SOS for the Dollar

The dollar continues to sink against most major currencies.

No one in Washington seems to be all that concerned - after all, a weaker dollar presumably makes American products and workers more competitive globally, so what's the worry?

Overseas, of course, the rapidly dwindling value of the dollar is a huge story.

As background, here's columnist James Mackinosh writing in this morning's Financial Times:

Weak, weaker, weakest. The Fed's own measure of the dollar in real terms against America's main trading partners shows that it ended March at its lowest since it first traded freely in 1973. Since then it has fallen further, as Mr. Bernanke's supportive comments on Wednesday, far from shoring up the greenback, accelerated its decline. Worse-than-expected economic growth added to the dollar's woes.

Much of the recent rise in gold and other precious metals, of course, can be traced to the increasing concern that the dollar may be losing its luster as the world's reserve currency.

With no obvious replacement for the dollar, world central banks are either turning to gold or, in the case of Hong Kong and Singapore, considering using a basket of currencies rather than the dollar to peg the value of their own currencies.

For now our markets seem unconcerned - stocks continue to inch higher, and bonds are increasing in value as well. But a longer-term bout of dollar malaise may eventually come back to haunt us.

"Where Should I Invest Money Now?"

I've been getting lots of questions recently from clients and prospects who are struggling with the current investment climate.

The economic data has been soft recently, even though first quarter earnings reports are generally better than expectations.

Stocks have moved up sharply since the beginning of the Fed's QE2 program last fall, but now it appears that the Fed is moving to the sidelines, at least for the time being.

Bonds, meanwhile, continue to rally, and yields have moved down sharply since early February. At this writing, the 10-year Treasury yields 3.32%, which is almost exactly where they were at the beginning of 2011.

Municipal yields have dropped for the last 11 days in a row, and the AAA municipal now yields 2.91%. Municipal supply has been relatively light this year for a variety of reasons, and investors have become more comfortable with the idea that municipal doomsayers like Meredith Whitney were overly pessimistic.

So, with cash and bond yields so low, and the economy showing signs of weakness, what should the individual investor do?

With this as a backdrop, I thought I would share an email that I sent to a good client this AM:

Hi,

The most attractive areas for investment, in my opinion, pretty much mirror what I mentioned to you earlier this year.

Longer maturity municipals still offer reasonably attractive after-tax returns in a low yield world.

Large cap, dividend-paying stocks are trading at a lower valuation than many other sectors of the market. In some cases, the dividend yield on the stock is better than the bonds issued by the same corporation. In addition, while the general economic news seems to have turned softer, the first quarter earnings reports for most companies have been pretty good.

I still don't find any value in shorter maturity bonds. Yields are way too low (e.g., the 2-year Treasury note yields a whopping 0.65%) unless you are super bearish on the world.

Shorter municipals, by the way, also are mostly yielding less than 1%, so I wouldn't be rushing into this sector either.

Finally, we are currently favoring the U.S. stock market vs. the overseas markets. In particular, the emerging markets look very expensive vs. the U.S., particularly when you consider that the central banks in places like China and Brazil are trying to slow their economies. Only in the U.S. and Japan are governments attempting to help economic growth and, to us, you'd rather be investing in places where you have fiscal and monetary tailwinds.

Hope this is helpful,

Dave

TIPS: Great Deal for the Government, Bad for Investors

If you truly are worried about a resurgence of inflation - which Random Glenings is not, but this is a minority view - you might be considering an investment in Treasury Inflation-Protected Securities (TIPS).

Please don't.

Quick background: TIPS offer investors the theoretical ability to hedge assets against inflation. Although the nominal yield on TIPS is lower than traditional US Treasury securities, the principal balance of your investment is adjusted higher each year based on the change in the CPI.

There are numerous problems with TIPS from both a structural and liquidity standpoint, but I won't go into them here.

My most relevant point today is that with all of the current hype about inflationary pressures, investors seem to be willing to pay almost any price for protection.

Thus, at the present time, the nominal yields - that is, the cash flow you the investor will be receiving periodically over the life of your investments - are ridiculously low on TIPS.

For maturities out to six years, for example, nominal yields are negative. Put another way, you are paying the government a fee each year for the supposed inflation protection. Even 10-year TIPS are yielding 0.72%.

Ah, you say, but at least I am protected against inflation.

Well, maybe, but if you just leave your money in a money market fund, or invest in short maturity CD's, you will be better-protected and have considerably more liquidity.

Why is that?

If you look back historically - say, over the last 60 to 70 years - short term interest rates and inflation rates track very closely. In the language of economists, "real" short-term interest rates are 0% over longer periods of time.

This stands to reason, even in today's environment. If the Fed were to witness a resurgence in inflationary pressures, they would most likely ratchet up short term rates fairly quickly.

In other words: Don't buy TIPS. As a fellow citizen of the United States I appreciate your efforts to reduce our government deficit, but there are better ways to contribute.

What Happens When the Fed Leaves The Party?

There was a time when the Federal Reserve, and the Fed's policy decisions, received as much media attention as my beloved New England Revolution soccer team.

Back in the Carter administration, for example, then-chairman G. William Miller joked that when he was first appointed head of the Federal Reserve, his relatives thought he was going to head up a bourbon company.

(Mr. Miller was famous for insisting that Fed meetings should be over as quickly as possible, and he often succeeded: it was not unusual for a Miller-led meeting to conclude in 10 minutes.)

No more. The Fed, and Fed actions, are scrutinized and discussed as much as any government actions.

And so last weekend, right next to the stories of the wars in Libya and elsewhere, there was a front page story in last Sunday's New York Times discussing whether the Fed's second round of quantitative easing (so-called QE2) had any positive effect on the economy other than causing stock prices to move sharply higher.

http://www.nytimes.com/2011/04/24/business/economy/24fed.html?_r=2&hp#

The consensus in the article was essentially that QE2 was a flop, a zephyr in the economic breeze.

I'm not really sure this is true, and the news magazine The Economist begs to differ as well:

So what happened after Mr Bernanke made it clear to markets that the Fed would act again? Growth accelerated, from a 1.7% annualised pace in the second quarter to 2.6% in the third quarter and 3.1% in the fourth quarter. Inflation expectations ceased falling and began rising back to normal levels. Confidence rose. And the pace of hiring improved meaningfully. In both February and March, private firms added over 200,000 jobs. Since the Fed's policy began, the unemployment rate has fallen a full percentage point.

http://www.economist.com/blogs/freeexchange/2011/04/monetary_policy_3

My point in mentioning all of this today is that there seem to be unmistakable signs that economic growth is beginning to slow again - just when the Fed is ending its QE2 program.

Some economists are pointing towards higher oil prices, which certainly is playing a large role in changing consumer behavior. Housing continues to sputter along, and unemployment rates are far higher than they typically would be in a normal economic recovery.

First quarter GDP will be reported later this week, and it will probably be around +1.5%, down considerably from the fourth quarter of 2010, when GDP came in at +3.1%.

Then there's my favorite barometer, the bond market. Bond yields have fallen 21 basis points over the last 9 trading days, and the 10-year Treasury now yields 3.36%. Apparently there are lots of investors who think locking in returns just north of 3% is better than any alternative.

I remain positive on the stock market for the time being, but diligence remains important in this environment.

Pepsi Thinks Inflation is Bubbling Up

Hugh Johnston is the chief financial officer of PepsiCo. According to an interview published in this morning's Financial Times, Mr. Johnston is not happy with the way the Fed focuses on the so-called "core" inflation rate.

Mr. Johnston believes that the government's way of reporting inflation understates the impact that rising food prices are having on consumers.

Quoting Mr. Johnston: "The reality right now is that food and fuel are quite inflationary", particularly on families earning less than $70,000 a year. While the core inflation rate is being quoted at 1.2%, food prices have climbed 2.7% over the past year, and gasoline prices prices have increased +28%.

The calculation of inflation is always controversial, but it seems to be getting more press than normal these days. The bond market doesn't seem to be worried - the 10-year Treasury is yielding around 3.4%, or about 40 basis points less than a year ago - but that hasn't stopped any number of analysts from commenting that inflation is just around the corner.

Yesterday's New York Times carried a short piece that talked about the problems of reporting inflation especially when it comes to food and energy.

At the top of the list for year-over-year changes in food and energy costs (according to the Bureau of Labor Statistics):

Gasoline +28%
Lettuce +27%
Bacon +16%

But look at the bottom of the list:

All fresh fruit -2%
Wine unchg.
Eggs +1%
Poultry +2%

Inflation rates, like so much data, can be subjective in the way they are reported.

As previous posts on Random Glenings have indicated, food and fuel prices are notoriously volatile, which is why they are excluded from core inflation calculations. In 2008, for example, oil prices peaked in the spring, but then proceeded to fall by more than -53% for the next 12 months.

Stocks Ignore S&P, Roar Ahead

After a rocky start to the week, the stock market roared ahead yesterday.

S&P warnings about the future credit ratings of trillions of dollars of US debt may prove prescient in the future, but for now the market wants to move higher.

The Financial Times this morning had an article titled "Investors Seek Clues in a Cloudy Earnings Picture". Written by Michael Mackenzie and Michael Stothard, the piece had a number of interesting statistics on the market.

Company earnings reports have been reasonably good for the first quarter of 2011. While we are still early in earning season, of the 60 companies in the S&P 500 that have reported 78% have beaten expectations.

The blended earnings growth for the S&P 500 in the first quarter is running at +12%, roughly equal to expectations at the beginning of the year.

Not surprisingly, the sectors with the highest earnings growth rates include materials (+39%); energy (+31%); and industrials (+23%). Not coincidentally, these three sectors have been the best performers in the S&P year-to-date.

And, according to the Financial Times, the forward 12-month P/E ratio for the S&P is 13x, which is below the average of the last 10 years.

Interesting, Merrill Lynch research indicates that their retail investor is selling, not buying this market. Here's an excerpt from Merrill's David Bianco earlier this week:

Overall flows: Largest net sales since May 2010
The first week of reporting season was met with widespread selling of US stocks by BofAML clients. Net sales of $1.6bn last week (4/11-4/15) were the largest level of net sales since May 2010. This compares to net buys of $0.28bn the prior week. All three client types (hedge funds, institutional clients, and private clients) were net sellers last week. Hedge funds returned to net selling of US stocks last week after net buying for the prior three weeks. Over the past year, hedge funds have not been net buyers for more than three consecutive weeks. All three size segments (small, mid and large) also saw net sales last week.

In my opinion, in addition to reasonably good fundamentals, the huge reservoir of liquidity that the Fed and Bank of Japan are providing the markets are also aiding the stock market.

There will be a time to sell stocks, but I don't think we're there yet. I think the party ends when the Fed starts raising interest rates, but this doesn't seem to be in the cards for a few months at least.

Housing Continues to Suffer

Housing is a mess.

While most of the attention of financial analysts and media is focused on the rapid rise in the prices of commodities like oil and gold, housing prices in many parts of the country continue to tick lower.

The problem is largely psychological. Even if they can afford it, no one wants to buy a house if they think prices will be lower 6 months ago.

I had a long conversation last week with someone who is very involved in the home mortgage market in the Boston area.

After her children graduated college, she and her husband decided to "downsize" and sell their house.

After sitting on the market for several months, they finally sold their home, but at a price well below assessed value ("my neighbors are not happy with us", she said with a rueful smile).

So what now?

Well, this well-connected, savvy mortgage lender has decided to rent. She, like many Americans, believe that housing is trapped in a downward price spiral. While renting a home lacks that psychic appeal of owning real estate, at least you don't feel like your retirement assets are locked up in a depreciating asset.

Here's the change of housing prices since their peak in 2006, courtesy of the blogger West Wing:

Home prices (median) since '06 peak: Miami -32%, Tampa -33%, L.A. -35%, San Diego -37%; Phoenix -50%; Ft. Myers -54%; Vegas -55%

Little wonder that most Americans are avoiding buying homes.

Bloomberg carried an article about this trend yesterday. Here's an excerpt, with the full link below:

The most affordable real estate in a generation is failing to lure buyers as Americans like Pauli sour on the idea of home ownership. At the end of 2010, the fourth year of the housing collapse, the share of people who said a home was a safe investment dropped to 64 percent from 70 percent in the first quarter. The December figure was the lowest in a survey that goes back to 2003, when it was 83 percent.

“The magnitude of the housing crash caused permanent changes in the way some people view home ownership,” said Michael Lea, a finance professor at San Diego State University. “Even as the economy improves, there are some who will never buy a home because their confidence in real estate is gone.”

Americans Shun Most Affordable Homes in Generation as Owning Loses Appeal - Bloomberg

Joshua Boger of Vertex

Last month I went to a reception here in Boston held in honor of Wesleyan University's president Michael Roth.

I didn't attend Wesleyan, but my son Michael is a sophomore. Both my wife and I have become big fans of the school, and of President Roth.

The head of Board of Trustees at Wesleyan is Joshua Boger, who is founder of Vertex Pharmaceuticals.

Mr. Boger introduced President Roth at the reception, but to be honest I didn't know too much about either Joshua or Vertex.

Well, maybe I should have.

Vertex is a very interesting company, and is doing work that hopefully will address some serious health issues in our society. The Massachusetts-based firm is involved in cutting-edge research in the development of drugs to help patients deal with both hepatitis C as well as cystic fibrosis.

It has also been a terrific stock (ticker: VRTX), to put it mildly, nearly doubling in the last three years.

Wesleyan put out this video featuring Joshua Boger, and I thought it was so good that I wanted to post it here.

S&P Warns, Bond Market Yawns

The stock market was rocked yesterday, and prices generally moved sharply lower.

Most news stories are citing the move by Standard & Poor's to put the credit quality of the United States on "negative" credit watch.

To be honest, I'm not exactly sure what the move by S&P means. How can the credit quality of an entity that can print money to pay off its debt move lower?

It would appear that the bond market shares my sanguine views. Treasury bond yields moved slightly lower. The 10-year Treasury note now yields 3.38%, or almost 40 basis points lower than two months ago (take that, Bill Gross!).

In any event, most investors remain very skittish about investing in anything, particularly stocks.

Most can lay out the bear case for stocks pretty well. Poor economic fundamentals in key sectors like housing and employment are felt by most of us. The highly partisan budget battles in Washington over relatively trivial savings make real fiscal reform seem unlikely. Memories of the horrific bear market in 2008 remain fresh in most investors' minds.

And yet stocks continue to move higher, yesterday notwithstanding. The S&P 500 is up over+11% in the last six months. While we are still only partly through reporting season, corporate earnings remain good.

Last Sunday's New York Times carried a good column by Jeff Sommer discussing the huge "wall of worry" that stocks have been climbing. What was particularly interesting about the column was that it contrasted the views of two former Merrill Lynch analysts, Rich Bernstein and David Rosenberg.

Here's an excerpt:

The stock market’s 80 percent rise since March 2009 has been one of the greatest bull runs in history, {Bernstein} says, and while the American economy has its problems, it is clearly strengthening and corporate profits are rising. Yet anxiety about the American market is profound, he says, and many investors have been avoiding American stocks, pouring money into emerging market stocks and bonds instead. That makes no sense to Mr. Bernstein, a longtime bear who turned resolutely bullish in July 2009.

“It seems no one wants to believe in the stock market in the United States,” he said. “People don’t accept that the American economy may actually be strengthening. And they go for emerging markets, which are wildly overpriced. What in the world is going on here?”

The Wall of Worry Has Never Looked So High - NYTimes.com

To me, I think you have to stay in stocks until the Fed turns off the liquidity tap. True, days like yesterday are no fun, but it seems to me that the trend for the general market remains higher.

Uh, Oh: Analysts are More Bullish than Company Managements

What does it tell you when Wall Street analysts are moving their earnings forecasts higher - but management is moving its guidance lower?

It tells you that this market might be more risky than is generally perceived, according to Savita Subramanian speaking yesterday at Merrill Lynch.

Savita is a quantitative analyst; she uses the huge database of economic and market data at Merrill to derive her portfolio recommendations.

The trick in quantitative work, of course, is that past data is not always the best guide for the future. Moreover, as Savita noted yesterday, market leadership can change fairly quickly, and what is working during one period of time may not work in the next period.

Still, this wide divergence between the analyst community and management pronouncements troubles Savita. If nothing else, she said, analysts usually follow management lead in developing their forecasts, so we are in a fairly unusual period.

According to Savita, the widest disparity between the analysts and management can be found in the energy sector. While virtually no company managements have raised earnings guidance, Wall Street has been aggressively raising their earnings forecasts by a ratio of 3:1 (that is, there have been three times as many upward revisions to EPS forecasts by the Street to downgrades).

Other sectors where Wall Street is more bullish than the companies include technology and materials.

In Savita's work, companies that beat Wall Street forecasts are more likely to outperform the market in the next 3 to 6 month period. On the other hand - and here's the part we should worry about - companies that fail to beat Street forecasts are more likely to underperform.

As we are just beginning the release of first quarter earnings, this might be something to monitor.

Ken Burns at the MFA

Mrs. RG and I went to the Museum of Fine Arts here in Boston last night to listen to a talk by filmmaker Ken Burns.

Burns is famous for his terrific documentaries that periodically appear on PBS. His work is largely focused on American history, and has covered such topics as the Civil War; Jazz; Baseball; World War II: and the National Parks.

The talk was great. This is the fourth such lecture that we have attended at the MFA this season, and this one was easily the best. At the end of his prepared remarks the audience erupted into a standing ovation, so our opinion seems to have been shared by most in attendance.

Most of his comments were focused on the documentary that Burns produced in 2009 that focused on our National Parks. Burns noted that unlike most other nations, American has preserved large tracts of wildlife and scenery not just for the enjoyment of the rich or privileged, but for all Americans.

The author Wallace Stegner apparently wrote that our national park system was "America's best idea". Upon reflection, I think that with the exception of the uniquely American idea that "all men are created equal", Stegner might be right.

What made Burns's comments so poignant, I think, was his obvious passion for the stories behind American history. As he said, his films "bring the dead back alive". We learn through Burns's films that people like Abraham Lincoln; Jack Johnson; Babe Ruth; and John Muir were not just historical curiosities but real human beings who lived in eras that were both different and yet the same as the world we inhabit today.

Burns also discussed his own personal story. His mother died when Ken was only 12 years old, and his father apparently suffered greatly in his years as a single parent. Ken said that once he entered high school he never doubted what he wanted to do with the rest of his life, even though he only took one history course in school.

Ken Burns wrote an editorial that appeared in the New York Times earlier this week discussing the 150th anniversary of the start of the Civil War. Here's an excerpt from that piece, with the full link below:

And in our dialectically preoccupied media culture, where everything is pigeonholed into categories — red state/blue state, black/white, North/South, young/old, gay/straight — we are confronted again with more nuanced realities and the complicated leadership of that hero of all American heroes, Abraham Lincoln. He was at once an infuriatingly pragmatic politician, tardy on the issue of slavery, and at the same time a transcendent figure — poetic, resonant, appealing to better angels we 21st-century Americans still find painfully hard to invoke.

The acoustic shadows of the Civil War remind us that the more it recedes, the more important it becomes. Its lessons are as fresh today as they were for those young men who were simply trying to survive its daily horrors.

http://opinionator.blogs.nytimes.com/2011/04/11/a-conflicts-acoustic-shadows/?scp=2&sq=Ken%20Burns&st=cse

What if Congress Just Adjorned for the Next Two Years?

You probably saw this, but I thought it was pretty interesting.

The papers are full of earnest discussions about how to deal with the rapidly rising federal budget deficits.

Pundits from both the right and the left are weighing in, and President Obama is scheduled to give a major talk this afternoon about reforming Medicare.

But, as Dave Leonhardt of the New York Times and Annie Lowrey of the Washington Post have written, if Congress were to simply go home and let the current tax policies remain in place, much of the deficit could be eliminated in the next few years.

Here's an excerpt from the Leonhardt column this AM:

If Mr. Obama wins re-election, he could simply refuse to sign any budget-busting tax cut for the rich — who, after all, have received much larger pretax raises than any other income group in recent years and have also had their tax rates fall more. Republicans, for their part, could again refuse to pass any partial extension.

And just like that, on Jan. 1, 2013, the Clinton-era tax rates would return.

This change, by itself, would solve about 75 percent of the deficit problem over the next five years. The rest could come from spending cuts, both for social programs and the military.

http://www.nytimes.com/2011/04/13/business/economy/13leonhardt.html?_r=1&ref=business

And Lowrey writes this in the on-line magazine Slate:

But the truth is we don't need any of these plans. Every one of them is entirely unnecessary for balancing the budget and eventually reducing the debt. They may even be counterproductive. Thus, Slate proposes the Do-Nothing Plan for Deficit Reduction, a meek, cowardly effort to wrest the country back into the black. The overarching principle of the Do-Nothing Plan is this: Leave everything as is. Current law stands, and spending and revenue levels continue according to the Congressional Budget Office's baseline projections. Everyone walks away. Paul Ryan goes fishing. Sen. Harry Reid kicks back with a ginger ale. The rest of Congress gets back to bickering about mammograms. Miraculously, the budget just balances itself, in about a decade.

http://www.slate.com/id/2291054/

So there you have it: Let's let Congress just go home for the next couple of years. Oh, they'll continue to be paid - it's part of the budget, after all - but applying the Hippocratic oath of medicine to governing ("First, do no harm") might be the best solution.

Dollar Continues to Move Lower

As Random Glenings has been discussing for the past couple of weeks, the carry trade continues play a significant role in global markets. Currencies in high yield markets are rocketing higher. Commodities also are moving sharply higher as well. Meanwhile, the US dollar and Japanese yen are sinking.

There were several articles in the press over the past few days that Fed officials are reluctant to raise short-term rates any time soon. And, for obvious reasons, the Bank of Japan is also in an accomodative mode.

Meanwhile, the rest of the world is tightening. Last week, for example, the European Central Bank (ECB) raised short term rates to 1.25%. China also raised short-term interest rates for the fourth time this year. Brazil's short-term rates are now double-digits.

So, with US and Japanese interest rates set to remain low for months, and the rest of the world moving interest rates higher, the markets have taken notice.

The dollar has been weakening against every major currency other than the yen. Speculators and investors are borrowing funds in Japan and investing everywhere, but particularly in higher yielding currency markets. The Australian dollar has just hit it highest level since 1983.

I don't know how this all ends, but it seems to me that something has to give.

Here's a excerpt from Reuters yesterday:

Still, this yen carry trade is likely just in the beginning stages. Our BOJ sources have said they are worried about a suddenly weak yen at a time when Japan is needing to import even more energy and stuff for reconstruction. Let’s see. At the end of the day, the BOJ is underwriting another carry trade. So is the Fed. The ECB’s rate hike – whatever you think about hiking rates while the third euro zone member in the past year is getting a sovereign debt bailout – has underscored how the Fed is going to lag, and that means the dollar remains a carry funding currency.

http://blogs.reuters.com/eric-burroughs/2011/04/11/the-carry-trade-never-dies/

I think for the near-term the carry trade remains positive for equity markets. Longer term, however, the jury is still out.

Do Stocks Offer an Inflation Hedge?

I posted a couple of pieces last week about dividend-paying stocks vs. longer maturity bonds.

One argument in favor of stocks over bonds is that they offer at least some protection against inflation, at least in theory.

If you believe that inflationary pressures are about to explode to the upside - which Random Glenings does not, by the way - it seems logical that you should be favoring dividend-paying stocks.

Yesterday's New York Times carried a good column authored by Paul Lim which discusses how much inflation protection stocks could offer investors.

As it turns out, as Mr. Lim writes, the degree to which stocks offer inflation protection is partly dependent on just how high inflation rates go:

...Ned Davis Research, based in Venice, Fla., recently analyzed how the market performed in different inflationary environments over the past four decades. While the Standard & Poor’s 500-stock index posted double-digit gains, on average, when inflation has been between 1 percent and 4 percent, stocks fell at an annualized rate of 1.4 percent when inflation jumped to between 4 percent and 9 percent.

What’s more, in periods when the inflation rate is accelerating, not all types of stocks perform the same way. Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research, looked at periods since 1970 when the year-over-year change in the Consumer Price Index was accelerating. He found eight such sustained periods, and saw that half of the 10 market sectors, on average, gained ground during those times; the others declined or were flat.

Stocks That Can Do Well Even if Inflation Rises - NYTimes.com

Three Reasons to stay Bullish on Stocks - and One Reason to Worry

I just finished my quarterly letter to my institutional clients which I have reprinted below.

I remain positive on the near-term outlook for stocks, since most of the reasons for the first quarter rally remain in place. On the other hand, the high degree of bullish sentiment and complacency gives me pause, and I think that this is not a "buy-and-hold" market.

Despite a blizzard of bad news, the stock market turned in its strongest quarterly performance in 13 years during the first three months of 2011.

The S&P 500 produced a total return of nearly +6% during the first quarter. The energy sector (+16% for the quarter) was the clear winner, followed by industrials (+8%). Laggards included utilities (+2%) and consumer staples (+2%).

Markets are being buoyed by several factors, but here are the most important in our opinion:

1. The Fed continues to be very accommodative. Since the announcement of QE2 in late August, the market has turned in very handsome returns – the S&P is up over +27% in the last 7 months. Interest rates (as measured by the U.S. Treasury 10-year note) are still lower than they were a year ago, helped by the Fed’s active program to support the bond market;

2. News from corporate America is generally positive. Many companies are reporting near-record profit margins despite tepid sales growth. Continued cost cutting measures - including layoffs – have helped, as has utilizing the internet to improve efficiency. Outsourcing manufacturing to lower wage countries has also helped;

3. While investors might be still scarred by the difficult bear market of 2008, the investment alternative to stocks are less attractive. Low interest rates have made holding cash unappealing. Shorter maturity bond yields also remain at record lows. In many cases, dividend yields are higher than corporate bond yields issued by the same company.

We remain positive on the stock market for the next few months at least. The Fed is unlikely to change its accommodative stance any time soon, especially since housing remains mired in a deep funk. Corporations are generally optimistic, and are looking to overseas markets as a possible source for new growth opportunities. Finally, valuations of stocks also are not out-of-line with historic averages.

That said, we are mindful that it is often during periods of widespread bullish sentiment that markets become most dangerous. Numerous recent surveys have indicated that both institutional and individual investors have turned very positive on the outlook for stocks, which is a marked contrast from a year ago.

Don't Bother Looking at Stock Charts Today - They're All Moving Higher

I went to hear Mary Ann Bartels yesterday. Mary Ann is the chief technical analyst at Merrill Lynch, and a very good one, in my opinion.

Mary Ann has also been at this game for a while, so I respect her opinions since they are tempered by experience. Put another way, Mary Ann is not one to get carried away with either enthusiasm or pessimism, but rather lets her analysis of the markets guide her thoughts.

Mary Ann's comments were almost entirely bullish. She noted that all of the markets - stocks, commodities, high yield bonds - are all in confirmed up-trends. Even Treasury bond prices remain in a reasonably strong up-trend, despite the back-up in rates this week.

This synchronization of the global markets is something I discussed earlier on Random Glenings. Normally markets don't all move in the same direction, but not right now: the slope of the line might vary, but most the directions are up.

Ah, I know what you're thinking: Markets don't move in one direction. If everyone is on board with a market or particular stock, that's the time to be heading for the exits.

And it's true, there is clearly a dangerously high consensus that stock prices are headed higher. The most recent survey done by the American Association of Individual Investors shows that just 15% are bearish - yikes!

Problem is - and this was noted by a hedge fund manager at the meeting - it's hard to fight the strong positive tone to this market.

As I listened to Mary Ann, I think the real issue is what's driving global markets, which is the world's central banks. The Fed, of course, has been a hugely positive force for all markets, and now the Bank of Japan is helping as well.

Meanwhile, the economic fundamentals remain weak. Housing looks poised for another dip lower. Unemployment is slightly better, but I don't think a 9% unemployment rate is anyone's target. Corporate earnings are good, but mostly because of cost-cutting and outsourcing; we truly are in the midst of a jobless recovery.

But for now, I think you have to stay fully invested. The time to get worried will be when the Fed starts tightening policy, but I don't think that will happen for some time. True, there is the possibility of higher oil prices choking consumer spending, but there aren't any signs of this just yet.

In other words, we're in a liquidity-fed bull market, but once the Fed removes the juice it will be time to scramble to safety.

Three Big Investment Thoughts from Chuck Clough

Chuck Clough spoke at the Boston Security Analysts Society yesterday.

Chuck was a top-notch strategist for Merrill Lynch for many years, and was ranked as the #1 Wall Street investment strategist for 12 straight years by Institutional Investor. He left Merrill about 10 years ago to start his own money management outfit, which has done very well.

I have been a big fan of Chuck's for many years. His modest, unassuming manner belies a very broad and deep intelligence about the capital markets. Like all strategists, he's not always perfect on timing (he was bearish too early on tech stocks in the late 1990's, for example, but was ultimately proved right) but I have always found Chuck to be worth a listen.

His presentation lasted for about 45 minutes, so I won't be able to do full justice to all of his thoughts, but I thought I would share some of the highlights.

1 Stocks: Chuck remains bullish on the stock market despite the strong gains already recorded. He noted that unlike in previous economic recovery cycles, corporate America is throwing off huge sums of cash.

Microsoft, for example, has a free cash flow yield of 13%, meaning that it will earn enough cash to equal its market capitalization in about 7 years.

Chuck was also positive on the automotive supply sector, noting that the last recession took out huge amounts of capacity that will not be coming back. This means that when auto sales improve (which they eventually will, given the average age of the U.S. cars) these companies will have huge pricing power.

2. Emerging Markets: Chuck remains very bullish on this area, and would use the most recent pullback in EM stocks as an opportunity to add to positions. He believes that the bearish commentary surrounding the Chinese financial sector is overblown, and ignores the fact that Chinese banks are largely owned by the government.

That said, Chuck would focus on the smaller and middle-sized companies in China, which have considerably better growth profiles than the larger companies.

3. Interest Rates: Chuck thinks that interest rates will stay long for a long period of time. He noted that private sector debt is nearly 3x US GDP, and this will need to at least partially repaid before significant credit demand returns. In addition, with so much debt outstanding, and rise in interest rates will have a significant impact on economic activity, and so in effect will be self-regulating.

Judging from the audience questions, there was not a lot of agreement with Chuck on this view. The consensus is still looking for interest rates to move higher, and for inflation to return, but Chuck does not agree.

"All Together Now" - The Markets Move As One

I posted a note yesterday that noted that the Fed's actions last fall - so-called QE2 - were very successful, at least in terms of the markets.

The S&P 500, for example, just recorded its best quarterly return since 1988: +5.9%. For the last 6 months, the S&P is up nearly +17%.

Bonds have also held in nicely, with the 10 year Treasury yielding 40 basis points less than a year ago, at 3.40%.

So what's to complain about?

Not much, I guess, unless one stops to consider that all sectors - stocks, commodities, bonds - have moved in the same direction recently. To me, this implies that investors are not necessarily investing with an eye towards an improving economy, or threats of inflation or deflation.

No, it seems more likely that most investors are realizing that the central banks of the world are providing large boosts of liquidity which are making their way into the global markets. The best way to make money, then, is to buy assets - any assets - and join the party as prices rise as one.

Problem is: What happens when the central banks scale back?

Last Sunday's New York Times carried a column authored by Jeff Sommer that discussed the recent synchronized movements of the world's markets. Here's an excerpt from the piece titled "When Markets Move as One":

... “In current market conditions, there is little point trying to understand the nuances between different asset classes, or the relative value within asset classes. Commodities behave like bonds, which behave like equities. They are no longer easily identifiable, uncorrelated trades.”

Furthermore, Mr. Williams said, close correlation of seemingly disparate assets implies that many portfolios may not be as diversified as we may think.

While the ride is enjoyable, there is the more worrisome thought of the other side of the "risk on" trade: What happens if everyone heads for the exits at the same time?

Mr. Sommer goes on, quoting Eswad Pasad, a professor at Cornell University:

“Financial markets are supposed to be very helpful in diversifying risk, but the whole point is you want uncorrelated returns across markets,” he said. “If markets are more correlated now, it may be because people are trying to diversify by investing globally, but when there is a trigger event — when something nasty happens in the world — they sell assets across markets, and the usefulness of this entire diversification strategy must come into question.”

When the Markets Move as One - NYTimes.com

The Fed Takes a Victory Lap - But What Happens Next?

Last fall, after the Fed announced its second round of quantitative easing (a.k.a. QE2), Ben Bernanke wrote an editorial in the Washington Post.

Here was an excerpt from that piece, which was published on November 4, 2011 (I have added emphasis):

Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html

If you ever needed confirmation that the Fed wanted you to buy stocks and bonds, this was it.

And here's what Random Glenings wrote in early November:

Wednesday, November 3, 2010

The Fed Wants You to Buy Stocks and Bonds

..I don't know if there is a precedent for this, but Fed Chairman Bernanke has an editorial in this morning's Washington Post...


In other words, the Fed wants bond and stock prices to move higher, and is willing to throw a cool $900 billion ($600 billion + reinvestment of interest from existing holdings) into the capital markets between now and the end of June 2011 to help this happen.

Do you really want to bet against the Fed?...

..I'm not sure about the longer run impact of QE2, but for now I think you need to be fully invested in the markets.

Well, the Fed "won". We just finished the best first quarter for the S&P 500 since 1988 (+5.9%). For the last six months, the S&P is +17.3%. And Treasury 10 year bond yields have defied expectations, and at 3.45% its yield is nearly 40 basis points lower than a year ago.

Question is: What happens next?

It is not inconceivable to me that QE3 is possible. Although Corporate America seems in pretty good shape, housing is depressed (to put it mildly), real income growth remains stagnant, and unemployment is still too high.

However, the political reality is that there is no appetite in Washington for more government
intervention in the markets. So we will have to see whether the recent market gains can hold without market support.

There is, however, considerable skepticism among the market pundits that the Fed can go quietly into the woodwork. Bill Gross from Pimco, for example, has been quite vocal in his belief that Treasury yields will need to rise considerably from current levels to induce private investors to purchase bonds.

Should be an interesting second quarter.

Bogle on the Markets

I might not always agree with John Bogle but I always find his comments thought-provoking.

John is best known as the founder of mutual fund giant Vanguard. He was also an early advocate of index funds, and has remained passionate about the benefits of indexing for individual investors.

(John also worked for a time at my old firm: Scudder, Stevens and Clark. However, due to his iconoclastic beliefs, and the fact that he did not believe in the value of active management, he was shown the door. He then went on to start Vanguard, and the rest, as they say, is history).

John wrote a column in Wednesday's Financial Times that made a number of good points about investor expectations. I don't know if I totally agree, but here's what he wrote:

Over the past century, for instance, the US stock market has provided an average annual return of about 9 per cent - 4.5 per cent from dividend yields and 4.5 per cent from earnings growth. But today's dividend yield is only about 2 per cent, meaning that a critical component of the stock market's return has been slashed by more than one half.... ...combining the two tells us that reasonable expectations for nominal returns on stocks over the coming decade are likely to centre around 7 per cent, several percentage points below the long-term norm.

FT.com / Markets / Insight - Wall St’s illusion on historical performance

Bogle goes on to note that investors should not only focus on gross returns from their investments but expenses associated with their investment activities.

John estimates that the typical mutual fund charges fully 2% annually (including expense ratios, estimated portfolio turnover costs, and sales loads) which would obviously have a significant impact on net returns.

Finally, Bogle notes that investors should also focus on inflation in calculating their investment results. Even if inflation rates remain low (which Random Glenings believes), even a 1.5% inflation rate for the next ten years means that the real purchasing power of today's dollars will be 14% less by 2021.

Worth a read.