Thursday, March 31, 2011

G7 Central Banks "Carry" Markets Higher

I've seen very little written about the Japanese yen "carry trade" in the US press, but the Financial Times has done a nice job of following the story.

I first posted about the carry trade last week. Since then, the yen has weakened by 9%, and markets around the world have generally strengthened. If this trend continues, it could turn into a major story in the global markets in the next few months.

Background: the carry trade is nothing more than a strategy where an investor borrows funds in a low rate country like Japan and invests in other global assets such as higher-yielding bonds; commodities; or stocks.

The major risk to the carry trade (besides the leverage) is that the currency markets work against the investor.

However, when the G7 central banks (including the Federal Reserve) intervened in the currency markets a couple of weeks ago to weaken the yen, this signaled to the world that the yen strength would not be allowed.

Here's an excerpt from today's FT:

Analysts say that the move {by the G-7 central banks to weaken the yen}, as well as a belief in the financial markets that G7 policymakers will intervene again if necessary to cap fresh yen gains, has spurred investors to resume using the yen as a funding vehicle for carry trades. / Currencies - Yen back in favour for carry trades

Wednesday, March 30, 2011

Dividend-Paying Stocks or High Quality Bonds?

This morning I had a good meeting with a very smart client.

Much of our discussion revolved around the outlook for interest rates, and the role that bonds should play in a client portfolio.

Although my client is part of the intelligentsia that reads Random Glenings (and so is familiar with the deflationary trends that surround us), my client believes we are heading for inflationary times.

The combination of loose monetary policy, and an undisciplined government piling on debt, will inevitably lead to inflation, said my client. His view, of course, is shared by the majority of economists and investors.

If he is right, buying a 10 year Treasury bond yielding 3.5% makes no sense if you can invest in a stock that pays a dividend in the 3% range. There are many dividend-paying stock in industries like energy, industrial and utilities would fit the bill.

The best case scenario for a bond holder, he pointed out, was that interest rates stayed around today's levels, or move slightly lower. This scenario would result in a respectable rate of return.

However, if inflation picks up even a small amount from today's levels, the real return for the bond holder will be fairly unattractive.

Buying shares of companies that pay dividends, on the other hand, at least give the investor the chance to maintain purchasing power, since presumably the value of the company would rise at least in line with inflation.

Now, admittedly, this did not happen in the 1970's, when stocks proved to be poor inflation hedges and delivered mediocre returns, but one could also argue that the starting valuation of the stock market was less attractive than it is today.

This was also the point that Warren Buffett made last week while he was traveling in India. Here was an excerpt from a Wall Street Journal article last week:

"Inflation is a very cruel tax," said Mr. Buffett, because it lowers the worth of your paper money.

He said one of the best ways to keep the value of your money growing is to invest in good businesses and companies which keep growing. That helps investors "maintain purchasing power no matter what happens to the currency," said Mr. Buffett.

He advised against buying long-term bonds of any government, because both inflation and printing of new currency lowers the value of these investments.

The problem, of course, is that most of us can't resist reacting to daily movements of the stock market.

Dividend-paying stocks might make sense for a longer term time horizon, but most of us have trouble keeping volatility in perspective when markets fall.

Tuesday, March 29, 2011

Deflation Watch Continues: More Bad News on Housing

I've written several times about the dismal state of the housing market.

But, unfortunately, the news keeps getting worse.

The most relevant point, to me, is that housing prices continue to fall despite the huge efforts of the federal government to reverse the tide. Mortgage rates are still very low relevant to the historic experience of the last few decades, and statistical data would suggest purchasing a home rather than renting is a more attractive option than it has been for decades.

Still, as is true in stock markets, psychology tends to almost always win out over data, at least in the short run, and housing is no different.

In my conversations with real estate brokers and home builders, the number one impediment to someone buying a home today is the pervasive belief that house prices will be lower 6 months from now. No one wants to feel like a sap for plunking down a large chunk of their life savings to buy a home that they are not sure will maintain its value.

Then there's this: according to data released yesterday, fully 13% of the homes in the United States now stand vacant. In addition, S&P estimated that there is nearly a 4 year backlog of houses that are either in default or foreclosure.

Here's an excerpt from today's news from Bloomberg (I have added the emphasis):

The S&P/Case-Shiller index of property values in 20 cities fell 3.1 percent from January 2010, the biggest year-over-year decrease since December 2009, the group said today in New York....

...Eighteen of the 20 cities in the index showed a year-over- year decline, led by a 9.1 percent drop in Phoenix. In January, prices in 11 markets dropped to fresh lows from their 2006, 2007 peaks, the same as in December....

...The median price of existing homes, which make up more than 95 percent of the market, slid 5.2 percent from a year earlier, erasing all gains made after February 2002, according to the National Association of Realtors. New-home prices dropped to the lowest level since December 2003, a Commerce Department report showed.

Home Prices in 20 U.S. Cities Fell 3.1% From Year Earlier (3) -

Talk about deflationary pressures!

Monday, March 28, 2011

The Financial Sector Comes Roaring Back

It's hard to believe that it was only three years ago that the entire financial system stood on the brink of total disaster.

Starting with the forced merger of Bear Stearns with JP Morgan, 2008 was indeed an annus horribilis for the entire financial sector.

But that was then, this is now.

With huge dollops of financial assistance from the federal government, banks, insurance companies and brokers have come roaring back. A recent post from the Wall Street Journal notes:

Friday’s revisions to U.S. gross domestic product contained news on fourth-quarter profits. Top-line, or pretax, operating profits economywide hit a record high at the end of 2010. All of the gain was in the financial sector.

Since {2008}, the sector has come roaring back. The GDP report shows finance profits jumped to $426.5 billion. While profits haven’t returned to their high levels of 2006, the gain in finance profits last quarter more than offset a drop in profits posted by nonfinancial domestic industries.

After rising like the Phoenix, the financial industry now accounts for about 30% of all operating profits. That’s an amazing share given that the sector accounts for less than 10% of the value added in the economy.

However, financials have underperformed the S&P recently. Merrill Lynch strategist Mary Ann Bartels believes that the weakness may be a sign that the yield curve (i.e. the difference in yields between the 2-year Treasury and 10-year Treasury) may be flattening, which historically has been a significant headwind for financial companies.

For me, I have been struggling with this group for some time. My biggest concern is housing, the huge overhang of mortgage debt that remains from the excesses of the past decade.

But for now, the financial group is partying like 2006.

Friday, March 25, 2011

Stock Markets Buoyed by G-7 Central Banks?

There's a cacophony of negative news in the morning press: dismal housing market; weak durable goods reports; Japan; Libya; and so on.

But the stock market continues to do well. In fact, at the market close last night, the S&P 500 is just 2.5% below than the multi-year high reached in last month.

There are lots of catalysts for the bullish tone of the market. However, yesterday's Financial Times carried an important reason that really hadn't occurred to me: the return of the "carry trade".

In simplest terms, the carry trade simply is a technique where investors borrow funds in low yield countries (like Japan) to invest in other markets, including equities and commodities.

The risk in the carry trade is currency. At some point the investor needs to repay the funds, but if the currency markets don't cooperate the investor could lose money.

Earlier this month, when the central banks of the G-7 actively intervened in the currency market to slow the appreciation of the yen, they effectively put a ceiling on just how much the yen could appreciate. This could unleash huge dollops of liquidity into the world markets.

Here's the relevant paragraphs from yesterday's story:

All that, though, could be about to change if the belief that central banks have imposed a ceiling on the yen gains traction. And a return of the carry trade would have the potential to lift prices of risky assets – equities and commodities are already well into a bull run – even further, analysts say.

“There is another wave of global liquidity in the making, this time coming out of Japan. This liquidity will not stay in Japan and will boost asset prices elsewhere,” says Hans Redeker at BNP Paribas

The impact of currency intervention, if sustained, could have a similar effect to the US Federal Reserve’s preparations in the summer of 2010 for a second round of “quantitative easing”, its huge bond-buying programme to kick-start recovery. The Fed’s action lifted shares and weakened the dollar.

“This time it will be the yen funding another rush into global assets,” says Mr Redeker. “We buy aggressively into risk and see the yen moving lower.”

Thursday, March 24, 2011

Crisis in Japan Spurs U.S. Investors to Buy the Nikkei

Americans are, in general, a pretty optimistic people.

Maybe it's the fact that most of our ancestors left their native lands for the U.S. in search of a better life. Or maybe it's the fact that most of the major wars that have occurred over our country's history have largely occurred outside of our shores.


Here's a recent example:

Japan is a difficult place to be right now, to put it mildly:

  • Radiation concerns have now spread to Tokyo, where citizens are being advised to avoid tap water for their infants;
  • The nuclear plants in Northern Japan continue to verge on the edge of disaster, although there has been some encouraging news recently;
  • The Japanese government just doubled its estimate of the cost of rebuilding the infrastructure lost in the tsunami, to almost 4% of GDP;
  • Rolling blackouts are now expected to the norm through at least the summer months;
  • And the death toll keeps rising.
So what's the reaction of U.S. investors?

Buy stocks, of course!

From Warren Buffett to the smallest retail investor, there seems to be the perception in this country that Japan is the overseas market of choice. As this morning's New York Times explains:

Even as the aftershocks from the earthquake pushed financial markets sharply lower last week, American investors poured $1.2 billion into Japanese equity exchange-traded funds, or E.T.F.’s., according to new data. It was the biggest weekly inflow on record, a trend suggesting that some investors are already betting that the crisis may be just an interruption to a market rally.

U.S. Investors Pour Money Into Japanese E.T.F.’s -

It will be interesting to see how this Japanese stock market interest works out.

Before the tsunami there had been some discussion that Japan was an interesting investment idea mostly based on its low relative valuation, so perhaps the U.S. investors' collective instincts are correct.

On the other hand, I suspect that patience and a long-term investment horizon will also be required to make Japanese stocks work well for U.S. investor - and we Americans are not known for our patience.

Wednesday, March 23, 2011

Deflation Watch #2: Food Inflation is a Myth

This from the blog Business Insider:

Deflation Watch Continues: Housing Goes Splat

I normally would not comment on monthly data but the most recently housing numbers are, well, sobering.

Here's the data from Bloomberg's story today (I have added the emphasis):

Purchases of new U.S. homes unexpectedly declined in February to the slowest pace on record and prices dropped to the lowest level since December 2003, adding to evidence the industry is floundering.

Sales decreased 16.9 percent to a 250,000 annual pace, figures from the Commerce Department showed today in Washington. Economists surveyed by Bloomberg News projected a gain to a 290,000 rate, according to the median estimate. The median price fell 8.9 percent from the same month in 2010.

But wait, there's more good news:

The median sales price dropped to $202,100 in February from $221,900 a year earlier, today’s report showed. Last month’s median price was the lowest since $196,000 in December 2003. The share of homes sold for $500,000 or more fell in February, matching January 2009 as the lowest on record.

Now, I'm sure some of these figure can be blamed on the horrible weather on the east coast in February.

Still, I'm pretty sure that the west coast had seasonable weather last month, so it can't be all weather-related.

And you would think that plummenting house prices would lead to at least some increase in new home sales.

No, actually: Even with home prices dropping by 14%, new home sales were the lowest in the 50 year history of the data.

Housing is one of the biggest components of the typical household expenses, so these figures have a real impact.

Tuesday, March 22, 2011

When will the Problems in the Euro Block Hit the Markets?

The markets have been remarkably resilient in the face of multiples worries.

Japan, Libya, rising commodity prices, increased Chinese censorship - nothing seems to bother the investor community. Stock markets around the world had a collective hiccup when the tsunami hit Japan, but now show every sign of recovering.

And in this morning's trading the euro is hitting a 4 month high versus the dollar. Globally, at least, investors are looking at the euro zone as "safe harbor".

But is it really?

Robert Samuelson wrote an interesting editorial in yesterday's Washington Post pointing out that the problems in Europe continue to fester, despite the fact that the world's attention is turned elsewhere:

While the world has been transfixed with Japan, Europe has been struggling to avoid another financial crisis. On any Richter scale of economic threats, this may ultimately matter more than Japan’s grim tragedy. One reason is size. Europe represents about 20 percent of the world economy; Japan’s share is about 6 percent. Another is that Japan may recover faster than is now imagined; that happened after the 1995 Kobe earthquake. It’s hard to discuss the “world economic crisis” in the past tense as long as Europe’s debt problem festers — and it does.

Europe’s finances may shake the global economy more than Japan’s tragedies - The Washington Post

The European Central Bank has been lurching from one bailout plan to the other in a desperate attempt to keep the whole euro idea afloat.

While Germany prospers, Greece; Ireland; Portugal; and even perhaps Spain are, as Mr. Samuelson puts it, "in receivership".

How long can this continue is anyone's guess. The willingness of the international community to lend money to Germany and France at rates near or below U.S. Treasury yields has been helpful, but I suspect investors will one day run out of patience.

As Mr. Samuelson notes later in his editorial:

The whole scheme {of the euro bailouts} is debtors lending to debtors. It could collapse if investors conclude it’s unworkable, dump bonds and demand higher interest rates.

...What would happen then is anyone’s guess. Would defaults occur? Would a banking crisis follow? Would some countries abandon the euro?..

.. Would the European Central Bank — the continent’s Fed — buy vast amounts of government bonds? Would the International Monetary Fund organize a bailout, financed heavily by China, to rescue Europe?

Monday, March 21, 2011

Shifting Burdens of Debt Still Weigh on Economy

If you had the chance to watch the video interview with Ray Dalio of Bridgewater - posted last week on Random Glenings - you saw a terrific explanation of the process of leveraging/deleveraging that economies through history have experienced.

As Dalio discussed, much of the economic growth in the United States over the last decade or so was fueled primarily through debt.

This is the pattern that many countries throughout history have followed, most notably Britain in the 19th century and Japan in the latter part of the 20th century.

The problem with taking on debt to boost economic activity is that eventually the bill needs to be paid. When this time comes, countries face years of sluggish economic activity, as growth in real income is needed to repay lenders. For example, even before the calamities of the last few weeks, Japan's economy was mired in the malaise that had plagued it for more than 20 years.

Dalio believes that the U.S. is in the midst of this deleveraging process, and I agree. This means, among other things, anemic economic growth, low wage growth, and potentially deflationary pressures.

For the stock investor, this period is not necessarily bad. Low interest rates will tend to boost values of common equities, assuming that the underlying economic growth is at least modestly positive.

Floyd Norris had a good column in Saturday's New York Times discussing how both the financial and household sectors have been reducing their debts at a rapid pace:

Over the last two years, financial sector debt fell by nearly 9 percent each year, for a total reduction of $2.9 trillion. To put that figure in perspective, it is more than the entire financial sector debt that was outstanding in 1990, the beginning point for the accompanying charts.

It is also larger than the $2.5 trillion total current obligations of state and local governments.

While on the surface this data is encouraging - since it means that we are moving along briskly in the deleveraging process, which sets the stage for future economic growth - the chart accompanying the article illustrated just how large the debt burdens of our society have become.

For example, while Norris correctly heralds the fact that total debt in the financial sector has fallen significantly, it still stood at an eye-popping $14.2 trillion at the end of 2010. Household debt - which helped fuel the economic growth over the last decade - stood at $13.4 trillion at the end of 2010.

And here's one more sobering fact. While it is true that both financial and household debts have been declining over the past couple of years, debt at the federal government level has grown by nearly the same amount - $3 trillion.

In my opinion, then, all this means that the debt burden for our society has been shifting more to the government, and away from the private sector, meaning potentially more deleveraging pain ahead.

Friday, March 18, 2011

Rebuilding Japan

The news from Japan seems a little more encouraging this morning, but it's way too early to say that the worst of the nuclear crisis is over.

In addition, the enormous task of helping the victims of the tsunami is only beginning.

Still, as an investor, it is not too early to think about what will happen after the crisis abates in Japan.

Japan is the third largest economy in the world, populated by a very smart workforce and world class companies. Economic growth for the last 20 years has been anemic as the country still recovers from the excesses of the last 1980's but it is still a very rich country.

Japan has experienced natural disasters before, like the Kobe earthquake in 1995. They have shown themselves to be incredibly resilient, and I have no doubt that they will emerge stronger from the horrible events of the past few weeks.

Barclays estimates that the cost of Japan's recent disaster will be in the neighborhood of $60 billion to $120 billion. However, if the Japanese authorities are able to contain nuclear damage, it could very well be that the cost comes in at the lower end of these estimates.

This morning's Financial Times notes that the eventual cost of the Kobe earthquake reconstruction was around $120 billion, but it appears that this time around there are much fewer damaged buildings, which again is cause for hope.

Japan can afford this bill, as staggering as the numbers are. Even the upper end of the Barclays estimates is around 2% of Japanese GDP. In addition, the Japanese government was already on the verge of yet another stimulus plan, so in a sense they were already planning to spend this money.

I'll be writing more about this topic in the days ahead, but at this point it seems likely that US industrial companies are likely to be bigger winners.

Despite the coordinated intervention of the G-7 earlier this morning, the yen still stands at 15 year highs relative to the dollar. US companies will be offer incredibly competitive pricing to help rebuild Japanese infrastructure.

In addition, the world has suddenly become anti-nuclear. How long this sentiment persists is obviously unknowable at this point - particularly since nuclear offers clean reliable power to many parts of the world - but new power plants will need to be built. Companies like General Electric should benefit (along with other industrial companies like Siemens from Germany).

I've been slowly adding to positions in industrial companies in client portfolios this week, and will probably continue to add next week after I've had the chance to do more reading this weekend.

In the meantime, let's hope and pray that they get those plants under control.

Thursday, March 17, 2011

Ray Dalio of Bridgewater

You may not have heard of Ray Dalio of Bridgewater Associates, but in the investment world he is right up there with Warren Buffett and Bill Gross.

Bridgewater is one of most successful hedge fund operators. After returning nearly +45% (!) last year for its investors, Bridgewater now manages roughly $59 billion, which makes it one of the largest funds in the world.

From time-to-time I have subscribed to Bridgewater's research, and have found it very useful (unfortunately, I have not been able to achieve the same level of investment success!).

So when I came across this interview with Ray Dalio that first appeared on CNBC I thought I should take a look.

If you have time (the interview lasts about 24 minutes) I would suggest you take a look as well.

As you can see from the interview, Dalio thinks that 2011 will still be a good year for stocks, but is less sanguine about the prospects for 2012.

He thinks that we continue to be in a deleveraging part of the business cycle, which will cause growth in the U.S. to be sluggish for a number of years.

Wednesday, March 16, 2011

Krugman on Liquidity Traps and Interest Rates

Lots going on today.

The nuclear situation in Japan apparently getting worse (if that's possible). Saudi Arabia has sent troops into Bahrain.

And, as I write this note, the 10-year Treasury is trading at 3.17%, while the stock market is taking it on the chin.

The strong rally in the bond market has been anticipated by faithful readers of Random Glenings. Interest rates have declined more than 50 basis points from their recent peak in early February 2011, defying the overwhelming consensus that that rates are poised to move higher.

Ah, not so fast, I can hear you say. Aren't rates are moving lower on Treasurys because of horrible news in Japan? And isn't it more likely that investors are only buying Treasurys in a "flight to safety" mode, and will quickly dump bonds once some the overseas situations calm down?

Well, maybe. But maybe we're in an old-fashioned Keynesian liquidity trap, where no amount of monetary stimulus "moves the needle" when it comes to the economy.

Here's an excerpt from Paul Krugman's blog via the New York Times. After noting that interest rates continue to fall despite huge federal deficits, he presents the following:


If you had told most people, back in 2007, that the federal government would soon be running budget deficits in the vicinity of 10 percent of GDP, most of them would have predicted soaring interest rates. In fact, quite a few people did predict just that — and in some cases lost a lot of money for their investors.

But it hasn’t happened. Short rates have stayed near zero; long rates have fluctuated with changing views about the prospects for recovery, but stayed consistently below historical norms. That’s exactly what those of us who understood liquidity-trap economics predicted, right from the beginning.

Yes, We're In A Liquidity Trap -

Tuesday, March 15, 2011

Is Yale's Approach Good for Wesleyan?

Last week I had the chance to attend a reception here in Boston for Michael Roth, President of Wesleyan University.

My son Michael is a sophomore at Wesleyan, and is having a terrific time. Not only is he being challenged academically (Michael is actually taking a class this semester from President Roth, who is rumored to be a tough grader), but he is also playing on the Wesleyan tennis team.

Roth's talk covered a wide range of topics, and was both interesting and entertaining. However, his comments at the end of his remarks caught my attention, since they concerned Wesleyan's endowment.

Wesleyan has gone through some relatively rocky times in its handling of its endowment funds. Although they still have a pretty sizeable sum under management (around $525 million), the performance of the portfolio lagged a number of its peers. In addition, at the end of 2010, they filed a lawsuit against its former CIO alleging conflicts of interests in some of his business dealings.

Earlier this year Wesleyan hired Anne Martin from Yale to manage their endowment. A number of schools have hired former investment professionals from Yale in an effort to duplicate the apparent success that David Swensen at Yale has been able to achieve over the years.

As faithful readers of Random Glenings might recall, last week I published a memo that my colleague Barbara Cummings and I wrote to another endowment fund that was attempting to duplicate the Yale model. Specially, Yale emphasizes the use of alternative investments as opposed to the traditional balance approach using publicly-traded stocks and bonds.

The question in my mind: Does the Yale model really work? Are their returns truly superior to the old-fashioned balanced approach?

According to this week's Economist, it appears that maybe the Yale approach really isn't all that is cracked up to be:

Martin Leibowitz of Morgan Stanley has analysed the characteristics of endowment portfolios over the past ten years. He looked at three portfolios: a classic 60/40 US equity/Treasury bonds split; a Yale-like portfolio with seven separate asset classes; and a portfolio with international diversification but without the illiquid private-equity, hedge-fund and real-estate portions. What is remarkable about these portfolios is how closely correlated they all are with the S&P 500. Even the Yale-like portfolio had a correlation of more than 0.9 (where 1 is a perfect fit).

But then there's more:

Sadly for the Yale-like portfolio, its beta {price sensitivity relative to broader market changes} rose sharply in the third quarter of 2008 when the market was in turmoil as Lehman collapsed. The beta then fell again as the market recovered in 2009 and 2010. In short, the benefits of diversification were highly diluted. In beta terms, endowment portfolios traded like a traditional 60/40 fund in the boom and then were more volatile in the bust.

Put another way, as a tuition-paying parent of a Wesleyan student, I sure hope Ms. Martin carefully considers just how much she wants Wesleyan to duplicate the Yale experience.

Monday, March 14, 2011

Want Better Investment Returns? Stop Trading on Instinct

The world is obviously in turmoil.

Earthquakes in Japan, civil unrest in the Middle East - you name it, this is one of those times that reading the newspaper takes twice as long as normal.

A lot of investors - including me, perhaps - will look at everything that is going on and try to figure out areas that will either prosper in the months ahead (e.g. building companies in Japan) or ones that should be avoided (e.g. the nuclear industry anywhere).

As it turns out, according to a recent study cited in Saturday's New York Times, this is probably a better time to sit tight.

Authored by Paul Sullivan, the article (with the full link below), the piece was titled "When to Buy or Sell? Don't Trust Your Instincts" . According to research done by Phillip Maynim and Gregg Fisher, in periods of volatility the real value of an investment adviser was restraining the impulse to actively trade:

...the value of investment advisers was not in the stocks or mutual funds they recommended but in their ability to restrain investors from impulsively trading at the wrong time. It cites data showing that aggressive orders by individuals can cost them about four percentage points a year.

The study found that as volatility increased the urge to trade also increased - to the detriment of investment returns:

More than that urge {to trade} not going away, the Maymin-Fisher study found, it reappears just after a sudden rise or fall in the market. In other words, investors did not trade in expectation of intense volatility or even during it, which might be rational. They waited until the period of greatest volatility had passed and then looked to do what any adviser would tell them not to do: sell at the bottom or buy at the top.

Put another way, this may in fact be one of those times that simply reading the newspaper - and resisting the urge to "place a trade" - might be better for your investment returns than any other investment activity.

Friday, March 11, 2011

Three Rules of Investing from Ned Davis

I have written a number of times on this blog about Ned Davis Research (NDR).

NDR maintains a massive database of economic and market data to make investment recommendations. It goes without saying that I am a big fan of their work.

However, I have never heard the founder of NDR speak - until yesterday.

Ned Davis was in town to give an hour-long talk to the Market Technicians Association, and I was in the audience.

As you might expect, he was an engaging speaker, and had a number of interesting and sometime amusing anecdotes about some of the experiences he has had in investing for nearly 40 years.

I won't go through all of the points he raised in this talk, but I thought I would share his three rules for stock market investing:

First: Don't Fight the Tape. Ned noted that most investors lose money by trying to go against the prevailing trend of the market. It sounds obvious, but if the charts indicate that the market wants to go higher you need to be invested. And, of course, when the charts turn ugly, you should head for the exits, and stay there until opportunity appears again.

(Right now NDR indicators that the market remains in an uptrend, even though the momentum is less than it was a year ago. They are still overweight equities.)

Second: Don't Fight the Fed. When the Federal Reserve is pumping money in the system, and keeping interest rates low, this is nearly always positive for the stock market. Ned noted that this is not a perfect rule: Japan has been adding money to their economy for 20 years, with no positive effect on the stock market, but he thinks this is unusual.

(Even if QE2 disappears, the Fed is not likely to raise interest rates for many months. In fact, Ned even raised the possibility of QE3 if the economy starts to sputter in the fall).

Third: Be Wary of the Crowd at Extremes. By this Ned means that whenever crowd sentiment becomes overwhelming bullish or bearish on a sector you need to be concerned. Ned uses data from the American Association of Individual Investors (AAII), since they are actually investors, rather than consumer confidence numbers.

(This indicator is flashing yellow at this time, since the most recent AAII survey indicates that 73% are bullish on the prospects for stocks. If this bullish sentiment continues to creep higher, Ned would begin to think about reducing stock positions).

Good thoughts from a market veteran.

Thursday, March 10, 2011

Seven Reasons Bill Gross Is Not As Bearish As You Think

Yesterday Pimco announced that its $237 billion Total Return fund was cutting its position in U.S. Treasurys to zero.

Since fund manager Bill Gross is widely respected in the bond and investment community, this move received considerable press attention.

Gross's decision has been mostly reported as a move by a savvy fund manager anticipating higher interest rates as well as a reputation of the Fed's QE2 program.

I might be wrong, but I don't really think that Gross is as bearish as reported.

I'll go into more bond details below, but I think this is more a move on the of Mr. Gross to use his "bully pulpit" to get Congress to act on the budget deficit than a serious warning of significantly higher interest rates.

In fact, I would suggest that his portfolio moves - if correctly reported by the press - are actually positioning for a better economy in a fairly benign interest rate environment.

First, some background. Here's the excerpt from this morning's Financial Times on Pimco's move:

The world's largest bond fund {Pimco's Total Return fund} has cut its holdings of US government-related debt to zero for the first time since early 2008 in the latest sign of increasing investor expectations of rising interest rates...

..."Yields may have to go higher, maybe even much higher, to attract buying interest." {Mr. Gross} said.

But here's the part I want to focus on. The FT reports that Pimco:

"After slashing its government-related holdings to zero, Pimco Total Return assets are primarily in US mortgage, corporate bonds, high yield and emerging market debt.

The fund holds 23 per cent of its assets in net cash equivalents, defined as any instrument that has a low sensitivity to movements in interest rates."

However, there is a basic inconsistency between what Pimco is saying and how they are positioned.

Let me give you a few reasons:
  • The large cash position is almost certainly part of a barbell trade - that is, combining cash and longer maturity bonds instead of just buying intermediate securities. The yield curve today is as steep as it has been since the late 1970's, so this trade makes sense;
  • If you think interest rates are going to rise sharply, you really don't want to own mortgage-backed securities (MBS). When rates in general rise, prepayments of mortgages slow. This means that the average life of an MBS extends when interest rates rise, which is of course exactly what you don't want in an rising interest rate environment;
  • If Gross truly believes that Treasury rates are poised to move sharply higher, it would be hard to believe that corporate bonds will offer any protection either. Why? Well, most corporate bonds are traded relative to a Treasury benchmark, e.g., a 10 year corporate bond will be priced relative to a 10 year Treasury note. If Treasury yields are set to soar, corporate bond rates will as well, and the prices of both sectors will tumble together;
  • Corporate bond spreads (i.e. the yield advantage of corporates vs. Treasurys) has narrowed dramatically over the last couple of years. Indeed, spreads have gotten so skinny in recent months that in many cases it is hardly worth the candle to buy corporates instead of highest quality Treasurys. Gross seems to betting that economic conditions will continue to show modest improvement, which would keep spreads tight;
  • Higher interest rates would kill the lower quality corporate area. By definition high yield borrowers are companies that have high debt burdens and uncertain business outlooks. If rates on Treasurys soar, high yield borrowers would be smacked, and defaults would rise as well;
  • Higher US interest rates would also hurt the emerging markets. Countries like Brazil have been raising domestic interest rates dramatically to offset commodity price pressures. What would be the impact on their economy if US interest rates were to suddenly spike?
  • Finally - and Bill Gross knows this better than I do - the capital markets are awash with liquidity. Banks already have more funds than they know what to do with, and there is no evidence that the Fed will be pulling liquidity out of the system any time soon. If the Fed stops buying Treasurys, it will certainly remove a marginal buyer, but there's lots more buyers to step in.
Don't get me wrong - I have enormous respect for Bill Gross and Pimco. It's just in this case I think they have a different agenda than what you're reading today.

Wednesday, March 9, 2011

Demographics Determine Longer Term Market Trends

I was first introduced to the work of Dick Hokenson when he was an analyst and then chief economist at Donaldson, Lufkin & Jenrette. After stops at other Wall Street firms, he currently has his own company (Hokenson & Company).

Dick's specialty is demographics. More specifically, Dick attempts to come up with investment ideas and themes based on his work on areas like population growth; labor force trends; and productivity. The idea is that factors like the average age of a population will have a greater impact on areas like, say, housing than interest rates.

For example, Dick has always used the age of a country's population as a means to predicting future economic growth and stock market returns. He was bullish on the emerging markets long before the consensus simply because stronger population growth in countries like Brazil. Younger people buy houses and consume more products than older citizens, which helps the overall economy.

His work has always been unique. Unlike most Wall Street analysts, Dick tries to figure out how demographics will impact the investment markets. Although his views are naturally longer term in nature, his work is always thought-provoking.

The most recent issue of CFA Magazine carried an interview with Dick. Here's a couple of excerpts, with the full link below.

First, Dick notes that many parts of the world - notably Japan - are not only seeing an aging population, but are also seeing a shrinking population. This is one of the reasons that Japanese interest rates are so low:

What’s the relationship between shrinking populations and low interest rates?

There is a very strong relationship between nominal long term interest rates and nominal long-term GDP growth. I have seen studies that tracked this relationship back to the 1800s. If you do a supply-side decomposition of the GDP,in terms of population, labor force, and productivity, you end up with a very strong causal relationship between labor force and nominal GDP. And labor force growth is slowing—it is slowing worldwide. That will continue to pull down nominal GDP and nominal interest rates

And then there's the themes that Random Glenings has been sounding for at least the past year:

What’s the biggest demographic story investment-wise?

If you think about one of the most important things somebody who manages money has to make a decision about, it’s the outlook for inflation. If you get that wrong, you are going to have a big negative impact on your performance. In the 1960s and 1970s, people underestimated inflation and got burned. But for much of the past 30 years, it has been the other way around. People have underestimated the structural disinflation. Otherwise, in 1981, you would have bought the 14¾ U.S. 30-year Treasury bond. In 1981, there were no buyers. And as interest rates were falling, there were still no buyers. Those people said, “They are declining, but they will start rising again,” and that has been part of the issue for the past 20 years. I have talked for 20 years about low interest rates, and people look at me and say, “You went to too many Grateful Dead concerts and inhaled too heavily.” If you look in the press, everybody believes in inflation—that [Federal Reserve Chairman] Bernanke is going to reflate us, that inflation is going to be back next year or a year after, and that interest rates will be higher.
Why don’t you think there will be inflation?

If you have very low interest rates and you have an age structure where people don’t borrow money (aging populations), it doesn’t matter what the price of money is. You can push out money, but it doesn’t go anywhere.

So that’s the question—is inflation caused by money supply or money demand? If it is money supply, then it is a central
bank issue and the Central Bank is going to control it. But if it’s money demand, then it is a demographic issue. I think it’s a demographic issue. The age structure of the population matters in terms of whether you can reflate. And since the population of the world is aging, reflation becomes less and less likely.

Tuesday, March 8, 2011

Three Questions On Oil

Much of the financial press - and many of my recent discussions with clients - have centered around the oil market.

Oil, of course, is a hugely complex topic, so I will not attempt to address all of the implications of the events in the Middle East on world oil markets.

Instead, I want to try to briefly answer three questions that seem to arise frequently.

First: Will the recent jump in oil prices lead to broader inflationary pressures?

My answer: Maybe, but it's not as a straightforward as it was in, say, the mid-1970's, when the Arab oil embargo caused inflation in this country to soar. The reason is that oil as a percentage of the typical household expenditures has declined significantly from a generation ago.

This week's Economist has several good pieces about Libya and oil. Here' s an excerpt from their "Oil Briefing" in the March 3 issue:

Economists do not expect a repeat of the 1970s, when oil-price rises led to “stagflation” in the rich world. Olivier Blanchard, chief economist of the IMF, and Jordi GalĂ­, of the Centre de Recerca en Economia Internacional in Barcelona, point out that two recent oil-price rises—one beginning in 1999 and another in 2002—were of the same order of magnitude as during those turbulent years. But the effect on both inflation and unemployment in the rich world was much smaller: in America, for example, a rise in inflation of only 0.7 percentage points on average, whereas the 1970s shocks had caused a rise of 4.5 points in the two years after the shocks.

The rich world is less vulnerable now because it has substantially reduced the amount of oil used per unit of output. America’s economy in 2009 was more than twice as large in real terms as in 1980. Yet over that period America’s oil consumption rose only slightly, from 17.4m b/d to 17.8m. Europe actually used less oil in 2009 than in 1980, even though its economy had grown.

Next: Should the Fed and the European Central Banks raise interest rates in response to the rise in oil prices?

Again I turn to the Economist:

In recent years, with inflation expectations more stable, central banks have responded more moderately to higher oil prices. But in July 2008 the ECB raised short-term interest rates because it feared that a rise in headline inflation would feed a wage-price spiral. In retrospect, that was a mistake. The global economy was already slowing, and over the next year both headline and core inflation (which excludes energy) fell sharply in the euro zone. Although America's Federal Reserve did not tighten, it hinted at the possibility, which prompted markets (wrongly) to anticipate a rate increase. These hawkish signals may have compounded the slide in economic activity already underway.

Finally: Will the rise in oil prices weaken the economy?

This of course is the big question for investors, since shares of many companies have risen in anticipation of continued improvement in economic conditions.

I think for the time-being we remain in a muddling growth market, and that energy will not yet hurt economic growth. However, if oil prices continue to rise, it could very well choke off some of the economic improvement we have recorded over the last few quarters.

Monday, March 7, 2011

Opportunities in the Maelstrom: Munis Continue To Perform Well

Two good articles appeared in yesterday's New York Times about the municipal bond market.

The first one was by Roger Lowenstein, and was titled "Broke Town, U.S.A."

Lowenstein is an excellent observer of the financial scene. Among other books* he has written was a prescient book called While America Slept which correctly forecast the current crisis in the public pension arena.

What I like about yesterday's article was a couple of points. First, Lowenstein agrees with Random Glenings in that he foresees that most municipal bonds will pay as scheduled.

However, he takes it a step further, and notes the misery that past debt obligations will inflict on today's citizens:

But what if the burden of municipal woes falls elsewhere than on bondholders? Yes, cities and states have creditors. They also have citizens who rely on their services and who pay the taxes, and they have public employees who are dependent on stable public-sector jobs and often-ample benefits. {Meredith} Whitney isn’t wrong about a crisis in local government; the crisis is here. The question is, will it be articulated in terms of bond defaults or larger kindergarten classes — or no kindergarten classes at all? The efforts in Wisconsin and elsewhere to squash organized labor suggest that politicians are no longer so willing to protect public employees. Teachers and nurses are likely to suffer well in advance of investors.

So it was with no small sense of irony that the Times' business section had a good piece discussing how well investors who ignored the naysayers at the end of last year and bought munis have done so far this year:

This great exodus {by retail investors} has contributed to short-term price distortions. Small investors have been hurt by selling low, and, as always, smart money has entered the fray. Speculators have had easy pickings.

“Some of the trades in this market have been very sweet lately,” said Matt Fabian, managing director of the research firm Municipal Market Advisors. Muni yields began rising in November, and prices, which move in the opposite direction, fell, hitting a trough on Jan. 14, he said.

Swept up in the price movements were some red-hot munis — including those Cornell and Harvard bonds. (Although state and local governments, as well as water systems and sewer districts, are classic issuers of munis, universities may also offer them through various means.)Traders who bought a 30-year Cornell 5 percent bond in mid-January and sold it last week would have pocketed a quick 9.3 percent profit, he said. Trading the equivalent Harvard bond over the same short period would have produced a 6.3 percent gain.

*I highly recommend Lowenstein's earlier books on Warren Buffett and Long-Term Capital (titled When Genius Failed).

Friday, March 4, 2011

Memo to Investment Committee

I am a co-manager on a reasonably-sized endowment fund - my friend and colleague Barbara Cummings manages the bond portion of the portfolio, while I handle the equities.

This fund was recently approached by a large brokerage firm with an aggressive recommendation to move a significant portion (25%) of their assets into "alternative investments" (i.e. private equity and hedge funds).

In addition, the brokerage representative suggested adding a 12% exposure to the convertible bond market.

Then investment committee asked us to write a memo asking what we thought about their ideas. Here's what I wrote:

March 1, 2011

Asset Allocation Plan

Thank you for the opportunity to join the discussion regarding the proposed changes in your asset allocation plan.

We will state our conclusions upfront, followed by a more detailed discussion on our views on alternative investments. We hope you will not hesitate to ask us to elaborate further on any of the points discussed in this memo.


We respectfully disagree with the idea of moving 25% of the market value of your portfolio to alternative investments. For a number of reasons, we do not believe your endowment would benefit from having a large exposure to an illiquid asset class whose historic returns have been mixed at best.

We would also suggest eliminating the fund’s exposure to the convertible bond market. Convertibles by design are mediocre investments: they don’t yield as much as the senior debt of the issuing corporation, and the usual conversion premium to the common stock offers muffled returns relative to a direct investment in common stock.

In short, based on our experience, we believe that your investment portfolio would be best served by investing in a more traditional mix of publicly traded common stocks and bonds. Variations in asset classes – e.g. small vs. large-cap; domestic vs. international – could achieve the desired diversification result without sacrificing either returns or liquidity.

We understand the intellectual logic behind investing in private equity and hedge funds. However, as the financial woes of large private equity investors such as Yale and Harvard suggest, these sectors are far from the “free lunch” that private equity sponsors proclaim.


The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains. Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses. Investors who put money with such managers should be labeled patsies, not partners.

-Warren Buffett – 2010 Berkshire Hathaway Annual Report to Shareholders

The investment management area at the Boston Private Bank works with a number of pension and endowment clients. The typical size of our institutional relationships ranges in the area of $5 million to $20 million, with our largest relationship totaling nearly $150 million in size. In short, we have considerable practical experience in the management of endowment portfolios.

As the committee is well-aware, David Swensen at Yale University was the intellectual pioneer in directing larger endowment funds from the public markets towards the private equity and hedge fund areas. Broadly stated, Mr. Swensen’s research indicated that superior returns could generated if an investor was willing to accept less secondary market liquidity.

For years this approach seems to have worked well, and numerous other well-known endowment funds followed the Yale model and moved large portions of their portfolios into the private capital markets.

However, the last few years have demonstrated that there is no “free lunch” available in the private markets. Several problems have become apparent:

  • Superior returns from private investments often depend on the stock market. If the new issue market is not conducive to new offerings, private equity returns could suffer;

  • The ultimate payout from a private equity investment often takes years to unfold. It is not uncommon for an investor’s money to be tied up for 7 years or longer;

  • Fees can be quite large on private investing. A typical arrangement could include a 5% “placement” fee following by annual fees that can reach 2% or more;

  • Valuation of private investments can be, by definition, quite arbitrary. It is difficult to value a start-up, for example, if there has been no secondary market activity for similar companies. This obviously makes it quite difficult to determine periodic investment results;

  • Returns from private equity and hedge fund managers can vary widely. Truly superior long term results are achieved by only a handful of managers. Indeed, Mr. Swensen himself suggested that smaller institutions avoid the private equity and hedge fund arenas since only the largest and most knowledgeable institutions (e.g. Yale) have the resources to determine superior managers;

  • The actual cash returns from hedge funds can vary widely, and are often taxable as short-term capital gains. While this latter point will obviously not affect Littleton, it does illustrate that the typical hedge fund manager is incented to aggressively trade the portfolio (from both the long and short sides), often with deleterious effects on long-term returns.

Thursday, March 3, 2011

What To Do With Bank Stocks?

The financial sector represents almost 16% of the S&P 500.

Only the technology sector (roughly 19% of the S&P) is a larger weighting. So if you are managing equity portfolios that use the S&P as a benchmark (as I do), you have to try to figure out how you invest in the sector.

It was only a little more than 2 years ago that the banking and brokerage sectors nearly collapsed. Without the aggressive intervention of the Fed and Treasury departments, the economic consequences would have been dire.

Although it is very trendy these days to blame government for everything, the simple truth is that the federal government saved the day. Not only is commerce gradually returning to normal, but the costs to the taxpayers (mostly in the form of TARP) has turned out to be nearly zero.

Who would have thought.

Problem now is that the very same problems that nearly destroyed the system are still very much evident. There still remain thousands, if not millions, of home mortgage loans that are underwater, and the outlook for housing is still very poor, in my opinion. Derivative products tied to mortgage loans also are pervasive in the system.

Then there's the problem of growth. Speaking as someone who works at a bank, we have lots of money to lend, but face a real paucity of credit-worthy borrowers. This is part of the problem the Fed is facing, by the way: the central bank can keep adding money to the system, but it is largely being reinvested in Treasurys, which doesn't do too much to either help the economy (or help bank profits, for that matter).

I ran across a couple of good comments about the banking sector that do a good job of describing where the current situation.

First, from The Economist, which compares the large multinationals to the experience of the Japanese banks in the 1990's:

But it is the second decade of Japan’s banking depression that carries the gloomier message, especially for Western bank shareholders. They should not be deluded by the recent flurry of reasonable results into thinking that their prospects are rosy. When the private sector is deleveraging and interest rates are low, banks normally struggle to make adequate profits. To ensure long-term prosperity, European and American firms will surely have to cut costs and re-engineer products more than they have done so far. It will take a long time.

Then there's the article in Der Spiegel, the German news magazine. The most recent issue features an interview with economist Barry Eichengreen, who describes the situation of the European banks as follows:

Europe's banks are in far greater danger than people realize. Most people now understand that last year's stress tests didn't tell us much. The tests were a token gesture and lacked realistic scenarios. They completely ignored the liquidity risks that banks could face. Regulators will not be allowed to get away with that this time. However, what would put my mind at rest more would be if the responsibility for carrying out the stress tests went to the European Commission. National regulators are too susceptible to pressure from the regulated.

SPIEGEL: How much money do the banks need to crisis-proof their balance sheets?

Eichengreen: As a rough estimate, I'd put the costs for recapitalizing the German and French banks at 3 percent of Franco-German gross domestic product.

SPIEGEL: So about €180 billion.,1518,748239,00.html#ref=nlint

So you can see my problem.

Wednesday, March 2, 2011

Crisis in Public Pensions? Blame the Stock Market

Ezra Klein of the Washington Post had a good article today about the apparent "crisis" in the funding of public pensions.

Klein cites a paper written by Dean Baker of the Center for Economic and Policy Research. Titled "The Origins and Severity of the Public Pension Crisis", Mr. Baker writes that much of the $1 trillion funding shortfall that is usually cited as a "crisis" in the media is actually tied more to the stock market malaise over the last few years rather than any funding shortfall.

As Klein writes (I have added the emphasis):

{The underperformance of stock managers}, not union greed, is what has left state pension plans in apparent crisis. The conventional analysis right now is that pension plans are underfunded to the tune of about a trillion dollars (though there are good questions about how honestly state pension data are reported). If the stock market had simply performed as well as Treasury bonds in recent years, about $850 billion of that shortfall wouldn't exist. Much of the remaining gap is explained by states cutting back on contributions because they need to balance their wrecked budgets.

But Klein goes on to write that Baker warns that we are about to err on the side of being too conservative on the expected level of returns going forward. This is important since the lower the expected return, the higher the apparent funding gap:

But Baker -- who did predict the housing crisis and so has some actual credibility on this subject -- thinks that some analysts have perhaps overlearned the lessons of the past few years. They're predicting rates of return going forward, he argues, that are much lower than what we should expect. He expects returns averaging around 7 percent from 2012 to 2022 -- not the 4 percent or so that some analysts are predicting.

Ezra Klein - What you need to know about state pension systems

One final point that I would make. I wrote last year about the fact that many public pension plans were cutting back on their allocation to stocks in favor of bonds.

I noted that this made no sense, since by definition pension plans should have a very long time horizon, and stocks will almost certainly provide better long-run returns than bonds (especially given the starting level of interest rates).

And that risk remains today. The more conservative the investment strategy that a pension plan adopts, the more likely it is to have funding difficulties in the future.

Tuesday, March 1, 2011

Where Have You Gone, Meredith Whitney? Munis continue their strong rally

Defying doomsayers like Ms. Whitney, the municipal bond market continues to roar ahead.

Lack of new issue supply has helped, as well as the growing realization that not all municipal bond debt is set to default.

According to Merrill Lynch, the muni market has experienced strong rallies for the last 12 days. Over the last couple of weeks, while the yield on 10-year Treasury notes has declined by almost 24 bp to 3.42%, the 10-year AAA muni rate has declined by a whopping 42 bp to 2.97%.

Put another way, the ratio of 10 year AAA muni bond yields to comparable Treasury yields is now 87%, which is slightly below the last year's average.

At the beginning of the year munis were actually yielding more than Treasurys, which in retrospect represented a terrific buying opportunity (a fact noted by Random Glenings at the time).

My friend Nancy Marandett from Morgan Stanley brought a recent article from Bond Buyer to my attention. Titled "Bankruptcy's Bright Side: Even Under Chapter 9 Investors Get Paid", the article discusses the hold that bond holders have over most municipal borrowers.

Namely, failure to pay interest and principal in a timely fashion means that cash-strapped municipalities will be shut out of the credit markets, which is the last thing they need.

Here's an excerpt from the article, with the full link below:

With pundits predicting a "wave of bankruptcies" in the municipal market this year, experts say one thing should be kept in mind: the majority of distressed issuers undergoing the Chapter 9 process don't end up stiffing bondholders.

Dreadful images conjured up by all the talk of bankruptcy stem from what often happens in the corporate world when a company goes bankrupt. Corporate bondholders routinely take huge losses and it's not uncommon for companies to liquidate their holdings at fire-sale prices, distributing the losses far and wide.

But history suggests that municipal market dynamics compel issuers to continue paying bondholders.

Take Orange County, Calif., which infamously declared bankruptcy in 1994 after some leveraged bets on derivatives turned sour. The bankruptcy debacle — it was the nation's fourth-largest county by population — has since served as a warning that even a municipality not experiencing stagnant growth and a demographic exodus can end up in Chapter 9. But it's worth remembering how much bondholders lost during the 18-month case: not a dime.