Random Glenings

The Value of an Asset

2012-01-30T09:47:00.002-05:00

You don't have to be involved in the investment management business to know that, in the end, an asset is really only worth what someone else will pay for it.

This seems almost too obvious, but I was reminded of this simple rule over the weekend.

There was an article in the New York Times yesterday about an ongoing debate in the classical music world. Violins and cellos made by such old masters as Stradivarius command huge prices among the great musicians in the world:

Several factors put old Italian instruments on top. Superb wood, perfected design, the highest craftsmanship and special varnish all came together in Cremona and its environs from 1550 to 1750. The sheer number of years being played is a factor. Repeated vibrations have an effect on the wood’s structure, causing cells to break down in a way that produces a more flexible sound, some violin experts say. “By playing an instrument, it opens up its pores,” said the violinist and conductor Pinchas Zukerman, who plays a 1742 Guarnerius del Gesù. “The voice becomes purer and brighter.”

The prices these instruments can command are daunting. The piece notes that

...Stéphane Tétreault, an 18-year-old Montrealer who is being loaned the 1707 Countess of Stainlein Stradivarius cello that belonged to Bernard Greenhouse, a founding member of the Beaux Arts Trio, who died last May. The Greenhouse family sold the instrument two weeks ago to an anonymous patron in Montreal for an undisclosed amount, but one said to surpass the previous record of $6 million.

http://www.nytimes.com/2012/01/29/sunday-review/the-value-of-valuable-violins.html?_r=1&src=me&ref=general

I ran into Richard Ortner, head of the Boston Conservatory, at a benefit concert last night, and had a chance to talk to him about the price of instruments.

Richard emphatically confirmed the facts in the article, noting that string players can often amass debts similar to a home mortgage in order to secure one of the classic string instruments.

By contrast, said Richard with a laugh, players of metal instruments like a flute or horn get off pretty lightly; the top price for a flute, for example, is probably no more than $20,000.

Investing in stocks, in a way, also reflects the basic fact that any particular company is really worth what the collective market wisdom will pay for it.

The Financial Times on Saturday had a good piece about the strong rally in financial stocks that has occurred this month.

As some of my earlier posts noted, the fundamentals for bank stocks really haven't improved all that much from last year. European banks underperformed their American counterparts in 2011, but lately have rebounded sharply.

Investors have been encouraged that the actions by the Fed and the European Central Bank (ECB) will be sufficient to allow the European banks to survive and even prosper. In particular, the ECB's Long Term Refinancing Operation (LTRO)
injected nearly 1 trillion euro into the banking system last month, which seems to have at least stabilized the financials for now.

So the value of bank stocks at this point can be hazy, but it seems to me that it really can't be argued on fundamentals alone at this point. Prices are moving higher, and if the goal is to increase the value of your portfolio then you have to at least think hard about the banking group. As the article notes:

...{Thomas Moore, equity manager in Edinburgh, suggests that} investors ignored the power of the LTRO for a month and even now this is a lot of negative feeling about banks around. "There is a lot of pessimism out there. It suggests there is still scope for valuations to re-rate...

Similarly, credit analysts at Citi say: The fact that investors are so reluctant to commit to the rally and the effect of the LTROs makes it all the more likely that it continues for considerably longer than people envisage - or indeed, by more than is warranted by the fundamentals."

http://www.ft.com/intl/cms/s/0/256559cc-4905-11e1-954a-00144feabdc0.html#axzz1kx253gR0

So the lesson from the classical music world can be applied to bank stocks: whether you agree or not, prices are going higher, simply because that is the price that people are willing to pay.

The Rich Among Us

2012-01-27T16:10:00.000-05:00

Presidential candidate Mitt Romney released his tax returns earlier this week. In 2010, the former Massachusetts governor paid a tax rate of less than 14% despite making more than $20 million.

No one, I believe, has suggested that Romney did anything wrong. Indeed, Floyd Norris in this morning's New York Times wrote that he probably paid too much taxes based on the current tax code:

But what really stands out is the mind-numbing complexity of tax laws, and about how hard it seems to have been for even the high-priced help Mr. Romney can afford to get things right.

In one case, the trustee for one of the Romney trusts sent two letters to the Internal Revenue Service electing to use an apparently irrelevant section of the tax code, and in the process misstated the facts involved.

That mistake did not affect the taxes owed, but another error was more significant. It appears that the return filed by that trust overstated capital gains realized by nearly $300,000, causing Mr. Romney and his wife to pay about $44,000 more in taxes than they owed.

http://www.nytimes.com/2012/01/27/business/economy/mitt-romney-paid-more-taxes-than-he-owed-high-low-finance.html?page

As someone who still does his own taxes - albeit with the massive assistance of TurboTax - I can feel Governor Romney's pain when it comes to figuring out today's tax code.

I will leave it to you to decide whether it is "fair" that someone making millions of dollars a year pays taxes at a lower rate than most working Americans. Romney and other rich Americans are merely following the laws passed by Congress, which over the last few decades have nearly always focused on lowering taxes for the wealthiest Americans.

Tax rate aside, however, there is the question whether our societal values are skewed too far to people that know how to "work the system", as Warren Buffett was quoted earlier this week in an article that appeared on Bloomberg:

“It’s the wrong policy to have,” Buffett told BloombergTelevision’s Betty Liu in an interview today. “He’s not goingto pay more than the law requires, and I don’t fault him forthat in the least. But I do fault a law that allows him and meearning enormous sums to pay overall federal taxes at a ratethat’s about half what the average person in my office pays.” ...

“He makes his money the same way I make my money,” saidBuffett, 81. “He makes money by moving around big bucks, not bystraining his back or going to work and cleaning toilets orwhatever it may be. He makes it shoving around money.”

http://www.bloomberg.com/news/2012-01-23/buffett-blames-congress-as-romney-pays-15-tax-for-shoving-around-money-.htm

There have been other periods in our country's history when the wealthiest citizens were not so prized by the nation. John Rockefeller, Henry Ford and Andrew Carnegie were envied for their wealth, but few really looked to them as role models.

The highest marginal tax rate in the 1950's - under a Republican president - was 90%, yet I can find little evidence that anyone found this progressive tax code all that unfair (or that economic growth was stifled in any way).

I think that one reason the ultra-wealthy among us remain iconic figures is that fact that they do not flaunt their riches in the same fashion as in earlier times.

Buffett, for example, still lives in the house he bought in Omaha in 1957. Steve Jobs of Apple lived modestly by all accounts, preferring a Zen-like existence which included few material possessions. Others still are working despite having more money than they could possibly ever need, most recently Mark Zuckerberg of Facebook.

Then there's Bill Gates, the richest American who ever lived who has created the largest philanthropic organization ever existed. Gates has been in Europe this week, and there was a good article about him in London Telegraph.

As the article notes, despite his vast riches:

Bill Gates has frugal tastes. Asked to name his luxuries, he lists DVDs, books and takeaway burgers. It is hard, however, to think that any fast-food outlet would get rich on Gates’s custom. During a long list of engagements beginning well before dawn, he consumes nothing but cans of diet cola.

For America’s wealthiest citizen, austerity is relative. The retinue of staff and the private jet hint at a fortune said to be approaching £40 billion. As he told pupils at a south London school he visited this week: “If I hadn’t given my money away, I’d have had more than anyone else on the planet. Ninety-nine per cent of it will go.”

http://www.telegraph.co.uk/technology/bill-gates/9041726/Bill-Gates-I-wrote-Steve-Jobs-a-letter-as-he-was-dying.-He-kept-it-by-his-bed.html

It will be interesting to read years from now how history views our society's attitude towards the rich among us. But what is striking to me is that a time when real income for most Americans have been stagnant that no one begrudges the kudos that go towards the wealthiest.

The Fed Learns from Japan

2012-01-26T12:24:00.002-05:00

Yesterday's announcement that the Fed would be keeping rates at essentially 0% until 2014 is fairly important, in my opinion.

Recent economic data has shown some improvement in the economy. Unemployment is still too high, but at least the unemployment rate is moving lower, not higher. Housing is also showing some signs of trying to find a bottom, helped by record low mortgage rates. And bank loan demand is picking up, albeit from very depressed levels.

So it's interesting that the Fed is committed to an easy monetary policy rather than tightening, as so many were expecting. Moreover, according to the New York Times, the majority of Fed governors may not want to raise rates until 2015:

...the Fed published for the first time the predictions of the committee’s members on when they would raise interest rates. It showed that 11 of the 17 members expected the Fed to raise rates by the end of 2014. Taken together, the documents suggested that the Fed expected to keep rates near zero until late 2014, but probably not any longer than that.

http://www.nytimes.com/2012/01/26/business/economy/fed-to-maintain-rates-near-zero-through-late-2014.html?_r=1&hp

To me, this shows that the Fed has taken the Japanese experience of the past two decades to heart.

In the 1990's, after the land and stock markets imploded, Japanese officials gradually reduced interest rates to almost 0% in an effort to try to revive their economy. This of course is very similar to what the Fed has done in this country.

However, the Bank of Japan was constantly looking for opportunities to raise rates again, as many in Japan felt that low interest rates were imposing a harsh burden on savers. So, every time economic data indicated that Japan's economy was reviving, the BOJ would start to raise interest rates. Unfortunately, the BOJ's move to tighten credit would usually interrupt the economic revival, and they would be forced to loosen credit again.

Fed Chairman Bernanke studied the Great Depression of the 1930's in great detail while he was a professor at Princeton. Because of his background, Bernanke was a fairly vocal critic of the BOJ's actions in the 1990's, because he felt their actions were either too cautious or too precipitous in raising interest rates too soon.

Hence yesterday's announcement.

To me, this means that savers are going to be forced to make a decision: keep their funds in a bank or money market account earning essentially nothing for the next few years, or invest some of their savings in stocks or bonds. And with interest rates on bonds at 60 year lows, it seems more likely that we will eventually start to see more flows into the stock market.

I think that Bernanke's moves have mostly been good ones, even though many of this year's Presidential candidates have used the Fed and Bernanke as one of their favorite punching bags.

The Washington Post carried a good piece this morning discussing the Chairman's almost zen-like calmness in the face of often withering criticism:

Newt Gingrich called Bernanke “the most inflationary, dangerous and power-centered chairman of the Fed in the history of the Fed.” Ron Paul accused Bernanke of “inflating twice as fast as Greenspan.” Mitt Romney joined the others in saying he wouldn’t reappoint Bernanke, who was first appointed by President George W. Bush.

On Wednesday, Bernanke allowed himself just a passing reference to such critics. “The low level of inflation is a validation,” he said. “There are some who were very concerned that our balance-sheet policies and the like would lead to high inflation. There’s certainly no sign of that yet.”

He deserves credit for keeping his equanimity as the Republican candidates abuse him. And, at long last, he has some results to show for the work he has done.

http://www.washingtonpost.com/opinions/ben-bernanke-smiles-in-the-face-of-critics/2012/01/25/gIQAizaWRQ_story.html?wpisrc=nl_opinions

It's Never Been More Expensive to be Defensive

2012-01-25T13:12:00.001-05:00

As regular readers of Random Glenings are aware, I have been very cautious in my approach to the financial sector for the past year or so.

I have also been cautious on global market, believing for most of 2011 that the best markets were to be found in the US.

But now perhaps the time has come to reconsider my position.

Ah, ha! you say. I thought you were saying that the underlying fundamentals were terrible for the banks and insurance companies. Low interest rates, meager loan growth, and massive debt overhangs - aren't they still weighing on the group?

Oh, and the euro issues are still very much with us, aren't they?

Well, yes. But as famed economist John Maynard Keynes is reported to have once said: "When the facts change, so do my opinions. What do you do, sir?"

There are several factors that have evolved in the past few weeks to have caused me to seriously reconsider my bearish stance on the financial group and international investments.

The biggest one occurred last month, in Europe. As you no doubt read, the European Central Bank (ECB) pumped nearly 1 trillion euro in the large eurozone money center banks. These loans were made for a three year term, which essentially protects the banks until 2014.

Meanwhile, the Fed pumped hundreds of billions of dollars into the interbank lending market in Europe, averting a certain credit collapse.

While most of this money now sits on deposit - the euro banks remain determined to shrink their balance sheets, and improve their capital ratios - the truth of the matter is that the ECB and the Fed have apparently staved off financial Armageddon.

So disaster is off the table, for now, at least. Greece may yet default, but it seems more likely that the euro zone will limp along for at least for the next couple of years or so.

But a recovery is not yet being priced into the financial stocks, or in many markets across the globe. Sentiment is just too bearish.

Merrill Lynch's chief global strategist Michael Hartnett was in town yesterday, and I had a chance to hear his thoughts. The story he told goes something like this:

Everyone across the global seems to share the same sentiment. Stocks in the US will be in a trading range, and further upside from current levels seems limited. The euro zone is in free fall, and it is only a matter of time before Europe falls apart. China is heading for a major slowdown, as are many other emerging markets. The only safe areas to invest are US Treasurys and dividend-paying US stocks.

Michael's perceptions are confirmed by valuations in the bond and stock markets.

Investors are still piling into Treasury notes, despite the fact record low interest rates. The Fed is apparently going to keep its target funds rate at near 0% until 2014, yet corporations and individuals continue to pile into money market funds.

In the stock market, dividend-paying "safe" stocks are commanding a huge premium to every other sector, despite the fact that growth prospects in these sectors are every bit as turgid as those found in the financial sector.

For example, here are the forward price/earnings ratios of some of the sectors in the S&P 500 (figures provided by Merrill Lynch):

Telecom 16.4x

Utilities 14.4x

C. Staples 14.3x

---------------------------
Tech 11.7x

Energy 10.8x

Finance 10.4x

The reason, I would argue, that telecom and utility stocks are commanding the highest P/E ratios boils down to the fact that the sector offers high dividend yields.

But can you really argue that telecom should trade at a 50% premium to technology?

Now let's take a look at the world markets:

North America 12.0x

Asia Pacific 11.4x

Europe 9.9x

Emerging Markets 9.4x

See the pattern? A year ago it was an article of faith that investors should have a large portion of their investable assets in the fastest growing parts of the world - namely, the emerging markets. However, investor sentiment has turned so cautious and bearish that only the most defensive stocks and bonds are favored.

The title of this piece says it all.

Being defensive may feel comfortable, but I suspect a few years from now we'll look back in wonder at investors happily locking in meager returns, and shunning opportunities that are staring them in the face.

Calculating Investment Returns

2012-01-24T10:23:00.003-05:00

The calculation of returns from any asset class - stocks, bonds, funds, etc. - is on the surface a straight forward proposition.

The problem is the most conventional calculations don't take into account a number of other factors, including survivor bias, the timing of cash flows, or performance fees.

I was reminded of this challenge the other day when I was attending a presentation discussing the merits of hedge funds as part of an overall investment strategy.

The presenters were making the case that as a whole the returns for hedge funds investors have largely been superior to conventional "long only" investments in the market.

Moreover, according to their calculations, the returns have been achieved with less volatility, so the case for hedge funds should be self-evident.

However, as numerous commentators have pointed out, its not that simple.

Although there is nearly $1.9 trillion invested in hedge funds at the present time, the community is far from being homogenous. There are numerous different types of funds, for example, ranging from so-called macro funds (which bet on the direct of global markets) to relative value arbitrage (trying to gain based on price differences between related securities).

Then there is the problem of survivor bias.

Most funds start out relatively small, build a track record, and then grow as investors flock to the most successful hedge fund operators.

However, numerous funds start out, and then fail, as the results either do not attract new investor dollars or returns are not sufficient to earn performance fees.

Yesterday's Financial Times had a short piece about the disappointing returns for many in the hedge fund community, and what it has meant for compensation:

More than two-thirds of hedge funds are below their high-water marks, the point at which they are able to charge investors performance fees, according to Credit Suisse.

The main source of income for hedge fund managers is their share of investment profits, typically 20 per cent; but if a fund drops in value, the manager must recoup past profits before charging any more performance fees...

...Just over a third of event funds, which seek to trade around corporate activity such as mergers, or long-short equity funds that pick stocks, are at least 10 per cent below their high-water marks.

http://www.ft.com/intl/cms/s/0/82b2ba54-43bd-11e1-adda-00144feab49a.html#axzz1kNlTGi8O

And what about the timing of cash flows?

An obvious example of this is famed hedge fund manager John Paulson, who made more than $5 billion betting on the collapse of the US housing market. Paulson's incredible track record was compiled while his funds under management were relatively modest by hedge funds standards. However, once word spread of his midas touch, Paulson attracted huge amounts of assets. But then last year, after several ill-timed bets on bank stocks, Paulson's investors lost 40% of their funds.

So the question becomes: What were the returns for Paulson's investors?

Author Simon Lack writing in his new book Hedge Fund Mirage: The Illusion of Big Money andWhy It's Too Good to be True walks through the math of why returns for most hedge fund inveors have not been as attractive as advertised.

Say an investor places $1 million with a hedge fund at the beginning of the year. The fund has a terrific year, gaining +50% for the next 12 months, meaning the closing account value is $1.5 million. Net profit to the investor: $500,000.

Terrrific! says the investor. Let's add another $1 million to our investment, since the fund is clearly a winner. The investor now has a total of $2.5 million invested in the hedge fund.

Unfortunately, the next year turns out to be a disaster - the fund is down -40%.

The investor's $2.5 million is now worth $1.5 million. Since he had put a total of $2 million with the hedge fund, the loss of $500,000 means that his investment return is now -25%.

However, under conventional reporting standards, the hedge fund will report an average annual return over two years of +5% (+50% for year 1 and -40% for year 2). While this is mathematically correct, the actual investment experience has been considerably more disappointing than reported.

While Lack is specifically targeting the hedge fund community in his example, I think you could also make the same mathematical argument for any investment. For example, Fidelity's Magellan Fund produced terrific returns for its investors in the early years, when it was relatively small, but only index-like returns when it grew to nearly $100 billion in size.

I haven't even begun to discuss the whole question of hedge fund fees - which are generous, by any standards - but the whole issue makes me wishing there was a better way to figure out investment results.

Job Market Blues

2012-01-23T13:55:00.001-05:00

The New York Times has run several articles over the past few days that have provided a glimpse into some of the reasons behind our stubbornly high rate of unemployment.

The Times had a long piece "above the fold" on yesterday's front page discussing technology giant Apple.

Apple is valued by the stock market at roughly $400 billion, which makes it essentially tied with Exxon Mobil for being the largest company (by market cap) in the United States.

According to the article, Apple earned nearly $400,000 per employee last year, a level of profitability that surpasses Google, Exxon or Goldman Sachs.

However, rather than focus on Apple's "insanely" great products, the authors discussed the company's manufacturing facilities, most of which are located in at a place called Foxconn City, located in China.

Here's a brief description of Foxconn:

To Apple executives, Foxconn City was further evidence that China could deliver workers — and diligence — that outpaced their American counterparts.
That’s because nothing like Foxconn City exists in the United States.

The facility has 230,000 employees, many working six days a week, often spending up to 12 hours a day at the plant. Over a quarter of Foxconn’s work force lives in company barracks and many workers earn less than $17 a day. When one Apple executive arrived during a shift change, his car was stuck in a river of employees streaming past. “The scale is unimaginable,” he said.

http://www.nytimes.com/2012/01/22/business/apple-america-and-a-squeezed-middle-class.html?pagewanted=3&ref=general&src=me

It's not just that Chinese workers will accept miserable working conditions for low pay; they also offer foreign companies an incredibly deep poor of engineers and other technically-trained workers that this country simply cannot:

Another critical advantage for Apple was that China provided engineers at a scale the United States could not match. Apple’s executives had estimated that about 8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers eventually involved in manufacturing iPhones. The company’s analysts had forecast it would take as long as nine months to find that many qualified engineers in the United States.

In China, it took 15 days.

In a depressing contrast, back at American colleges and universities, more attention is being paid to athletics, at the expense of academia.

Ohio State, for example, just hired famed football coach Urban Meyer at a salary of $4 million per year, and numerous perks including the use of a private plane.

Meanwhile, research grants are being reduced by university administrations looking for ways to contain costs.

Here's an excerpt from the Times this morning:

{Ohio State Physics Professor Gordon} Aubrecht says he doesn’t have enough money in his own budget to cover attendance at conferences. “From a business perspective,” he can see why Coach Meyer was hired, but he calls the package just more evidence that the “tail is wagging the dog.”

Dr. Aubrecht is not just another cranky tenured professor. Hand-wringing seems to be universal these days over big-time sports, specifically football and men’s basketball. Sounding much like his colleague, James J. Duderstadt, former president of the University of Michigan and author of “Intercollegiate Athletics and the American University,” said this: “Nine of 10 people don’t understand what you are saying when you talk about research universities. But you say ‘Michigan’ and they understand those striped helmets running under the banner.”

http://www.nytimes.com/2012/01/22/education/edlife/how-big-time-sports-ate-college-life.html?pagewanted=1&ref=edlife

The article goes on to describe the near-fanatic following that successful big-time collegiate athletics has engendered on many college campuses today, often at the expense of students studies.

Meanwhile, in the Far East, colleges and universities pay scant attention to athletics, believing that students should focus on their studies.

Finally, this whole move to manufacturing offshore has reduced the negotiating power of the typical American worker.

Lockouts have apparently become more common in many businesses, as company management has gained the upper hand in many wage negotiations:

“This is a sign of increased employer militancy,” said Gary Chaison, a professor of industrial relations at Clark University. “Lockouts were once so rare they were almost unheard of. Now, not only are employers increasingly on the offensive and trying to call the shots in bargaining, but they’re backing that up with action — in the form of lockouts.”

The number of strikes has declined to just one-sixth the annual level of two decades ago. That is largely because labor unions’ ranks have declined and because many workers worry that if they strike they will lose pay and might also lose their jobs to permanent replacement workers.

Lockouts, on the other hand, have grown to represent a record percentage of the nation’s work stoppages, according to Bloomberg BNA, a Bloomberg subsidiary that provides information to lawyers and labor relations experts. Last year, at least 17 employers imposed lockouts, telling their workers not to show up until they were willing to accept management’s contract offer.

http://www.nytimes.com/2012/01/23/business/lockouts-once-rare-put-workers-on-the-defensive.html?hpw

Little wonder, then, that attacks by presidential candidates on countries like China have hit a very responsive nerve among the electorate.

An Inconvenient Disconnect

2012-01-20T13:12:00.001-05:00

It is an old Wall Street axiom that the markets in the short run are voting machines, but in the long run weighing machines.

"Nothing But Blue Skies Ahead!"

Stocks or industry sectors can enjoy investor popularity for a period of time based on a particular mood shift among investors. However, in order to make longer-term investment sense, the fundamentals of the stocks have to catch up with the share price.

The markets continue to have a good tone. As I noted yesterday, the S&P 500 is off to its best start in 25 years, and most clients seem considerably more relaxed than just a few months ago.

However, I am becoming a little troubled by the disconnect by the rise in the overall market and the increasingly negative tone of analyst comments.

I wrote a long email to some of my fellow colleagues here at Boston Private Bank, reflecting some of my concerns.

The overriding issue, it seems to me, is that stocks are being bought because the potential returns from most other asset classes are so unappealing.

The best performers last year, for example, were found in the dividend-rich utility and consumer staples areas. It's not that the business prospect for these companies is all that great; no, instead the fact that they pay relatively high dividends and are generally household names (think Colgate; Coca-Cola; and Southern Company) make them appealing to investors.

Meanwhile, the Wall Street analysts I respect are saying, "Hey, wait a minute - some of these stocks don't deserve to trade at a premium valuation based on their fundamentals."

Typically Street analysts are more optimistic than the general public, but now I am getting the impression that we are in an opposite situation.

I got some strong reactions to my mildly cautious email yesterday.

One manager basically told me, look, the markets are a forward-looking animal, and that stocks may be anticipating better economic times ahead. A better economy will lead to upward revisions in earnings forecasts, which will make today's prices look more reasonable.

Maybe, but I have been through this before, as my email suggested:

Stocks are off to their best start since 1987. Since I’mprobably the only one on the team that was investing 24 years ago, let me tellyou what happened.

Stocks kept moving higher for most of the year, but so too didbond yields. The fundamentals did not support the move in stocks, but no oneseemed to care. Then came October 1987 – stocks fell by -25% in one week,if my memory serves. Panic ensued. Clients were not amused.

I actually have very fond memories of 1987 – as a bond manager,we made huge returns in the fourth quarter, since we were very long ourbenchmark. But since I don’t do bonds anymore (directly, at least), Idon’t really care to go through all of this again.

They say that famed hedge fund manager Michael Steinhart used tosell all of the stocks in his portfolio at the end of the year, and then startreinvesting the proceeds, to make sure that he really wanted to hold onto thestocks in his accounts.

The market seems very complacent, in my opinion. I thinkeveryone is sick of talking about the euro, deficits and banks, and are buyingstocks because everything else offers essentially no return.

Ned Davis Research reported that stock short interest is at thelowest levels since 2000. I think the hedge funds got smoked in thefourth quarter – especially October – and are mostly long at this point.

So here’s my problem: While I might agree that stocks will offer superior returns on a longer term basis, I am having trouble getting excited about the near-term prospects:

Consumer staples - +30% premium to historic valuation. Uninspiring fundamentals. Sector analyst at Citi Wendy Nicholson just said thisAM that she would not buy any of the names, and Bryan Spillane at Merrill saidbasically the same thing on Tuesday when I saw him.

Consumer discretionary – the consumer is probably OK at thispoint, but names like McDonald's and Nike have already had huge moves. Are they still a buy?

Health care – The analysts atthe UBS conference we attended a couple of weeks ago were basically negative oneverything in each of their eight sectors.

Industrials – I saw analyst Jason Feldman at UBS yesterday, whoI think is pretty good. His point was that to buy his stocks here youhave to model a pretty strong second half pick-up in 2012, no Europeanrecession, and some euro stability. Is this likely?

Utilities – big premium to historic valuations based ongood dividend yields. Fundamentals don’t really support prices – justyield-hungry investors;

Financials – this group is having a strong January, but has anything really changed? Slow loan growth, bloated infrastructure, and potential legislative headwinds all weigh on the prospects for many financial stocks. Ned Davis had a piece that notedthe short interest on the group fell from 39% seven weeks ago to 27% now. Also, most managers are underweight, which means like me that are slightly panickythat financials are now working. But has anything fundamentally changed?

Energy – seems to me this group only works well if Iran closesthe Strait of Hormuz. Natural gas prices are low, and there’s too muchinventory. Warm winter doesn’t help.

Tech – largest weight in the market, at 20%. Everyone loves Apple, but with a market cap of $400 billion it is hard to see this stock continuing to grow as fast as it had been. Many publicly-traded tech stocks are mature businesses; the faster growing companies like Facebook are all private.

Telecom – do you really think the long term business prospectsfor AT&T and/or Verizon are all that thrilling? I think likeutilities these stocks are being bought for yield.

The Market Melts Up

2012-01-19T09:16:00.001-05:00

Last August, when the stock market was in the midst of one of its worst quarters in the past decade, I wrote several pieces suggesting that investors should look past the concerns of the day and focus on the longer term fundamentals.

Here's an excerpt from a piece I wrote on August 8, 2011, titled "Seven Reasons Not to Panic:

Weak economic data. S&P downgrades US debt. Eurozone in crisis. Gold soars above $1,700.

Stock markets tumble around the world, and the S&P 500 has lost more than 11% since the end of April...

... Finally, at times like this, it is worth remembering Warren Buffett's axiom to "Be greedy when others are fearful, and fearful when others are greedy".

When you see so-called smart money investors stashing funds in Treasury Bills yielding 0%, or even paying custodian banks like Bank of New York Mellon a fee to place deposits, you have to believe that a lot of bad news is already priced into the markets.

In my opinion, for the longer term investor, stocks represent the best combination of yield and potential capital appreciation.

I see little or no value in shorter maturity bonds yielding less than 1%.

http://randomglenings.blogspot.com/2011/08/seven-reasons-not-to-panic.html

(The S&P finished the quarter with a loss of -14%, so perhaps a little panic in mid-August would have been appropriate. On the other hand, thanks to a strong stock rally in October 2011, stocks regained all of the prior months' losses to finish the year with a modest +2.1% total return.)

Which brings us to today.

The same factors that were apparently causing the markets to swoon a few months ago - euro crisis; S&P downgrades; financial turmoil - are now being greeted with a collective yawn by the markets. Indeed, the S&P is off to its best start to a year since 1987, according to Bloomberg:

U.S. stocks are off to the beststart in 25 years as investors speculate Federal ReserveChairman Ben S. Bernanke has done enough to insulate the economyfrom Europe’s debt crisis.

The S&P 500 has gained 4 percent, the most since it rose 10percent over the first 11 days in 1987, according to datacompiled by Bloomberg. Stocks are overcoming earnings thattrailed estimates by the widest margin in three years asimprovements in hiring, manufacturing and car sales extend thebiggest fourth-quarter advance since 2003.

http://www.bloomberg.com/news/2012-01-19/s-p-500-rallies-most-since-87-as-bernanke-economy-weathers-europe-concern.html

Interestingly, despite the ebullient mood on Wall Street, the credit markets are still signalling distress in the global financial system.

Yields on high quality government bonds remain far below the levels of a year ago. Ten year Treasury notes, for example, offer investors a yield of just 1.9%, almost half the 3.5% yields of a year ago.

Many analysts are warning that the advance in stock prices is not justified by company fundamentals.

For example, industrial analyst Jason Feldman of UBS told me and a few other investors in a meeting yesterday that the recent advance in share prices of names like General Electric reflect overly optimistic assumptions about 2012.

Consumer staples analysts Wendy Nicholson of Citigroup - one of my favorite analysts - left a voicemail to clients this morning telling them to avoid all of the stocks in her sector. According to Wendy, stocks like Colgate and Procter and Gamble do not reflect the weakening trends in their underlying fundamentals.

Finally, only 47% of the companies in the S&P that have reported earning thus far have beaten expectations. This is the lowest level in years, according to Bloomberg.

While welcome, this month's rally has occurred on relatively low volume and listless trading. Like the old western movies - when cowboys would say things like "It's quiet - too quiet, if you ask me" - it is worrisome that complacency seems so widespread.

And as I wrote last August, the second part of Warren Buffett's axiom "be fearful when others are greedy" may in fact be the best advice for now.

Pity the Poor Analyst

2012-01-18T14:16:00.004-05:00

Wall Street analysts have long been the target of investor skepticism.

It seems like it is almost a rite of passage for business school professors to publish papers deriding the Street, pointing out that analysts are usually too bullish on the companies they follow. A typical academic analysis will point out that many Street analysts will have "buys" on 70% or more of the stocks they follow, which usually proves to be overly optimistic.

Far be it from me to defend Wall Street, but I think that some of the criticism is somewhat misguided.

To begin with, anyone that makes an investment decision based solely on (free) Street research deserves what they get. In any other business - autos, appliances, etc. - the consumer assumes that any research they get from their salesperson is biased. Why should the Street be any different?

Wall Street analysts are trapped in a system where they are forced to serve several masters. Even if they are pessimistic on the prospects for the companies they follow, downgrading a stock's rating can often career limiting. Wall Street, after all, is in the business of selling stocks and bonds; why would you tell your customers not to buy your products?

Company managements can become very unhappy if analysts write uncomplimentary reports. I have had numerous analysts tell me stories of how they have been denied access to senior managements of companies they follow in the aftermath of a ratings downgrade. No access to senior management presents a formidable challenge to an analyst following a particular group.

I was reminded of the plight of the typical Street analyst when I attended a lunch meeting yesterday.

This respected analyst follows the food and beverage companies. The stocks in his group have done very well in the past year. Investors have flocked to stocks like Coke; Pepsi; General Mills; and Kraft in search of high dividend yields and relatively predictable business models.

Problem is, the stocks today in general appear to be "fully priced" (to use Street lingo), with the P/E multiples on most stocks at roughly +30% premiums to historic averages. In particular, when you consider that most of the growth from the food and beverage group has come from the emerging markets, it seems likely that the economic slowdowns in places like Brazil and China will hit the companies.

But here's the rub: of the 26 stocks this analyst follows, fully 14 are rated "buy"; 7 rated "neutral"; and only 5 "sell".

So I asked the analyst: What gives?

Well, he said with a rueful smile, in my company 's rating system, only 25% of my coverage universe can be rated "neutral". In addition, our global strategist is recommending overweighting the stocks in my group. And, finally, names like Coke are so widely held among client portfolios that if I ever put a "sell" on these stocks, management and the brokers would go crazy.

Hence the apparent bullish stance on the group.

Cavaet emptor.

Does Anyone Care About Eurozone Downgrades?

2012-01-17T11:17:00.002-05:00

Lots of news coming out of Europe over the last few days, most of it negative.

As you no doubt read, last Friday Standard & Poor's not only downgraded several eurozone countries, but also the European Financial Stability Facility (EFSF).

Another ratings agency - Fitch's - announced that it was almost certain that Greek would be defaulting on its debt by the end of February, and Greek debt is now trading at 30% of face value in the secondary market.

Interestingly, though, the markets took all of the news with a collective shrug. It appears that the term I mentioned last week - Eurofatigue - remains firmly in place in the market's collective psyche.

It could just be that no one really cares all that much about what American rating agencies think about the debt markets; after all, interest rates on US Treasury 10 year notes have fallen by nearly 100 basis points since the US was downgraded by S&P last July.

European political reaction to the credit downgrades was outrage, as could be expected. However, rather than argue with the S&P analysis (as the US did last summer), the Europeans want to take it a step further; they want to regulate the agencies, according to Reuters:

LONDON, Jan 16 (Reuters) - Standard & Poor's credit rating downgrades of nine euro zone countries will fuel attempts by European Union lawmakers to slap stricter curbs on sovereign ratings...

...the EU is going further than theUnited States or what was agreed globally by the G20 to rein inagencies. The bloc's latest legislation is largely directed atthe global market dominance of the "Big Three" ratings agencies:S&P, Moody's and Fitch Ratings.

{European Union financial servies chief Michel} Barnier said in a speech in Hong Kong on Monday he wanted tosee rating agencies operate in full transparency.

"I am surprised time and time again by the timing agencieschoose to make such announcements," Barnier said. "I think itwould be right for agencies to take better account of theunprecedented efforts being made by government".

http://www.reuters.com/article/2012/01/16/eu-ratingagencies-regulation-idUSL6E8CG1GK20120116

The markets may not care now, but it seems likely that unless current trends change, they will eventually.

Writing in the Financial Times over the weekend, columnist Wolfgang Munchau points out the true significance of the rating changes; eurozone policy makers seem helpless to stop the downward spiral of many of its members:

Even economic reforms, necessary as they may be for other reasons, cannot solve this problem. This is another European illusion. We are now at the point where effective crisis resolution would require a strong central fiscal authority, with the power to tax and allocate resources across the eurozone. Of course, it will not happen.

This is the ultimate implication of last week's rating downgrades. We have moved beyond the point where a technical fix would work. The toolkit is exhausted.

http://www.ft.com/intl/cms/s/0/987fd2fe-3ddc-11e1-91ba-00144feabdc0.html#axzz1jjL2TBDk

Euro Fatigue

2012-01-13T11:35:00.002-05:00

For the second half of 2011, nearly all market discussions began and ended with some sort of comment about the euro.

Now, however, even though the euro situation is far from "solved", it seems that the collective market has turned its attention to other discussions.

Writing in yesterday's Financial Times, columnist James Mackintosh pointed out that the conventional view in the investment world is, "America good, Europe bad. The US economy is surprisingly strong, while Europe is perhaps already in recession." But, as Mr. Mackintosh points out:

No wonder investors prefer the US, with the S&P 500 up 15 per cent, including dividends, since Europe's autumn bottom.

But wait! Eurozone shares, including dividends, are up 15 per cent too. Charts of the two are almost indistinguishable.

http://www.ft.com/intl/cms/s/0/dc7c59b4-3c60-11e1-8d72-00144feabdc0.html#axzz1jGBQuRRb

However, while the equity market may be weary of worrying about euro, the crisis is far from over, at least as far as the credit markets are concerned.

Earlier this week, Switzerland was able to sell 15 year bonds with a yield of less than 1%. US Treasury yields continue to move lower as well, as worried investors flock to our bond market in favor of security. Here's the story from yesterday's Bloomberg:

The Treasury sold $21 billion of 10-year notes at a record low yield as speculation France may loseits top credit rating amid Europe’s debt crisis bolstered therefuge appeal of U.S. government securities.

The bonds drew a yield of 1.90 percent, compared with aforecast of 1.928 percent in a Bloomberg News survey of nine ofthe Federal Reserve’s 21 primary dealers. The bid-to-coverratio, which gauges demand by comparing total bids with theamount of debt offered, was 3.29, versus an average of 3.11 forthe past 10 auctions.

http://www.bloomberg.com/news/2012-01-11/treasury-sells-10-year-notes-at-record-low-yield-of-1-9-on-refuge-demand.html

Then there are concerns about Hungary, another euro block country in serious fiscal straits. Here's an excerpt from New York Times columnist Paul Krugman's blog:

The markets have issued a judgment on Hungary as well. Last week, the forint reached an all-time low against the euro and Hungary was unable to sell short-term government bonds in the markets. Its 10-year bonds must promise a nearly 10% yield, unsustainable over the long haul. . After Europe showed yesterday that it was ready to pressure Hungary into complying with its demands, Hungary’s short-term bonds must now promise nearly the same yield as its long-term bonds, but that is an improvement over not being able to generate any acceptable bids for short-term debt at all. .

http://krugman.blogs.nytimes.com/2012/01/12/somewhere-in-europe/?scp=8&sq=hungary&st=cse

Oh, and what about that money that the European Central Bank gave the large European banks at the end of last year to avoid a credit crunch?

Well, it turns out that the banks just took the funds and stuffed them into reserves. None of them apparently have any interest in resuming lending activities to bolster the European economy:

Banks are hoarding the EuropeanCentral Bank’s record 489 billion-euro ($625 billion) injection into thebanking system, thwarting attempts by policy makers to avert a credit crunch inthe region.

Almost all of the money loaned to 523 euro-area lenderslast month wound up back on deposit at the Frankfurt-based central bank insteadof pouring into the financial system, according to estimates by BarclaysCapital based on ECB data. Banks will use most of the money from the three-yearloans to meet their refinancing needs for this year and next, analysts atMorgan Stanley and Royal Bank of Scotland Group Plc estimate.

http://www.bloomberg.com/news/2012-01-11/banks-in-europe-resist-draghi-bid-to-avert-credit-crunch-by-hoarding-cash.html

Now, there are a few hopeful signs: Spanish and Italian government bond yields, for example, have moved sharply lower after successful bond auctions.

However, the fundamental problems facing the euro zone have not disappeared, despite the fervent wish that they will.

Put another way, the end game has not yet been played.

Are Hedge Funds the Solution to the Public Pension Crisis?

2012-01-12T11:15:00.001-05:00

The investment landscape has been frustrating everyone over the past few years, particularly for those tasked with coming up with investment strategies for public pension plans.

Bloomberg reports this morning, for example, that the pension actuary for New York City will be recommending that the City reduce its assumed pension return assumption from 8% to 7%. While this might seem logical - the plan has earned less than 4% per annum for the past decade, after all - it does have significant financial consequences:

New York's chief actuary isrecommending that the city’s $115.2 billion pension plans lowertheir assumed annual rate of return on assets to 7 percent from8 percent, which would open a funding gap of at least $2 billionnext year, according to two people familiar with the proposal.

The article goes on to note how much pension costs have grown in the past decade:

New York's pension costs have increased to $8.5billion this year -- including the reserve -- from $1.5 billionin 2002, when Mayor Michael Bloomberg first took office,representing almost 13 percent of the $66 billion budget forfiscal 2012.

http://www.bloomberg.com/news/2012-01-11/nyc-actuary-said-to-seek-lower-pension-fund-rate-of-return-of-7-from-8-.html

One major problem, of course, is the relatively meager return from stocks over the past few years. Bonds have been a big winner for the past decade, but with interest rates now at 60-year lows it is difficult to make the case that bonds will provide attractive total returns in the next few years.

So alternative assets classes have jumped to the attention of nearly every plan sponsor. But do the alternatives to stocks and bonds actually deliver the goods?

In short: mostly no.

Take hedge funds, for example. There have been numerous articles and books written recently that fund managers have done a relatively poor job at delivering the returns that the sector once promised.

Writing in Monday's Financial Times, columnist Jonathan Davis cites a new book about hedge funds that has just been published.

Named The Hedge Fund Mirage, author Simon Lack uses his many years of working with hedge funds at JP Morgan to uncover the basic truths about the sector.

According to Mr. Davis, here's the basic thrust to Lack's book:

In fact, concludes Mr. Lack, while many hedge fund managers have prospered from hefty fees, the bulk of their investment gains have not been shared with clients. On an asset-weighted basis, measuring cash invested to cash returned, hedge fund investors in aggregate, while narrowly beating the average return from equities, would have made more money over the past decade from investing in government bonds, and even from Treasury bills.

http://www.ft.com/intl/cms/s/0/c68c0250-379f-11e1-a5e0-00144feabdc0.html#axzz1jGBQuRRb

There are lots of reasons for the disappointing returns from hedge funds, but one of the biggest reasons is the size of the industry.

When the hedge fund industry was just starting, potential returns could be startling, simply because there was so little competition. Now, with nearly $2 trillion in the hedge fund sector, managers not only are struggling for good ideas, but the shear size of the funds they manage forces them into making large "macro" economic bets which have unfortunately mostly not proven to be successful.

And so the search for investment solutions continues.

Will Rising Dividend Yields Woo Back Reluctant Investors?

2012-01-11T11:35:00.000-05:00

In 1949, Benjamin Graham published a book called The Intelligent Investor.

Graham - who was Warren Buffett's teacher at Columbia Business School, and is widely cited as being the founder of modern stock security analysis - was attempting to explain to wide audience why at least some of their savings should be invested in common stocks.

He had a tough audience. As Graham noted in his introduction, fully 80% of Americans surveyed in 1948 thought that common stock investing was too risky for the average citizen.

This was not too surprising, if you think about. After the stock market crash in 1929, the market briefly recovered, then collapsed in the wake of the Great Depression. The market recovered during World War II, but the broader market averages were essentially only back to where they were 20 years before.

I remembered Graham's book, and his survey, when I read this article on Reuters this morning.

Titled "Generation Yikes: Why Young Savers Are Avoiding Stocks", the piece discussed the fact that younger workers - who should in theory have the longest time frame for investing - are largely shunning the stock market.

According to the article, a survey done by money manager MFS Investment Management found that fully 52% of Generation Y investors (those under the age of 31) say that they will never be comfortable investing in stocks.

The article goes on:

...the MFS survey, which asked investors which asset classes they would deem an "excellent or very good place to invest." The only area on the rise: Safe harbors like bank CDs, savings accounts and money markets. As for stocks, from February to October of last year, that number was sliced in half: Only 18 percent of Americans now see equities as a very good place to put their money.

Judging from fund flows, that dire sentiment is having very real effects on asset allocation. Retail investors pulled almost $37 billion from stock funds in 2010, and more than $101 billion over the first 11 months of 2011, according to the Investment Company Institute.

http://www.reuters.com/article/2012/01/10/us-investing-geny-idUSTRE8091F920120110

I'm not suggesting that we are totally in the same situation to the late 1940's - valuations are not as low as they were back then, for example - but there might be some similarities.

For example, stock dividend yields in the 1950's were far higher than bond yields. No one would think of taking the risk of buying a stock without getting a handsome cash return every year.

So perhaps dividends will begin to increase significantly, as companies are forced to part with some of their massive cash hoards in order to entice more interest in their stocks.

This was the thrust of an article titled "Dividends Rise in Sign of Recovery" in this morning's New York Times. The author noted that some of best performing stocks last year offered some of the highest dividend yields:

If analysts’ forecasts come true, that trend will continue later into the year, as companies release more of their cash and try to win over investors still hesitant about putting their money back into stocks.

“The idea is beginning to percolate a little bit in management suites that paying a bit higher percentage of your earnings in dividends might be a way to a higher stock price and better benefits for shareholders over all,” said Edward F. Keon, portfolio manager for Quantitative Management Associates.

http://www.nytimes.com/2012/01/11/business/rising-dividends-expected-in-2012-as-companies-woo-investors.html?pagewanted=1&src=rechp

Although dividend-paying stocks were big winners last year, I think they will continue to be favored by cautious stock investors in 2012.

Coin Flips, Samuelson's Problem, and Stock Market Investing

2012-01-10T09:11:00.003-05:00

I love this anecdote that Daniel Kahneman wrote about in his book Thinking, Fast and Slow:

The great Paul Samuelson - a giant among the economists of the twentieth century - famously asked a friend whether he would accept a gamble on the toss of a coin in which he could lose $100 or win $200. His friend responded, "I won't bet because I would feel the $100 loss more than the $200 gain. But I'll take you on if you promise to let me make 100 bets."

Kahneman goes on to describe why Samuelson's friend was so clever.

The outcome of one coin flip is, of course, a random event. Over time, however, it will almost certainly be true that heads will come up 50% of the time, which means that:

Matthew Rabin and Richard Thaler pointed out that "the aggregated gamble of one hundred 50-50 lose $100/gain $200 bets has an expected return of $5,000, with only a 1/2,300 chance of losing any money and merely a 1/62,000 chance of losing more than $1,000".

So why am I bringing this up today?

Historically investing in stocks has been a money-winner. According to the brokerage firm Franklin Templeton, looking back over the last 85 years, stock market investors have made money 71% of the time on an annual basis (including 2011, by the way). And for a 10 year period, stock market investors have made money 95% of the time.

The simple solution to investing, then, is to stay invested.

Like Samuelson's friend, you know the longer you play the market, the more likely you are to gain profits.

Is the Japanese Economy Really As Bad as Portrayed?

2012-01-09T10:09:00.000-05:00

In the late 1980's, I started traveling to Japan a couple of times a year.

Japan was the envy of the world at that time. Books were published in the US describing how the Japanese "miracle" had turned a country ravaged by World War II into the most vibrant economy in the world. Land values soared in Japan, and at one point it was estimated that the land under the Imperial Palace (3 miles in circumference) was worth more the entire state of Colorado. The Nikkei hit 39,000 in 1989, and few observers dared to suggest that Japanese stocks were overvalued.

My work in Japan was mostly with the banking area. Using Fannie Mae mortgage-backed securities, I had developed and managed a series of mutual funds targeted for Japanese banks and insurance companies. The funds were mostly successful - the demands for alternative asset classes in the Japanese financial sector were high - so I had the chance to meet with Japanese executives on a regular basis.

The timing of my work in Japan - which extended from 1989 to 1997 - gave me a front row seat at the unraveling of the Japanese miracle. As it turned, my initial trips to Japan also coincided with the peak of Japanese economy. In retrospect, the entire Japanese financial system was in the midst of a giant bubble, which started to deflate in 1990. Since so much of the system was based on leverage, the more prices fell, the more the decline accelerated, as panicked borrowers sold assets to meet repayment demands. The largest Japanese banks - which had been so eager to fuel land and stock speculation - turned into "too big to fail" zombies in just a few years, kept alive by the government.

Japan is often cited as a cautionary tale in this country. There are numerous unfortunate similarities: high debt levels, rampant financial speculation, and huge money center banks weighed down by the legacy of bad lending. Indeed, Fed Chairman Bernanke was critical of Japanese authorities for not being more aggressive in addressing their problems in the 1990's, which in part explains some the Fed's moves in the past few years.

However, in recent months there have been several commentators that have been suggesting that, hey, maybe living in Japan these days really isn't so bad after all - the stock market be damned.

Typical was an article in yesterday's New York Times. Titled "The Myth of Japan's Failure", the author Eamonn Figleton cites numerous statistics and anecdotes to bolster his contention that Japan's economic condition is actually better than portrayed in the West. Here's an excerpt:

...By many measures, the Japanese economy has done very well during the so-called lost decades, which started with a stock market crash in January 1990.

By some of the most important measures, it has done a lot better than the United States. Japan has succeeded in delivering an increasingly affluent lifestyle to its people despite the financial crash. In the fullness of time, it is likely that this era will be viewed as an outstanding success story.

http://www.nytimes.com/2012/01/08/opinion/sunday/the-true-story-of-japans-economic-success.html?_r=1&src=me&ref=general

Worth a read.

Readers Challenge Random Glenings

2012-01-06T11:57:00.001-05:00

I have received a few comments recently from loyal readers of Random Glenings.

As might be expected from such an elite group, their thoughts have been very insightful and challenging, so I thought I would mention them today.

"Isn't everyone bearish on the financials?"

I wrote a long piece yesterday discussing why I remain very worried about the prospects for the financial sector. However, one reader called to suggest that this is a consensus view. Moreover, with valuations of many bank stocks at record lows, one could argue that a lot of the "bad news" has already been priced into the stocks.

I, too, have seen the surveys that indicate that the single most disliked group is the financial sector. However, my contention is there is still a significant difference between what investors are saying and how they are investing.

At the height of the financial crisis, financials represented 9% of the S&P 500. Today this number is 14%, which makes it the second largest sector (by market capitalization) in the S&P after the technology group. True, financials represented more than 20% of the market in 2007, but I would argue that this just meant that they were overvalued 5 years ago.

Put another way: someone must be buying the stocks.

"You're wrong on Europe and the Emerging Markets. European stocks are trading at very cheap levels relative to the US. And growth rates in the emerging markets will rebound in 2012, and the stocks do not yet reflect this. You should be adding more international exposure in your portfolios."

This is a tougher one to challenge. Even though US market returns were flat last year, they far outperformed international (-12% in 2011) and emerging markets (-13%). If the euro crisis can come to some sort of resolution, European stock markets could surprise on the upside.

Emerging markets could also be a surprise this year. Recall that a year ago most of our concerns were about inflation in countries like China and Brazil due to their extremely fast rates of growth. Governments acted to tighten credit to slow the rates of growth in many emerging markets countries, and were largely successful. Thus it was not surprising that the emerging markets stocks followed.

I think I need to do more work on international stocks in the next few weeks.

"Your generally positive stance on healthcare stocks is misguided. Government spending on Medicare and Medicaid has to slow meaningfully if the federal deficit issues are to be addressed, and this will weigh heavily on the group."

I attended a health care forum yesterday sponsored by Citigroup which featured 8 different analysts from all of the various healthcare sectors. With the exception of one analyst - who specialized in healthcare IT - all were neutral or negative on their outlooks for 2012. The single most cited concern was cutbacks in Government spending.

I am not disputing that health care costs are the single biggest issue that needs to be addressed if we are to make any headway on reducing the federal deficit. The numbers are indisputable; at the current rate of growth (+8% per annum), health care costs will soon overwhelm every other category of federal spending.

My question is timing. In an election year, it seems unlikely that either political party will do anything to offend older voters. Moreover, while many agree that health care spending is out of control, there is little consensus on what exactly should be cut. I don't believe that much will change until it becomes absolutely necessary, which means that true health care reforms will not take place for at a few years at least.

Healthcare stocks are generally trading at inexpensive levels, and many pay attractive dividends. These two qualities will keep the sector buoyant in 2012, in my opinion.

Investors Still Too Optimistic on Financial Sector

2012-01-05T09:34:00.002-05:00

The problems of the financial sector are pretty well known. Let me just talk about a few of them.

Low interest rates are killing the insurance companies. Earning interest on the "float" - the difference in time from when premiums are received versus when claims are paid - are important part of industry profits. When rates are as low as they are today, earnings will take a big hit.

Life insurance companies sold billions of annuity products to savers over the last few years offering returns of 5% or higher. These were sold with the expectation that interest rates would move higher, but rates have confounded the "experts" and moved to 60-year lows. Where are the insurance companies investing to earn their promised returns?

The flat shape of the US Treasury yield curves - especially on shorter maturities - makes it very difficult for banks to make money, especially when loan growth remains tepid. Historically banks could take deposits and invest in Treasury notes if there was not sufficient loan demand, but the difference between deposit rates and Treasury yields has shrunk dramatically. You may think earning 0.5% on a 6-month CD is puny, but banks have few places to go to make any kind of spread.

Then there's the regulatory front. Although banks have become masters lobbyists, and have been very effective in blocking meaningful changes, the sentiment has definitely turned so anti-Wall Street which probably means that changes are coming.

For example, the so-called Volcker Rule (named after former Fed chair Paul Volcker) bans proprietary trading at investment banks. If the Volcker rule becomes effective, Brad Hintz of Sanford Bernstein estimates that Wall Street's fixed-income desks will experience a 25% decline in revenue and a 33% cut in pre-tax margins.

Oh, and discussions of stock transaction tax - now nicknamed the "Robin Hood Tax" - continue to gain momentum. The idea is to charge a small tax (around 0.25%) on every stock trade, and use the proceeds to whittle down government debt. Already the French and German governments have announced that they are in favor of such a tax, despite opposition from the UK and the US. If enacted, imagine the impact on trading volumes if so-called high frequency trading is curtailed.

I could go on but I hope you get the idea.

So what are investors doing with this information?

Well, judging from where funds are being invested, the collective judgement of the market is that financials will be a good place to invest in 2012.

Here, for example, are the top five sector weights (by market cap) in the S&P 500 as of yesterday; notice what is the second-highest ranked:

Technology                           19%
Financials             14%
Energy            12%
Health Care            12%
Consumer Staples       11%

Then there's more: here's an excerpt from a note from the blog Zero Hedge:

Morgan Stanley {has calculated} that the relative contribution of financial stocks to the change in full S&P earnings (combined they account for 26.3% of the change from the actual $883.5 billion to $970.6 billion). Specifically we are looking at Bank of America, which with a forecast surge in Earnings from ($2.5) billion to $10 billion accounts for 14.1% of the entire change in S&P earnings forecasts. And since the S&P is simply the Earnings number multiplied by some multiple, all consensus views that have 1400 as their 2012 year end forecast rely on bank of America to account for nearly 20 S&P points!

http://www.zerohedge.com/?page=1

The apparent discrepancy between fundamentals and market pricing will be an important area to watch in the financial sector in 2012, in my opinion.

And, unfortunately, fundamentals tend to win out over sentiment over time.

Don't Worry, Whitney - Lots of Bond People Got 2011 Wrong

2012-01-04T12:06:00.000-05:00

Municipal bonds turned in a very strong performance in 2011.

Here's what John Hallacy, a municipal bond analyst at Merrill Lynch, reported last week (I added the emphasis):

The BofA Merrill Lynch Municipal Master Index returned 11.189% for 2011. This compares with total returns of 9.185% for the US Treasury/Agency Master Index,7.507% for the US IG Corporate Master Index and 4.501% for the US Corporate High Yield Index, for the year. The best performing munis were on the long end ofthe curve and A- and BBB-rated credits

http://rcr.ml.com/Archive/11122140.pdf?w=dglen%40bpbtc.com&q=EWmIeUQlxyP!QB77ytkdwA&__gda__=1325695582_47206218ea7e0b4edf8917d2d4287734

One of the big reasons that municipals did so well last year occurred on December 14, 2010.

The CBS news program 60 Minutes interviewed a Wall Street analyst named Meredith Whitney. Ms. Whitney - whose claim to fame was correctly calling the massive problems in banks stocks in 2007 - suggested in the interview that we could see "50 to 100 sizable defaults, {maybe} more" in the municipal bond market in 2011.

Predictably, municipal bond investors panicked, and headed for the exits at the end of 2010, and municipal bond yields soared.

Now, as we all know, the rate of default in 2011 was actually slightly lower than 2010, and those same investors who had fled the municipal bond market returned with a vengeance, driving municipal bond prices higher and producing the strong returns noted by Merrill Lynch.

Whether Ms. Whitney actually predicted huge municipal bond defaults in 2011 is open to question. Writing in the November 2011, Vanity Fair financial writer par excellance Michael Lewis reviewed the transcripts of the CBS interview, and found that what Ms. Whitney actually said was that municipal bond credit worthiness would continue to deteriorate in 2011, which in fact has proven to be the case.

But that hasn't stopped Wall Street and municipal bond managers from telling all who would listen that they had been right, and Meredith Whitney was wrong.

Yet as I thought about it, I don't really think any economist or bond manager should be proud of their record in 2011.

For example, few, if any, economists forecasted interest rates falling to 60-year lows by the end of 2011.

Many bond managers thought that high yield bonds were a sure bet in 2011 ("just look at the high levels of corporate cash!") but as the Merrill Lynch piece indicates, high yield was the poorest performing sector of bond market.

And what about Bill Gross - the most successful bond manager of our generation - pulling client money out of the Treasury bond market in mid-2011, only to miss the huge rally in the wake of the European-induced flight to quality?

Where was the "smart money" when S&P downgraded the credit quality of the US government in August? Other than nodding sagely about the irrationality of Washington, few bond managers had the courage to add to positions.

I could go on, but you get the point. Forecasting is generally a fool's errand - it's usually only a matter of time before events prove predictions wrong.

Or, to put it another way, Ms. Whitney was not alone in proving her fallibility in 2011.

Listening to the Silence

2012-01-03T10:41:00.001-05:00

A few weeks ago I wrote a piece about the backlash against emails, instant messaging and mobile phones.

Intel, for example, is experimenting with a "no email" Friday for its engineers, where no one is allowed to email anyone else in the company. Face-to-face meetings, or even an old-fashioned phone call, has been reinstituted as the communication vehicle of choice at this leading technology company.

The experiment has gone so well that Intel is considering making emails obsolete for the entire company on Friday.

Over the weekend the New York Times carried an article about how more families are looking for ways to disconnect the internet, at least for a short while. Here's an excerpt from the piece entitled "The Joy of Quiet":

In barely one generation we’ve moved from exulting in the time-saving devices that have so expanded our lives to trying to get away from them — often in order to make more time. The more ways we have to connect, the more many of us seem desperate to unplug. Like teenagers, we appear to have gone from knowing nothing about the world to knowing too much all but overnight.

http://www.nytimes.com/2012/01/01/opinion/sunday/the-joy-of-quiet.html?_r=1&src=me&ref=general

Roger Cohen writing in this morning's New York Times also comments on the increasing demands that workers be allowed to disengage from instant communications, even for a short while. Here's an excerpt from his editorial:

Let’s hear it for Volkswagen at the start of 2012. The German automaker has responded to demands from its works council by agreeing to stop the e-mail server to its BlackBerry-using employees a half-hour after their shift ends, only restoring it 30 minutes before work begins the next day.

...The Volkswagen decision reflects growing evidence of stress-related burnout tied to employees’ inability to separate their working and private lives now that developed societies live in a 24/7 paroxysm of connection.

phttp://www.nytimes.com/2012/01/03/opinion/cohen-a-time-to-tune-out.html?hp

I can personally attest to how pleasant life can be without instant messaging.

Last week my family and I traveled to Montreal for a few days of vacation.

We had a great time - none of us had ever been to the city, and despite the cold we had the chance to explore many of the museums, restaurants and other attractions that Montreal offers.

One of the reasons the trip was was so pleasant was the fact that none of us could use our iPhones or iPads to connect with friends and family back home.

It was actually a little humorous at first. We arrived at our hotel, and all four of pulled out our Apple products to try to connect to the internet.

However, since we were in Canada, and our American service contracts did not allow for international service, no one was able to connect, despite our almost desperate attempts.

So what happened? We reconnected with each other. As we walked through the Montreal, we found ourselves looking up, not down at our iPhone. Forgotten arts like conversations were rediscovered, and we were reminded about how special family times can be.

And when we returned home - and the iPhones were up and running - we also discovered that we really hadn't missed a thing..

Happy New Year!

Thirty Years and Counting

2011-12-23T08:43:00.008-05:00

I will be on vacation next week, so this will be my final posting on Random Glenings in 2011. I thought I would take a break from the usual economic/market commentary and take a brief look back.

All the best for a happy and prosperous 2012!

Thirty years ago, in December 1981, I graduated from the Business School at Indiana University. Against the advice of my professors, I decided to head east, and start a career in investment management.

The investment management business was considerably different than it is today. After the "Go-Go Years" of the 1960's - when mutual fund managers like Gerry Tsai at Fidelity had achieved an almost cult-like status by achieving spectacular returns - stocks had fallen to earth in the 1970's.

The Dow Jones Industrial Average hit 1,000 in 1969. The market then started the slide that would take the Dow below 600 in 1974. Gradually prices improved, but it wasn't until 1982 - the year that I started my investment career - that the Dow returned to the 1,000 level.

Investors fled stocks in the 1970's for safer havens like bank accounts. The industry greatly suffered - Fidelity, for example, nearly went out of business in the decade, saved only by the introduction of money market funds.

There was more. Academic research indicated that markets were mostly efficient - that is, all available information about a stock was already reflected in its price, and there was no need for fundamental research. Why should anyone pay for investment advice if the markets were totally efficient?

Individuals were largely not involved in the stock market. In 1980, less than 10% of the American population had any of their net worth tied up in stocks. Stock market activity was an interesting news item, but it had a minimal impact on the daily lives of most people.

The firm I joined - Scudder, Stevens & Clark - was the oldest independent money manager in the United States. Scudder managed $12 billion when I joined it - the largest money manager in the country.

Scudder's investment business was largely focused on high net worth investors. We had some prestigious institutional relationships - the Ford Foundation and Harvard University were large clients - but most institutions were more comfortable with large passively managed bond portfolios.

Scudder too had experienced rough times in the 1970's. All of the partners had been required to pony up money to keep the firm afloat in the bear market that never seemed to end. Salaries were low - no one went into the money management business to get rich.

The firm was understandably frugal when it came to expenses. A sign in the Men's Room reminded users that "It only takes a little soap, and lots of water, to get your hands clean". The expense of personal long distance calls were the responsibility of the employee, and monthly phone bills were carefully monitored.

I was heavily in debt by the time I finished business school, and asked Scudder to help pay for my moving expenses. Reluctantly they agreed, but only after I got several competing bids from moving companies.

Even so, I had to wait more than a week after I started at Scudder for my furniture to arrive. A sleeping bag, and one pot for cooking, were the total sum of my furnishings during my first days in Boston.

It goes without saying that my salary was nothing special, either. Although I was one of the top students at Indiana, my starting pay at Scudder was well below average compared to my fellow graduates.

Scudder's attitude towards paying new employees was best summarized by Ted Scudder, in an excerpt from a speech that all new hires were required to read:

"Right now you are worth less than nothing to us, since you have no clients or investment expertise to help the firm. Still, we realize that you could not work with us if we did not pay you, but you should be aware of the sacrifice that the partners are making on your behalf."

Even with all of this background - low pay, crummy markets, frugal management - I was thrilled to be working at Scudder.

Scudder had almost a family-like culture. Everyone worked hard, but family and friends were important as well. When an employee suffered a personal loss - as I did in my early years - no one could have been more supportive than the management of Scudder.

But the business of Scudder was managing money. Fortunately for me, it was a great time to be an investor.

Stocks were trading at single digit multiples, and dividend yields were well north of 5%. Rather than talk about opportunities, however, the media largely focused on how poorly stocks had performed in the 1970's. No one had any interest in buying a piece of a business whose growth rate was far ahead of where it was being valued in the market.

Bond yields had steadily risen throughout the 1970's as inflation rates steadily moved higher. By the late 1970's, inflation was running at double digit rates, and new Fed Chairman Paul Volcker decided the time had come to slay the inflationary dragon. The Fed's policies eventually worked, but at a cost of extraordinary high interest rates.

Thanks to Paul Volcker, when I started at Scudder short maturity rates were nearly 20%, and long maturity Treasury bonds yielded more than 14%.

With record high short-term rates, money market funds were the rage. In 1981, money market funds had returned in the neighborhood of 15% to investors. Few observers bothered to point out that high short term rates would certainly be short-lived; in fact, Volcker started to cut rates in August 1982, and money market yields quickly followed suit.

My first assignment at Scudder was a corporate bond credit analyst. Investors could make serious money by doing fundamental research on bonds, and Scudder was one of the best. Since Scudder was literally the only investment firm that devoted any resources to bond research at the time, I can safely say that I worked in the best bond research areas in the country.

It is obvious in retrospect that investors should have been throwing any savings they had into the markets, but after the Lost Decade of the 1970's no one had the stomach.

For the period starting in January 1982, and ending at the end of 1999, stocks produced a 19% compound annual return. Even long government bonds gave anyone brave enough to invest in the market a 13% compound annual return.

If there is one constant that has remained the same over my 30 years in the business, it is this:

Investing on the basis of past returns is nearly always a bad decision.

And the corollary to this is:

Reversion to the mean is one of the most powerful forces in the capital markets.

Over most periods of time, stocks will outperform bonds. This only makes sense: an investor in a company should earn higher returns than someone who lends to the company. Returns from safe cash investments like money market funds have historically returned the rate of inflation, which also makes intuitive sense.

Or, put another way, no one ever got rich investing in money market funds.

Investors in 1981 were not interested in stocks or bonds because they had performed poorly over the prior decade. No one focused on valuation, or was able to see that most of the investment worries were already priced into the market.

Smart investment managers like Scudder tried to point out the opportunities to clients, but very few would listen.

Which brings us to today.

Similar to the start of my career, stocks have been disappointing performers for the past 12 years. Looking squarely in the rear view mirror, investment thinking today focuses largely on the myriad of risks in the market.

Investors would rather buy Treasury bonds yielding less than 1% for 5 years rather than subject their capital to any possible risk. Again, this is similar to where I started, when investors flocked to money market funds.

Alternative investment vehicles like private equity or hedge funds have gained appeal among institutional investors based on past returns. Never mind that some of these gains have been earned by taking outsized risks.

Instead of buying large cap dividend-paying stocks offering all-in (earnings yield + dividends) yields around 15%, investment committees would rather place their funds which the latest "hot" manager - just like Gerry Tsai at Fidelity in the 1960's.

There is one major difference between today and 30 years ago: the public.

In 1982, most workers were covered by some sort of pension plan. It was not necessarily to invest in stocks since your employer paid your retirement benefits.

Today this has all changed. Pension plans have largely disappeared - even public plans are trying to force employees to convert to self-funded retirement vehicles. Workers may not want to learn about the stock market, but they really have no choice.

More than 70% of Americans today have some exposure to the stock market, and their recent experience has obviously not been positive. Convincing the average investor to focus on long term returns - especially when it comes to retirement savings - is obviously a challenge.

But in my opinion, if investors have any hope of having enough money to enjoy their retirement years, a significant portion of their savings will have to be placed in common stocks. The potential outcome of returns from nearly every other asset class is simply too unappealing to reach any other conclusion.

I've been lucky to be involved in the investment management business for the past three decades.

And while I'm not sure what is in store for the next 30 years, I'm looking forward to writing another long post about the past in 2041.

Looking Ahead - Reluctantly

2011-12-22T09:49:00.004-05:00

I have written several times over the past few weeks about the futility of forecasting.

However, investing is all about preparing for the future, so I want to share what I have been telling clients recently.

The basis of my strategy for 2012 comes from Ray Dalio, founder and president of Bridgewater Associates.

Bridgewater is the largest and one of the most successful hedge fund operators in the world. Managing $125 billion for large institutions and pension funds, Bridgewater's investment returns have consistently been among the best in the investment world.

Dalio wrote an editorial piece in the Financial Times in late October discussing the current state of the world. Here's how I described it in my post dated October 25, 2011:

Dalio believes there are three important trends to consider right now:

We are in the midst of a massive de-leveraging process. Dalio notes that he is not only concerned about the huge government debts around the globe, but also the massive amount of debt that individuals also have amassed. In his opinion, the process of reducing this debt will be a drag on economic growth for years;
Governments are largely out of ammunition. Dalio believes there is are few alternatives left for our elected officials to improve the current economic climate;
We are at each other's throats. The tone of any policy debate has become incredibly nasty and strident, and no one seems to want to try to come up with any workable solutions. This, in Dalio's opinion, is probably the biggest danger to our economies and markets.

Here's the final paragraph of Dalio op-ed piece:

If we calm down and work together to properly manage this difficult situation....we can get through this deleveraging without great pain. If we can't, we may experience an economic, social and political collapse.

http://www.ft.com/intl/cms/s/0/ed4439d4-fbeb-11e0-9283-00144feab49a.html#axzz1bnIVgYrW

The reason I like Dalio's logic is that I believe it sets a very reasonable framework for investment strategies.

For example, in a world characterized by deleveraging, lenders are obviously at a disadvantage - hence, I would continue to avoid bank stocks.

Deleveraging - combined with massive liquidity injections by the central banks of the world - also means that the price of money will remain relatively cheap. Thus, interest rates will probably remain low for longer than people expect. Bonds will offer a good buffer if markets turn ugly, but returns can only be modest from today's starting levels.

Low interest rates also raise the attractiveness of dividend-paying stocks.

Points two and three relate to government policy.

Fed interventions in markets during the past two years were crucial for many reasons, but they were a major contributor to capital market returns.

Do you think it was just coincidence that the stock market swoon this summer came shortly after the end of the Fed's second round of quantitative easing? I don't.

But I would agree with Dalio - I doubt that the Fed could muster the political support for another massive market intervention except under the most dire scenarios. Investments in 2012 will rise or fall based on their own merits - no Ben Bernanke to the rescue.

The final point is being illustrated once again in Washington. I don't know where you stand on this whole debate on extending the payroll tax cut, but the partisan bickering is once again discouraging.

It's hard to believe that our political system will function any better next year, when Presidential campaigns are in full swing. Problem is, partisan politics could lead to poor policy decisions, and this to me is one of the major risks to investors next year.

Europe, Email, and Other Pressing Questions

2011-12-21T12:21:00.004-05:00

Here's what passes for "good news" in Europe these days:

Banks in Europe have been under a severe liquidity crunch over the past few weeks as lenders across the world - especially in the United States - have pulled back their credit exposure.

A couple of weeks ago the Federal Reserve made hundreds of billions of dollars available to the European financial community who were starved for dollar funding, but this was still not sufficient liquidity.

Enter the European Central Bank (ECB), which also opened the borrowing window to banks with few alternatives available. And here's what happened, according to the New York Times this morning:

In its role as lender of last resort to banks, the E.C.B. allocated 489.2 billion euros, or $644 billion, to 523 institutions, through what are known as long-term repurchasing operations. That was well above the roughly €300 billion average estimate of analysts polled by Reuters and Bloomberg News, though estimates had been widely divergent.

The injection of three-year funds was one of the new measures announced by the E.C.B. on Dec. 8 to calm European credit markets, which have become increasingly frothy as the euro zone crisis wears on. It was the first time that the E.C.B. has extended such loans for longer than about a year. Banks will pay the benchmark interest rate, currently 1 percent.

http://www.nytimes.com/2011/12/22/business/global/demand-for-ecb-loans-surpasses-expectations.html?_r=1&hp

Initially European markets soared - the ECB to the rescue!

Then the sobering reality hit: borrowing from the "lender of last resort" (i.e., the ECB) can hardly be taken as an all-clear signal.

All it really means is that the ECB has postponed the Day of Reckoning for a few months.

But the market took it as good news anyway.

-------------------------------

That's not what I really want to talk about today, though.

Like millions of other people, I am an active user of email. The days of ringing phones and huge mail volumes have long gone. If you were in my office on most days, the most frequent sound you would hear would be the clicking of my keyboard as I respond to clients and analysts.

While I appreciate the efficiency of email, I must confess there are days that I wish the volumes would decline. On a typical day I probably get 150 to 200 emails a day, and nearly all seem to require varying degrees of attention.

I have been reading more articles recently about how companies and people are trying to minimize their email involvement. Interesting, the companies at the forefront of the movement seem to be technology companies, which were the pioneers in email a couple of decades ago.

There was an article in yesterday's Financial Times describing the backlash against email. Entitled "The end of email"?", the piece discussed actions that people are taking to either avoid email messaging or are turning to other social media communications to discuss routine matters with colleagues.

Here's an excerpt:

However, for many companies, it is simply that email is seen as inefficient. "We believe email is fundamentally unproductive, you need to sift through too many documents and things get lost, " says Leerom Segal, president and chief executive of Klick, a Canadian digital marketing company. "It has no prioritisation, no workflow, and assumes that the most important item is the one at the top.

http://www.ft.com/intl/cms/s/0/5207b5d6-21cf-11e1-8b93-00144feabdc0.html#axzz1hBJ49JOw

The article goes on to discuss how some companies like Intel are experimenting with "no-email Fridays", encouraging engineers to solve problems by phone or face-to-face instead.

It may be that the problems in Europe are more important than email overload, but I suspect the latter will be easier to solve in the long run.

Forecasting Follies

2011-12-20T08:09:00.004-05:00

Writing in his book Thinking, Fast and Slow, psychologist and Nobel Prize winner Daniel Kahneman discussed the perils of overconfidence.

He talks about the illusion that all of us to some degree share about our ability to forecast the future.

Although there is overwhelming historic evidence that many events - political, markets, etc. - are merely random, it doesn't prevent us from listening to forecasts from learned experts.

For example, here's one experiment that Dr. Kahneman describes:

For a number of years, professors at Duke University conducted a survey in which the chief financial officers estimated the returns of the Standard & Poor's index over the following year. The Duke scholars collected 11,600 such forecasts and examined their accuracy. The conclusion was straightforward: financial officers of large corporations had no clue about the short-term future of the stock market; the correlation between their estimates and the true value was slightly less than zero!

Kahneman goes on to describe how the professors asked the CFO's to give "confidence ranges" in which they were fairly certain that their forecasts would be accurate.

Here again, unless the CFO's gave a sufficiently wide range of potential outcomes (e.g., that the market would return somewhere between -10% and +30%), the actual results compared to the "highly confident" forecasts were often wildly different.

I bring this all up because year-end tends to be the time of year when you will see all types of forecasts, ranging from the markets, weather, or elections. However interesting these discussions might be, we should recognize that statistically most of them have little chance of actually coming to pass.

Writing on the blog Business Insider, former Wall Street analyst Henry Blodget discusses the fallibility of forecasting.

He cites a number of different areas where analysts and economists from the Street have been consistently wrong, yet continue to make forecasting that somehow continue to gain a wide following.

For example, he notes that most economists will forecast moderate growth for the coming year. The reason is simple: for a mature country like the United States, moderate growth tends to be the norm. Forecasting strong growth, or a severe downturn, may make headlines but can be severely career limiting if the forecasts prove inaccurate.

Here's what Blodget writes:

If economists can't predict the future, why do they always predict that the economy will grow about 4%? Because that's what the economy's long-term growth average is--and, therefore, that's the prediction that gives the economists the best odds of being generally "right" (or at least not too embarrassingly wrong).

Just as no one ever gets fired for buying IBM or hiring someone from Harvard B-school, no one ever gets fired for predicting that the economy will do about as well as it has always done. And, of course, staying close to the average also gives the economists the best chance of being close to right. So that's what economists predict!

Read more: http://www.businessinsider.com/economist-forecasts-wrong-2011-12#ixzz1h56NPkie

Consider yourself warned!

Euro Fatigue

2011-12-19T11:35:00.003-05:00

Although the news from Europe continues to be mixed at best, the markets seem to have accepted that the worst is over - for now.

Interest rates on Italian and Spanish debt have fallen significantly over the past week, for example, as the combination of European Central Bank intervention and the latest euro block decisions seem to have beaten back the bears.

What is not clear is whether the public at large is willing to accept austerity for the next several years in return for saving the euro.

This is one of the crucial questions, in my opinion: it is all very well and good for leaders to sit in a large ballroom and agree that cutbacks and tax increases should be imposed on the profligate countries like Spain, Italy, Portugal, et. al.

It is a far different matter to ask ordinary citizens to accept unemployment rates of 20% and a reduction in basic government benefit payments that had been already promised.

Yesterday's New York Times discussed the challenges facing most Europeans as a result of the euro crisis.

Written by an Italian commentator, here's an excerpt:

{Italian Prime Minister} Monti, a former university president, should be worrying less about defenders of old privileges and more about young people, who will bear the brunt of economic stagnation. Instead, his emergency package does little to end monopolies, shrink bureaucracies and reduce systemic corruption, reforms that would increase competition and spur growth.

Youth unemployment is already at nearly 30 percent. Mr. Monti is offering tax incentives to employers who create new full-time jobs for young people, and for women, who are underrepresented in the labor market. But with his package reducing demand, and older workers required to stay on the job longer to draw full pensions, it isn’t clear where those new jobs will be found. For years, young Italians have moved around Europe in search of jobs, and that outlet is closing as the Continent moves toward recession.

http://www.nytimes.com/2011/12/18/opinion/sunday/inside-the-euro-zone-bracing-for-austerity.html?_r=1

Just as in this country, there seems to be a growing sentiment in Europe that the burden of economic readjustment will be falling mostly on those least able to make sacrifices.

But for now at least it is nice to have a pause in the euro zone drama.

The Disconnect Between Stocks and Employment

2011-12-16T09:13:00.005-05:00

Unemployment remains stubbornly high, and the eurozone crisis lurches from one bailout package to the next.

Quoted in this morning's Financial Times, IMF Managing Director Christine Lagarde gave a speech in Washington yesterday warning that the world faces the risk of "economic retraction, rising protectionism, isolation and...what happened in the 30s {Depression}".

With this miserable background, why does the US stock market remain reasonably buoyant?

There are many reasons, of course, but one might be the simple fact that profitability is at all-time highs, largely based on the incredible efficiency gains that technology has brought to Corporate America.

On the other hand, looking at data going back to the end of World War II, labor compensation as a percentage of total nonfarm business output has never been lower.

Put another way: corporate profits have fully recovered to 2007, but labor's share of those profits continues to decline.

Even with stagnant wage growth, companies simply don't need to hire as many people as they had in previous recoveries to achieve the same levels of output. Moreover, some of the fastest growing businesses (i.e. technology) simply don't need that many people.

For example, Google employees around 27,000 people, and continues to hire at a fairly rapid clip. However, by comparison, General Motors in the 1970's employed well over 100,000 people through its operations.

I don't think this is just a political question. You can argue about worker retraining, or the need to improve our education systems to compete in the 21st century, but the huge amount of workers who cannot find work is a tremendous economic burden as well.

Here's how the FT put it yesterday:

{The share of income that has fallen to workers}has fallen to its lowest level after records began after the second world war and is part of the reason why incomes at the top - which tend to be earned from capital - have risen so much. If wages were at their postwar average share of 63 per cent, workers would earn an extra $740bn this year, according to FT calculations.

http://www.ft.com/intl/cms/s/0/1bf8e7ba-2578-11e1-9cb0-00144feabdc0.html#axzz1ghromZhS

And since the marginal propensity to spend is higher for lower wage workers, imagine how much stronger economic growth would (not to mention tax revenues!) if we can get the employment picture to brighten.

In the meantime, though, we will probably continue to have this disconnect between capital market performance and economic reality.

The Fed and the European Banking Crisis

2011-12-15T09:24:00.005-05:00

Fed Chairman Bernanke held a meeting with Republican Senators yesterday.

The timing of this meeting makes absolute sense, as always:

the government is on the verge of yet another possible shutdown over a trivial dispute over a payroll tax that both parties profess to want to pass;

The federal debt burden continues to mount as no serious solutions to our budget deficits have been proposed;

And the approval rating of Congress hovers around 8%, meaning that probably their own families think they're incompetent.

So what better time to head over the Federal Reserve Building and do a heart-to-heart with the head of the one institution in Washington that is at least trying to help the country's weak economic growth.

But I digress.

After the meeting, a number of the Senators indicated that while Bernanke is "very concerned" about Europe, he has no intention of directing any sort of Fed intervention:

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. Lindsey Graham, a South Carolina Republican, said Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks. Both senators spoke to reporters after leaving the one-hour session at the Capitol in Washington.

http://www.bloomberg.com/news/2011-12-14/bernanke-tells-senators-federal-reserve-has-no-plan-to-aid-european-banks.html

Left unspoken was the fact that the Fed already has intervened.

Just a couple of weeks ago, the Fed opened the dollar interbank market to all European banks, lending dollars to all who needed funding at essentially 0% rates of interest. Without the Fed, the dollar-starved European banks would have been on the verge of collapse.

And this is the real problem in this whole euro mess: No one really knows how vulnerable the banks really are.

New York Times columnist Jesse Eisinger wrote a piece last October about the banks.

In the column, he noted that by most conventional measures the banks and brokers seem to be in much better shape than they were during the financial crisis of 2008.

However, financial stocks keep falling, as investors have very little faith in both the numbers and the managements of our largest financial institutions:

Yet, the moment one examines almost any detail of the global financial system, faith falters once again. Take the uncertainty about the derivatives markets. Morgan Stanley has a face value of $56 trillion in derivatives. That’s really nothing. JPMorgan Chase has more — amounting to the G.D.P. of large countries — a face value of $79 trillion in derivatives. If something goes wrong with just one-tenth of 1 percent of those trades, it’s kablooie.

Now those are gross numbers. Many people would dismiss those totals as ridiculous and misleading. Anyone who brings them up is merely displaying ignorance. The banks’ derivatives portfolios are full of off-setting trades that net out at a smaller number.

Derivatives can be dismissed as a popular bugaboo, but they really are just a symbol of the larger problem. A litany of daily stories reveals all kinds of reasons that banks don’t trust each other. To take just one news item, almost at random: Bloomberg News reported the other day that a Danish bank was refusing French sovereign debt as collateral.

Nobody really knows how much exposure the American banks have to the European financial and political crisis, with the Treasury Department minimizing the issue while other outlets raise the specter of catastrophic problems.

http://www.propublica.org/thetrade/item/trust-bust-why-no-one-believes-the-banks

So Bernanke and the Senators can agree that Europe should fix their own problems, but the truth is elusive, and we're really all in this together.

Uh, Oh - Public Pension Funds Making Bigger Bets to Cover Shortfalls

2011-12-14T11:04:00.003-05:00

The current market environment is incredibly frustrating for most investors.

Interest rates are at 60 year lows. Bank deposit rates are mostly below 1%. Stock returns will be flat in 2011 - again. The S&P 500 remains 17% below year end 2007 (talk about depressing!).

If you believe - as I do - in Regression to the Mean, and the under performance of stocks relative to bonds over the last few years will reverse itself.

In particular, I think that investors in large cap, dividend paying US stocks will earn good returns for the next few years, although it will almost certainly be a bumpy ride.

In other words, in my opinion, patience is the most important investment consideration at this juncture.

Unfortunately, if you're on the investment committee of a large pension plan, there is a constant pressure to improve returns, even if it means taking on more risk.

For example, this morning's New York Times discusses the increased allocation of public pension plans to private equity investments.

Private equity has an aura about it. The idea that a small group of incredibly savvy investors will be able to invest in the next Apple, Facebook or Google and deliver outsized returns is very attractive after the disappointing returns in the public market over the last decade.

Whether this is truly the case is debatable, but that hasn't stopped billions from flowing into private equity. Here's an excerpt from the article:

At the same time, pension plans everywhere are also desperate for yield. Pension plans are reportedly underfinanced by anywhere from $700 billion to as much as $4 trillion, depending on the calculations. Poor returns over the last few years have not helped. Over the last five years, the average state and local pension fund has returned 4.7 percent, according to Callan Associates.

Pension plans hope to make up these lost years and reach performance targets that in some cases are still set at a hopeful 7 to 8 percent a year. Private equity has traditionally been a high-performing asset class, and shifting more assets into this and other alternative investments like hedge funds is seen as a possible solution. Wilshire & Associates recently found that the average pension fund had increased its allocation to private equity to 8.8 percent in 2010 from 3 percent in 2000.

http://dealbook.nytimes.com/2011/12/13/wall-st-s-odd-couple-and-their-quest-to-unlock-riches/?src=me&ref=business

I hope this shift works out, but past history is not hopeful.

Hedge funds were once thought to be the panacea to institutional funds, for example,but recent data indicates that more than 75% of the hedge funds in existence have produced mediocre, or no, returns to investors.

The problem is when large sums of money are allocated to areas where investment opportunities are limited, overall returns are usually disappointing.

Market Forecasts, And Regression to the Mean

2011-12-13T09:14:00.003-05:00

I've been reading Daniel Kahneman's excellent new book entitled Thinking, Fast and Slow.

The book was recently listed as one of the best non-fiction books of 2011 by the New York Times. Based on my reading, I would agree with the Times.

Dr. Kahneman won a Nobel Prize in 2002 for his work on behavioral psychology. However, his book is very readable, and targeted for a larger market. For anyone interested in the quirkiness of how our minds work, and how we often make decisions that sometimes seem totally irrational, it will make an excellent addition to your holiday reading list.

One of the points that Kahneman makes in his book is that we often place too much time looking for causality in trying to explain events.

Sometimes events are just random - coming up tails nine times in a row when you're flipping a coin doesn't necessarily mean that the tenth flip will be heads; the odds are always 50/50, regardless of prior results.

At other times, though, changes occur that are the result of simply regression to the mean.

Kahneman discusses the fact in a large sample size you will often get data points that seem far out of the norm. However, overall results will very often return to the longer term averages, and that any interpretation of random results that doesn't include regression to the mean are usually incorrect.

I have been thinking of Kahneman's work when I am trying to come up with the best advice to help clients structure their investment portfolios.

The last 10 years have been relatively poor ones for stock investors, while bond investors have enjoyed a very healthy run.

However, over longer periods of time, stocks have produced much higher rates of return than bonds.

If regression to the mean holds, then, the next decade should be much better for stocks than bonds, simply because the magnitude of stock underperformance relative to bonds has been so unusual relative to historic norms.

Note that this forecast isn't based on guessing on economic outlook, Fed policy, euro, etc. No, all it's based on is simple statistics.

Think back to the end of 1999: Stocks had just completed one of the most remarkable runs in capital markets history, while bonds had been consigned to those poor souls who didn't understand the bull case for stocks.

As we now know, this was exactly the time that stock investors should have been heading for the exits and piling into bonds based solely on regression to the mean. And yet if you look back you will see few, if any, advisors were recommending an overweight in bonds.

Note that even if I had told you in late 1999 that the US economy would continue to thrive for most of the coming decade, you still would have been better off in bonds, not stocks.

Or, put another way, regression to the mean, and not economic or market forecasts, may be a more useful investing tool for investors truly focused on longer term results.

Blind Men, Elephants and Europe

2011-12-12T08:41:00.003-05:00

You probably remember the ancient Hindu parable about blind men being asked to describe the features of an elephant.

Here's one version, according to Wikipedia:

A Jain version of the story says that six blind men were asked to determine what an elephant looked like by feeling different parts of the elephant's body. The blind man who feels a leg says the elephant is like a pillar; the one who feels the tail says the elephant is like a rope; the one who feels the trunk says the elephant is like a tree branch; the one who feels the ear says the elephant is like a hand fan; the one who feels the belly says the elephant is like a wall; and the one who feels the tusk says the elephant is like a solid pipe.

A king explains to them:

"All of you are right. The reason every one of you is telling it differently is because each one of you touched the different part of the elephant. So, actually the elephant has all the features you mentioned."

http://en.wikipedia.org/wiki/Blind_men_and_an_elephant

The situation in the eurozone can be likened to this parable.

After the conclusion of last Friday's conference, equity investors cheered: An agreement was reached! Stock prices soared.

But bond investors disagreed: Oh, no, the agreement has no teeth - better run from risk, and dive into the highest quality bonds possible! US Treasury yields dropped, and the Treasury yields remain at 60-year lows.

And it's hard to figure out what commodity investors were thinking, especially looking at the price of gold.

If we were truly approaching financial Armageddon , you would think that gold prices should be soaring - but they're not. There could be some technical reasons for gold's ambivalence (rumors said that European banks were selling or lending their gold hoards to raise dollars), but gold prices have declined by -6% in the past three months.

My wife and daughter headed out yesterday to do their part to spur economic growth (no signs of a spending slowdown in the Glen household!) so I had plenty of time to read papers, magazines, and blogs to try to sort this all out.

But to be honest, I feel a little like those blind men: judging where we are now pretty much depends on where you are looking.

That's Fine, But Did I Make Any Money?

2011-12-08T09:34:00.003-05:00

In late 1999, when I first joined Boston Private Bank, I had the chance to make a number of new business presentations with one of our top salespeople named Trip Hargrave.

Trip was successful for a number of reasons, but one of his best traits was his ability to help prospects come to decisions.

For example, often a prospect would make the first decision - yes, they wanted to open an investment account - but froze when it came to asset allocation.

The correct balance between stocks, bonds, and any other asset class is a very difficult decision, but Trip made it simple.

Here's the only question he would ask:

"Historically, stocks have returned 12% per annum, and bonds 6%. Which return would you prefer?"

Um, let's see: do I want 12% or 6%?

Easy, right?

But, as it turns out, that was the wrong decision, at least for the first decade of this century.

Starting at the end of 1999, the investing in the stock market - as measured by the S&P 500 - was a money-losing proposition. Meanwhile, bond investors nearly doubled their money, assuming interest payments were reinvested.

This is not to pick on Trip - who remains a friend of mine, even though he no longer works here at Boston Private - but rather to highlight the problem of using past performance results to make investment decisions.

Fortune magazine had a good article discussing this issue. Fortune focused on Legg Mason's legendary stock investor Bill Miller, who for 15 years straight outperformed the S&P 500 but then stumbled in the last few years.

Fortune asked a simple question: Yes, Bill Miller's performance numbers were great, but investors in his fund on average make any money?

Here's what they wrote:

{Mutual fund consultant} Morningstar crunched Miller's numbers for me, showing that his average investor had a considerably lower return than the fund posted during his long hot streak.

The fund made 16.44% a year in gains and reinvested dividends during that period, but the average investor made only 11.34%. Miller's average investor actually underperformed the S&P (which returned 11.51% annually during his streak), even though his fund way outperformed the index...

"It's human nature for investors to act this way," says Don Phillips, Morningstar's president of fund research. "When stocks are popular and the market is rising, everyone wants to invest." Then, when the market hits a bad patch, many fund investors sell near the bottom, giving them the worst of both worlds: buying high and selling low.

http://finance.fortune.cnn.com/2011/12/07/bill-miller-legg-mason-returns/?iid=SF_F_LN

Today people are generally wary of the stock market, which is not suprising given the anemic returns of the last few years.

And yet, looking forward, are you more likely to produce better returns by investing in stocks or bonds?

Or, as my friend Trip might say, bonds are now trading at yields not seen in 60 years, and stocks largely yield more than corporate bonds and valuations are not unreasonable.

Which area do you think makes the most sense?

Message From the Markets?

2011-12-07T11:03:00.004-05:00

Trying to understand the "message from the market" is, in my opinion, a little like looking at modern art: you see what you want to see.

For example, bond yields on Italian and Spanish debt have plummeted in the past few days. After rocketing past 7% a couple of weeks ago, the combination of European Central Bank intervention as well as a dollar infusion from the Fed has caused a large bond rally in the offerings of both countries, and yields are back below 6% this morning.

Many analysts are pointing to the action in the bond market as a clear signal that creditors are becoming more convinced that a clear and decisive action will be taken by euro zone leaders by the end of this week.

I hope this is true, but there is another possibility.

The German solution for the troubled sovereign borrowers in the euro zone is austerity: cut government spending and raise taxes. The near-term economic pain might be significant, the Germans are arguing, but fiscal responsibility is the only long-term solution.

On the other hand, as the New York Times pointed out this morning, the cure for the euro crisis might lead to significant economic malaise.

Yields might be falling because investors now believe the German solution make bonds a superior investment to most other asset classes.

Here's what the Times editorial said this morning:

But the Franco-German recipe will exacerbate Europe’s fundamental problem: lack of growth. While German officials insist that budget discipline will restore markets’ confidence, markets understand that a deepening recession will make it even harder for weak nations to repay their debts.

Europe’s deeply indebted nations certainly must get their budgets under control, reform labor markets, sell state properties and become more competitive. But that can’t be done without any growth. Germany could provide some of the needed boost: saving less and spending more; absorbing more imports from neighbors. But the plan provides for no German stimulus. In fact, the International Monetary Fund expects Germany to spend less: cutting its budget deficit to just over 1 percent of gross domestic product next year.

http://www.nytimes.com/2011/12/07/opinion/the-wrong-fix.html?_r=1&ref=opinion

Trading volumes in the stock market this week have been remarkably light: investors know that the next direction for the market depends on the announcement from the euro group later this week.

All Europe, All the Time

2011-12-06T08:38:00.004-05:00

As I look back at some of my recent posts, it seems that the majority are focused on Europe and the euro zone crisis.

For better or for worse, the European community is the whole game for the markets right now.

If the European leaders can come up with a workable plan to save the euro, the equity markets will probably rocket ahead. The alternative, of course, is pretty bleak and dismal for the world's economies.

But this might just be my opinion, speaking as an American.

Ezra Klein of the Washington Post had an interesting column yesterday discuss the almost unnatural calm that he witnessed in Germany last week:

In more than a dozen discussions with policymakers, I’ve noticed that Germans just do not talk about this crisis the way anyone else does....

They seem serenely confident that it will all work out, and this will end with a stronger, more united Europe. There’s less panic than you would expect. Less panic, certainly, than there is among American economists and policymakers.

http://www.washingtonpost.com/business/economy/germanys-calm-in-the-face-of-europes-debt-crisis/2011/12/05/gIQAxUohXO_story.html

It could be that the German government is simply aware that it holds all of the cards, and that its positions will ultimately carry the day.

The problem I have is that most of the German ideas focus on austerity and economic pain. Here's Wolfgang Munchau writing in yesterday's Financial Times:

Contrary to what is being report, Ms. Merkel is not proposing a fiscal union. She is proposing an austerity club, a stability club on steriods. The goal is to enforce life-long austerity, with balanced budge rules enshrined in every national constitution. She also proposes automatic sanctions with a judicially administered regime of compliance. She rejects eurobonds on the grounds that they reduce pressure on fiscal discipline.

http://www.ft.com/intl/cms/s/0/874af280-1cde-11e1-a134-00144feabdc0.html#axzz1flJRsTSD

American rating agency Standard & Poor's warned that Germany and five other members of the eurozone that they face the possibility of losing their AAA credit rating if a responsible solution to the current crisis is not announced.

The cynic in me was unimpressed by S&P's announcement. Interest rates in the United States plummeted after S&P downgraded the U.S. last summer to AA+.

At the end of the day, it seems that all of this drama boils down to asking the citizens of numerous countries to accept austerity and poor economic conditions for many years in order to pay back the bankers.

And while no one doubts the moral righteousness of this position, I wonder how long before popular backlash begins.

Ireland is often cited as the model for some of the other debt-burdened countries, the New York Times reports this morning, yet the Irish are less than thrilled with how the burden of debt repayment has hurt their daily lives:

Pain is inevitable in any nation overwhelmed by its debts, which in Ireland continue to climb rather than fall as a percentage of gross domestic product. But the Irish example shows the dangers of taking from ordinary people to pay off creditors rather than sharing the burden more broadly.

For example, welfare payments have steadily been reduced even as the unemployment rate has ticked up to 14.5 percent, and is forecast to remain high at least through next year.

The Irish are not prone to protest, but now more are being organized, inspired by the Occupy movement in the United States.

http://www.nytimes.com/2011/12/06/business/global/despite-praise-for-its-austerity-ireland-and-its-people-are-being-battered.html?pagewanted=2&_r=1&ref=business

Finally, there is this quote at the end of the Times's article which sums it up best:

“The euro zone is entering a very serious slump, and it is not certain the euro will survive in its current form,” said Simon Johnson, a professor at the Massachusetts Institute of Technology’s Sloan School of Management and a former chief economist at the I.M.F. “Why Ireland would want to spend its time being a model student in the context of the broader European mishandling of the situation, I don’t know.”

Question Authority

2011-12-05T08:35:00.003-05:00

As we approach year-end, you're certain to see a wave of news stories offering perspectives on the outlook for the coming year.

True confession: This exercise drives me crazy, as I feel it is almost always a waste of time.

As that great philosopher Yogi Berra once said: "It's tough to make predictions, especially about the future."

But still people persist in trying to forecast the next 12 months, and since apparently someone reads these, it's worth going back and seeing how well the "expert" predictions fared for 2011.

Here was one that was a favorite of many market strategists a year ago:

Historically, the third year of a Presidential cycle has been good for stocks. If you go back to the third year of a President's term - either Republican or Democrat - stocks have usually produced attractive returns. Ergo, stocks should do well in 2011.

So what's happened in 2011? Writing in this Saturday's New York Times, Floyd Norris took a look:

Through November, an investor in the stocks in the Standard & Poor’s 500 had a small profit of 1.1 percent this year, including reinvested dividends. But that figure was a 6 percent loss a week earlier, before investors took pleasure from positive reports of post-Thanksgiving retail sales and became more optimistic that another round of European summit meetings next week would reduce the threat of a new financial collapse.

http://www.nytimes.com/2011/12/03/business/as-a-market-predictor-a-trusty-guide-falters.html?_r=1

Psychologist Dan Kahneman points out that it is a natural human tendency to look for patterns where none exists. Could the "Presidential Cycle" be a perfect example?

Oh, and was there a single strategist that thought that interest rates would plummet to 60-year lows?

And what about those confident predictions that U.S. investors should plunk a large sum of their funds in overseas markets? The world's markets have almost all been money losers this year - the US market returns may be weak, but at least they're positive.

I could go on, but you get my point.

My advice: Recognize that predictions of the future are best left to soothsayers. In my work, I try to find investments that will fare well in a number of different scenarios, including those that might seem wildly implausible at the time.

What Are The Mortgage-Backed Securities Markets Telling Us?

2011-12-02T11:31:00.005-05:00

For several years I managed portfolios of mortgage-backed securities for institutions and mutual funds.

Mutual funds investing in mortgage-backed securities guaranteed by GNMA ("Ginnie Mae") were very popular in the late 1980's and early 1990's. Ginnie Mae carries the full faith and credit of the United States government, so investors are protected from losses from mortgages. Other funds backed by FNMA ("Fannie Mae") and FHLMC ("Freddie Mac") also were very appealing, even though these agencies carried the implied, but not direct, government guarantee.

The appeal of high dividend payouts from government guaranteed mortgages was very attractive to investors dependent on income, especially retirees. For example, I was lead manager on a Ginnie Mae mutual fund targeted to AARP members which grew to a peak of $8.2 billion in five years.

(Of course, Ginnie Mae funds can still lose money if interest rates rise, like they did in 1994. After investors learned this harsh reality, the popularity of Ginnie Mae funds understandably waned).

There are several dynamics to managing mortgage-backed securities, but one of the most important is to try to anticipate prepayment speeds.

As we all know, mortgages can be paid prior to maturity for any number of reasons. When you sell your home, for example, you typically pay off your mortgage. Or if mortgage rates fall, many homeowners will refinance their existing mortgages into new, lower rate mortgages.

One other reason for the early prepayment of mortgages is something that we used to not focus on too much: namely, existing mortgages on a home that is foreclosed will be paid off early when the home is resold at auction.

If you're a manager of a mortgage-backed securities portfolio, then, trying to figure out the approximate rate of prepayment can make the difference between a successful investment and one that produces only mediocre results.

In a period of declining interest rates, the older higher rate mortgages are typically refinanced, but at varying rates of speed. Today, with so many homeowners facing the unpleasant reality that their homes are worth less than their mortgages, refinancing speeds have been considerably slower than economic models would suggest.

While this has resulted in very attractive returns for mortgage-backed investors, it also tells a fairly dismal tale of the state of the housing market in the United States, as Floyd Norris points out in this morning's New York Times:

In normal times, old securities with relatively high interest rates would have virtually disappeared as owners refinanced, paid off the old mortgages and took out loans at lower rates. But these are not normal times, and speculators now are profiting from the woes of homeowners who cannot refinance but have not defaulted. Because Fannie and Freddie guarantee the loans, buyers of those securities are sure to recover the amounts lent.

Prices of high-coupon mortgage securities rose to unprecedented heights earlier this year as investors concluded that those who had not refinanced by then would never be able to do so, and that owners of the securities would be able to collect above-market interest rates for a long time. Those prices have declined, but not by very much, since the administration announced its refinancing plan.

http://www.nytimes.com/2011/12/02/business/time-to-accelerate-the-housing-recovery-floyd-norris.html?pagewanted=2&ref=business

As Mr. Norris points out, many economists in agreement that true economic recovery in the United States will not begin until housing improves.

The unfortunate truth is that until some resolution is reached on how to handle underwater mortgages - and take some of the "juice" away from mortgage-backed investors - our economy recovery seems destined to be muted.

Are The Banks Now Bailed Out?

2011-12-01T08:38:00.009-05:00

Judging from yesterday's huge rally on Wall Street, and reports of highly successful French and Spanish bond auctions this morning, it would seem that yesterday's coordinated central bank intervention has turned the tide in euroland.

I hope so but I am skeptical.

I had a savvy client email me last night asking whether we should begin buying European bank stocks for his portfolio.

After all, he pointed out, the usual valuation metrics for bank equity analysis are all indicating a sector that is hugely undervalued.

If the central bank actions are effective, couldn't possibly see a rally in financial stocks similar to 2009, when financials nearly doubled from March 2009?

Well, maybe, but I think there are several factors considerably different from those in 2009.

First, I think that the political mood (i.e. anti-banker) is considerably less sympathetic to financials than prevailed earlier.

It's not only the protest movement "Occupy Wall Street" - even the President seems to be running for re-election on a more populist platform. Pushing through bank bailout packages similar to those of 2008-09 seem unlikely.

Second, the Fed is, in my opinion, largely "out of bullets". Interest rates are already at 60-year lows. The Fed's two rounds of so-called quantitative easing has pushed mortgage rates to multi-decade lows (yet housing remains in a funk).

Yesterday's actions added dollars to a world banking system that was starving for liquidity, but it will not change the fundamental credit issues that Europe faces.

Third, I'm not sure that the traditional bank metrics are all that meaningful right now. If the assets on the books of the major multi-nationals were worth anywhere close to reported values, why don't they just sell them to raise capital?

In fact, even in America there is considerable evidence to suggest that the mortgages on the books of US banks are not worth their stated values. Here's a note from this morning's New York Times:

A new analysis suggests that the tide of home foreclosures isn’t going to recede soon.

The report from the Center for Responsible Lending, “Lost Ground, 2011,” finds that at least 2.7 million mortgages loaned from 2004 through 2008, or about 6 percent, have ended in foreclosure and that nearly 4 million more home loans (roughly 8 percent) from the same period remain at serious risk.

Put another way, “The nation is not even halfway through the foreclosure crisis,” says the report, which analyzed 27 million mortgages made over the five years.

http://bucks.blogs.nytimes.com/2011/11/30/foreclosure-crisis-isnt-even-halfway-over-analysis-finds/?ref=business

Finally, several recent news reports have looked back to the period of 2009 and found that the "all clear" signals that were flashed by bank CEO's were, well, lies.

Here's the report from Bloomberg earlier this week:

The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. Now, the rest of the world can see what it was missing.

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue.

And here's what the bankers were telling the press:

Bankers didn’t disclose the extent of their borrowing. On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed “one of the strongest and most stable major banks in the world.” He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day.

JPMorgan Chase & Co. CEO Jamie Dimon told shareholders in a March 26, 2010, letter that his bank used the Fed’s Term Auction Facility “at the request of the Federal Reserve to help motivate others to use the system.” He didn’t say that the New York-based bank’s total TAF borrowings were almost twice its cash holdings or that its peak borrowing of $48 billion on Feb. 26, 2009, came more than a year after the program’s creation.

http://www.bloomberg.com/news/2011-11-28/secret-fed-loans-undisclosed-to-congress-gave-banks-13-billion-in-income.html

Like the old axiom goes, "Fool me once, shame on you. Fool me twice, shame on me".

Even if today's situation is more dire than 2008, I think the popular mood will not support anywhere near the level of intervention.

I remain wary of bank and other financial shares.

Hurrah! The Fed To The Rescue - Again

2011-11-30T13:42:00.006-05:00

Stocks rallied sharply today on the back of a coordinated intervention by the world's central banks, led by the U.S. Federal Reserve.

Market rumors suggest that at least one major bank in Europe was on the verge of failing due to not being able to secure funding.

This would not be surprising: across the globe, financial institutions including American money market funds and Asian pooled investment vehicles have been rapidly reducing their European financial exposure.

It is also apparently consensus opinion among the world's financial leaders that letting Lehman Brothers go under in September 2008 was a mistake.

Today's move puts government money behind this view.

The larger question, of course, is whether this intervention is simply buying time, or whether there is a larger, more comprehensive solution to the euro crisis in the wings.

At the same time, all of these hundreds of billions being tossed around the world is beginning to make me just a little uneasy about how dominant a role that central banks have become in the global economy.

Today's move, for example, effectively inserts our central bank into the midst of the euro zone crisis. Is that really part of the Federal Reserve charter?

Oh, and I understand the argument that says that money is truly a global commodity, and that the Fed is acting to protect US interests.

Still, the real reason the Fed and company needed to act was the refusal of the German government to take any action. And it is not clear that today's actions are doing anything more than delaying a Day of Reckoning for the euro zone.

The United States went off the gold standard* in 1971. President Nixon was desperately trying to figure out a way to frustrate the currency markets, which he believed was unfairly attacking the dollar. Nixon was initially successful, as the dollar rallied, but inevitably economic fundamentals won the day, and the dollar has steadily declined over the next few decades.

Fast forward 40 years. Today we think nothing of literally trillions of dollars being created by central banks around the world that stave off credit market dislocations. Ben Bernanke might be one of the smartest people to ever head a central bank, but the numbers have become staggering.

I don't know how this all resolves itself. Worries that massive injections of liquidity being added to the system will lead to inflation have to date been unfounded. The money has to come back out of the system but until the twin reasons behind our financial system woes are addressed - the American housing market, and the rapidly weakening state of European sovereign debt - it seems more likely that we will see more central bank interventions in the months ahead.

*As I have written numerous times on this blog, I am most decided not a huge fan of investing in gold. On the other hand, having a gold standard definitely created a brake on government actions.

Why Won't the Germans Come to the Rescue?

2011-11-29T08:50:00.008-05:00

“The problem in politics is this: You don’t get any credit for disaster averted. Going to the voters and saying, ‘Boy, things really suck. But you know what? If it wasn’t for me, they would suck worse.’ That is not a platform on which anybody has ever gotten elected in the history of the world.”

-Rep. Barney Frank, quoted in this morning's New York Times, to the CBS “60 Minutes” correspondent Leslie Stahl

Pity the poor Germans.

After years of prosperity and fiscal probity, the Germans are now being blamed for bringing the eurozone - and possibly the world's economy - to the brink of disaster.

Poland's foreign minister Radoslaw Sikorski gave a speech in Berlin yesterday which was reprinted in this morning's Financial Times. Here's an excerpt:

I demand of Germany that, for its own sake and for ours, it help the eurozone survive and prosper. Nobody else can do it. I will probably be the first Polish foreign minister in history to say this, but here it is: I fear German power less that I am beginning to fear its inactivity. You have become Europe's indispensable nation. You may not fail to lead: not dominate, but to lead in reform.

Then there's columnist Joe Nocera writing in this morning's New York Times:

Today, it is Germany that is making policy moves that seem insane. Locked into their modern-day orthodoxies, German politicians look at Greece with something akin to contempt. Aid to Greece — aid that is given grudgingly, when it is given at all — must be accompanied by severe austerity measures, the Germans believe, because the Greeks need to learn how to live within their means, the way Germans do.

http://www.nytimes.com/2011/11/29/opinion/nocera-germany-cuts-off-its-nose.html?_r=1&ref=opinion

But harkening back to Rep. Frank's quote, would the world really be so grateful if the Germans came up with a few spare trillion euro to bail out its neighbors?

And what would the verdict of German voters be on Chancellor Merkel's government if she orchestrates a bailout?

Then there's the small matter of German constitutional law.

Last September, the German Constitutional Court ruled that while it would reluctantly accede to allowing German participation in the European Financial Stability Facility, any permanent financial commitment to the eurozone by the German government could potentially be in violation of German law.

For example, there have been several proposals that the European Central Bank issue eurobonds which would carry the joint credit backing of all of the euro community, most importantly Germany.

However, it's not clear that the German government could even make such a commitment even if it wanted to, according to the on-line magazine Der Spiegel:

But euro bonds would be an entirely different case. Wolfgang Münchau, the Financial Times columnist... points out that they would be everything that the German Constitutional Court finds questionable about bailout programs thus far. They would have the potential to make Germany liable for debts incurred by other countries in the euro zone, the program would be huge (otherwise there would be no point in introducing them in the first place) and German guarantees could be triggered by the actions of foreign governments. "The court's verdict leaves me no alternative but to conclude that (euro bonds) are indeed unconstitutional,"

http://www.spiegel.de/international/europe/0,1518,799803-4,00.html

U.S. stocks soared yesterday on rumors that the euro crisis was nearing a resolution. However, this optimism seems premature, at least based on the news from Europe today.

Time will tell.

Anyone Have a Spare $3 Trillion?

2011-11-28T08:31:00.005-05:00

The markets are up sharply this morning on rumors of a possible solution to the euro zone crisis.

I hope the rumors are right, but unfortunately I am a little skeptical. The euro problems are enormous, and political solutions among 17 different member states are not going to be easy.

For example, last Wednesday CNBC interviewed Oliver Sarkozy, the half-brother of French President Nicolas Sarokozy (tip of the hat to blog Zero Hedge).

While I doubt that his more famous relative is giving him any inside information, Oliver Sarkozy happens to be a director of the Carlyle Group, and seems to be pretty well connected. He also is pretty good at math.

As you can see for yourself in the interview below, Mr. Sarkozy figures it would "only" take $3 trillion to stabilize the European banking system. Here's how he figures it:

"The math I'm working with is very simple. In the US banking sector, we had $3 trillion of wholesale funding that needed to be stabilized, got stabilized by the implementation of TARP which saw the US treasury buy $212 billion worth of preferred in the banking sector to stabilize that $3 trillion, give our banks the time to work through their problem assets.

In Europe, that $3 trillion is $30 trillion. so if you multiply the $212 by 10, you get the $2.12 trillion. In my view, the issues on the European banks are bigger than the issues on the books of the US Banks. So if you want to stabilize that $30 trillion and in my view it's not that you want to, it's that you have to, you do not have a choice, you're going to have to be at least at 2.1 trillion and I suspect it may need to be more."

http://www.zerohedge.com/news/sarkozy-europes-liquidity-run-has-begun-because-there-30-trillion-problem

Credit Crisis Worsens in Europe

2011-11-23T08:17:00.004-05:00

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.” - Rudiger Dornbusch

The situation in Europe continues to worsen.

New leaders have been installed in Italy and Greece, to no avail. Spain held an election last weekend that should have provided some comfort to the capital markets, but instead Spain is now paying a higher rate of interest on its short term debt than Greece.

The role of the European Central Bank (ECB) remains critical. Reluctantly, the ECB has been pulled into the crisis even as there is little agreement on how far it can go without violating its original charter.

In the meantime, the ECB has provided essentially the only bid for Italian and Spanish bonds in the secondary market. In addition, European banks have turned to ECB for critical funding as credit conditions in Europe continue to tighten.

And now Germany - the bastion of the euro zone - is having its own credit quality questions.

Today's German bond auction was one of the worst in recent memory. Trying to sell €6 billion 10 year bunds, investors only bid for €3.6 billion, meaning that the Bundesbank is now the not-so-proud owner of €2.4 billion bunds that it will attempt to sell in the coming weeks.

The U.S. government has been the beneficiary of the euro zone crisis. The U.S. Treasury sold $35 billion in 5 year Treasury notes yesterday at a yield of 0.937%, which is the lowest yield on record. Indirect bidders - mostly foreign central banks - bought 44% of the deal, while investors only bought 9% of the new issue. Safety of principal, not yield, is driving Treasury bond prices these days.

OK, I know this is the day before Thanksgiving, and I should be giving thanks to the Europeans for helping us keep our government's interest costs lower.

But time is working against European leaders, and we can only hope that a workable solution to all of this is figured out in short order.

Why Did Gilead Pay So Much for Pharmasset?

2011-11-22T08:39:00.008-05:00

The health care sector was rocked yesterday by Gilead Sciences's $11 billion buyout of Pharmasset.

Located in Princeton, N.J., Pharmasset is a company that is developing a treatment for hepatitis C, a disease that affects an estimated three to four million Americans. As many as 170 million people worldwide are also estimated to have hepatitis C, which is often caused by use of contaminated needles.

The infection can cause serious liver damage, and treatment so far have involved a combination of pills and injections. Pharmasset is working on treatments will be all-oral (i.e. no needles) with considerably less negative side effects.

But still: the total worldwide market for hepatitis C treatments is estimated to be around $3 billion per year. Gilead is paying $11 billion for a company that has 52 employees, lost $92 million last year, and that is working on a drug that will not be available until 2014, if it proves to be successful.

Only time will tell whether Gilead's move is visionary or ill-considered. What it does highlight, however, is the fact that returns from research and development efforts in the drug industry have been steadily declining, despite the massive amounts of funds being thrown at new drug development.

Before yesterday, Gilead's management was widely regarded as one of the smartest in the biotech field. It is unlikely that they would suddenly become reckless and pay too much for Pharmasset unless they felt that the returns from buying the company would not outweigh what they could achieve on their own R&D efforts.

According to the consulting firm Deloitte, as discussed in an article in yesterday's Financial Times:

The average internal rate of return on R&D for the top dozen pharmaceutical companies fell from 11.8% in 2010 to 8.4% this year, while the cost of developing a new drug rose from $830 million to $1.1 billion.

The problem is not only the cost of developing new compounds. Bringing a new drug to market involves massive amounts of testing that can last for years, and often can wind up in failure. Even drugs that eventually are brought to market can be pulled; just last week the FDA pulled Genetech's Avastin, a widely-used treatment for breast cancer, from the market after patient data indicated that it carried considerably more negative side effects than trials had indicated.

The health care sector faces a number of significant headwinds in the coming years. Costs continued to rise, yet there is widespread support for trying to contain costs of medicine, including drug prices.

In other words,the days of high earnings growth for the health care sector seem to be largely in the past.

More Municipal Cuts

2011-11-21T08:55:00.005-05:00

Last Friday, Detroit Mayor Dave Bing announced plans to lay off 9% of Detroit's public work force.

The Mayor's cuts will directly affect 1,000 municipal workers, but will also have a significant impact on thousands of poor and elderly citizens who demand on government services.

Detroit's moves will doubtlessly be repeated by dozens of municipalities across the U.S. by cash-strapped cities and towns in the months ahead. Already there have been several towns in California that have not only laid off administrative officials but also police and firemen as well.

Once home to some of the strongest and most vibrant economies in the United States, Detroit in recent years has turned into one of the hardest hit of the major U.S. cities. Fully one-quarter of the homes in the greater Detroit area, for example, now stand vacant. The level of unemployment in the greater Detroit metropolitan area is 13%. Cuts in municipal services will hit hard.

Worries about municipal credits have waned over the course of this year. Concerns about the fate of the euro, and euro zone bonds, have rightly dominated investment discussions recently.

But that doesn't mean that municipal finances have improved. Like Marley's ghost, most municipals are bound by the chains of poor decisions and bad contracts forged in earlier years.

It seems likely that discussions about the poor state of municipalities will begin again.

An article in last Saturday's New York Times notes that Mayor Bing's cuts may not do enough to help:

For months, Mr. Bing and other leaders have bemoaned the city’s financial state as dire, but a new urgency has clearly set in. The mayor has called on union leaders to agree by next week to concessions to their existing contracts, even as City Council members have suggested that Mr. Bing’s cuts may not go far enough and that even sharper layoffs may be needed.

There is a looming threat hanging over all such talks: the possibility that the state may ultimately find Detroit’s woes so troubling that it requires the appointment of an outside manager to take control of the city, Michigan’s largest. State officials say that so far, no such plan is under way.

http://www.nytimes.com/2011/11/19/us/detroit-to-lay-off-9-percent-of-public-work-force.html?_r=1&scp=1&sq=detroit%20layoffs&st=cse

Is The US De-Coupling from Europe's Woes?

2011-11-18T08:43:00.003-05:00

Is the US dancing while Europe is burning?

The news from Europe remains troubling, to say the least. Yields on Italian and Spanish bonds remain elevated, despite the best efforts of the European Central Bank (ECB).

The 17 members of the European union continue to squabble, and the rhetorical levels continue to move higher in each passing day.

Liquidity is drying up as banks desperately try to reduce their sovereign credit exposures.

Ambrose Evans-Pritchard of the London Telegraph writes this morning that Asian buyers are also trying to reduce their European bond holdings:

Asian investors and central banks have begun to sell German bonds and pull out of the eurozone altogether for the first time since the debt crisis began, deeming EU leaders incapable of agreeing on any coherent policy...

Traders say Asians are taking profits on Bunds and pulling out, with signs that even China's central bank is shaving holdings. Mid-east wealth funds have remained firm.

http://www.telegraph.co.uk/finance/financialcrisis/8897775/Asian-powers-spurn-German-debt-on-EMU-chaos.html

Meanwhile, Spanish Prime Minister Zapatero is insisting that ECB step up its intervention in the capital markets to try to keep interest rates low:

José Luis Rodríguez Zapatero, Spain’s prime minister, on Thursday became the latest leader to demand that the bank find a solution to the euro crisis, saying that “this is what we transferred power for” and that it had to be a bank “that defends the common policy and its countries.”

Mr. Zapatero made his unusually blunt statements on a day when markets sagged further and contagion continued its seemingly inexorable spread from the small economies on Europe’s periphery to Italy, Spain and even France at the core. Spain was forced Thursday to pay nearly 7 percent on an issue of 10-year debt, the highest since 1997, while investors demanded the largest premium for buying French as opposed to German debt in the decade-long history of the euro.

http://www.nytimes.com/2011/11/18/world/europe/european-central-bank-resists-calls-to-act-in-debt-crisis.html?hp=&pagewanted=print

At the same time, however, both the U.S. economy and our markets remain remarkably unaffected by the euro crisis.

Many businesses report that activity remains reasonably strong, and in some cases improving. Warren Buffett remarked the other day that only 5 of the 70 businesses owned by Berkshire Hathaway are showing any signs of weakness, and all of these are related to housing.

Recent US economic data also show signs of strengthening, as Neil Irwin reports in this morning's Washington Post:

... following a year of one economic disappointment after another, a variety of economic indicators are pointing in a more positive direction...

..new reports showed strong results on two key measures of economic activity in October: A 0.5 percent gain in retail sales and a 0.7 percent gain in industrial production. Also welcome news: Inflation is becoming more subdued, with consumer prices falling 0.1 percent in October. That leaves the Federal Reserve more flexibility to take action if the economy worsens.

Putting all the recent evidence together, forecasting firm Macroeconomic Advisers projects that the economy will have grown at a 3.2 percent annual rate in the final three months of 2011, compared with a 1.4 percent average pace of growth through the first nine months of the year.

http://www.washingtonpost.com/business/economy/economy-steadily-picking-up-steam-but-analysts-warn-of-obstacles/2011/11/17/gIQAy84uVN_print.html

Our markets also appear slightly confused. Although Treasury bond yields remain at historically low levels - indicating there is still a strong desire for safety among a large class of investors - stocks continue to trade with a good tone, and have largely held on to October's gains.

We will see.

The Euro Comes to the US

2011-11-17T08:33:00.006-05:00

Markets took a tumble yesterday after Fitch's Ratings released a report saying that Europe's debt crisis may be a significant threat to American banks.

I can't believe this was really fresh news to anyone.

To me, what it really illustrates is the fact that U.S. investors have been assuming for months that euro crisis will all somehow just work itself out. While that might still be the case, global bond markets are telling you a completely different story.

Yields in "safe haven" countries like Germany (1.86% on 10 year bunds) and Sweden (1.66%) continue to move lower. Even the U.S. - which was only downgraded last summer - still can find investors willing to lend it 10 year money at 2.01%.

Meanwhile, the countries that really need the cash are getting killed. Even after massive intervention by the European Central Bank (ECB), Italy still needs to pay almost 7% to borrow money. Spanish 10 year notes now yield 6.60%, up from 5% a month ago.

And now France (mon dieu!) is coming under attack. French bonds are trading at levels nearly 200 basis points higher than Germany. If France is in trouble, then the euro really is in dire straights.

With all of this as a backdrop, it is little wonder that European banks are desperately trying to secure funding. Here's how the blog Business Insider describes the situation:

Specifically, traditional sources of bank funding in Europe, such as institutional investors and other banks, are getting cautious as fears grow about the need for sovereign debt restructurings. As liquidity dries up, the only reliable source of funding is often the ECB.

But the ECB only accepts certain types of assets as collateral for loans, and some banks are running out of those assets.

So they're turning to investment banks and other "counter-parties" that have them. And they're entering into "swap" agreements in which they exchange their assets for the counter-parties' assets and then stock-pile the latter assets for use as collateral.

And that's a fine plan... until the music stops and one big "counter-party" fails.

So is it really a surprise that the US banks are also at risk?

Bond Traders vs. the European Central Bank

2011-11-16T09:50:00.004-05:00

In January, 1993, President-elect Bill Clinton was discussing fiscal policy with several economic advisors.

The topic was deficit reduction, and his aides were telling the newly elected President that the success or failure of his administration depended on a credible deficit reduction plan. If he failed, the bond market would punish the economy with higher interest rates.

According to Washington Post author Bob Woodward - as detailed in Woodward's book The Agenda - Clinton's face turned red with anger as he said:

"You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of f**king bond traders?"

I was reminded of this anecdote when as I have been reading about the ongoing euro bond debacle.

The success or failure of the euro zone ultimately will not rest on any particular politician or grand strategy. Instead, it will rely on whether the countries most at risk - Greece, Spain, Italy, et. al. - will be able to finance themselves at reasonable levels of interest rates.

So far, the "f**king" bond traders do not seem to be impressed.

Reuters is reporting this morning that the European Central Bank has been intervening heavily in the bond trading of Italy and Spain. Even with the ECB intervention, yields have been soaring for euro bonds from these countries.

Italian euro bonds now yield almost 7%. The contagion is now apparently spreading to other countries, even France. The yield spread between French euro bonds and German bonds is at levels not seen since the early 1970's.

Investing Like Warren

2011-11-15T08:24:00.005-05:00

Warren Buffett announced yesterday that he amassed 5.5% of IBM stock over the past few months.

While this is interesting news - Buffett has always said that he doesn't understand technology well enough to invest money in the sector, but apparently IBM is transparent enough - what really caught my eye was the way he went about analyzing the company.

Buffett was interviewed on CNBC yesterday for about 3 hours. The complete transcript of his thoughts can be found on the CNBC website, but several comments stood out to me:

He has been reading IBM's annual report for 50 years. I don't think he was just reading the President's letter - I'm sure he has been studying it from cover-to-cover for half a century. But it was only this year that he began buying stock;
He never met IBM senior management. In fact, at one point in the interview he mispronounces current CEO Sam Palisano's last name. While this is consistent with Buffett's investment style - focusing on the business, not the management - this too is far different than most investment managers;
He was buying IBM stock at near all-time highs, but seemed genuinely unconcerned about the price. Buffett notes in the interview that he bought railroad stocks at their highs also, and has made a bundle;
Buffett re-read former CEO Lou Gerstner's book about IBM Who Says You Said Elephants Can't Dance before buying stock. I wrote about this book a few months ago here on Random Glenings, and now you have Warren Buffett's recommendation as well (!);
He liked the idea that IBM has dramatically reduced the number of options outstanding from 240 million to 30 million today. This, in Buffett's opinion, is a sign of respect for the shareholder.

I could go on, but I think you get the point. The investment genius of Buffett has been earned by more than 50 years of study, and what often seems effortless is actually the result of countless hours of study and preparation.

Finally, I liked this quote from Buffett about where investors should be putting their money today:

{Buying IBM and other large cap stocks}t also means that some great big strong American companies look very cheap compared to investment alternatives. I mean, in the end, you know, you're sitting with money in your pocket. Do you leave it in your pocket, you get zero on, do you put it in a money market fund, you still get zero on it, do you buy 10-year Treasuries and get 2 percent, or do you buy American businesses that are earning very good money, that have high returns on equity, have high returns on incremental capital, are buying in their stock at a rapid rate so that your ownership in the business increases significantly? I love all those things. Now, you measure one vs. the other. But in the end, you have—you know, you do something. Doing nothing is doing something.

http://www.cnbc.com/id/45290263/

More on Europe

2011-11-14T09:34:00.004-05:00

If you think replacing the leaders of Italy and Greece over the weekend gives an "all clear" to the European community, German Chancellor Merkel would suggest otherwise.

Here's an excerpt from a Reuters news piece desribing Merkel's speech this morning in Leipzig:

"Europe is in one of its toughest, perhaps the toughest hour since World War Two," Merkel told her conservative party in Leipzig, saying she feared Europe would fail if the euro failed and vowing to do anything to stop this from happening.

But in a one-hour address to the Christian Democrats (CDU), Merkel offered no new ideas for resolving the crisis that has forced bailouts of Greece, Ireland and Portugal, and has raised fears about the survival of the 17-state currency zone.

"If the euro fails then Europe fails, and we want to prevent and we will prevent this, this is what we are working for, because it is such a huge historical project," Merkel said in the east German city of Leipzig.

http://www.reuters.com/article/2011/11/14/us-eurozone-idUSTRE7AC15K20111114?feedType=RSS&feedName=topNews&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+reuters%2FtopNews+%28News+%2F+US+%2F+Top+News%29&utm_content=Google+Feedfetcher

Then there's the human costs of the euro crisis. Across Europe, ordinary citizens are seeing their standard of living shrink dramatically as governments struggle to comply with the demands of European leaders lead by the French and German governments.

Here, for example, is an excerpt from last Friday's Financial Times. In a small article titled "Sign this and accept a 25% salary cut", the FT described how highly educated members of the upper middle class in Greece are being forced to take huge pay cuts or else lose their jobs:

...White collar workers such as Constantinos Makris, a stockbroker in Athens, are also feeling the sting. Managers "gave me a call one morning and said 'Would you come downstairs?'...Then they said 'Sign this paper and accept a 25 per cent reduction in your salary'. After threatening to quit, Mr. Makris eventually settled for a smaller cut.

http://www.ft.com/intl/cms/s/0/c6acdf40-0bb0-11e1-9a61-00144feabdc0.html#axzz1dh2kdsTS

The problem is not just belt-tightening; it's a sense that the good times might gone for a generation, thanks to debt obligations incurred by governments who understood that the path to power was to never tell voters "no".

In post-World War II Europe, austerity ruled for years. Rolling Stone guitarist Keith Richard, for example, describes in his autobiography Life that he never tasted sugar for the first nine years of his life after being born in 1946 due to post-war shortages. Everyone understood why basic necessities were rationed, which seemed to make it more bearable.

Today, according to this morning's New York Times, citizens are facing the hard times with more bitterness than a couple of generations before:

In the lands of southern Europe, used to getting by with wile and guile, the prospect of hardship seems all the more bitter, illuminating, as it does, what outsiders cast as an all-too-predictable national failure to live up to the membership rules of the euro club that were devised and watched over by hard-nosed Germany in particular.

Modern austerity could never be described as an ethic; for southern European nations squirming under pressure from the Continent’s wealthier northern lands, it is an affront to come to grips with the legacies of economic ill-discipline. And in the north, it is a high price to pay to rescue the profligate south.

Austerity is a time bomb ticking ever louder.

http://www.nytimes.com/2011/11/14/world/europe/austerity-in-europe-brings-bitterness-unknown-in-postwar-era.html?hpw

Are We Facing A Repeat of 2008?

2011-11-10T09:40:00.008-05:00

The crisis in Europe is raising uncomfortable memories among investors.

Several commentators harken back to the latter days of 2007, when it seemed that the subprime mortgage crisis would be limited to just a small segment of the credit markets.

Then, as now, the stock markets kept rallying, eventually reaching new highs in October 2007. At the same time, the credit markets were already showing signs of strains, which eventually manifested itself through the demise of Bear Stearns in early 2008 followed by Lehman Brothers in September 2008.

I don't need to mention that the stock market eventually wound up falling -34% for the calendar year 2008, with most of the decline occurring in the last three months of the year.

I have two thoughts today, one positive and the other negative.

I wish I could be more definitive but I think the situation in Europe is just too fluid - and potentially too catastrophic - to be confident of how this all plays out.

But here's my positive thought: unlike 2008, when the credit markets totally froze, credit today is widely and readily available. Total corporate bond issuance this week, for example, will be well over $30 billion, and most issues have been gobbled up by yield-hungry investors.

Moreover, corporate America is awash in cash. Corporate treasurers have generally positioned their companies' finances to be able to withstand another shutdown of credit availability, at least for a while.

Now for my negative thought: In 2008 and 2009, there was a massive government response in response to the credit crisis. The Fed slashed interest rates, offered guarantees on money market funds, aggressively bought debt in the secondary market - you name, the Fed did it.

The other branch of the federal government did their part also. The Obama administration forced through a fiscal stimulus package of nearly $800 billion. Two years later, it is not clear how much impact this spending actually made on the real economy, but if nothing else it was a huge psychological boost.

I very much doubt this could happen today in the U.S. today, let alone Europe.

Technically the Fed could enact something like QE3 (where it would buy mortgages in the secondary market) but the political reaction would probably be extremely negative. And the talk in Washington is all about cutting spending, not fiscal stimulus.

The most recent proposals from the Europeans basically boil down to cutting spending and tightening credit, which makes no sense to me. When the European Central Bank cut rates earlier this week, they made it clear that they considered it a temporary move. In short, there is almost an Calvinist attitude towards dealing with the debt crisis, which probably means any solutions will not work.

Finally consider this: In 2008, three US government officials - Bernanke, Paulson and Geithner - could sit in a room and come up with solutions. Today, in order to get any resolution in Europe, you essentially have to get 17 different countries to agree,which to date has proven to be nearly impossible.

Several commentators - including one of my favorite columnists Ambrose Evans-Pritchard of the London Telegraph - have suggested that if the US and China joined forces they could end this crisis in the European credit markets*. However, I think this is simply not going to happen.

I am very concerned, to say the least.

*http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100013198/america-and-china-must-crush-germany-into-submission/

Are Bank Stocks A Value Trap?

2011-11-09T10:30:00.004-05:00

I got together yesterday afternoon with a pretty savvy client.

The meeting was great - as always, we had a spirited exchange of ideas.My client likes not only to hear some of my recent investment thoughts, but challenge my thinking as well.

We got to talking about the financial sector, and banks in particular. I reiterated my generally bearish views on the financial stocks despite the fact that on a pure valuation they look very attractive.

My client - who used to manage money for a couple of decades - pointed out the some of the historic valuation metrics for banks could be flawed.

He noted that banks used to be like utility stocks are today: boring, slow growth stocks whose main attractions were dividends and stability.

Money center banks today have little resemblance to the large banks of a generation ago. Any restrictions on their activities have largely disappeared. Banking is also much more concentrated in just a few large entities which, as the events of 2008 illustrated, are largely "too big to fail".

I think my client is right: simply saying "oh, look how cheap the price/book ratios are for the money centers" is not necessarily going to be a good guide to profitable investment opportunities.

Even if the crisis in Europe is contained to the European banks - which quite frankly I very much doubt - banks still face the prospect of very slow loan growth in a world focused on de-leveraging.

Moreover, with yields in the bond market so meager, net interest margins are being pressured like never before.

I remain cautious on the group.

Corporate Treasurers Continue to Stockpile Cash

2011-11-08T08:55:00.004-05:00

Around the world, corporations are awash in cash.

There is an estimated $1.9 trillion stashed in US corporate coffers, yet the dividend payout ratio for the S&P 500 is a meager 26%.

Numerous companies are sitting on cash stockpiles that are far in excess of any possible corporate use; Apple, for example, will have nearly $80 billion in cash by the middle of next year, yet does not pay a dividend.

So why are corporations continuing to raise cash at record rates?

Nearly $20 billion in new corporate debt issues came to market yesterday, and underwriters are looking to sell an additional $10 billion or more in this holiday-shortened week. Only one company - Amgen - has announced that it will be doing a stock buyback with the proceeds of its $6 billion offering. The rest apparently are just going to hold onto the cash.

According to CNBC:

If the corporate issuance this week surpasses $30 billion, it would be for the fourth time this year. The last was in May, when the week of May 20, issuance reached $35.97 billion. There have been 11 weeks of $30 billion plus issuance since April, 2008.

http://www.cnbc.com/id/45194318

Corporate treasurers are justifiably nervous about the state of the credit markets. They remember all too well the credit crunch of 2008, when borrowing window slammed shut for all but the highest rated borrowers. Better to stash cash in Treasury bills - even at 0% interest rates - than to not be able to fund normal business operations.

And it's not likely that we will see a resurgence in M&A activity, even though it might make sense. Citing a survey from Fidelity International, here's an excerpt from another article on CNBC yesterday:

Companies' cautious outlook has also led firms to avoid growth through acquisitions, the survey said, adding however that conditions were right for a resurgence of M&A activity given strong balance sheets, low interest rates and attractive valuations.

Fidelity analysts said roughly 84 percent of companies they covered had either dismissed M&A entirely to drive growth or were only considering it on a small scale.

"That's because they are generally paralyzed with fear about what's going on in the world, and they don't really want to do anything with the cash," {one Fidelity analyst}said.

"They are worried that they may have to survive a six-month period where global liquidity freezes again."

http://www.cnbc.com/id/45200565

With interest rates so low, huge positions in cash are not especially helpful to shareholders, but it appears that caution is outweighing investment considerations for the time being.

My Education at Parents Weekend

2011-11-07T09:15:00.006-05:00

My wife and I traveled to Wesleyan University this past weekend to visit our son Michael, who is a junior at Wes, for Parents Weekend.

We had a great time - the weather was very pleasant for this time of year, with temperatures reaching the mid-50's by mid-afternoon while were in Middletown.

The campus, too, was in surprisingly good shape considering the fact that much of the town was without power for most of last week in the aftermath of the snow storm.

We attended a number of different lectures given by Wesleyan professors, which gave us a glimpse of what a terrific education Michael is getting. We had time to walk around campus, and also attended a football game.

In short, we got the full higher education education experience in just a couple of days.

One of the things that struck me, however, was the dearth of any passionate protest movements on campus. True, there was the usual signs protesting pollution, or conditions in rural India, but most seemed fairly perfunctory. Perhaps this is a good thing, but maybe it also reflects a student body more interested in jobs and the economy than global concerns.

I don't think this is confined to Wesleyan. According to an article in this past weekend's Financial Times titled "Harvard rebels snub Bush aide's economic class", one of the hot protest topics on campus at Harvard revolves around what is being taught in introductory Economics:

On Wednesday, about 70 students walked out of Economics 10, the introductory class Professor {former Bush economic advisor Greg} Mankiw teaches, to protest at what they called a bias towards a destructive brand of free-market economics.

"We found a course that espouses a specific - and limited - view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today, {said the students}. There is no justification for presenting Adam Smith's economic theories as more fundamental or basic than, for example, Keynesian theory."

http://www.ft.com/intl/cms/s/0/5aae33bc-069b-11e1-8a16-00144feabdc0.html#axzz1d24r3L8e

Given my experience as an undergraduate at the University of Michigan - where the hot topics were areas like Vietnam or legalization of marijuana - the "hot buttons" on campus have changed considerably in a generation!

What if Greece Just Says No?

2011-11-03T09:37:00.005-04:00

I've been trying to figure out what happens if Greece simply defaults.

It's easy to dismiss the cries of protest emanating from the Greek populace about the terms imposed by the European leaders as part of a bailout package.

After all, the thinking goes, the Greeks lived well beyond their means for many years. Borrowing levels soared, and a corrupt and in-bred government did little if anything to improve basic government functions like tax collections.

And yet, the terms of last week's deal are incredibly draconian. Greece is expected to accept austerity measures for the next 10 years. Unemployment will soar, probably in excess of 20%, for years to come. Public services will be cut and the standard of living of most Greeks will deteriorate further.

All this so the big European banks can be repaid for loans that never should have been made to begin with.

I'm not defending Greece - they could have stopped this train wreck long ago - but I am also questioning whether the medicine is more than most populations would reasonably be expected to take.

A number of commentators have begun to say maybe Greece should just default. Yes, the near term consequences could be dire, but longer term the country could wind up ahead.

Iceland, for example, told its bank creditors to take a hike back in 2008 when it was in the middle of its own credit crisis. As Bloomberg news wrote earlier this year:

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its largest lenders in receivership. It chose not to protect creditors of the country's banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

http://www.bloomberg.com/news/2011-02-01/iceland-proves-ireland-did-wrong-things-saving-banks-instead-of-taxpayers/

And where is Iceland today? Quoting Bloomberg:

In the beginning, banks and other financial institutions in Europe were telling us 'Never again will we lend to you' {one Iceland official} said. "Then it was 10 years, then 5. Now they say they might soon ready to lend again"

The political winds are considerably different than 2008, when the world was told that we were facing financial Armageddon if the banks were not bailed out.

At this point I think the risks are much greater for French and German banks - and I think that Greek Prime Minister Papandreou had figured this out long ago.

The More Things Change, The More They Stay the Same

2011-11-02T10:42:00.005-04:00

French diplomat Charles Maurice de Talleyrand once famously said that the Bourbon family dynasty that "had learned nothing and forgotten nothing."

This quote came to mind when reading about the fall of MF Global.

The investment "bets" that MF Global had made were not on the surface particularly aggressive. From what I read, the firm had amassed huge positions in short sovereign debt of countries like Italy which are trading at a modest discount to par in the secondary market.

The idea was simple: at the end of the day, it seems very likely that all of most, if not all, of the debt would be repaid in a year or so.

The problem is the fact that MF Global borrowed heavily to buy as much of the sovereign debt as it could. When its creditors turned skittish, and pulled their credit lines, MF Global tried to get out of its positions, but there is obviously not a particularly strong bid for euro bonds these days.

Exit MF Global.

This strategy seems very similar to the ones followed by Long Term Credit Management (LTCM) back in the late 1990's. There again, a group of very smart investors decided to leverage up their investments in sovereign bonds issued by countries like Russia. When Russia defaulted, LTCM collapsed.

Ironically, one of the firms that helped liquidate LTCM was Goldman Sachs, headed by none other than Jon Corzine. Corzine, of course, is the head of MF Global, and pushed MF Global to make the same type of leveraged bets on sovereign debt that LTCM had done.

And now MF Global has reached the same fate as LTCM.

Roger Lowenstein wrote an excellent book about the hubris that ultimately lead to the demise of LTCM called "When Genius Failed: The Rise and Fall of Long Term Capital Management". He wrote a column for Bloomberg yesterday which discussed the similarities of LTCM and MF Global:

MF Global was leveraged 30 to 1, shades of LTCM. And of MF Global’s roughly $40 billion in assets, more than $6 billion were in volatile European sovereign debts. Corzine was the author of the firm’s strategy of risking its own capital. He wanted a firm like {LTCM}, and he got one. Corzine also approved the strategy of loading up on European debt. According to the Wall Street Journal, he told a company executive that “Europe wouldn’t let these countries go down.” Just as, 13 years ago, traders believed that Russia wouldn’t default.

Corzine’s bet may still prove correct; “these countries” -- Italy and Spain, for instance -- may emerge from the current crisis solvent. But if they do, MF Global will not be around to reap the gains. Because the firm was so highly leveraged, and because it was dependent on short-term financing, its liquidity dried up and it failed. This seems to be the lesson that Wall Street never learns.

http://www.bloomberg.com/news/2011-11-02/corzine-forgot-lessons-of-long-term-capital-roger-lowenstein.html

As Talleyrand might have said: Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same).

November Starts on a Rocky Note

2011-11-01T11:00:00.004-04:00

I'm worried about how quickly the apparent Greek debt accord reached just last week in Europe is unraveling.

The decision by Greek Prime Minister Papandreou to put the European Community's plan to a vote in the Greek Parliament illustrates very clearly which country is in control. And, no, it's not Germany - it's Greece.

John Maynard Keynes once famously observed that "If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has."

Greece knows that if it defaults on its debt obligations, and it is forced out of the eurozone, the consequences will be huge for all of the remaining members.

The major euro players are trying to force draconian austerity measures on Greece in return for more financial help. But my suspicion is that Papandreou knew this wouldn't fly in Athens, but went along anyway last week. Some observers noted his almost surreal calm in the midst of the conference; maybe he is a better poker player than the other leaders thought.

German Chancellor Merkel - who expanded so much political capital on last week's agreement - must be hugely frustrated at this point.

My real concern is what happens next. I doubt they will convene another European summit if the Greek parliament does not agree to the terms imposed last week. And the ECB is not the Fed - it can't just print money to intervene in the capital markets.

I am getting the uneasy feeling that we saw this meeting before, in 2008. Could the collapse of MF Global be this year's Lehman Brothers?

Debt Continues to Haunt Global Economies

2011-10-31T14:39:00.005-04:00

Even though there's snow on the ground, and many homes in New England are without power, it's Halloween.

It seems appropriate, then, to on the "debt ghosts" coming back to haunt us in the economy.

If the specter of this past weekend's storm wasn't enough to haunt you (we just got power back this morning), consider this discussion of the global debt burden that arose at a recent conference sponsored by the Economist magazine (I have added areas of emphasis):

Typically, however, the other striking speech came from Kyle Bass, the investor, which illustrated the other side of the problem. He pointed out that total global credit rose from $80 trillion in 2000 to $210 trillion today. In many nations, debt is three to four times GDP. These figures have normally been seen only in the course of major wars (i.e 1914-1918 and 1939-1945) when the result was a complete wipeout for creditors of the losing states.

http://www.economist.com/blogs/buttonwood/2011/10/unemployment-and-deleveraging?fsrc=nlw%7Cnewe%7C10-28-2011%7Cnew_on_the_economist

Mr. Bass's figures include the so-called shadow banking system, which are entities that exist outside the normal banking channels (e.g., money market funds) that also provide credit.

These debt figures are obviously staggering. Now, to be sure, some would argue that they could be overstated, since much of what is considered "debt" are actually credit derivatives that probably will not be exercised.

But still: $130 trillion in a decade?

The Financial Times also picked up on some of the figures that Mr. Bass discussed, noting (again, I have added emphasis):

A study by the Financial Stability Board of the 11 largest economies with significant shadow banking found the sector, which previously peaked at $50,000 bn in 2007, dropped to $47,000 bn in 2008, but is now back up to $51,000 bn. It now constitutes more than a quarter of the financial system and is about half the size of traditional banks....

Regulators fear {non-bank credit} remains a big threat to long-term stability, particularly as more activities move out of the bank sector to escape tighter regulation there.

http://www.ft.com/intl/cms/s/0/39c6a414-00b9-11e1-930b-00144feabdc0.html#axzz1cNzz8NPv

In short, while we continue to talk about paying off past debts and getting our global economy on a sound footing, the numbers would suggest that in fact we're heading in the opposite direction.

One final thought: Imagine if the shadow banking system was subject to the same capital rules as the banks? It might make the system more stable in the long run, but the shorter term consequences would be very negative.

European Banks

2011-10-28T16:55:00.005-04:00

The markets had a huge rally yesterday with the news of the apparent resolution to the Greek debt problems.

European bank share prices soared, led by a rise of more than +20% in French bank stocks.

As I will explain, I can understand why banks are rallying - they're getting bailed out (again).

What I can't figure out is why the solution is anything but very bad news for European economies.

Here's the part that I'm focused on: the plan calls for banks in Europe to raise capital between now and the end of June next year. The figures being thrown around are around 110 billion euros, or about $150 billion.

The idea is laudable: banks need to raise more capital in the event of other sovereign credit problems, especially in countries like Ireland, Spain, Portugal or even (gulp) Italy.

Problem is, most bank stocks in Europe are trading below book value, just like in the U.S.

Issuing equity capital below book value is a sure-fired way to kill your stock value, and it seems logical that most bank managements will be reluctant to do so.

Which then leads to the real heart of the matter. For this, let me show you a very simplified bank balance sheet:

Assets

Loans and Investments 100

Total Assets 100

Liabilities & Capital

Deposits, Borrowings* 94

Bank Capital 6

Total Liabilities and Capital : 100

What you can see here is a fairly typical balance sheet which has 6 euros supporting 100 euros of loans and investments. This ratio - 6 euros for 100 euros of assets - is 6%, which is roughly where most of the European banks currently stand. This 6% figure is called the capitalization ratio.

The agreement reached yesterday called for bank capitalization ratios to be raised to 9%. The question is: how can this be done when bank stocks are trading below book value?

Simple algebra will tell you that if you're not going to sell stock, you have to reduce your assets.

If you have 6 euros in capital, and you want the capitalization ratio to go to 9%, you have to shrink the amount of assets to 67 euros, or about one-third less than their current levels.

If this is the case, this will be hugely depressing for Europe. Reducing loan portfolios by 33% between now and next June doubtlessly will entail economic pain. Shrinking the debt markets so quickly means less credit available for all kinds of meaningful economic purposes.

Now, some of the people I have spoken to say I am being too pessimistic.

First, it was announced yesterday that the authorities will be watching the banks very carefully to make sure they don't just shrink their balance sheets in the manner I am suggesting. Honestly, I don't know how effective moral suasion can be in this case, but maybe it will work.

Second, the banks themselves are claiming that they can simply retain more earnings and build capital through business operations. Well, maybe, but these are big numbers, and loan growth in Europe is really slow.

Oh, and the banks might cut their dividend payouts (as French PM Sarkozy suggested yesterday) to retain more earnings. But how does this make bank shares attractive to investors to provide needed capital?

Maybe the banks don't need to shrink their balance sheets: maybe they can just sell off huge chunks of their loan portfolios to other investors, which means that the credit will still remain in the system.

Problem with this happy scenario is that it implies that banks will be able to sell their loan portfolios at attractive prices. We tried this in the U.S. in 2008, and essentially failed - the bids were at huge discounts to book.

If you are a buyer of bank loans, and you knew the banks had to sell, are you really going to make an aggressive bid?

I could go on, but you can see my problem. If the politicians force their solution on the banks, and the "happy" solutions don't pan out, it has the danger of tipping a fragile economic situation into something more serious.

More more ominous note: Almost immediately after the Greek deal was announced yesterday, the Irish Prime Minister was quoted as saying, hey, we would like that deal also - why should we be forced to pay back all of our debt at face value if the Greeks only have to pay 50%?

Look for the rest of Southern Europe to follow Ireland.

Lots to ponder this weekend.

BTW: The funding of the loans is largely done through deposits and borrowing. In the case of the European banks, they make extensive use of the money markets. This makes the Europeans more vulnerable to changes in credit perceptions, since lines can be quickly pulled if any lender becomes nervous.

Richard Rosenbloom

2011-10-27T09:44:00.004-04:00

One of my favorite clients died earlier this week.

Although Boston Private Bank prides itself on confidentiality, I think I can make an exception in this case, because Dick Rosenbloom was more than a client to me.

I first met Dick in the spring of 2000. He was still teaching at the Harvard Business School, where he was the David Saranoff Professor of Technology. In the summer, Dick and his wife Ruth would head out to the Bay Area, where he was consulting at Hewlett Packard. He was also on the board of Arrow Electronics.

Although I was managing an equity portfolio for Dick, I often felt like I was learning more from him than vice versa. His insights on the world in general, and technology in particular, were incredibly interesting and helpful.

Dick made a terrific market call in August 2000. He had just finished reading Robert Shiller's book Irrational Exuberance, which described the incredible overvaluation of the stock market at that time. Although I was on vacation, Dick called me and told me to sell nearly all of the stocks in his portfolio.

The S&P 500 then started the swoon from which it has yet to recover; the market is off nearly -20% from the time Dick told me to sell.

Dick took the proceeds from his stock sales and moved them into bonds, where he also did very well. Here again his instincts were uncanny: In the midst of the credit crunch in the fall of 2008, for example, he pushed us to invest in bonds issued by banks and brokers, correctly surmising that the government would never let our largest financial institutions fail.

But there was more to Dick than investing - much more. He was totally devoted to his family. He loved talking about his three children, and their activities were always a source of interest. When his wife Ruth became ill, he became a full-time caregiver, and never complained about the burden. Her death left a void in Dick's life, but he continued to live life as best as he could even after the loss of his best friend.

I always enjoyed meeting with Dick to catch up on the markets as well as family. To be sure, Dick could be very challenging, as all good teachers can be to students.

For example, Dick disliked the idea that institutional investors had diversified portfolios, and pushed me to put only my very best ideas into his accounts, regardless of whether it increased volatility. Thanks to his prodding, I must confess that my equity performance numbers in Dick's portfolios were among the best in my client book.

Dick moved to New York City in his last years, and loved the energy and vitality of the City. While I had not seen him as much as I would have liked after he moved, we talked occasionally on the phone, and our conversations were always pleasurable.

Dick will be missed not only by me, but several other members of the Boston Private Bank community who knew him well.

More on Bank Stocks

2011-10-26T12:18:00.004-04:00

We had a long and heated discussion here at the bank this morning about investing in the financial sector.

The S&P 500 has slightly more than 13% weighting in the financials. Underweight the sector in client portfolios, and financials rocket ahead like they did at the end of 2010, your relative performance suffers.

On the surface, the group looks incredibly cheap. The money center banks in particular are trading at a price/book ratio not seen in 30 years, so it would seem that they are ripe for investment opportunity.

But not to me.

Yes, I recognize that the problems of the financial sector are widely known, and that any "good news" from Europe could cause the group to soar.

Moreover, if the glimmers of economic resurgence continues, financials historically have done very well when economies are healing.

My main problem with the group relates in part to the post from yesterday about Ray Dalio. Dalio's company Bridgewater Associates focuses on what they don't know as much as what they believe, which is an approach I favor as well.

So, what is it that we don't know about the financial sectors health?

Plenty, I would argue.

For example (quoting from Monday's Financial Times Lex Column):

Try this on your credit card company: your creditworthiness has weakened, so you write down the value of what you owe to reflect the greater risk that you will not pay it all back and credit the difference to your personal account. That is exactly what accounting allows; the top five big US banks - Citigroup, Bank of America, JP Morgan, Morgan Stanley and Goldman Sachs - have just reported gains equivalent to more than four-fifths of their quarterly $16bn net profit as a result of falls in the value of their own debt and credit standing. Now European banks are set to report with the same system.

http://www.ft.com/home/us

Bank of America reported reasonably good earnings last week - until you stop to consider that it needed 15 separate "one-time" boosts to get to a reasonable earnings number.

This, by the way, was on the heals of the 16 different "one-time" boosts that BofA employed in the second quarter.

So, in fact, we really have no idea what banks are even making.

Then there is the simple problem of low interest rates. Banks typically make a good chunk of their earnings from the spread between short term and long term interest rates. However, with loan demand tepid, and rates on Treasurys at 1% or less on all but the longer maturities, there is no spread available.

This becomes particularly important to banks at the present time, when they are being inundated with deposits. As Monday's New York Times pointed out:

Normally, banks earn healthy profits by taking in deposits and then investing them or lending them out at substantially higher interest rates than what they pay savers. But that traditional banking model has broken down...

Today, banks are paying savers almost nothing for their deposits. As it turns out, the banks are not minting money on those piles of cash. Lending levels have not bounced back from only a few years ago and the loans going out are not keeping pace with the deposits rushing in.

http://www.nytimes.com/2011/10/25/business/banks-flooded-with-cash-they-cant-profitably-use.html?_r=1&scp=1&sq=banks%20cash&st=cse

And what do we know about the quality of bank balance sheets? Nothing. Banks have been reluctant to write down non performing loans since they do not want to recognize losses.

In short, we don't know what banks are actually earning, nor do we know anything about credit exposure. With the economy mired in de-leveraging mode, prospects for loan growth do not seem promising.

So what is the catalyst for bank stocks? I'm hard pressed to find one, but I will continue to look.

One final point: one of my fellow managers kept insisting that "everyone" is bearish on the financial sector, and banks in particular. He concludes that the contrarian play, then, is jumping back in the sector.

However, financials still represent the second largest sector weighting in the S&P index, despite massively underperforming the rest of the market this year.

The stock market that by definition has to have a buyer for every seller, there apparently are still lots of folks that believe that the banks are about to turn.

Ray Dalio of Bridgewater

2011-10-25T08:00:00.003-04:00

I had the chance to watch Ray Dalio of Bridgewater Associates being interviewed on the PBS talk show Charlie Rose last week.

Ray Dalio is one of the most successful money managers of our generation. Starting in 1975, his firm now manages approximately $125 billion for a wide variety of clients, including some of the largest public pension plans. Last year, Bridgewater was the top performing hedge fund in the United States, proving that size isn't necessary a deterrent to performance.

Unfortunately I was not able to figure out how to imbed the video from Mr. Dalio's appearance. However, if you have 37 minutes at some point, and want to hear from one of the Best, I would encourage you to visit http://www.charlierose.com/ and watch the entire interview.

Bridgewater is a "macro" investor, which means that they place their investment bets based on their work on global economic and market trends.

One of the most interesting parts of the interview, in my opinion, is how much Mr. Dalio says that his firm focuses on what they don't know. Unlike many investors - who make a specific forecast, then invest accordingly - Bridgewater considers a wide range of scenarios, and tries to figure out investments that will do well in a variety of different outcomes.

In this tendency Bridgewater is not alone. It seems to me most of the best investors - including Warren Buffett - spend more time on downside risks than they do opportunities. Despite their enormous success, Dalio and Buffett are humble enough to recognize that events often take place that virtually no can anticipate, and they make their investments accordingly.

Dalio has an editorial in this morning's Financial Times in which he repeats some of the themes that he discusses on the Charlie Rose program.

Dalio believes there are three important trends to consider right now:

We are in the midst of a massive de-leveraging process. Dalio notes that he is not only concerned about the huge government debts around the globe, but also the massive amount of debt that individuals also have amassed. In his opinion, the process of reducing this debt will be a drag on economic growth for years;
Governments are largely out of ammunition. Dalio believes there is are few alternatives left for our elected officials to improve the current economic climate;
We are at each other's throats. The tone of any policy debate has become incredibly nasty and strident, and no one seems to want to try to come up with any workable solutions. This, in Dalio's opinion, is probably the biggest danger to our economies and markets.

Here's the final paragraph of Dalio op-ed piece:

http://www.ft.com/intl/cms/s/0/ed4439d4-fbeb-11e0-9283-00144feab49a.html#axzz1bnIVgYrW

Managers, Pigeons, and The Perils of Overconfidence

2011-10-24T08:51:00.007-04:00

Let's start the week with a pop quiz.

I am going to sit you down in front of a screen where I will flash two lights: red and green. I will tell you the sequence is completely random, but 80% of the time the light will flash green.

And, oh, by the way: one of my assistants will be doing the exact same experiment in the next room, only she will be having a pigeon doing the guessing.

Who do you think will get more right? You or the pigeon?

Now we'll start our experiment. I will start flashing the light, and I want you tell what color is coming up next.

Here's what you should do: I have already told you that 80% of the time the light will flash green, and that the sequence will be totally random. So, the correct guess will always be "green", so you will be right 80% of the time.

But that's not what most humans do. They tend to look for patterns where none exist. Here's how Jason Zweig described our human tendencies in his book Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich:

Human, however, tend to flunk this kind of experiment. Instead of just picking green all of the time and locking in an 80 percent chance of being right, people will typically pick green four out of five times, quickly getting caught up in the game of trying to call when the next red flash will come up. On average, this misguided confidence leads people to pick the next flash accurately on only 68 percent of their tries. Stranger still, humans will persist in this behavior even when the researchers tell them explicitly...that the flashing of the lights is random.

Meanwhile, the other room, your pigeon competition is guessing correctly 80% of the time, since the bird automatically picks green every time. Mr. Zweig explains:

...birds seem to stick within their limits of their abilities to identify patterns, giving them what amounts to a kind of natural humility in the face of random events. People, however, are a different story.

In short, the pigeon probably wins.

---------------------

I was reminded of this story yesterday, when I read a piece by Dan Kahneman in yesterday's New York Times about the perils of overconfidence.

Dr. Kahneman was awarded a Nobel Prize in 2002 for his groundbreaking research into behavior finance. He has also written extensively about how one should view any predictions about future events, especially economic or related to the stock market, with a grain of salt.

In my field, you often read predictions about the future course of the stock market, or the direction of interest rates. These pronouncements are usually made with great confidence, yet are often just as likely to be wrong as they are right.

Just as in the behavior experiment, we humans like to look for patterns where none exist. We might know, for example, that investing in stocks will tend to outperform other asset classes, yet we persist in trading in and out of the market based on our belief that we will be able to "time" the market.

Here's Dr. Kahneman's advice:

We often interact with professionals who and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness. ls who exercise their judgment with evident confidence, sometimes priding themselves on the power of their intuition. In a world rife with illusions of validity and skill, can we trust them? .... We can believe an expert who admits uncertainty but cannot take expressions of high confidence at face value. As I first learned on the obstacle field, people come up with coherent stories and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness.

http://www.nytimes.com/2011/10/23/magazine/dont-blink-the-hazards-of-confidence.html?pagewanted=4&_r=1&ref=general&src=me

TIPS Are a Crowded Trade

2011-10-21T09:54:00.006-04:00

Ned Davis - founder of Ned Davis Research, a market research firm that I highly respect - has three simple rules for investors:

Don't fight the tape (i.e., when the market is trending in one direction, don't try to fight it);
Don't fight the Fed (i.e., when Fed policy is easy, buy stocks, or vice versa);
Be wary of crowds at the extremes (i.e., when sentiment is overwhelmingly skewed in one direction, be careful).

I have often thought of Ned's rules, but I was particularly reminded of rule #3 this morning, when I read this sentence from an email sent by Brad Hintz, Bernstein's financial analyst (TIPS are "Treasury inflation protected securities"):

Yesterday, the U.S. Treasury sold $7 billion of 30-year TIPS at a record low yield of 0.999%. Demand was very strong as the bid-to-cover ratio was 3.06, well above the average of 2.40. Indirect bidders, a class of investors that includes foreign central banks, purchased 43.2% of the securities, above the average of 40.0% for the past four auctions

Think about that: there apparently is a large enough group of investors so convinced that inflation will be roaring back that they are willing to lock in returns of less than 1% for the next 30 years (!).

I know I wrote yesterday that investors should avoid predictions, but here's one that I can safely make: The world will look alot differently in 2041 than it does today.

So does that mean that bonds are overvalued?

Well, maybe, but I think with the Fed keeping short rates at 0% for at least the next couple of years, and deflation, not inflation, a bigger risk, bonds can still play a role in investor portfolios.

But for investing, it still seems to me that dividend-paying, large cap stocks are the way to go. So too does legendary investor Leon Cooperman, who is not a big fan of bonds.

Instead, Mr. Cooperman likes stocks:

“I wouldn’t be caught dead owning a U.S. government bond,” he said today during a presentation at the Value Investing Congress in New York. “Not because I have a problem with the credit. I have a problem with paying 35 percent on the 2 percent to Uncle Sam, and then have a 2 to 3 percent rate of inflation,” he said. “It’s confiscation of my capital. I think I’m too smart to play that game.” ...

Stocks are cheap relative to history, relative to inflation, relative to interest rates,” he said. “The recent facts suggest the economy is accelerating moderately.”

http://www.bloomberg.com/news/2011-10-18/cooperman-says-u-s-will-avoid-recession-stocks-appealing-1-.html

How Not to Set Investment Strategy

2011-10-20T10:57:00.006-04:00

"Prediction is very difficult, especially about the future"

One of the biggest mistakes that investors make, in my opinion, is to try to overlay their views on the economy or interest rates on their investment strategy.

It seems to make logical sense: first you forecast the economy, then the direction of interest rates. Once you've figured this out, you turn your attention to what stocks or bonds will provide the best returns under the scenario that you expect.

Problem is, the accuracy of most forecasts - especially about the economy, interest rates and the stock market - are usually poor at best.

The academic literature is full of examples of how many of the most prominent and learned among us have failed to anticipate changes in the economy. It's not for lack of trying, but rather that it's just too complex.

Take interest rates, for example. Here's a short note written by John Carney the CNBC blog Net, Net:

The latest note from James Bianco points out that Bloomberg’s monthly survey of economists almost always forecasts high rates for 10-year Treasurys in the next six months.

Since 2002, Bloomberg has been asking economists where they think interest rates will be six months into the future. Out of the 104 surveys completed, 100 of them forecast high rates in six months.

Every single survey for 2011, for example, the majority of economists polled forecasted higher rates.

Interestingly, the economists are always right when predicting falling rates—although this has only happened four times so far so the sample may be too small to matter.

http://www.cnbc.com/id/44963277

Now, with interest rates at 60-year lows, what's the next direction for rates?

Truth is, no one knows for sure.

It seems to me that one should focus their investment attention on sectors that offer the most value under a variety of different scenarios, no matter how far fetched they might appear.

*This quote is usually attributed to Niels Bohr, a prominent Danish physicist, although Bohr himself attributed it to others. Whatever - I like the quote.

What to do about Bank Stocks?

2011-10-19T10:22:00.006-04:00

I first wrote about this topic last March. Fortunately, I concluded that it was not yet time to dive into the sector, despite the fact that the valuations appeared very attractive.

Here's what I wrote then:

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

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

http://randomglenings.blogspot.com/2011/03/what-to-do-with-bank-stocks.html

Lots has happened in the last 6 months, but nothing (in my opinion) has changed in terms of the headwinds facing my industry.

Loan growth remains sluggish. Low interest rates are killing bank net interest markets. Credit metrics for the banks are starting to show deterioration again, after several quarters of improvements.

And recent results from the money center banks appear attractive, yet once you dive into the numbers much of the recent bank profitability has been achieved through "special items".

Consider Bank of America, which posted stronger results than expected, and BAC soared by +10%. However, according to this morning's New York Times:

Still, the story behind {Bank of America's} $6.23 billion profit was mostly a tale of one-time gains from accounting changes and asset sales, including $4.5 billion from positive adjustments to the value of its outstanding debt, a $1.7 billion accounting gain on the perceived riskiness of its debt and a pretax gain of $3.6 billion from the sale of half its stake in China Construction Bank....

Without the special items, Bank of America would have earned about $2.7 billion, which included pulling back $1.7 billion it had set aside, largely for borrowers who fail to pay their consumer and credit card loans.

Jason Goldberg, an analyst with Barclays Capital, counted 15 special items in the quarter, down from 16 in the second quarter but more than the 12 in the first quarter. “It’s a big company undergoing a transformation.”

http://dealbook.nytimes.com/2011/10/18/bank-of-america-gives-up-its-title-as-biggest-in-u-s/?scp=4&sq=bank%20america&st=Search

Now, I am a fan of Jason Goldberg, but is it really a positive that the number of special items in Bank of America's earnings has fallen from 16 "one-off" items to 15?

Then there's this: I asked Rich Sipley, a fellow portfolio manager here at Boston Private Bank (and loyal reader of Random Glenings) a simple question yesterday.

Me: "If bank stocks are so cheap, why are we seeing more acquistions?"

Rich: "No one wants to sell at these prices."

That's why Rich is a good portfolio manager.

That said, there is more feelings that the longer term outlook is for a large increase in bank merger activity, simply because the costs of banking in this country are rising significantly at a time when revenue growth has been nonexistent.

This morning's Financial Times carried a piece this morning discussing the need for the banking sector to shrink in the U.S.

According to the article, a recent report by turnaround specialists Alvarez & Maral suggests that large U.S. regional banks will "need to cut expenses by up to 40% to cope with slower economic growth, increasing pressure to cut staff or merge with rivals".

Here's the problem:

Companies such as Regions Financials - which is trading at about a third of its book value - and Sun-Trust banks - trading at about half of its book value - will be among those facing pressure either to pare back their operations significantly or merge with competitors. Many already have announced cost-cutting measures to placate investors.

From 2002 to 2006, banks' ROE was about twice as high as their cost of equity capital, according to Alvarez & Marsal. Since 2008, the cost has exceeded the return, a trend that is forecast to continue until 2013.

http://www.ft.com/intl/cms/s/0/63b17772-f353-11e0-
b11b-00144feab49a.html#axzz1bA0s3gvl

So for now I remain very defensive in my bank positions in portfolios.

Market Volatility

2011-10-18T11:05:00.004-04:00

The blog Zero Hedge posted an excerpt this morning from Michael Higley's weekly "By the Number$" newsletter:

During the first 4 months of the year through 4/29/11, the S&P gained +9.1% (total return). From 4/29/11 to 10/03/11 (i.e. approximately the 5 months that ended just 2 weeks ago), the S&P 500 lost 18.6%. But in the last 9 trading days through last Friday (10/14/11), the stock index gained +11.5%. The net YTD result: down 1.1% as of 10/14/11.

http://www.zerohedge.com/news/some-market-fun-numbers-art-cashin

Put another way, net-net, stocks have gone nowhere this year, but its been a helluva ride.

To me, this year's volatility illustrates the futility of trying to time the market. Others, however, continue to try to trade the market, despite the overwhelming evidence that most trading makes money for the broker, not the investor.

I continue to think that dividend-paying, large cap stocks are the only game in town for most investors who can take a longer term time horizon. I don't know what the market will do next week, or next month, but I find it hard to believe that over the next three to five years stocks will not be the superior asset class.

One of the more bullish market analysts this year has been Lazio Birinyi, but he wrote a piece in this morning's Financial Times modestly changing his tune.

Mr. Birinyi now describes himself now as being only moderately bullish. He is concerned about data showing an economy that is decelerating, and the possibility that the European and Asian markets will also drag on the US stock market.

That said, Mr. Birinyi would not abandon the market, noting that some of the bearish arguments that are currently making the rounds have been made for years. Abandoning the market based on current sentiment, as Mr. Birinyi notes:

I don't know how and when this will end. One clue might be to look for negative reports. On March 9, 2009, at the bottom, the Wall Street Journal's Money section headlined "Dow 5,000? A bearish possibility."

And one of the longest market stories in last year's New York Times - again at the bottom for markets that year - was subtitled "Wall Street tallies new losses with a bear market in mind."

http://www.ft.com/intl/cms/s/0/fc1da9e2-ef78-11e0-941e-00144feab49a.html#axzz1bA0s3gvl

Investing in Farmland

2011-10-17T08:35:00.003-04:00

In the early 1980's, when I was just getting started in the investment business, there was widespread consensus about where all "smart" investors should have funds: gold and oil.

Gold hit a high of $850 in 1980, while oil had reached $39 a barrel in the same year. The thinking among most institutions was that commodities in general, and gold and oil, in particular, were only destined to move higher in price, especially since they had outperformed all other asset classes in the prior decades.

Then reality hit. Gold prices started to fall, and by the year 2000 gold was priced at $250 an ounce, or nearly -70% lower than two decades earlier.

While gold prices have recovered recently, investing in gold in 1980 would have yielded a return of less than 1% per annum for the past 30 years, far below traditional investments in either stocks or bonds.

Oil prices, too, had peaked in 1980, even though it was not apparent to anyone at the time. Oil prices fell by more than -75% by 1986 to less than $10 a barrel, as oil supplies far outstripped demand.

Like gold, oil prices eventually recovered, but here again the returns from investing in oil have been barely higher than 2% per annum over the last 30 years.

Which brings me to farmland investments.

The current investment du jour is farmland, according to Gillian Tett of the Financial Times. In her piece last Saturday, Ms. Tett notes that TIAA-CREF, the huge pension fund targeted largely to educational and non-profit institutions, is now apparently the largest owner of U.S. farmland today.

Other large institutional investors have joined TIAA-CREF in their appetite for farmland. According to an OECD report, notes Ms. Tett, 54 investment funds now have $7.44 billion of agricultural investments around the world, and this is "expected to double or triple in the near to long term".

The logic of investing in farmland is to me eerily reminiscent of the same reasoning that lead investors to pile into oil and gold investments a generation ago: the world is changing, the amount of farmland is finite, etc.

Oh, and the historic returns from investing in farmland have to date been far better than investing in stocks or bonds.

Now, it could be that I am too cynical, but after growing up in the Midwest I can tell you that farmers tend to be pretty good judges of the value of their land.

And if farmers are selling to the "shrewd" money managers from New York, I would be more than a little cautious.

Past performance, as people in my industry constantly remind us, is no guarantee of future results. I would be willing to bet that returns from indiscriminate farmland investments will be poor indeed relative to other alternatives in the years to come.

Investment Choices in a Low Return World

2011-10-14T09:01:00.004-04:00

It has been said that democracy is the worst form of government except all the others that have been tried.
-Winston Churchill

When I look at the asset markets today, I am reminded of Churchill's quote.

Investors and savers face a fairly unappetizing menu of investment choices these days.

Stay in cash and earn nothing for the next two years?

Buy high quality bonds with yields at 60-year lows?

Buy stocks whose returns over the last decade or so can best be charitably described as mediocre?

Yikes.

You already know where I stand on this: I think that dividend-paying, larger cap stocks offer the best combination of income and capital appreciation potential.

Still, there is no question that stocks will continue to show more volatility than most would prefer as the world struggles with the mountain of debt we accumulated over the past decade.

The Economist has written in this week's issue about the difficult choices facing investors these days.

For example, the article cites a Deutsche Bank study on bonds:

Deutsche Bank’s study suggests that, if yields revert to the mean, investors in 30-year Treasury bonds will suffer an annualised loss of 3.3% over the next five years and 1.3% over the next ten; investors in ten-year bonds will suffer annualised losses of 4.3% and 2% respectively.

http://www.economist.com/node/21532286

And what about commodities? Here's The Economist's view:

The problem with gold, and other commodities, is that with no yield or earnings they are hard to value. Demand from Asian countries has certainly pushed up prices; non-oil commodities have trebled over the past decade. But if the economy does start to slip into recession, commodity prices could fall very sharply; they almost halved between March and December 2008. This year they have dropped by around a fifth since February.

I could go on, but you get the idea: there are very few safe havens in today's world.

Still, as both The Economist and other analysts have suggested, buying higher yielding equities trading at reasonable valuations offer the best potential returns from a relatively meager list of alternatives.

The key, in my opinion, will be to focus on companies whose dividend is not only attractive today, but has the potential for growing along with inflation in the years to come.

Fortunately, there are numerous companies that fit the bill. Corporate America flush with cash, and margins are at record levels. Payout ratios for most companies is at historically low levels, which gives the chance for dividends to grow.

Stocks Do A Three Year Round Trip

2011-10-13T10:15:00.003-04:00

Last week, on October 3, the S&P 500 closed at exactly the same level that it closed on October 3 three years ago: 1099.23.

As John Authers noted in his column in the Financial Times last weekend:

"Buy and hold" investors in US stocks had spent three of the most exciting years in financial history getting back to exactly where they started...

Stocks have endured a lost decade. And looking just at the past three years, all the gyrations since then have left us exactly where we were only three weeks after the fall of Lehman Brothers.

http://www.ft.com/intl/cms/s/0/5c82c53a-f0d0-11e0-aec8-00144feab49a.html#axzz1affz7M13

No wonder investors are discouraged.

The question is whether the period going forward will be any different than the fall of 2008, when stocks started the swan dive that did not end until March 2009.

I think it will be, although there is still the possibility of a negative political "surprise" from either Europe or Washington.

Unlike the fall of 2008, when the credit markets were virtually shut, corporate America is flush with cash, and credit is widely available for most credit-worthy borrowers. In addition, most corporations report that business trends remain favorable, although corporate CEO's have been very careful in their expansion plans.

Economic data also suggests an economy that is expanding, albeit at a tepid pace. Last Friday's non-farm payroll report, for example, indicated an economy that was adding jobs at a rate faster than most economists had predicted.

Still, stocks are searching for the catalyst that will restore a sustainable rally, and that seems to be lacking at this point.