Friday, August 31, 2012

A Different, More Optimistic View Of Spain

Last spring my wife and I traveled to Barcelona. We had a marvelous trip,  and found the city to be extremely welcoming and culturally exciting.

The timing of our April trip was propitious.

Only two weeks before we arrived, there had been a massive protest against the government's austerity programs right outside the Barcelona stock exchange.

Walking by the exchange during our visit you could still see the marks on the walls of the exchange where protestors had thrown rocks and paint.

But still:  the restaurants were full, and the shopping areas mobbed.  For all of the troubles that the international press had reported, Barcelona seemed to us to be a vibrant and bustling place.

We had coffee with a couple who live in Barcelona.  They confirmed that while beneath the surface economic conditions were less than ideal, the actual living experience of most citizens in Barcelona was not all that bad.

The Financial Times had an interesting piece about the contrast between life in Spain and the steady stream of poor economic data emanating from official sources:

For foreign investors arriving in Madrid, signs of economic duress are not always as obvious as they might have imagined.

Bars are regularly full, traffic appears steady and, most surprisingly, the country's youth, of which more than half are not in work, appear subdued.

"People who come from abroad for the first time are often surprised," a banker who organizes meetings for overseas managers says.  "They expect there to be young people rioting on the streets." 

So we were not alone in our puzzlement.

But what about 50% Spanish unemployment rates in people aged 16 to 25 that is often reported?

Well, as the article notes, it turns out that this figure is slightly misleading.

While Spain uses the methodology employed by all EU members to calculate youth unemployment, most recently at 53.5 per cent, the percentage of young people who are unemployed, looking for work and outside education or another form of activity stands at 23 per cent - a very large, but less alarming number.

"It is a diagnostic error to take these numbers at face value," {Spanish labor expert Angels} Valls says. "Fifty per cent youth unemployment is not the same as half of all young people being out of work."

I have read elsewhere that reported Spanish unemployment rates have always been higher than most other countries.  In 2007, for example, unemployment rates never got below 15%, despite the housing-fueled boom that was going on in Spain at the time.

The reason?  Well, let's just say that many Spanish workers share the same aversion to paying taxes similar to other Southern European nations.

This is not to belittle the very real financial problems that Spain faces.  Earlier this week Catalonia - the region in Spain which includes Barcelona - officially asked the Spanish government for 5 billion euro as emergency funding.

But the contrast between the strains in the Spanish financial system and its citizens' economic reality is striking nonetheless.

Thursday, August 30, 2012

Is Europe Improving?

European stocks have been on a tear this summer.

Using the Vanguard European ETF as a proxy (ticker: VGK), European stocks are up more than +16% since June 1 compared to +10% for the S&P 500:

And while it is obviously too early to declare an "all clear" on the euro zone economic woes, there is some evidence to suggest that some of the strong medicine administered by Brussels and Berlin may be working, according to an article in the German news magazine Der Spiegel:

The euro zone's crisis-hit countries are becoming more competitive, according to a new German study. Wage costs are down, and the countries are reducing their trade imbalances. Painful reforms appear to be slowly bearing fruit, and the euro zone might even return to growth next year....

 Experts reacted positively to the new figures, saying that the crisis-hit countries are much further along with reforms than is generally believed. "The euro zone has already done most of its structural homework," Folker Hellmeyer, chief economist at Bremer Landesbank, told the Financial Times Deutschland. "The process of adjusting trade imbalances in the euro zone is in full swing," said Andreas Rees, an economist at the UniCredit bank.

The DIHK believes that efforts to make euro-zone countries more competitive will start to bear fruit in 2013. Likewise, the organization expects the euro zone to see growth of 0.7 percent in 2013, up from a 0.2 percent contraction in 2012, and predicts that Europe could even be a driver of global growth in the coming year. The expected uptick is also likely to benefit German exporters, the DIHK said, as 59 percent of German exports go to other EU countries.

Borrowing costs in countries like Spain and Italy also appear to have stabilized, albeit at significantly higher levels than "safe" countries like Germany.

Pundits have had a field day for most of the past year projecting a collapse in the euro; what if they're wrong?

Wednesday, August 29, 2012

Staying the Course
Source:  Stocktwits

Recent conversations with clients have largely centered on what could go wrong in the market over the next few months.

My response to all of these concerns has largely been centered around the chart shown above.

Over the very long time period, stocks have historically provided the best returns for anyone with a long term time horizon.

The market swoons of 2002 and 2008 were outliers, as the above chart shows. Both market tumbles were related to specific events (9/11, in the case of 2002, and the credit crisis of 2008) which have been relatively rare in our country's history.

Stock returns have generally ranged between -10% and +30% since 1825, as you can see from the chart. That doesn't mean that the market will always move higher, but it does mean that the odds are with you.

Yes, stocks could go lower in the next few weeks.  The S&P 500 is up more than +13% for the year. With the exception of May, returns for most months in 2012 have been positive, so a correction of -5% or so would not come as a surprise.

But relative to nearly every other viable investment alternative, stocks still offer the best chance for longer term gains.

Thanks to CBS MarketWatch, I will also begin to reference a new book out by Vanguard founder John Bogle.

Titled "Clash of the Cultures: Investment vs. Speculation", Bogle offers simple, common sense approaches to investing that will serve nearly every investor well.

What I like in particular is Bogle's 10 rules of investing, which offer some of the best advice for investors that I have read in a long while (reprinted from Allan Roth's column in CBS MarketWatch):

1. Remember reversion to the mean. What's hot today isn't likely to be hot tomorrow. The stock market reverts to fundamental returns over the long run. Don't follow the herd.

2. Time is your friend, impulse is your enemy. Take advantage of compound interest and don't be captivated by the siren song of the market. That only seduces you into buying after stocks have soared and selling after they plunge.

3. Buy right and hold tight. Once you set your asset allocation, stick to it no matter how greedy or scared you become.

4. Have realistic expectations. You are unlikely to get rich quickly. Bogle thinks a 7.5 percent annual return for stocks and a 3.5 percent annual return for bonds is reasonable in the long-run.

5. Forget the needle, buy the haystack. Buy the whole market and you can eliminate stock risk, style risk, and manager risk. Your odds of finding the next Apple (AAPL) are low.

6. Minimize the "croupier's" take. Beating the stock market and the casino are both zero-sum games, before costs. You get what you don't pay for.

7. There's no escaping risk. I've long searched for high returns without risk; despite the many claims that such investments exist, however, I haven't found it. 
And a money market may be the ultimate risk because it will likely lag inflation.

8. Beware of fighting the last war. What worked in the recent past is not likely to work going forward. Investments that worked well in the first market plunge of the century failed miserably in the second plunge.

9. Hedgehog beats the fox. Foxes represent the financial institutions that charge far too much for their artful, complicated advice. The hedgehog, which when threatened simply curls up into an impregnable spiny ball, represents the index fund with its "price-less" concept.

10. Stay the course. The secret to investing is there is no secret. When you own the entire stock market through a broad stock index fund with an appropriate allocation to an all bond-market index fund, you have the optimal investment strategy. Discipline is best summed up by staying the course.

Monday, August 27, 2012

Bond Investors Scoff At Credit Risk

source:  Barron's, August 25, 2012

It was only a couple of years ago that investors were worried by municipal credit worthiness.

Wall Street analyst Meredith Whitney - who famously blew the whistle on the sorry state of the banking system in 2007 - went on the the CBS news program 60 Minutes in December 2010 to warn of impending crisis in the municipal credit markets.

After her appearance, municipal bond prices cratered, as panicked investors dumped their holdings.  Eventually, though, the markets stabilized, and when actual municipal defaults actually declined in 2011 Ms. Whitney's remarks were quickly dismissed.

But the state of municipal finances is still precarious, as last weekend's front page article in Barron's made clear.

The chart above is taken from the Barron's piece.

The most interesting part of the chart is on the states listed in the lower right hand side, on the bottom.

Take for example the state with the highest ratio of debt + pension liability to GDP, Connecticut.

While this is only one measure of credit risk, the fact that the Nutmeg State has a higher level of debt obligations than any other state in the United States would lead one to believe that Connecticut debt should trade at a considerable yield premium to other states.

But, as the chart shows. the demand for tax-free Connecticut paper is such that the state really is not being penalized at all in the secondary market.

Massachusetts, by the way, is not all that much better, as can be seen.

The lack of regard for risk in the bond market stands in stark contrast to the stock market.

The best performing sectors in the stock market over the last 18 months or so have had two characteristics in common:  stable business models and high dividend yields. Thus, utilities; telecom; and consumer staples have been strong relative performers, while the growth sectors of the market have been largely ignored.

In the bond market, meanwhile, the desire for yield has overtaken any concerns about credit quality.

The Financial Times noted last week that sales of junk bonds have reached $220 billion so far in 2012, the second-largest level ever. Only in 2011 - when sales of below-investment grade securities hit $235 billion during the same time period - has issuance reached this lofty level.

Meanwhile, Europe and Asian issuers are also finding a robust appetite for their debt offerings, despite the widely-publicized economic concerns. In Europe, roughly $12 billion in corporate debt has been issued in August compared to an average $8 billion, according to the FT.  In Asia, nearly $41 billion has been issued compared to the historic monthly average of $27 billion.

Demand for municipal debt has followed the same trends as the taxable markets.  Robust demand for municipal bonds has pushed yields to historic low levels.

But when the Oracle of Omaha starts reducing his exposure to municipals, should others take note? Here's what Barron's wrote:

That {municipal debt} strain was brought into sharper focus recently with Berkshire Hathaway's disclosure that it had terminated $8 billion of municipal derivatives contracts. Those contracts were effectively bullish bets on state finances. Berkshire CEO Warren Buffett is bullish no more. The company's $30 billion bond portfolio is light in munis, and Buffett is warning about rising municipal bankruptcies and of the risks of insuring tax-exempt debt. "The stigma probably has been reduced when you get very sizable cities like Stockton and San Bernardino to do it," Buffett told Bloomberg television last month, referring to the bankruptcy of the two California cities. The fiscal pain -- and credit risk -- is more pronounced at the local than state level.

Is There A Bubble in Higher Education?

The Rotunda at UVA
My daughter Caroline starts classes this week at the University of Virginia (UVA).

My wife and I took her to Charlottesville last week, and experienced the bittersweet emotions that parents go through when a child leaves home. Still, we are thrilled for her, and we are confident that she has a terrific four years ahead of her.

Getting into UVA is not easy.  Here's what the Washington Times reported last week:

Recession? What recession?

At top area colleges, applications for admission are actually up, despite continuing economic stagnation at the national level...

Earlier this week, Theresa Sullivan, the president of the University of Virginia, where move-in kicks off Friday, said the college had received a record number of applications — 28,200 — and accepted 3,416, or 12.1 percent of first-year students. (This compares with 34,302 students applying to Harvard, with an acceptance rate of 5.9 percent.)

I have read any number of articles in recent months discussing the so-called "bubble" in higher education.
These commentators suggest that the rapid rise in college tuition has priced a college education beyond the reach of many families. With entry level jobs scarce, paying tens of thousands of dollars for a higher education degree seems an needless extravagance to many families.
Moreover, the argument goes, advances in technology will eventually make physically attending classes on a college classes an anachronism. Microsoft founder Bill Gates was quoted earlier this summer:

The cost of an education just keeps going up. So you've go to see if you can change the way the system works. Having a lot of kids sit in the lecture class will be viewed at some point as an antiquated thing.
I'm not sure that higher education tuitions are necessarily in a "bubble".  To me, bubbles exist in markets where prices are far out of line with demand. 
The demand for a spot in a freshman class at places like Harvard and UVA would suggest that price is not the issue - there is an incredible desire for education at the top schools in this country.

In fact, you could almost argue that the top schools could charge even higher tuition rates based purely on demand (which I am not suggesting, by the way!).

The trouble in higher education is at schools deemed to be less desirable for whatever reason, as the Washington Times article also notes:
But the positive numbers from elite schools appear to be outliers. More disquieting trends have emerged at the other end of the spectrum, where U.S. colleges are beginning to see a drop in the demand for freshman places as high tuition costs and financial problems force families to think twice about taking on the burden of paying for their children’s higher education.

The Arlington-based National Association for College Admission Counseling (NACAC) reports that 375 colleges find themselves this year with vacant places: Last year, the figure was 279.

Then there is a large movement towards on-line education.  Here's an interesting talk at TED by Stanford professor Daphne Koller about what we are learning about offering college courses on-line:


Wednesday, August 22, 2012

What We Can Learn From Norway's Approach to Asset Allocation

I will be traveling the rest of the week. Random Glenings will next be published on Monday, August 27.

The Financial Times had an excellent piece on Monday concerning the investment approach of Norway's Government Pension Fund Global (GPFG).

Titled "Norway's National Nest Egg", the article describes how the Norwegians have built a formidable track record of success through a transparent, straightforward investment strategy:

The {GPFG} has grown faster and been more successful than anyone envisioned.  Originally expected to last 30 years or so, the fund - now in its 22nd year - is expected by politicians to last for a century or more.

Norway is one of the wealthiest countries in the world.  While traditionally export activities have been a major driver of economic activity, Norway's huge natural resources have become perhaps the most important source of national wealth in recent years.

In particular, Norway is the world's sixth largest oil exporter, and second largest gas exporter.  Revenues from the sale of energy products have resulted in massive amounts of wealth flowing into the country.

The GPFG was established in 1990 to manage Norway's resource wealth in a long-term and sustainable fashion.  The country's leaders were eager to avoid the so-called "Dutch disease" where a sudden increase in a country's wealth lead to a large jump in inflation.

In addition, the Norwegians recognized that energy was obviously a finite resource, and that investing the proceeds from the sale of oil and gas was the most prudent path to take.

GPFG has proven to be one of the most recognized and successful funds in th world.  Although the government can withdraw up to 4% of the fund's assets each year to supplement fiscal budgets, the fund is now expected well beyond the expected life of some of its natural resources.

Interestingly, however, its current asset allocation is a very traditional mix of 60% stocks and 40% bonds - the same "boring" allocation that many money managers advocate for their clients. In recent years the fund has considered adding 5% in real estate, but it has moved in this direction slowly.

Norway's approach is in stark contrast to the widely-followed model espoused by David Swensen at Yale University.  Swensen argues that the market typically overpays for liquidity, and that significantly better returns can be found in less liquid asset classes such as private equity and hedge funds. 

The FT's article references a research piece published last year in the Journal of Portfolio Management.  Titled "The Norway Model", the authors (Chambers; Dimson; and Ilmanaen) discuss in more detail how the management of GPFG works, and why it has proven to be so successful:

...Norway is among the world's most visible investors, and consequently the Fund's rollercoaster experience has been experience has been scrutinized closely. Short-term underperformance during the recent financial crisis provoked widespread soul-searching and criticism within Norway.  Yet the GPFG fared better through the 2007-08 turbulence than most institutional investors, and by 2010 it had fully recovered the absolute and relative losses it experience over that period...

The Norway model is the virtually the opposite of the Swensen model. Norway has relied almost exclusively on publicly traded securities, it is constrained to a low tracking error, and it has a rigorous asset allocation that allows little deviation from the policy portfolio. More generally, it relies on beta returns, not alpha returns.  This contrasts with the Swenson model, which aims for investment managers to bridge their deficit in systematic risk exposure by exploiting market mispricing.

Tuesday, August 21, 2012

Report To The Investment Committee - August 2012

I am giving a presentation later this morning to an investment committee; here's a copy of my notes:

Market Overview
August 21, 2012

Macro Backdrop
·       Growth sputtering globally.  China and emerging markets in particular cause for concern;
·       Europe remains very fragile.  Policy managed to keep euro alive for now, but still very uncertain. Austerity programs in France, Spain, et. al. very unpopular. Unemployment high in most countries (Germany a notable exception);
·       US political atmosphere still very poisonous.  Little chance of meaningful change soon. Fiscal cliff at year end could hurt US economy in 2013;
·       Widespread cynicism re: financial system. Facebook IPO debacle soured investor moods. LIBOR scandal showed worst side of finance. Large losses at JP Morgan suggest that even the banks don’t know their risks;
·       Some positives:  Housing rebounding; auto sales robust

Capital Markets
·       Interest rates at record lows globally. Negative rates in Germany and Switzerland reflect widespread fear;
·       At same time, investor desire for yields remains huge. High yield bonds trading at historic lows in US and Europe despite concerns about economy. Investment grade bonds barely yield more than US Treasurys;
·       Monetary policy remains very accommodative but unclear whether further easing would offer any help.  Mortgage rates in US at record lows, but could be lower if banks priced at same spread vs. Treasurys;

Equity Markets
·       S&P 500 up more than +14% year-to-date (+9.1% LTM), and trading well above its 50- and 200-day moving averages. On the other hand, market gains very narrow. Larger cap stocks continue to march higher, smaller and mid cap stocks lagging significantly;
·       On an equal weighted basis, the prices on the S&P is up only +6.9% YTD (+1.9% for 12 months) vs. +9.7% YTD (+6.7% for 12 months);
·       Best performing sectors YTD have been (in order): telecommunications; consumer staples; and utilities.  Investors looking for income and safety in stocks, not growth;
·       Market volume on New York Stock Exchange has hit 2012 lows in recent session and is about half of where it was for the same week a year ago;
·       Fund flows remain skewed towards bonds:  equity funds, including exchange-traded funds, lost $6.3 billion last week while bond funds took in $3 billion. Stock funds lost $11.5 billion in the second quarter while bond funds gained $55.4 billion, according to Lipper;
·       Second quarter corporate reports showed slowing revenue but consistent earnings. Margins remain elevated relative to history;
·       Other signs of how disenchanted Main Street is with the stock market from technician Ryan Detrick (courtesy of The Reformed Broker blog):
            As we've been saying for years now, this market is headed higher for two reasons: First, price action continues to be constructive; and second, overall expectations are still too low. Remember, lowered expectations make it much easier to have good news and thus, buying pressure.
Here's a list of a few of the bigger-picture things I've noted recently as reasons to look forward to higher prices.
·        CNBC's low ratings show no one is interested in this bull market
·        75% of high school students believe the market is rigged
·        Bill Gross thinks stocks are a Ponzi scheme and the "cult of equity is dead"
·        Short interest is high and rolling over
·        Wall Street strategists are at 15-year lows in stock allocations
·        The American Association of Individual Investors (AAII) sentiment poll just had 13 straight weeks of more bears than bulls
·        There are huge outflows from equity mutual funds in the face of higher stock prices
These examples have all occurred over the past several months. Let's take a closer look at this. We have Wall Street avoiding stocks, we have Main Street avoiding stocks, and we even have the potential for a whole generation of stock investors who think the whole thing is rigged. Yet, the Dow Jones Industrial Average (.DJI) is about eight percentage points away from a new all-time high! Simply amazing when you think about it.