return to eco­nomic reces­sion more so.

Investors will be wise to take pru­dent pre­cau­tions before this nasty wake-up call arrives.

Click here to access Part II of this report (free exec­u­tive sum­mary; enroll­ment required for full access).

Tags: Cushing Oklahoma, Debt Crisis, Dominant Force, Global Economy, Global Production, Gregor Macdonald, Lows, Mainstream View, Market Perceptions, Martenson, Oil Demand, Oil Inventories, Oil Price, Oil Prices, Oil Storage, Price Discovery, Price Of Oil, Price Strength, Russia, Time Test, Universal View, Wtic
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Emerging-Market Stocks Have More Upside, But in Need of Correction

Tuesday, March 6th, 2012

In past arti­cles I referred to the rela­tion­ship between the MSCI Emerg­ing Mar­ket Index expressed in Swiss francs and China’s CFLP Man­u­fac­tur­ing PMI. By using arguably one of the world’s only non-fiat cur­ren­cies the influ­ence of cur­rency move­ments on the MSCI Emerg­ing Mar­ket Index is minimized.

The graph below illus­trates just how out of line and inex­pen­sive emerging-market equi­ties were com­pared to the state of the world’s growth loco­mo­tive in the lat­ter half of 2011 as the Euro­zone debt cri­sis spooked investors. The mar­ket returned to ratio­nal­ity as the cri­sis eased in recent months, with the MSCI Emerg­ing Mar­ket Index in line with February’s PMI of 51.0.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

But where to from here?

After col­laps­ing to 48.3 in Novem­ber last year my sea­son­ally adjusted CFLP Man­u­fac­tur­ing PMI for China increased for the third con­sec­u­tive month to 51.9 in Feb­ru­ary, with the drop in the reserve require­ment rate (RRR) of Chi­nese banks fil­ter­ing through to the econ­omy. As the global econ­omy is not out of the woods yet, the fur­ther cut in the RRR in Feb­ru­ary is likely to lend addi­tional sup­port to the sea­son­ally adjusted PMI and there­fore China’s econ­omy in com­ing months.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

After being held in check by the Golden Week cel­e­bra­tions of China’s lunar New Year from the sec­ond half of Jan­u­ary through mid-February, the unad­justed CFLP Man­u­fac­tur­ing PMI is likely to receive a sig­nif­i­cant sea­sonal boost in March and April.

Sources: CFLP; Li & Fung; Plexus Holdings.

I there­fore argue that the MSCI Emerg­ing Mar­ket Index in terms of Swiss francs is likely to be under­scored by the expected sea­sonal strength in the unad­justed PMI, as well as the accel­er­a­tion in growth as reflected in the sea­son­ally adjusted PMI, on the back of the reduced RRR of Chi­nese banks.

In a pre­vi­ous note I pointed out that changes in the direc­tion of China’s banks’ RRR were soon fol­lowed by direc­tional changes in the Shang­hai Com­pos­ite Index (SSEC 2410.45 ↑0.00%). In the fol­low­ing graph the cumu­la­tive change in the RRR was quan­ti­fied where a 0.5% change in RRR amounts to approx­i­mately US$60 bil­lion. When depicted against the MSCI Emerg­ing Mar­ket Index in Swiss francs it is evi­dent that changes in direc­tion in the RRR are fol­lowed by major changes in direc­tion of the MSCI Emerg­ing Mar­ket Index in CHF. The cuts in the RRR in the last quar­ter of 2008 were fol­lowed by a bot­tom in the MSCI Emerg­ing Mar­ket Index in the first quar­ter of 2009. The hike in the RRR in the first quar­ter of 2010 was ini­tially fol­lowed by the top­ping out of emerging-market equi­ties, while fur­ther increases led to a slump in equity prices. Although equity prices showed an improve­ment at the start of the fourth quar­ter last year the cut in the RRR pulled equity prices out of the doldrums.

Sources: NBSC; I-Net Bridge; Plexus Holdings.

The MSCI Emerg­ing Mar­ket Index has sig­nif­i­cantly out­per­formed the MSCI World Index since Decem­ber last year and is cur­rently in line with China’s unad­justed CFLP Man­u­fac­tur­ing PMI.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

The Shang­hai Com­pos­ite Index in terms of U.S. dol­lars rel­a­tive to the S&P 500 Index (SPX 1350.02 ↓-1.05%) has moved com­pletely out of line with the unad­justed CFLP Man­u­fac­tur­ing PMI, though.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

The appear­ance of another black swan will alter my view but as things are I am of the opin­ion that the rally in emerging-market equi­ties is likely to con­tinue over the next few months. That said, the mar­ket has had a huge run and, being over­bought, it is in des­per­ate need of con­sol­i­da­tion or even a major cor­rec­tion. I con­tinue to favor the Chi­nese stock mar­ket above other emerg­ing mar­kets and devel­oped markets.

Tags: Acceleration, Celebrations, China Economy, China S Economy, Chinese Banks, Currency Movements, Debt Crisis, Emerging Market Stocks, fiat, Fiat Currencies, Global Economy, Locomotive, Lunar New Year, Msci Emerging Market, Msci Emerging Market Index, Nbsc, Pmi, Rationality, Rrr, Swiss Francs
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The Bull Market in Stocks Looks Set to Continue – For Now

Wednesday, February 29th, 2012

Guest con­tri­bu­tion by Dominic Frisby, Mon­ey­Week

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

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

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

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

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

Which way will the mar­ket head next?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Tags: Asset Prices, Bond Markets, Bond Prices, Currency Devaluation, Dangerous Thing, Dominic, Forces At Work, Frisby, Global Economy, Government Bond Market, Government Bonds, Hard Core, Large Portion, Moneyweek, Natural Forces, Secret Of Success, South London, Stock Markets, Us Government, Vantage Point
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Albert Edwards Channels Conan — All Hope Must Be Crushed For A True Bull Market To Emerge

Thursday, February 23rd, 2012

While the bulk of tan­gen­tial themes in Albert Edwards' lat­est let­ter to clients "The Ice Age only ends when the mar­ket loses hope: there is still too much hope" is in line with what we have been dis­cussing recently: myopic mar­kets focused on momen­tum not fun­da­men­tals ("It's amaz­ing though how the mar­ket can get itself all bulled up and becomes con­vinced that we are the start of a self-sustaining recov­ery. And fun­nily enough there's noth­ing more likely to get investors bull­ish than a ris­ing mar­ket"), short-termism ("One thing you can say for the mar­ket is that it has an extremely short mem­ory"), and that so far 2012 is a car­bon copy of 2011 ("One thing you can say for the mar­ket is that it has an extremely short mem­ory. Let us not for­get that the per­for­mance of the equity mar­ket so far this year is almost exactly the same as we saw at the start of 2011 (in fact the per­for­mance has been sim­i­lar for the last 5 months"), his pre­vail­ing topic is one of hope. Or rather the lack thereof, and how it has to be totally and utterly crushed before there is any hope of a true bull mar­ket. And just to make sure there is no con­fu­sion, unlike that other flip flop­per, Edwards makes it all too clear that he is as bear­ish as ever. Which only makes sense: regard­less of what the mar­ket does, which merely shows that infla­tion, read liq­uid­ity, is appear­ing in the most unex­pected of places (read Edwards' col­league Grice must read piece on why CPI is the worst indi­ca­tor of asset price infla­tion when every­one goes CTRL+P), the real­ity is that had it not been for another $2 tril­lion liq­uid­ity injec­tion in the past 4–6 months by global cen­tral banks, the floor would have fallen out of the mar­ket, and thus the global econ­omy. In fact, how the hell can one be bull­ish when the only expo­nen­tial chart out there is that of global cen­tral bank assets prov­ing beyond a doubt that every risk indi­ca­tor is fake???

Why every last bit of hope must be crushed:

One key les­son from Japan is that an essen­tial ingre­di­ent to the end of a long val­u­a­tion bear mar­ket is revul­sion. It is when "buyers-on-dips" become "sellers-on-rallies". It is when vol­ume dries up to almost noth­ing. It is the loss of hope. In Japan we saw huge ral­lies in the Nikkei on the back of short-lived cycli­cal recov­er­ies. Each cycli­cal fail­ure and fur­ther new lows in the equity mar­ket saw hope being pro­gres­sively crushed. Pre­vi­ous US val­u­a­tion bear mar­kets typ­i­cally take 4 or 5 reces­sions to fully play out. We have only had two.

 

The mar­ket is once again in a hope phase — hop­ing that the US is now in a self-sustaining recov­ery; hop­ing that China might be soft-landing; hop­ing that the Greece bailout and the ECB liq­uid­ity polices have set­tled things down in the euro­zone. These bursts of hope are essen­tial in long bear mar­kets. Essen­tial in the sense that hope must be crushed. It will be crushed. Hope still beats in the breasts of equity investors. The mar­ket will rip out that hope and con­sume it in front of investors' eyes. Only then can the bull mar­ket begin.

On why he is not a flip-flopper:

Arielle, one of our senior sales­per­sons e-mailed me a cou­ple of weeks ago with a ques­tion: “Hi, any change in your views? Just checking…as I have ques­tions from Clients.” Read­ing between the lines I think the ques­tion was whether I am near throw­ing in the towel. Bloomberg reports that "Global Strate­gists Aban­don Bear­ish Views After Miss­ing Rally" — link. Rest assured, I am not one of them. What will make me more bull­ish? As I believe that we are still in the grip of a val­u­a­tion bear mar­ket the answer is easy — cheaper valuations.

Edwards, like Jan­juah, sees no point in try­ing to pro­vide pol­icy rec­om­men­da­tions as there is noth­ing that can fix the sys­tem now — implic­itly it is too late, as the Key­ne­sian end-game has taken us too far. We had a chance with Lehman in 2008 to reset the sys­tem and to bring it to a sus­tain­able foot­ing; it is now too late with every­one dode­catu­ple all in on a faulty system.

It is easy to moan that pol­i­cy­mak­ers are still mak­ing a mess of things and it would be fair to say that I cer­tainly moan more than most. I find it far harder though, when I am asked what I would do if I was stand­ing in pol­i­cy­mak­ers shoes. Let me make an admis­sion. I do not have the clar­ity of view that many have about the "right" pol­icy pre­scrip­tion for the cur­rent macromess. There are just bad and less bad choices. The key thing for me was not to get into this mess in the first place and I was amongst the vocal for many years about the ruinous polices that were being pur­sued. For me it's a bit like the old joke when you ask a local per­son the way to some­where and the extremely unhelp­ful answer after much intakes of breath is "Well, I wouldn't have started from here."

Finally, while we have cov­ered the topic to death, Edwards nails it on cor­po­rate profits.

A flat­ten­ing of the prof­its cycle is exactly what you might expect as the easy, early cycle pro­duc­tiv­ity gains come to an end. It is worth not­ing that the last time this occurred was just ahead of the start of the reces­sion which the NBER date as hav­ing started in Decem­ber 2007. Back then too, both mar­kets and pol­i­cy­mak­ers all felt the econ­omy was still quite healthy. Indeed nei­ther non-farm pay­rolls nor the head­line ISM sig­naled the econ­omy had already entered reces­sion at the end of 2007 - indeed like now, pay­rolls actu­ally accel­er­ated in the sec­ond half of 2007, just as prof­its began to slip!

Pretty much cov­ers it.

So to recap, Conan sum­ma­rizes best what is best for a bull market:

Tags: 5 Months, Asset Price, Bank Assets, Carbon Copy, Central Banks, Colleague, Conan, Confusion, CPI, Doubt, Edwards, Flip Flopper, Global Economy, Grice, liquidity, Momentum, Price Inflation, Risk Indicator, Short Memory, Trillion
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