Wednesday, February 29, 2012

"What Should We Do Now?" - Comments to the Management Committee

Along with several of my colleagues, I'm giving a talk today to senior management of my company about the markets.

I thought I would share some of my notes.

First, here's the question that's sure to be asked:

"Should I be buying stocks now?  What are you telling your clients?"

Yes.  Here's why:
  1. Stocks are the only game in town if you are truly interested in "maximizing real returns" (John Templeton's phrase).  Bond yields are at 60 year lows, and current Fed policy guarantees that cash promises to earn essentially nothing until 2014;
  2. If you believe - as I do - that there is a reasonable chance that the S&P will be at least 35% higher by the end of 2014 (please see yesterday's Random Glenings post), then trying to time the market is a futile exercise. Yes, the market will doubtlessly experience corrections in the next three years, but the longer term prospects look positive;
  3. Actions by the Fed and the European Central Bank have stabilized Europe.  Comparing the euro crisis to the financial crisis of 2008 is misleading - no one expected Lehman to go under.  The euro risks are already priced into the market;
  4. Bearish sentiment is pervasive. The press is full of stories about how vulnerable the stock market is, and domestic equity mutual funds continue to see outflows into bond funds.  Auto maker Ford Motor just moved 80% of its pension fund into fixed income, even though the plan is $15 billion underfunded - they decided they just couldn't handle the volatility of the equity markets.
  5. It's never been more expensive to be defensive.
More comments:
Clients appreciate the strong relative performance of their accounts on both the stock and bond fronts;

     However, they are frustrated as to what to do now.  Rates are low, and no matter how skilled the bond manager, the absolute returns will not likely be as strong as the last few years.  Stocks could potentially offer opportunity, but after 5 years of volatile markets and essentially no gains, adding to positions is difficult.

Here’s what we’re saying:

1.      The value of active bond management is magnified in a low interest rate environment.  Bonds can and should play a role in a balanced portfolio both to offer income as well as stability, but active duration management may be more important than it has been for years – the margin of error is so much smaller. Put another way, bonds are not “riskless”;

2.      Stocks offer better total return opportunity over the next few years but the path will not be smooth.  The list of potential problems is long, and largely relates to unpredictable geopolitical events.  Still, valuations on most sectors are more compelling than they have been in years, especially versus the alternatives;

3.      “It has never been more expensive to be defensive.”  The goal of true investment management should be to maximize real returns.  Even though inflation is low, it is still positive, and staying in cash means loss of real purchasing power;

4.      Alternative investments could help   However, even this sector is not a panacea, since it too will be volatile, and a longer term perspective is important;


Tuesday, February 28, 2012

S&P 1800?

"Could stocks be cheap?"

Dan McCrum had an interesting column in last Saturday's Financial Times.

Unlike the usual discussion of how financial Armageddon is right around the corner (please see yesterday's Random Glenings post), McCrum walks through the math of how the S&P could actually be undervalued at current levels.

I'll discuss his logic more fully below, but here's how he concludes his column:

So, come 2014, the companies of the S&P {500} might produce $125 or $130 of net profits. Perhaps they won't start to buy each other, pushing up valuations, and maybe savers will continue to prefer the safety of bonds even as inflation eats away at their nest egg.  But at 14 times earnings that would still translate into a market above 1,800.

Perhaps 2012 will be the year of missed opportunity?

What, I hear you say, how can this be?  Aren't you worried about the euro; Iran; budget deficits; and a lethargic housing market?  

How can you possibly say that stocks could rise more than +30% from current levels?

Well, the logic is fairly straightforward.

Yes, we are probably in a slow-growth world for a while.

McCrum assumes that the emerging markets will grow 4% to 6% in the next few years, which is actually below recent rates of growth.  Developed markets, meanwhile, will probably only grow at a +2% pace, also below historic trends.

All told, the overall average rate of growth for the global economies could run at +3% per annum.  Nothing too aggressive in this assumption.

Now, if the top line of the companies in the S&P mirror the global growth rates, revenues should grow at +3% per year for the next few years.

If this is the case, and company margins are maintained at around current levels (or slightly lower), earnings should grow at +6% a year.

With corporate cash levels at record high levels - about $2 trillion, at last count - the trend towards share buybacks should continue, despite the fact that many investors would prefer higher dividend payouts.

If corporations continue to buy shares back at current rates, earnings per share could easily grow at +8% a year for the next few years.

OK:  3% top line growth, 8% earnings per share.  What does this mean in terms of the market?

Consensus earnings estimates for the S&P 500 this year indicate that analysts expect the composite to earn $103 in 2012.  This, by the way, is no change from 2011, and I think this could be too pessimistic.


Now, assuming that the S&P earnings grow at +8% per year in 2013 and 2014. This translates into 2014 earnings of more than $120. 

Putting a 14x earnings multiple on $120 yields a S&P level of nearly 1700. 

If 2012 earnings return to the last five years trend growth rate of +3% per year, this gets 2014 earnings closer to $125, which gets you to McCrum's level of 1800 on the S&P (14 x $125 = $1750).

Now, the bears will argue that assuming a 14x earnings multiple is too high, despite the fact that:
  • the median S&P multiple for the last 20 years has been 18x;
  • the lowest S&P multiple (in 2009) was 11x;
  • the Fed has already announced that it will keep interest rates historically low through the end of 2014.
In other words, I think that 14x is fairly conservative in today's low interest rate environment.

Of course there's lots that can go wrong.  However, I would challenge the uber-bears on the world and the markets to walk me through how exactly they believe stocks will continue to disappoint.

An S&P level of 1750 in 2014 would only be +13% higher than the S&P in 2007, when earnings were $90 for the index.

The S&P was also around 1550 in 2000, when earnings were around $50, but the multiple at that time was still in the throes of the "bubble era".

Or, put it another way, there's probably more opportunity than risk in today's markets, despite the recent run-up.

Monday, February 27, 2012

Where Are the Bulls?

I was on vacation last week - the skiing was surprisingly good in Maine, by the way - so I spent the weekend trying to get caught up.


Warren Buffett's annual letter to shareholders was released on Saturday.  The press already reported some of the highlights - most notably, that he has appointed a successor but not yet released their name - but I urge you to read the whole letter.

One of the great parts of reading Buffett's letters is that he has a way of framing complex investment decisions in a clear, concise fashion that make it easy for most readers to follow.

For example, many of us (including me, unfortunately) tend to equate rising stock prices with investment success. 

However, Buffett argues that a true investor - someone with a long-term time horizon - should actually hope that the prices of stocks declines, so that attractive businesses can be purchased at lower costs:

The logic is simple:  If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rises.  You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those that will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who after the price of gas increases, simply because his tank contains a day's supply.

Buffett goes on to urge readers to go back to the basics, through a re-reading of Benjamin Graham's investment classic The Intelligent Investor.

I first read Graham 30 years ago, but I picked up the book again yesterday, after reading Buffett.  I had forgotten what a terrific read it is, and so I have decided to take the Oracle's advice, and will begin studying Buffett's former professor's book again.


Another part of what makes reading Buffett so refreshing is that he is upbeat and generally optimistic.

This is in stark contrast to most of the investment community, that seems to almost hoping for the markets to collapse so that their dire view of the world can be vindicated.

Jeremy Grantham of the investment firm GMO, for example, is someone who I have long admired and respected for his work.

But his most recent quarterly letter is so dire and unhappy that I fear for his health.  He finds little of investment anywhere, but leaves the question of what anyone who is trying to invest for retirement left unanswered.

Grantham is positively sunny, however, when compared to noted bond specialist Jeffrey Gundlach of DoubleLine Capital LP.

Gundlach - whose investment results in the fixed income arena are near the top of his competitive universe - now compares the United States to the last days of the Roman Empire, and foresees a similar fate for our country.  Unfortunately I could not post his company's exhibits on this site for copyright issues, but if you want to become truly depressed please feel free to do a quick Google search.


What's interesting about the plethora of bearish commentators that I read this weekend their underlying assumption that everyone else is so bullish.

Other than Buffett, however, I found little evidence of any euphoria, or even good spirits, in my weekend reading.

Moreover, it seems that the public doesn't believe the most recent market rise either.

For example, according to Merrill Lynch, domestic equity mutual funds just experienced their largest outflows in 10 weeks.  Most of this money is flowing right back into bond mutual funds, despite the fact most bond yields are now below inflation rates.

Moreover, according to Bloomberg, stocks are now near their cheapest level ever compared to bonds:
Earnings in the S&P 500 have more than doubled to $96.58 since 2009 and are projected to reach a record $104.28 this year, more than 11,000 analyst estimates compiled by Bloomberg show. The earnings yield, or annual profits divided by price, climbed to 7.1 percent, 5 percentage points more than the rate on 10-year Treasuries. That’s wider than in 97 percent of months in 50 years of Bloomberg data. 

I will be posting more thoughts this week, but for now I see no need to change my essentially bullish stance on stocks.

Friday, February 17, 2012

Consumer Staples Stocks: An Idea Gone Cold?

Tennis Anyone?
Random Glenings will not be published next week as the author will be on vacation.  Next post will be February 27.

One of best performing sectors in the stock market last year was the consumer staples area.

Investors flocked to companies like Coca-Cola; General Mills; and Procter & Gamble due to their relatively attractive valuations and handsome dividend yields.

Moreover, the thinking went, the products these companies offer are less vulnerable to economic shocks, thus making them the ideal choice for conservative stock investors.

Problem is, at some level any stock, even ones in stable business models, can become overpriced, and vulnerable to periods of weakness or sharp corrections.

Consumer staples stocks in the month of January fell by -1.7%, lagging the +4.5% rise in the S&P 500.

 Only two other sectors - the "safe" utilities and telecom sectors - were worse performances for the first month of 2012.

February has also largely proved to be unkind to the staples's sector.

Not only is the sector continuing to lag the broader market averages, but unwelcome (i.e. poor) earnings reports from Smucker's; General Mills; and Pepsi have all caused significant price drops in a group that was not supposed to be vulnerable.

The problems that many of these companies are facing relates to a very price-sensitive consumer.  Smucker's, for example, raised the price of its peanut butter Jif fairly significantly in the fourth quarter of 2011 to reflect the higher costs of peanuts.  However, at some price,  even "choosy mothers" will choose a generic peanut butter rather than branded, and so sales of Jif have suffered significantly in recent weeks.

Despite their recent weakness, most consumer stocks still are trading at a significant price/earnings premium to the broader market indices.  Many of these premium valuations are also at historic highs relative to the experience of the last decade.

Coca-Cola, for example, still trades a P/E that is 40% higher than the S&P 500.  It has only traded at this level twice in the last decade (2002 and 2008), and both times the stock fared poorly in the subsequent 12 months.  Other stocks in the group have a similar pattern.

The book of Ecclesiastes in the Bible teaches us that "there is a time for everything, and a season for every activity under heaven".

It might be that for now, at least, this is not the season for the consumer staples sector.

Thursday, February 16, 2012

Update on IRA Legislation

I wanted to make sure that you saw this piece from Deborah Jacobs regarding potential legislation regarding IRA's.

Ms. Jacobs is a columnist for Forbes as well as the author of a terrific resource guide to financial planning titled Estate Planning Smarts.

If you are at all interested in preserving your assets for the next generation, or even making sure that your portfolios are set up in the most tax-advantaged manner, I urge you to buy Ms. Jacobs's book.

IRA's have become a very popular means of saving for retirement in large part due to their tax efficiency.

IRA holders do not need to withdraw funds until they are at least 70 1/2, which means that the investments in the portfolio are free to grow tax-deferred.  When distributions are made from an IRA, of course, they are taxed at ordinary income rates, based on the life expectancy of the account holder.

There are lots of clever estate planning techniques using IRA's that individuals can utilize to minimize the tax bite from Uncle Sam. One way that many individuals have maximized the tax benefits of their IRA's has been to change the beneficiaries of their IRA to be the youngest possible heir. This technique thus "stretches" the tax benefits of their IRA.

As Ms. Jacobs writes:

Before Congress created Roth IRAs, the term “stretch IRA” was used to describe the strategy in which a spouse, child or grandchild inherits a traditional pretax IRA and then draws out distributions (and hence tax deferral) over his or her own life expectancy. The longer the life expectancy, the smaller–as a percentage of the IRA balance–each payout must be.

With a traditional IRA the money is taxed as it is taken out of the IRA wrapper, whether by the account owner or beneficiaries. So stretching out the IRA gives the funds extra years–potentially decades–to compound tax-deferred–a wonderful investment opportunity

However, what Congress creates, it can also change.  Apparently there is a move afoot in the House to force any holder of an inherited IRA to withdraw the entire value of the IRA within five years after the holder's death.  The only exception to this new rule - if enacted - would be if the inherited IRA is a Roth IRA.

Why make the change?  Taxes.

By forcing accelerated withdrawals from an inherited IRA, or making the original owner convert their traditional IRA to a Roth IRA, the day of reckoning in terms of taxes is moved up considerably.

Let's hope this bill is not passed.  At the same time, the very fact that it has been introduced with relatively little fanfare is perhaps an indication of the subtle ways that taxes will begin to be raised in the years ahead.

Wednesday, February 15, 2012

John Malone, Apple, and the Future of IT Hardware

In 1973, John Malone started a cable company named Tele-Communications Inc. (later shortened to TCI).

From a modest start, Malone relentlessly built his business, eventually becoming a billionaire in the process (trivia fact: Malone today is the largest private land owner in the United States, owning more than 2 million acres of land.)

Malone resigned as chairman of TCI in 1996, but not before establishing a reputation as a shrewd and ruthless cable operator.

Former Vice President Al Gore dubbed Malone "Darth Vader" due to his insistence that his company receive equity stakes in the cable programming services in exchange for carrying the content.

But here's the thing:  Malone hated the cable business.

He hated the fact that every time he wanted to raise prices he had to go before the local cable boards and, as he put it, "get my ass chewed out".

Malone hated the fact that he was constantly barraged by complaints about the service quality, even while communities tried to prevent him from recovering his costs to upgrade his equipment.

No, what John Malone really liked was the content business.

Eventually he got out of the cable business (selling at a handsome profit) and concentrated his efforts in a company called Liberty Media.  Liberty today owns a number of programming companies, including the Discover Channel, USA Network and Encore.

In other words, in John Malone's world, content is king, and the equipment is a means to getting his programming shown (and paid for).

I mention all of this today as a follow-up to my post yesterday about Apple.

Apple has taken the direct opposite approach that John Malone followed.  Content - music, videos, etc. - is for Apple merely a way to sell more equipment.  The company barely makes money on iTunes, for example, but without iTunes who would want an iPod?

Apple is a device company, not a content company.  The legacy of Steve Jobs is that the company is focused on developing "insanely great" products.

What Apple doesn't focus on is their stock price.

 UBS analyst Maynard Um told  a group of us yesterday that Apple's attitude towards Wall Street is indifference at best.  Financial people at Apple are second-class citizens, and considerations like dividends and stock buy-backs are generally afterthoughts.

Maynard also described how eventually Apple may be vulnerable.

At the present time, accessing information in the "cloud" is controlled by the hardware manufacturers.  For example, I have information on iCloud that can be accessed on either my iPhone, iPad or Mac (OK, I'm an Apple fan,).  However, I can't access my information on the iCloud on the Dell that I use at work.

But this will eventually change. As more information is in the cloud, consumers will eventually become resistant to using only one manufacturer's devices to get their data.  This means that the premium prices that Apple is currently able to charge for it products will eventually be forced to be cut, in Maynard's opinion.

That said, Maynard thinks that the pressure on Apple will not occur for some time.  All of the manufacturers have a vested interest in the current system, and have no interest in seeing device prices come under pressure if they become commoditized.

But if John Malone is right, and content is king, the fate of Apple and the other IT manufacturers will rest on their ability to integrate everything yet continue to earn terrific financial returns.

Tuesday, February 14, 2012


Last October, just after Steve Jobs died, I went to go hear Ben Reitzes of Barclays Capital talk about the Information Technology (IT) Hardware stocks.

Ben is a very good analyst, and his thoughts have always been useful to me in helping me find attractive technology stocks.  But his remarks that day were very different than most analyst comments, and proved to be remarkably prescient.

Ben's favorite stock pick in his group has been Apple.  In fact, Apple has been his number 1 pick for at least the last two years, if not longer.

"The problem you are facing," Ben said, gesturing to the assembled group of portfolio managers, "is that you cannot own enough Apple stock."

"Apple controls the entire IT space.  They dominate in music and tablets. Demand for the iPhone remains robust, despite threats from Google," Ben continued. "You  should have at least 5% to 10% of your portfolio invested in Apple stock, but you probably won't simply because of diversification requirements."

"But I'm telling you:  Apple is truly the only IT stock to own."

Most of us took issue with Ben's comments.  After all, the loss of Steve Jobs would be devastating to Apple - look what happened to Disney stock after Walt Disney died. And the sheer size of Apple - at that time nearly $400 billion - would surely begin to retard its growth rate?

Ben was undeterred.

Apple was big, but its prospects were ridiculously good.  A host of new products - including a foray into television - were coming up in the next year that would give Apple another leg higher.

Moreover, Apple was trading only 12x 2012 estimated earnings, which was a discount to the overall market (as it still is today).

Since that October meeting, Apple has soared +27%.

In the fourth quarter alone, Apple earned nearly $18 billion in free cash flow, and its cash hoard now stands at nearly $100 billion.

And yesterday, Apple stock traded briefly above $500.  With a market cap of $467 billion, Apple is now the most valuable company on the planet.

There will be a time to sell Apple stock, as there is with all stocks.  The products it makes - electronic equipment - are constantly being challenged by strong and innovative companies. There are doubtlessly new and innovative small companies that today are developing products that will someday challenge Apple's dominance.

Ben Reitzes put out a research piece this morning telling clients that Apple can still grow further.  He cites a new iPad that is scheduled to come out in the spring, as well as iPhone 5.  There are new Macs coming out, including a new MacBook.

Oh, and if Apple decides to use some of its cash to pay a dividend - which seems fairly logical, in my opinion - the stock could become even more attractive.

My natural instinct is to worry about companies like Apple, whose fame and following has become so strong.  But for now I think I should just listen to Ben, and enjoy the ride.

Monday, February 13, 2012

Starting Points Matter

From an article dated April 2, 2010:

"Starting and endpoints matter," Steve Galbraith, partner of Maverick Capital observed in pointing to a graph of S&P returns over the past 75 year, "and we started from a ridiculously blown-up level. But the reality is, even with the rally we've just had in the markets, this has been the second-worst decade ever for stocks.  And I'd much rather be investing now than 10 years ago."

 After I published my post on Friday comparing the returns of stocks, gold and cash over the span of my 30-year career, one of my colleagues challenged my methodology.

"Look, you 'gamed' the results", he said with a smile. "The 1980's and 1990's were some of the best years for stock market returns in U.S. history.  What if you changed the starting date? Would stock returns have been as attractive in a different period?"

Fair enough.  As the quote from Steve Galbraith says, starting and end points matter a great deal.  If you choose your time period correctly, you can "prove" the superiority of any asset class.

So let's concede my friend's point, and look at the returns from two other periods. But I can't help but make a few observations first.

True, the 1980's and 1990's were terrific times to be investing in stocks - or bonds, for that matter.  But it is also true that the last 12 years have been particularly poor ones for equity returns.

Cash returns have also been remarkably low during the last few years, reflecting both Fed policy as well as the deflationary trends sweeping our economy.  The total return from Treasury bills, for example, has been less than 0.5% in total for the last three years.  This is as bad as the rates that savers earned in the 1930's. 

The trend in gold prices was either flat to down for most of the last 30 years.  For example, the average gold price was $376 an ounce in 1982, and $310 in 2002.  Most of the rapid rise in gold prices has occurred since 2006, when the full fury of the financial crisis hit the world's markets.

So with these caveats in mind - poor returns from cash and stocks over the last decade, and a meteoric rise in gold prices for the last 5 years - let's take a look at some other periods of time.

If you invested $100 in all of the asset classes 20 years ago, here's where you would have stood at the end of 2011:

Cash  $188
Gold  $433
Stocks $446

Here again, stocks are the winner, although the advantage is considerably less.  What is clear, however, is that "playing it safe" was the clear loser.

What the gold bugs will point to is the past 10 years, when gold clearly was the winner:

Cash   $120
Gold  $560
Stocks $133

So if you had been smart enough to buy gold 10 years ago, what would you do today?

Friday, February 10, 2012

Warren And Me: Comparing Stocks, Gold and Cash

Warren Buffett has a piece in Fortune discussing why stocks continue to make sense for anyone with a long term time horizon. 

I urge you to read the whole piece. In typical Buffett fashion, he explains why the current mania for gold makes no sense for most investors.

He also politely disses bonds, quoting Wall Street investor Shelby Davis as saying,

"Bonds promoted as offering risk-free returns are now priced to deliver return-free risk."

As I discussed earlier this week, I went to an investor meeting here in Boston which discussed the investment merits of gold.  To my surprise, nearly the entire audience thought that gold should play a role in most investors' portfolios. Most investment professionals strongly believe that today's easy global monetary policies will inevitably lead to future inflationary pressures.

Buffett does not dispute the widely-held notion that paper currencies rarely hold their value in history, noting:

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as "income."

But would gold have helped investors concerned about maintaining real (i.e. inflation-adjusted) purchasing power?

Not surprisingly, Buffett says no. He cites the simple truth that stocks since 1965 have returned nearly +36% more than gold even after the miserable equity markets for the past decade.

I started in the business a little later than Warren Buffett, in 1982.  But I decided to copy Buffett (never a bad idea, by the way), and look at what investments would have done the best job of protecting me from inflation over the course of my career.

Although recent inflation rates have been relatively low, the real purchasing power of $1 dollar has fallen by nearly 60% since 1982.

The rate of inflation over the past 30 years (as measured by the CPI) has run at about 3% annually during the period.  If you are concerned about "maximizing real returns", it seems reasonable that at a minimum you should be targeting 3%.

If I had invested $100 in 1982, my savings would have had to grown to at least $240 by the end of 2011 in order to have maintained the same purchasing power as when I started.  In other words, I would have to earned 2 1/2x my original investment - after taxes and fees - to be as wealthy I was 30 years ago.

Money market funds were the rage in the early 1980's.  Unlike current Fed policy, interest rates had been ratched to record high levels to try to slay the inflation dragon.  Money market funds offered yields higher than 15% when I started in the business, and nearly all the "experts" agreed that this was an appropriate place for the average investor.

Gold also had recently completed a record run. After President Nixon took the United States currency off the gold standard in 1971, gold moved quickly from $35 an ounce to a peak of $850 in 1980.  Some of the bloom had come off the gold blossom by the time I started investing in 1982, but still the average gold price at the beginning of my career was around $400 an ounce.

Stocks were unloved.  Articles written by academicians noted that stocks had proven to be a very poor hedge against the inflationary pressures of the 1970's, and it was hard to find anyone that was excited about the prospects for stocks at the beginning of 1982.

So given the choices - cash; gold; or stocks - what was the correct decision?

Well, I did the math, and here's what $100 invested at the beginning of 1982 would be worth today:

Cash  $400

Gold  $418

Stocks $2,228

Ah, I can hear you say, this is an unfair comparison, because stocks did so well in the 1980's and 1990's. What if you changed the starting period?

I'll address that question in my next posting.

Thursday, February 9, 2012

What If the Markets Continue to Move Higher?

The markets are off to a strong start this year.

The S&P 500 is up more than +7% year-to-date, while foreign markets are generally up even more.

Although the economic news is undeniably getting better - last Friday's positive jobs report, for example, marked the 23rd consecutive month of positive job creation - the chorus of analysts and economists "fighting the tape" has grown ever louder.

After such a quick move higher, it does seem likely that we could see a mild market correction at some point.  But I think any correction would present an buying opportunity.

The problem with many of my investment management brethren, in my opinion, is that most share a fairly cynical view of the world.  After the last decade of feeble equity market returns, it is a much more comfortable stance to worry about all of the possible ways that the economy and markets could nosedive again.

But The Economist carried a blog a couple of days ago that asked a fairly provocative question:  If, in 2008, the Fed had stepped in and bailed out Lehman Brothers rather than let it fail, could the subsequent market collapse been avoided?

Or, put another way, what if the combined efforts of the European Central Bank and the Fed have staved off economic disaster in Europe at the end of last year?

If a Lehman-type collapse is no longer possible - at least for the near term -  is it possible the global markets could have a serious move higher based on the massive amounts of liquidity in the system?

To me, this is really what is going on in the markets right now.  Cash and bonds offer unappealing returns, making stocks the only game in town for anyone investing for the future.  The economy may not be robust, but it is going in the right direction, and for now that might just be good enough.

Here's an excerpt from the Economist piece:

And then it's impossible not to wonder: should Lehman have been saved? How might things have been different if the Fed had simply thrown gobs of money at the financial system? How might the euro crisis have gone differently? It's surprising how difficult it is to avoid thinking about the situation moralistically—to feel that there was indeed something good and purging in the near-collapse of the financial system. There wasn't, though. Lehman's shareholders were punished severely, but the vast majority of financial institutions made it through all right, despite the fact that their behaviour hadn't been much better than the victims'. And meanwhile, millions of workers and businesses suffered tremendously despite having done nothing wrong.

Still, what the central bankers giveth, they can also remove, as this Liam Halligan wrote earlier this week in the London Telegraph:

It must be said, though, that this shift in market sentiment was not sparked by any improvement in the economic fundamentals. What we’re seeing in the macro numbers, on the contrary, is evidence of further European economic deceleration and a rising chance of recession in some of the world’s biggest economies. 

What caused this rally, of course, was very explicit reassurances that the “big four” global central banks (the US Federal Reserve, the Bank of Japan, the Bank of England and, increasingly, the European Central Bank) will keep providing practically unlimited funds at interest rates close to zero. 

At the end of last year, the ECB pumped the best part of half a trillion euros of credits into the eurozone’s addled banking system. The markets expect that, now the Rubicon has been crossed, and German Chancellor Angela Merkel “finally gets it”, there will be much, much more to come. This outcome is now not so much a working assumption among traders, but more an article of faith.

In the end, money moves stock prices, not economic data or political rhetoric. 

And right now that money is moving into stocks.

Wednesday, February 8, 2012

"Gold Is the Courtesan of the Investment World"

From Fortune Magazine dated October 19,2010:

"Look," {Warren Buffett} says, with his usual confident laugh. "You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

Okay, so gold is not a screaming buy to Buffett. What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?

"Equities," Buffett answers without a moment's hesitation.

Yesterday the Boston Security Analysts Society held a luncheon presentation on investing in gold.

The title of the talk was "Bull vs. Bear - Gold".  Eric Biegelesisen from Windhaven Investment Management presented the bull case for gold investing, while Edward Chancellor from institutional investment manager GMO presented the bear case.

It was a very informative session, with both Eric and Ed presenting very coherent and thoughtful remarks on their particular point of view.  What I thought I would share today are some of the highlights of the hour-long presentation.

Before the talks started, the moderator posed a question to the room:

"How many of you believe that gold should play a role in client portfolios?"

To my surprise, nearly every hand in the room went up. 

Boston has never been known as "gold bug" haven but clearly the events of the last few years have chastened investors who previously stuck to more conventional bonds and stocks.

Eric's case for gold should be a familiar one to anyone who reads the financial press. 

Gold historically has been a store of value in inflationary times, or in times of political uncertainty. While inflation is not an issue today, many believe the hyper-expansive monetary policies of central banks around the world will inevitably lead to upward pressures on prices.

Gold is also fairly limited in supply. If  you took all the gold in the world that has ever been mined it will fill up one Olympic-sized swimming pool, as Warren Buffett noted.  Gold  also is only one of five elements on the Periodic Table that will not change its physical characteristics over long periods of time.

Gold, of course, is used by many central banks as a vehicle for storing wealth.

Finally, gold is highly desired by Asian investors, who have been large buyers of the metal.  With the rapid creation of wealth in countries like China, demand for gold will be constant, if not increasing, meaning that any weakness in gold prices will be met by strong demand from the Far East.

Ed did not necessarily disagree with any of Eric's thoughts, but rather felt that gold prices had gotten ahead of reality.

There is a time, Ed noted, that gold should be bought - but that time is when it is fairly valued, which it is not today.  In his opinion, gold should be priced around $450 an ounce, not $1,700, based on simply regressing the price of gold back through time to the present.

The problem, Ed said, is that the value of gold is essentially unknowable, since it does not offer any sort of income stream that can be discounted back to the present.

Gold has no industrial uses, nor can it be used as a medium of exchange.  Instead, gold is mined from the ground, polished, placed in vaults and guarded in  the hope that someday it will be worth more than its purchase price.

Gold's recent meteoric price rise has been driven by the historically low level of interest rates, in Ed's opinion.  With yields on cash so low, the opportunity cost of holding gold is minimal.

Ed said, look, if you're concerned about inflationary pressures, why not simply buy inflation-protected Treasury notes?  Or even high quality dividend-paying stocks, that at least can raise payouts if inflation rises.

Ed - who is the author of several books, and writes a regular column for the Financial Times - had a line that I thought was great:

"Gold is the courtesan of the financial markets - it is all things to all people. Concerned about central banks and the fallibility of paper currencies? Gold is the answer. Worried about holding value? Gold to the rescue.  Inflation? Gold again. Think the stock market is vulnerable?  Gold can help.  But can it honestly be all of this to all people?"

Finally, Ed cited a study by Goldman Sachs that studied the price of gold going back to 1265 using the U.K. pound sterling.  In this work, on a inflation-adjusted basis, gold has been at this level only twice in the last 800 years.  Buying gold today - at the wrong price, in Ed's opinion - means you might have to wait several hundred years to achieve a satisfactory return.

The audience was largely unmoved by Ed's remarks. The tone of the questions ranged from skeptical to almost hostile, mostly directed at Ed.  The group yesterday takes their gold views seriously, and don't want to be told that they are being swept up in an unsustainable bubble.

But I must confess that I was more convinced by Ed's comments than Eric's.  Gold might be an interesting trade, but the widespread enthusiasm for the metal makes me nervous.

I was also struck by Ed's aside that most people today are buying gold through the Gold ETF.  If one is truly concerned about government interference in the private markets, suggested Ed, what makes one think that the convertability of a gold ETF into the bullion would be allowed by governments if there truly was a moment of crisis?

Tuesday, February 7, 2012

Emerging Markets Update


The Financial Times has two articles this morning discussing the sudden investor appetite for stocks and bonds from the emerging markets.

The chart to the left of this piece visually illustrates what happens when investor sentiment changes from "risk off" to "risk on" in the emerging markets.

What I am showing here is the price action of the Vanguard exchange-traded fund (ETF) that invests in stocks emerging market countries like Brazil; South Korea; China; Taiwan; and South Africa.  The ticker for the funds is VWO.

 As you can see, the last couple of years have been quite a ride for investors, with VWO trading a 40% wide trading range.

More recently, from the lows reached last October, VWO is up nearly +18% through yesterday  Still, VWO is trading 14% below where it was in April 2011, and 25% lower than the all-time highs in October 2007.

VWO is currently trading at less than 10x estimated earnings for 2012, which makes it one of the cheaper sectors of the global stock markets.

Hence the investor interest.

Here's what the Financial Times wrote:

Money has poured into emerging markets this year, with funds dedicated to the asset class enjoying their best start to a year since 2006 amid continued investor wariness over developed markets.

Emerging market equity funds, which fell out of favor for much of last year, attracted $3.5bn in the week ending February 1, the most in almost a year, taking the total inflows this year to $11.3bn, according to EPFR Global, a data provider.

Emerging market bond funds saw inflows of $1.2 bn last week, the most since March last year. Buoyed by the renewed surge in capital inflows, emerging market currencies have also enjoyed a strong start to the year.

The FT also has a second piece titled "Brazilian Equities Burst Back Into Life in Global Rally".  The article notes that both the Brazilian stock market and economy are showing signs of a very strong rebound from the lethargy they had settled in last fall.

Both articles, of course, quote the usual cautionary commentary from global strategists, noting that markets that show such strong short term moves are often vulnerable to corrections.

This is true, of course, and price action in the emerging market bourses are usually more volatile than in the developed markets.

But still I think that 2012 could shape up well for the emerging markets for  a couple of reasons besides valuation.

First, the currencies of most emerging market countries can be much more readily controlled by government action than the more developed nations.  Last year, for example, both Brazil and China were aggressively tightening monetary policy to try to contain inflationary pressures.  The medicine worked:  their economies slowed significantly by late summer.  Now, however, both countries are trying to revive economic activity, and I suspect they will be successful.
Second, commodity prices play a much greater role in the daily lives of the citizens of the emerging economies. Ned Davis Research indicates that nearly 50% of the discretionary income of consumers are devoted to food and fuel costs, as opposed to only 15% in the developed nations.  With most commodity prices significantly lower than a year ago, there should be more money available to go into other parts of their respective economies.