Monday, April 30, 2012

Two Princeton Professors Have At It

If you grew up as I did - with two professors as parents - you learn pretty quickly that intellectual arguments in academia can be pretty intense.

Henry Kissinger once famously observed that "University politics are vicious precisely because the stakes are so small." Professors tend to be very smart, very opinionated, and not afraid to challenge authority, especially if they have tenure.

Before he became chairman of the Federal Reserve, Ben Bernanke was chairman of the economics department at Princeton University. Among the professors that Dr. Bernanke recruited and hired for Princeton was Paul Krugman, the Nobel Prize winning economist who also writes frequently for the New York Times.

Krugman has become a frequent critic of his former department chair's policies.  He feels that the Fed should be doing more to spur economic growth in the U.S. through more aggressive use of monetary policy.

Dr. Krugman has written a book entitled "End this Depression Now!" that is scheduled to be published in May.  An article adapted from his book was written in yesterday's New York Times magazine.

Krugman argues that there is a major disconnect between what Professor Bernanke thought monetary policy could accomplish, and what Chairman Bernanke is actually doing as head of the Federal Reserve.

He notes that Bernanke was very vocal in his criticism of the Bank of Japan throughout much of the 1990's for what Bernanke perceived to be a timid response to Japan's economic woes.

However, now that he is head of our country's central bank, Krugman believes that Bernanke is acting more like the bank mandarins in Japan that he once attacked.

Here's an excerpt:

The Bernanke Conundrum — the divergence between what Professor Bernanke advocated and what Chairman Bernanke has actually done — can be reconciled in a few possible ways. Maybe Professor Bernanke was wrong, and there’s nothing more a policy maker in this situation can do. Maybe politics are the impediment, and Chairman Bernanke has been forced to hide his inner professor. Or maybe the onetime academic has been assimilated by the Fed Borg and turned into a conventional central banker. Whichever account you prefer, however, the fact is that the Fed isn’t doing the job many economists expected it to do, and a result is mass suffering for American workers.

Last Thursday, at a regular press conference, Chairman Bernanke was asked to comment on his former colleague's views.

Ezra Klein of the Washington Post reported Bernanke's thoughts.  It's a fairly long quote, but I think it is worth repeating here:

There’s this view circulating that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies...the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation. And clearly, when you’re in deflation and in recession, then both sides of your mandate, so to speak, are demanding additional accommodation. In this case, we are not in deflation. We have an inflation rate that’s close to our objective.

Now, why don’t we do more? Well, first, I would again reiterate that we are doing a great deal -- policies extraordinarily accommodative; we -- and I won’t go through the list again, but you know all the things that we have done -- to try to provide support to the economy.

I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased pace of reduction in the unemployment rate? The view of the committee is that that would be very reckless. We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.

Far be it from me to get in the middle of an intellectual squabble between two eminent economists (my parents taught me well!), but here's my two cents:

It seems to me that the Fed has done an extraordinary amount under very difficult circumstances.  While it is easy to write from Princeton that the Fed should do more, recall that Bernanke's confirmation hearing was not an easy one, and his Senate approval was only a tepid victory.

Moreover, I am not sure that lower interest rates really would accomplish that much more.  Mortgage rates, for example, are already at historic lows, and housing affordability is at near-record highs.  Lower rates have allowed corporations to borrow at very attractive levels, yet much of the cash still sits on the sidelines.  Monetary policy cannot force companies to invest in plant and equipment that they do not need.

 Oh, by the way, whatever happened to using fiscal policy for economic stimulus?

Friday, April 27, 2012

For Every Season There is A Season

Dividend-paying stocks were the rage last year.

With bond yields plunging to 60-year lows, and the Fed signaling that it would keep short term borrowing rates at essentially 0% until at least the end of 2014, yield-hungry investors headed for stock market in search of income.

And so, in 2011, investing in stocks that paid the highest dividend yields was a "home run".  According to Merrill Lynch, high dividend paying stocks produced a total return of +18.5% last year, which included a price return of +12.6%.

Problem was, as so often happens, good ideas in the stock market are taken to extremes, and investors adjust.

The first quarter of 2012 was a miserable one for dividend-paying stocks.

While the S&P 500 was roaring ahead by nearly +13%, dividend-payers were punk performers, up a minor +3% total return for the quarter (again based on Merrill Lynch numbers).

So should you abandon the idea of investing in stocks that pay high dividends?

I don't think so, and neither does the Lex Column in today's Financial Times (the added emphasis is mine):

Yesterday, PepsiCo, ExxonMobil, Dow Chemical, Colgate-Palmolive and Kellogg all reported.  A mixed bag to be sure. But they share more than just being household names.

One thing that binds these companies together - as well as distinquishing them from the latest upstarts - is an obvious commitment to dividends.  Exxon increased its distribution by 7 per cent against 2011 and Dow said it would lift its dividend 28 per cent in the second quarter.  Even struggling Kellogg gave shareholders 3 cents more than last year. Colgate's payout ratio is 10 percentage points higher than it was a decade ago.  Theory says that dividends do not matter.  But the total return of each stock has either matched or trounced the S&P 500 index over the past 10 years.

Well put.

Thursday, April 26, 2012

Implications of the Third Industrial Revolution

Last week's Economist magazine carries a lengthy article about the the changes in global manufacturing.

I strongly encourage you to read the whole piece; it's very well-written, and also offers a number of interesting insights about how technology has transformed the way items are made and distributed.

Here's an excerpt:

Everything in the factories of the future will be run by smarter software. Digitisation in manufacturing will have a disruptive effect every bit as big as in other industries that have gone digital, such as office equipment, telecoms, photography, music, publishing and films. And the effects will not be confined to large manufacturers; indeed, they will need to watch out because much of what is coming will empower small and medium-sized firms and individual entrepreneurs. Launching novel products will become easier and cheaper. Communities offering 3D printing and other production services that are a bit like Facebook are already forming online—a new phenomenon which might be called social manufacturing.

The consequences of all these changes, this report will argue, amount to a third industrial revolution. The first began in Britain in the late 18th century with the mechanisation of the textile industry. In the following decades the use of machines to make things, instead of crafting them by hand, spread around the world. The second industrial revolution began in America in the early 20th century with the assembly line, which ushered in the era of mass production.

I was reminded of  the Economist's article earlier this week while I was listening to a presentation by Scott Davis.

Scott follows the U.S. Multi-Industry stocks for Barclays. This means that Scott tracks such companies as General Electric; 3M; Danaher; and Emerson.
I won't go into all of his thoughts - he's generally positive on the group, with "buys" on Honeywell; Tyco; and GE, among others - but I was struck by his comments on the global corporate environment.

Financial results so far for the industrial sector have been generally better than expected, especially in light of what is going on in Europe.  Scott said he has been pleasantly surprised that European sales trends have been essentially in-line with last year's results, despite all of the political turmoil and unusually cold winter.

Asia has been generally weaker than last year, but many of the countries are showing signs of revival (especially India), in Scott's opinion.

However, thanks to the incredible revolution in manufacturing processes, corporate earnings have continued to impress, for the most part.

At the same time, unemployment rates remain unacceptably high in most parts of Europe and the US.

The "third industrial revolution" may be good for corporations and their shareholders, but little benefit seems to be trickling down to the ordinary worker.

I noted with amazement yesterday the ability of Apple to ramp up production of its iPhones to nearly double the rate of a year ago, but I doubt that there was any need for a significant increase in workers.

This seems to be a common theme:  higher production does not mean more workers. Margins therefore can be maintained even if the environment is less than friendly, since output can be adjusted accordingly.

This in part explains the angst that many investors are experiencing.

The world feels bad - stagnant wages, civil unrest in Europe, etc. - yet corporate earnings continue to surprise on the upside.

For example, as of yesterday, of the 201 companies that have reported earnings in the S&P 500, 150 have beat earnings expectations, 26 have missed, and 25 have matched.

Can the stock market continue to rise even if the general living conditions do not improve?

For now, at least, the answer seems to be "yes".

Wednesday, April 25, 2012

Is Tim Cook the Real Hero at Apple?

Apple reported earnings last night, and they were simply astonishing.

Not surprisingly, the stock is up more than +9% at this writing - an amazing move for a stock with a market capitalization of more than $500 billion.

Oh, and not to mention that prior to today's move Apple stock was up +38% year-to-date.

Here's what the New York Times wrote this morning:

The company reported Tuesday that soaring sales of the iPhone, especially in China, helped Apple nearly double its profit in the company’s fiscal second quarter. 

Apple said it sold 35.1 million iPhones in the quarter, an 88 percent increase from the period a year ago. It sold 11.8 million iPads, more than double the number it sold in the same quarter last year. 

The article continues:

For the quarter that ended March 31, the company reported net income of $11.62 billion, or $12.30 a share, compared with $5.99 billion, or $6.40 a share, in the period a year earlier. 

Apple’s revenue was $39.19 billion, up from $24.67 billion a year ago.
Mr. Cook said that Apple’s quarterly revenue from China was $7.9 billion, about 20 percent of total company revenue. Furthermore, that was triple Apple’s China sales in the same period a year ago. In contrast, Apple’s China sales during its last fiscal year were about 12 percent of total revenue. Two years ago, Apple sales in China were 2 percent. 

There is so much to pause and digest in these figures that I could spend the rest of the day analyzing  the company.

But I am fixated on the company's ability to deliver 35 million iPhones, nearly double the pace of a year ago, as well as incredibly amount of iPads, more than two times the same amount of a year ago.

I can't prove it, but I would bet that nearly all of iPhones and iPads worked right out of the box.  

No design flaws, no excuses:  Apple products work.

This is the result of an incredible attention to detail in the the manufacturing of Apple products, lead by new CEO Tim Cook.

Steve Jobs was obviously the design genius behind Apple products, yet without the manufacturing sophistication to deliver massive quantities of high quality products Apple would not be the company it is today.

So what to do with the stock?

This is obviously a tough question.  The valuation of Apple is not out of line - at today's levels, it sports a price/earnings ratio of around 12x.  Relative to its incredible growth rate, Apple is arguably one of the cheapest stocks in the S&P 500.

It also now has an incredible $110 billion in cash reserves.  Although it recently announced that it will now pay a dividend that will offer a 1.8% yield to investors, from a financial standpoint Apple is the master of all it sees.

That said, there will be a time that Apple will fall to earth.

Here's what top ranked Bernstein analyst Toni Sacconaghi wrote this morning:

Despite strong Q2 results, we caution investors that revenue and EPS estimates for Q3 and Q4 may not increase, and note that relative to consensus, Apple's revenue guidance for FY Q3 was its 2nd most conservative in the last three years ; moreover, last time Apple gave guidance that was similarly conservative (for Q4 FY 11), it ultimately missed consensus revenues and EPS (which both of which had been revised upwards post-guidance).

But for now, if you're an equity manager trying to beat the S&P 500, it's tough to bet against Apple.

Tuesday, April 24, 2012

Surprise from Europe: Austerity Is Not Popular

The headline in this morning's Financial Times says it all:

"Leaders face austerity backlash"

Not surprisingly, most Europeans are not thrilled that they are being asked to accept a lower standard of living; high unemployment; fewer government services; and higher taxes.

Recent economic data released across Europe tell a recessionary tale.  Stock markets have also moved sharply lower - Spain's equity market, for example,  is now back to the lows seen in 2009.

So the question for U.S. investors is:  Does Europe matter?

In a global interconnected world, the obvious answer is that Europe matters very much.  However, here in the midst of earnings season, many U.S. companies are reporting earnings that are matching or bettering expectation.

Robin Wells wrote a column in today's London Guardian titled "European turmoil, American collateral".   In her piece she notes:

What are the implications for the US, economically and politically? Direct links between the US and eurozone economies are fairly minor: we don't export that much to them, they don't import that much from us, and US banks have had an extended time to cut their exposure to eurozone risk. Yet the collateral damage could still prove significant.

When the stock markets fall, consumer and business confidence falls, leading to cutbacks in spending – bad news for an American economy that is still mired in recession. In addition, crisis in Europe makes for a stronger US dollar, as investors flee to safer abodes. Again, bad for the economy as a stronger dollars hurts US exports.

I am inclined to agree with Ms. Wells.  The direct economic link between European angst and our economy may be more significant psychologically than in actual economic damage.

Still, psychology obviously plays a crucial role in financial market performance.  If investors begin to sense that Europe's troubles are spreading to our shores, it could make for a very long summer.

Monday, April 23, 2012

Report from Barcelona

My wife and I traveled to Barcelona in Spain last week.

We had a terrific time!

Barcelona is a beautiful city, rivaling Paris in some ways, in my opinion.  Christina and I spent hours just walking around through the streets, marveling at the architecture and occasionally grabbing a coffee at one of the outdoor cafes and watching the people stream by.

The city abounds with great museums, and the restaurants are first class. Our visit went by far too quickly, and hopefully we will get the chance to return someday.

But we were visitors, and so largely avoided seeing any signs of the very real economic problems confronting the Spanish citizens.

Spain is at the center of the most recent eurozone crisis. The Spanish government is desperately trying to comply with the demands of the European Central Bank in exchange for financial aid.  However, the pain that the austerity measures are inflicting are highly unpopular, and there have been numerous protests and riots in the streets of Barcelona.

And yet, as Paul Krugman pointed out in last week's New York Times, the problems in Spain are not the result of a profligate government.  Instead:

Consider the state of affairs in Spain, which is now the epicenter of the crisis. Never mind talk of recession; Spain is in full-on depression, with the overall unemployment rate at 23.6 percent, comparable to America at the depths of the Great Depression, and the youth unemployment rate over 50 percent. This can’t go on — and the realization that it can’t go on is what is sending Spanish borrowing costs ever higher. 

In a way, it doesn’t really matter how Spain got to this point — but for what it’s worth, the Spanish story bears no resemblance to the morality tales so popular among European officials, especially in Germany. Spain wasn’t fiscally profligate — on the eve of the crisis it had low debt and a budget surplus. Unfortunately, it also had an enormous housing bubble, a bubble made possible in large part by huge loans from German banks to their Spanish counterparts. When the bubble burst, the Spanish economy was left high and dry; Spain’s fiscal problems are a consequence of its depression, not its cause.

One thing that really struck me was how important the whole concept of the euro is not only to the Spanish citizens we spoke with, but also other Europeans that we had the chance to meet as well.

Euro flags abound in the city, and the euro is featured on all the license plates.  We met people from several different countries in Europe (the advantages of drinking great Spanish wine at tapas bars!), and all seemed very committed to the concept of the euro.  No one, it seems, wants to go back to the days of separate currencies and economic policies despite the current strains in the European union.

Too often, it seems to me, American commentators are quick to dismiss the euro as a failed experiment.  The euro is more than just a financial idea - it is a political structure that attempts to not only make the European economy competitive with the United States and China.

In other words, it seems to me that Europe is a long way from giving up on the euro and its member states.

Friday, April 13, 2012

Main Street to Wall Street: Drop Dead

Random Glenings will take a brief holiday rest next week.  My next post will be Monday, April 23.


Although the markets have lost a little ground so far in the month of April, the S&P 500 is still up almost +9% year-to-date, and nearly +25% for the last 6 months.

And while we are still early in earnings season, we have already seen some "upside earnings surprises" from such bellwether companies as JP Morgan; Alcoa; and Google.

Yet the general public is accelerating their departure from the stock market.

According to Michael Hartnett at Merrill Lynch, last week saw:

A week of risk capitulation.

Biggest outflows of 2012 for equities and commodities; first outflows of 2012 for High Yield and {Emerging Market} debt funds.

In contrast, inflows to Treasurys (largest since August 2011) and investment grade bonds.

In short, Main Street is giving a collective Bronx cheer to the investment community, which continues to sing the praises of stocks relative to bonds.

One of my colleagues told me that he has seen some data that indicated that nearly 80% of institutional investors had a positive view on the outlook for the stock market - but nearly the same percentage (80%) of individual investors had a negative view of the stock market.

In one way, this is not surprising:  the recent signs of economic strength have not translated in any meaningful way into either wage or job growth.

It's hard to get excited about stocks when you're worried about making ends meet.

Yet for retirement assets - which for most workers should have a long term time horizon - it seems that a majority of workers would rather earn less than 1% in a US Treasury or high grade corporate bond fund rather than stocks.

It will be interesting to see what happens when interest rates begin to rise.

I don't know when rates will rise meaningfully, but it only will take a small move higher to wipe out the coupon income for a year.

For example, the 10-year Treasury note yields around 2%. If the same note a year from now is yielding 2.25% - a tiny 25 basis point rise in interest rates - the capital loss of -2% will negate the coupon income for the entire year.

Now, if you buy a bond directly, as we do here at my bank, you will at least be assured that you will get your money back at maturity.

But there is no such comfort in buying a bond mutual fund, meaning that investors in bond funds could face significant losses in the years ahead.

Thursday, April 12, 2012

Should You "Sell in May and Go Away?"

I received a call yesterday from a concerned client.

"I have been speaking recently to a number of my smart friends" he said, "And all of them are getting out of the stock market."

"They tell me that they are worried about a number of things, but mostly about the reappearance of problems in the euro zone.  Europe is in turmoil. The failed Spanish auction earlier this week is only the beginning of a credit crunch."

My client paused, then went on.

"They also worry about the re-election of President Obama, which seems likely at this point. They believe that Obama is anti-business, and that after the election he is going to raise taxes and impose regulations that will hinder American business."

"Finally, my friends tell me that there is too much bullish sentiment around, too much complacency. After six months of strong stock market returns, investors have forgotten about the economy, and are depending on Bernanke and the Fed to bail everyone out."

"What do you think?"

I paused, then asked a question.

"Where are your friends putting the proceeds of their stock sales?  Bonds? Gold? Cash?"

"Anything safe," my client answered. "Their point is that now is not the time to be any asset that could be hit by another downturn in the global economy."

Here's how I responded:

There is no question that we've come a long way since last September, when the world's market looked ugly, and most of the investment conversations centered around gold. Typically when stocks rise by +25% or so in just a few months - as they have starting with the huge rally in October - it would not be surprising to see at least a modest stock market correction.

Moreover, there is some historic precedent for selling in May, and then reinvesting in the fall.  While not successful every year, spending the summer months on the sidelines in cash has worked enough times that it has become almost axiomatic among institutional investors.

But I question whether now is the time to selling stocks in favor of cash.

Money market rates remain essentially zero.  And, as Fed Vice Chair Janet Yellen said yesterday, there remains the very real possibility that rates could stay very low heading into 2015 (I have added the emphasis):

 WASHINGTON — Janet L. Yellen, the vice chairwoman of the Federal Reserve, said Wednesday that the lackluster trajectory of the economic recovery might require the Fed to continue its efforts to bolster growth even beyond the end of 2014...

She said that one economic model used by the Fed suggested that interest rates should be held near zero until late 2015. While others have suggested an earlier increase might be appropriate, she said there still might be reasons to wait, including the insufficiency of current policy and the risk that the economic recovery might falter.

With rates at 0%, and inflation running at 2%, the "real" cost of trying to time the market is a steady loss of purchasing power.

In addition, while it appears that the first quarter earnings season might be characterized by lackluster results and cautious guidance, it is worth noting what happened after fourth quarter 2011 earnings results were announced.

According to Merrill Lynch:

4Q '11 was the worst earnings season in terms of positive surprises since 4Q '08. Only 47% of companies beat on sales and 52% beat on EPS.

Then, after this "crummy" earnings season, the S&P 500 jumped by over +12% in the first quarter of 2012.

Another reminder that the economy and the stock market do not always move in the same direction.

Finally, as regards to bullish sentiment, it is not clear that "everyone" is really all that bulled up.

Outflows from equity mutual funds continue, especially from domestic mutual funds.  Main Street does not trust Wall Street.

Surveys of bullish sentiment do not indicate rampant optimism - at least the ones that I've seen.  For example:
NEW YORK (MarketWatch) -- Bullish sentiment fell among financial advisers surveyed in the weekly Investors' Intelligence poll from last Friday. 

The percentage of financial advisers who are bullish on the market fell to 48.4% from 52.7%, while bearish sentiment was unchanged at 21.5%. 

The percentage of financial advisers expecting a market correction rose to 30.1% from 25.8%. 

So here was my bottom line to my client:

Stocks remain reasonably valued, and there are few signs of "irrational exuberance".  The problems in Europe are well-known, and while the problems are huge and potentially unsolvable, a full-scale financial crisis seems unlikely at this point - no one wants to go through another credit crisis.

The alternatives to stocks - cash, bonds, gold, etc. - all pay low or no rates of interest, and offer a generally unfavorable risk/return trade-off to most investors.

The problem with market timing is that you have to be right on two decisions:  when to sell, and when to get back in.  Few, if any, investors have had much of a successful track record when it comes to trading the market.

So for now at least my client is going to sit tight.

Wednesday, April 11, 2012

April is the Cruelest Month

Judging from my conversations with friends and colleagues, I must be one of the last people in the United States to prepare my own taxes.

I do this masochistic ritual every spring.

Because I am in the financial advice business, and a good deal of my daily work involves advising clients on tax efficient investment strategies, I feel that it is a good exercise for me to actually get into the nitty-gritty of preparing tax returns.

But what a horrendous experience!

It's not that I actually use pencil and paper to fill out tax forms - Turbo Tax is a marvelous program, and every year it offers new features to try to make the tax preparation experience more bearable.

No, what really makes it hard is trying figure out how best to comply with our federal and state tax laws.

Like most people, I consider myself a fairly honest person, and I try my best to follow the government's rules.

At the same time, I always have the feeling that I am paying too much.  Every year, after I have filed my taxes, I always have the uneasy feeling that I have overpaid.

But my limited tax knowledge is the government's gain, I guess.

Turns out that I am not alone in my thoughts about taxes, at least judging from two articles in this morning's New York Times.

Eduardo Porter writes in a column published today:

Either you’ve hired an accountant to prepare your tax returns or you’ve spent countless hours plowing through schedule after schedule, noting deductions, exemptions and limitations and hoping the software you are using will get it right. Exhausted and anxious, you’re thinking surely there must be a better way. 
There are, in fact, more efficient ways for government to collect money. They are much less complicated. And they can raise a lot of revenue to solve our long-run budget deficit and pay for the increased benefits demanded by our aging society. What’s more, they can do so without raising income tax rates. Unfortunately, history suggests we won’t really consider these alternatives.

Over the years, there have been countless proposals to change our tax code.

Remember the "flat tax", where returns would be so simple that you could mail them in on postcard?

Or what about the value-added tax (VAT),which is widely used in Europe and is a relatively painless way to gather tax revenue?

Never happened.

As one of my professors at the University of Michigan explained to me years ago, the more efficient the tax code the less opportunity for governments to try to model the behavior of its citizens.

Unfortunately, in our zeal to allow governments to use taxes as a sort of "carrots and sticks" incentive system, our tax code has becomes so perverse and byzantine that only full-time practitioners can really "game" the system.

Take for example the use of private jets by corporate executives.

According to an article written by Steven Davidoff in the Times's "Dealbook" section, it is becoming more common for corporate executives to be able to enjoy the use of a private jet as a tax-free perk even if the flight is for personal use.

How can they do this?

As Mr. Davidoff writes:

... directors often dole out personal safety perks to ease a chief executive’s tax bill. By classifying the benefits as security measures, the executives typically get a better tax treatment on the services.

It’s a common corporate tax trick.

Each year, companies spend millions of dollars to ensure the ostensible safety of their executives, services that sometimes extend to others. Ford, for example, picks up the tab for family members who fly with {Ford CEO Alan} Mulally. The automaker estimated that it spent $178,571 on Mr. Mulally’s and his family’s personal air travel last year. Ford declined to comment.

Hence, to quote TS Elliot, April truly is the cruelest month, at least when it comes to taxes.

Tuesday, April 10, 2012

The Renaissance in U.S. Manufacturing

David Brooks has a good column in this morning's New York Times discussing the resurgence in American manufacturing.

Here's what he writes:

... Over the past five years, amid turmoil and uncertainty, American businesses have shed employees, becoming more efficient and more productive. According to The Wall Street Journal on Monday, the revenue per employee at S.&P. 500 companies increased from $378,000 in 2007 to $420,000 in 2011. 

These efficiency gains are boosting the American economy overall and American exports in particular. Two years ago, President Obama promised to double exports over the next five years. The U.S. might actually meet that target.

However, as Mr. Brooks notes, the resurgence in efficiency and profitability in U.S. manufacturing is not necessarily good news for the average American worker.

Companies have been using technology to make their operations more efficient. For example, it was only a generation ago that General Motors employed more than 400,000 workers in the United States; today, it produces nearly the same level of vehicle output with only a fraction of the previous workforce.

In addition, energy costs in the United States are a fraction of most of the rest of the world, thanks to the controversial fracking techniques that have unleashed huge supplies of natural gas.

States are intensely competing with one another to attract businesses, offering incredibly attractive tax incentives to companies who will open operations locally.

Meanwhile, overall tax rates are at historic lows in the United States, and there is apparently no political will to change this any time soon.

Meanwhile, wages in China - and other emerging markets - have risen to the point where the U.S. worker is cost competitive, after taking the superior productivity into account.

A number of analysts that I have heard recently have been echoing Mr. Brooks's comments. 

Yesterday, for example, I heard Merrill Lynch analyst John Inch described what he calls a "renaissance" that is occurring in the U.S. industrial sector.

He noted, for example, that Emerson Electric moved a large portion of its operations to China a few years ago.  Today apparently Emerson regrets this decision; not only is the cost advantage of China operations largely disappeared, but competition from other Chinese companies has driven their margins lower.

For a stock investor, then, one is left with the conundrum of record corporate profitability offset with stubbornly high unemployment rates.  How can the U.S. economy continue to improve if the American workforce is still so underutilized?

For now, at least, expect continued corporate growth - but a stagnant jobs market.

Monday, April 9, 2012

Market Gloom = Further Gains Ahead?

It is an old Wall Street expression that bull markets "climb a wall of worry"; that is, markets often rise when pessimism is rampant.

If that's the case, then perhaps we're in for an explosive second quarter rally, judging at least from what is being written in the financial press.

Here's just a sample of a few of the articles have been published over the last couple of days:

Headlines from this morning's Wall Street Journal:

Wake-Up Call for U.S. Stocks

Lackluster Profits For First Quarter May Rattle Shares

From yesterday's special "Mutual Funds Report" section in the New York Times:

Wary of Heights (and the Future) 

SEEING is supposed to be believing, but a second consecutive quarter of eye-popping gains for stocks has left many investors still unconvinced that the long-term trend is up.

The Standard & Poor’s 500-stock index rose 12 percent in the first quarter, after gaining 11.2 percent in the one before, yet the panic that was palpable last fall seems to have given way to doubt, more than to euphoria or even hope.

From yesterday's Financial Times: 

Investors braced for fall in US profits

Time To Panic About Europe Again 

“This is the Rodney Dangerfield of bull markets,” said Ed Yardeni, president of Yardeni Research. “It doesn’t get any respect. The naysayers have been badmouthing it really since the start.” 

Skeptical investment advisers find much to say nay about; they question that a bona fide recovery is in place or that the last disruptive piece of news has come out of Europe. 

Others, including Mr. Yardeni, are skeptical about the skepticism. “There have been numerous nearly apocalyptic scenarios out there that haven’t played out,” he said. “Despite the scares we’ve had, the global economy continues to grow. The adage about the market climbing a wall of worry has never been more relevant.” 

Friday, April 6, 2012

Fed to Investors: You're On Your Own

See ya!
Writing in yesterday's Financial Times, columnist James Mackintosh notes the schizophrenic mood of stock investors these days:

Here we go again.  For all the signs of economic recovery in the U.S., it turns out what investors really care about is QE3. Minutes of the Federal Reserve's policy meeting showed on Tuesday that another round of quantitative easing is somewhat less likely and the market reacted with a classic flight to quality.  The dollar and US and German bonds rose and pretty much everything else fell, notably gold and European equities.

In other words, as Mr. Mackintosh goes on to write, investors want both economic recovery and Fed stimulus - a combination that is unlikely to occur.

To me, today's relatively weak jobs report is basically confirmation of what Fed officials have been saying for the past few weeks.

Namely, while the economy is showing signs of growth, the recovery remains anemic, and unemployment will probably remain uncomfortably high for the foreseeable future.

I remain positive on stock investments, mostly because the alternatives offer such meager returns.

However, my bullish stance is not based on a new round of quantitative easing by the Fed.  I agree with what columnist Paul Krugman writes in this morning's New York Times that the political attacks on the Fed have intimated it from taking any new stimulus steps any time soon:

True, Mr. Bernanke likes to insist that he and his colleagues aren’t affected by politics. But that claim is hard to square with the Fed’s actions, or rather lack of action. As many observers have noted, the Fed’s own forecasts indicate that while things have been looking up a bit lately, it still expects low inflation and high unemployment for years to come. Given that prospect, more of the “quantitative easing” that is now the main tool of Fed policy should be a no-brainer. Yet the recently released minutes from a March 13 meeting show a Fed inclined to do nothing unless things take a turn for the worse. 

So what’s going on? I think that Fed officials, whether they admit it to themselves or not, are feeling intimidated — and that American workers are paying the price for their timidity. 

Thursday, April 5, 2012

The Problem with Rhode Island's Pension Plan....

….is that it has too much in assets that don’t offer much return potential.

Gillian Tett had a column in this morning's Financial Times discussing some of the reforms that state treasurer Gina Raimondo has been implementing in Rhode Island's pension system.

Tett start out by noting the dismal condition of the public sector pension system in the United States. With nearly $3 trillion in unfunded pension liabilities, she writes, the outlook is truly frightening, especially given the gridlock in our political system.

However, Tett says that some of the changes occurring in Rhode Island can offer a ray of hope.  After Ms. Raimondo was elected in 2009, she moved to try to address some of the problems that Rhode Island is facing:

..once in office, she raised the retirement age from 62 to 67, temporarily suspended cost-of-living increases for benefits, cut the annual assumed rate of return on pension assets from 8.25 per cent to 7.5 per cent, and replaced defined benefit schemes with a hybrid, partially defined contribution scheme.  In total, that lopped $3 billion from the state's public pension bill.

However, Tett does not address the issue of asset allocation, which regular readers of Random Glenings will recognize has been a favorite topic of mine over the past few weeks.

So I wrote Gillian Tett an email this morning in response to her column.  While I doubt my thoughts will get much notice, I thought I would share them with you here:

Rhode Island had only 23% in US stocks as of the date of the last report, and less than 50% in stocks overall.

Meanwhile, it has 23% in bonds (i.e. the same percentage as in US stocks) that are yielding probably 3% or less, and have huge capital risk once rates starting moving higher*. If you add its allocation to “real return” products (which are hedging against non-existent inflation pressures), RI has about 1/3 in low yield assets.

It also just made a major allocation to hedge funds, which has been a losing proposition for many states like California and Oklahoma.

While I agree with your column today that they are more responsible in other ways than other states (including my home of Massachusetts), I would be willing to wager that Rhode Island will not make its 7.5% actuarial rate.
I’m a big fan, by the way.


Dave Glen

*even if rates go lower – to, say, 1% - this would only be a 1 year boost to performance of the bonds.  You would then be faced with the same problem the Japanese banks and insurance companies have been facing for years.

Wednesday, April 4, 2012

Letter to the Investment Committee - First Quarter 2012

I just finished the my usual quarterly letter for my institutional clients; I have added a couple areas of emphasis:

The stock market enjoyed a strong run in the first quarter of 2012, continuing the rally that began last fall.

The S&P 500 returned +13% for the first three months of the year, making it the best first quarter return for the market since 1998. Financials and technology stocks lead the way, with both sectors increasing by more than +21%.  Last year’s winners – utilities and telecommunications – were the laggards during the quarter.

The question as we start the second quarter is how long the current market rally will continue.  

Skeptics point to last year, when the market also enjoyed a good start to the year only to see the early gains turn into losses by the middle of the summer.  They also note that while the U.S. economy continues to signs of moderate improvement, the rest of the industrial world is mired in recession-like conditions.  China’s economic growth has also clearly slowed, which could also negatively impact the rest of the global economies.

So should you “sell in May and go away” as so many analysts have suggested?

Well, maybe, but there is enough evidence to suggest that the market could have further room to grow.  

Bull markets typically “climb a wall of worry” and that has certainly been the case for the last 6 months.  Flows into domestic equity mutual funds, for example, continue to be negative – the average investor continues to flee the stock market in favor of fixed income, despite the historically low level of interest rates. 

Institutional investors have also continued to reduce their exposure to the U.S. stock market, believing that alternative asset classes such as private equity and hedge funds will provide better returns (despite significant evidence otherwise).

Although the stock market has rallied sharply since last September’s lows, the S&P is still well below its historic highs. At this writing the S&P is slightly above 1400, but it traded as high as 1580 in both 2000 and 2007.  Corporate earnings, meanwhile, continue to grind to record levels, making the overall valuation of the stock market reasonably attractive, especially relative to fixed income alternatives.

There is no question that we will see a market correction at some point in the next few weeks – markets almost never move in one direction, and there is no reason to expect that this time will be any different. 

However, we would view any correction as a chance to possibly add to equity exposure, since we believe that a diversified portfolio of carefully selected stocks will offer the best chance to earn competitive investment returns over the next few years.