About that "Level Playing Field"

Financial reporter Bethany McLean is out this morning with an excellent editorial discussing the futility of trying to make investment world a totally fair place.


McLean wrote her piece in the wake of the government's indictment yesterday against SAC Capital alleging, among other charges, insider trading.

Here's a short excerpt from the New York Times this morning discussing the case:

At the heart of the government’s case is an attack on SAC’s pursuit of an edge in stock trading. Though it has pushed into other investment strategies, at its core SAC has traditionally been an information-driven hedge fund, aggressively trading stocks around market-moving events like earnings releases and merger announcements.

At the height of SAC’s powers in 2006 and 2007, Mr. Cohen is reported to have earned about $900 million each year, helping to give the firm a certain mystique. But it also generated whispers about whether the fund routinely crossed the line.

http://dealbook.nytimes.com/2013/07/25/sac-capital-is-indicted/

The idea of eliminating insider trading, or any other activity that seems to give someone an unfair edge, is an appealing one.  All of us were taught from an early age that we should "play fair" in the schoolroom and the playground.

But Ms. McLean argues that trying to make the stock market a "level playing field" where all investors have equal access to information is a fool's errand:

No, life isn’t fair, and as we all know now, the playing field hadn’t been leveled. Individual investors, whether operating via discount brokerages or with the dubious benefit of Street research, were just cannon fodder for the so-called smart money—including, not surprisingly, Cohen’s SAC Capital — which made fortunes by shorting dot-com stocks ahead of the crash. (The “smart money” isn’t necessarily smart, but it is well-connected)....

http://blogs.reuters.com/bethany-mclean/2013/07/25/the-folly-of-trying-to-level-the-investment-playing-field/

McLean goes on to discuss how well-connected investors were able to spot problems at Dell, and earlier Enron, well before any individual investor could have known - and it was all legal:

But the line between what’s insider trading and what isn’t is most definitely not the line between what information an average investor can access, and what information a hardworking hedge fund manager who can spend thousands of dollars and hundreds of hours on expert research can access. “I shudder to think how much of my alpha comes from failed individual investors,” one hedge fund manager tells me... 

“Edge,” as they call it in the hedge fund community, can refer to inside information, but it can also be that little bit of knowledge gleaned from incredibly hard work. And within those circles, “edge” gets shared — but not with you.

One of the lessons they teach you in business school is that the stock market is always a place of contrasting opinions.

If you think a stock is a "buy" at $25 a share, for example, there is someone else out there who is equally convinced that the identical stock is a "sell" at the same price.

In order to buy or sell a stock, then, you have to ask yourself:

What do I know that the other fellow doesn't?

And if you don't know the answer, perhaps the lesson from this week's stories on SAC Capital is that maybe you shouldn't be playing the game.

Five Contrarian Investment Plays for 2012

As I mentioned yesterday, I've been attending an "Asset Gathering" conference here in Boston. 

Throughout the day I was struck by the near-uniformity of opinions when it came for the outlook for the markets.

In addition, nearly all the speakers shared similar themes when it came to asset allocation.

It is axiomatic in the investment world that in order to make money you have to have a opinion that is different than the consensus. Consensus views are usually already priced into the markets; if you want to make money, you have to wager that the consensus has it wrong in some respect.

Here are five topics that were discussed in great detail.  It seems to be a pretty safe bet that at least one, if not more, of these ideas will prove to be wrong:

1. Interest Rates Are Headed Higher.  Ever since 2002, strategists and economists have insisted that bond yields are too low, and the next move for rates is higher.  Interest rates, of course, have done just opposite of what every one forecast.  Maybe they'll be right this year.

Interestingly, in response to a question from the audience, no one on the panel discussing asset allocation thought you should be selling bonds now, even though they all thought that rates were headed higher.

2. Stocks are Due for a Correction of -5% to -10% fairly soon, probably in the second quarter.  Much of this sentiment is based on the strong move that the markets have had since last fall, and not so much on any fundamental data.

3. There is no value-add in active management of domestic stocks.  Interestingly, this sentiment is so widely accepted at a time when the correlations between stock price movements has been falling rapidly.  This should mean that a good manager will increasingly be able to find opportunities in sector or stock picks, but no one seemed to believe this.

On the other hand, all seemed to agree that active management of foreign stocks - including emerging markets - makes sense.

4. Alternatives should play an increasing role in client portfolios.  What's interesting about this widely-held view is that no one ever presents any data that shows that investing in private equity, hedge funds, etc. actually was a money-winner.  This is sort of the "Tinker Bell" approach:  Clap if you believe.

5. High Yield and Non-Dollar Denominated Bonds are Good Alternatives to US Treasurys.   However, if the economy is really on the precipice of another downturn - as several speakers suggested - junk bonds will fare very poorly.

And buying bonds of other countries carries significant currency risk - a rising dollar will wipe out any possible yield advantage from foreign bonds.

Every speaker agreed that "educating your client" would be a very important for success in the investment management business in 2012.

I might suggest that the education efforts could be aimed at the members of my industry as well.

Consumer Staples Stocks: An Idea Gone Cold?

Tennis Anyone?

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

Stock Analysts and Forecasts

“Isn't it interesting that the same people who laugh at science fiction listen to weather forecasts and economists?”

-Anonymous

I posted a note yesterday discussing the perils of using longer range forecasts to make investment decisions.

As it turns out, even analysts - who presumably spend all day, every day - thinking about the stocks that they follow are also fallible.

Yesterday Bloomberg carried a piece describing the results of a study of Wall Street analysts (tip of the hat to loyal reader Bob Quinn for pointing the piece out to me):

Companies in the Standard & Poor’s 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg. Now, banks’ favorites include retailers and restaurant chains, the industry that did best in last year’s rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits.

Analysts Prove Hazardous as Contrarian Stocks Surge (Update3) - Bloomberg.com

This is not, by the way, to necessarily trash the Wall Street community but rather to point out how difficult it is to make good recommendations that will deliver superior investment returns relative to the market.

The article carried the following quote which encapsulates the problem:

“When you have a stock that has 15 analysts covering it and it has 15 buys, I can’t imagine it has much outperformance left,” said {Don} Wordell, whose $1.64 billion RidgeWorth Mid-Cap Value Equity Fund topped 98 percent of peers in the past five years. “You’ve got a stock that has 15 sells on it, you’re set up there to have some strong outperformance.”

It seems to me that the value of Street analysts lies in the access that they typically have to management and other industry leaders. In my opinion, you don't use the Street's "buys" or "sells" for investment decisions but rather as a good source of scuttlebutt which helps you think about a particular sector or company.

The Power of Compound Interest

From the blog Clusterstock. I figure this woman achieved a compound rate of return of just over 17.5% since 1935.

You see a lot of these types of stories around Omaha, Nebraska, with people who had invested with Warren Buffett in the earlier 1960's, and never sold a share (see the Peter Buffett post on this blog earlier this week).

Think You Want to be a Hedge Fund Manager?

Steven Cohen is one of the largest hedge fund managers in the world. SAC Capital is widely known in the industry not only for its terrific returns but also its rapid-fire trading style.

If memory serves, it used to be that SAC represented 2% of the total volume of shares traded on the New York Stock Exchange.

The financial rewards of working at a hedge fund can be, of course, unbelievable, but the pressure can also be enormous.

There was a recent article in Bloomberg on Cohen and his investing operation. I have included a link to the entire article below, but I thought I would show an excerpt from the piece about what its like working at SAC:

Cohen, who lives on a 14-acre (6-hectare) estate in Greenwich, Connecticut, which he bought for $14.8 million in 1998, allowed a reporter to visit his offices in Stamford. He declined to comment for this article.

Though Cohen attends more golf and other outings than he once did, most days the balding, blue-eyed, stocky investment manager does what he knows best: He trades. He has a perch in the middle of the Stamford floor, and his bets account for about 10 percent of profits -- down from more than 50 percent 10 years ago.

He doesn’t like noise, so the phones on the floor don’t ring; they light up. He prefers jeans and sweaters to suits and looks more like a tax accountant on casual Friday than a trading titan running a $12 billion hedge fund firm.

Picasso to Warhol

Near the trading floor hang pieces from Cohen’s extensive art collection, which includes works by Vincent Van Gogh, Pablo Picasso and Andy Warhol.

Cohen maintains the temperature on the trading floor at 69 degrees Fahrenheit (21 degrees Celsius) to make sure no one dozes. If a portfolio manager or analyst can’t answer a question about a stock, Cohen is likely to lash out. “Do you even know how to do this f---ing job?” is a standard barb, current and former employees say.

Portfolio managers make money, or they’re fired. They usually last about four years.

http://www.bloomberg.com/apps/news?pid=20601108&sid=a0dqXyjnQ6dg

Implications of Senator Brown of Massachusetts for Stocks

Best Headline of the Day (from The Village Voice) :

Scott Brown Wins Mass. Race, Giving GOP 41-59 Majority in the Senate

It is too early to gauge all of the implications Republican Scott Brown's victory for the Senate seat. However, in my opinion, many of the near-term implications may be negative for the health care and utility sectors of the market.

Last fall, when it seemed likely that some form of national health care would pass, health care and drug stocks soared. The thinking seemed to be that Obamacare would lead to millions of people receiving health insurance, and thereby becoming more frequent users (this was the Massachusetts experience when our state required health insurance for all).

Now, assuming that any significant legislation will be either watered-down or delayed, some of the steam may go out of the health care group, with the possible exception of the managed care group.

The utility group may also be hit. The proposed "cap-and-trade" legislation that was targeted at reducing carbon emissions would actually have wound up to be a positive for utilities, who would have realized trading profits from the carbon grants (in Britain, utility companies minted money on the scheme when cap-and-trade was imposed several years ago). Now, however, it is unlikely that any significant carbon tax proposal will pass, given the opposition of the Republicans to the whole idea.

Less clear at this time are the implications for other sectors. For example, what happens to defense stocks (will the defense budget still be pared in 2011, once the planned Afghanistan pull-out starts?). And what about the banking and financial sector (will the Treasury secretary and Fed chairman have as much freedom to operate?)?

Finally, it will be interesting to see what happens with tax policy. The looming huge fiscal deficits are the legacy of decisions by both parties, and now the bill has come due. It's easy to campaign against raising taxes, but fiscal reality is not so simple.

Today's Comments from Warren Buffett

We've been having a spirited discussion this AM about the implications of the new Republican senator from Massachusetts - I'll post some preliminary thoughts later today.

In the meantime, I thought this AM's thoughts from Warren Buffett were interesting (courtesy of the blog "Clusterstock"):

Bob Farrell's 10 Market Rules to Remember

Bob Farrell was an acclaimed market strategist at Merrill Lynch from 1967-1992. Bob guided clients through the bull market of the late 1960's, followed by the bear markets of the mid-1970's, then the Great Bull Market which began in 1982.

Most of the good analysts in those days focused on the markets,and individual stocks, rather than trying to make huge macro bets on the economy. Consequently, they tended to have more success over time.

In any event, Mr. Farrell came up with these "Market Rules to Remember", which I believe still have relevance today. I thought they might be useful to post on my site.


1) Markets tend to return to the mean over time.

2) Excesses in one direction will lead to an opposite excess in the other direction.

3) There are no new eras — excesses are never permanent.

4) Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

5) The public buys the most at the top and the least at the bottom.

6) Fear and greed are stronger than long-term resolve.

7) Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names.

8) Bear markets have three stages — sharp down — reflexive rebound —a drawn-out fundamental downtrend.

9) When all the experts and forecasts agree – something else is going to happen.

10) Bull markets are more fun than bear markets

Update on Municipal Bonds

George Friedlander from Citigroup came out with an interesting piece on municipal bonds today. George has been a muni analyst for a number of years, and is very well-respected.

Here's a summary of some of his thoughts (edited by me in the interest of brevity):

Municipal yields are actually DOWN sharply from the end of 2008. So, in contrast to the yield rebound in Treasuries, AAA muni yields in 5, 10 and 30 years were DOWN 90, 52 and 89 basis points, respectively through year-end.

Reasons for this powerful relative performance fall largely into eight categories:

1. Muni yields had gotten distended on the upside at the end of 2008, as the capital markets collapsed, bond fund flows turned negative, leveraged investors unwound their positions.

2. Investors in all capital market sectors had sought protection from risk in the Treasury market, causing demand in that sector to overwhelm supply. Since then, the supply/demand imbalance has been largely unwound, causing Treasury yields to rise more thans every other major fixed income sector.

3. The collapse in short-term yields has forced investors to seek alternatives. In tax-exempt money market funds, specifically, yields are effectively down to zero.

4. Individual investors still have massive amounts in low-yielding short-term instruments. According to the Federal Reserve Flow of Funds Data, at the end of the third quarter 2008, the "Household Sector" (individuals and non-profits) held roughly $8 trillion in short maturity holdings. Even a continued trickle out of this vast pool of low-yield holdings can provide powerful demand for munis.

5. Flows into tax-exempt bond funds blew through all former record by a massive amount, with totals for 2009 of approximately $77 billion, according to AMG/Lipper. The prior record was $42.9 billion in 1993, so 2009 flows beat the record by roughly 80%.

6. There is no reason to expect that demand from direct buyers of munis will diminish any time soon, either. They, too, hold large amount of short-term instrument with very low yields, and in addition, higher income investors are looking at a substantial increase in maximum marginal tax rates by 2011, when the Bush tax cuts expire. In addition, the need to pay for Health Care reform, assuming it is enacted, could push taxes higher still.

7. There were significant supports for institutional demand for munis in the stimulus package in the form of changes in regulation for banks and property/casualty companies. Essentially these changes make munis even more attractive to these institutions.

8. The issuance of taxable Build America Bonds as a substitute for tax-exempt munis. Issuance of BABs started in April 2009, with large deals for the State of California and the New Jersey Turnpike, among others. For full-year 2009, the Bond Buyer estimates that $64.1 billion of BABs were issued, roughly 15% of total supply, but roughly 20% of supply since April when they first started to be issued.

Will Money Flow from Bonds to Stocks?

Maybe it will, but I believe any such shifts will be made slowly. In my opinion, the driver of stocks in 2010 will be earnings, and the Fed. Investors that moved from stocks to bonds last year need time to believe in the stock market again.

Here's a good comment from Mary Ann Bartels, technical strategist at Merrill Lynch, in her weekly strategy piece:

Investors may remain conservative

There is much chatter over fund flows into bonds (+ $300 billion) versus the
outflows in stocks (~$30 billion) in 2009. There are many that believe this
allocation to bonds will shift back to stocks as well as a portion of the high level of
cash still on the sidelines. Investors may return more slowly to the equity market
than historically has been the case as they have been hit by two major equity bear
markets combined with a housing bear market. The last time investors faced two
major equity bear markets was 1968-1970 and 1973-1974. As a result they
lowered their total stock and mutual fund holdings as a percentage of financial
assets from a peak of 35% to below 15%. They did not return in earnest until the
secular bull market of 1982 began.

What is different this time is the low interest rate environment. Investors will likely seek-out yield. Yield can be found in the equity market – in mega cap high quality companies.

Dividends

Floyd Norris has a short article (reprinted below) this morning in the New York Times talking about dividends. The piece describes how companies have been cutting dividends aggressively during the past year, often citing the need to conserve cash in the troubled financial markets as a rationale.

While I understand what happened last year, I also believe that we will see investors begin to demand higher dividend payouts in the future, especially as the economy begins to recover.

Dividend yields for much of the first half of the 20th century were considerably higher than bond yields. Investors did not view stocks as vehicles for capital appreciation, but rather investments in businesses that were expected to return cash to the owners (i.e., the shareholders).

When I was in business school, we were taught that the value of a stock could be derived from something called a "dividend discount model". This model essentially discounted back to the present the value of all dividends (including growth rates) that were expected to be earned in the future.

Put another way, the idea that someone would plunk a large chunk of their hard-earned savings into investments which did not return cash was thought to be appropriate for only the more speculative investors.

I think we will return to an emphasis on dividends for a couple of reasons. First, the dismal track record of stocks over the past decade means that companies will need to offer some inducement to prospective investors. Second, investors depending on stock investments for retirement need cash for living.

By the way, I understand that in theory it is more tax-advantaged for companies to buy back stock in the open market (which should raise the value of stocks) as opposed to paying dividends (which are currently taxed at 15%, but this will probably rise). Unfortunately, too many companies have used stock buybacks to offset large stock grants to senior management (e.g Cisco), and in the end shareholders did not benefit.

Off the Charts

As Dividends Have Fallen, So May They Rise

By FLOYD NORRIS

For the first time in at least half a century, American companies announced more dividend cuts than increases in 2009.

In a normal year, companies announce 10 to 20 times more favorable than unfavorable dividend changes, but the last two years have been anything but normal. The financial crisis forced many financial companies to reduce or suspend payments, and the ensuing credit crisis and recession led many other companies to cut back wherever they could.

But by the end of the year, there were indications that the recession was over and the number of negative dividend decisions began to decline, according to statistics compiled by Standard & Poor’s.

“The fourth quarter was in no way a good period for dividends, but compared to recent history it marks a significant improvement, and when added to the stabilization in increases, supports our belief that the worst is over for dividends,” said Howard Silverblatt, the senior index analyst at S.& P.

“Standard & Poor’s believes that the dividend recovery will be slow, and that it will take until 2012 to 2013 to return to where we were in 2007 and 2008,” he added.

Over all, Mr. Silverblatt said, dividend cuts in 2009 cost investors $58 billion.

The figures shown in the accompanying graphics compare the number of companies announcing either a resumption of dividend payments or an increase in the payout to the number announcing either a reduction or elimination of the dividend.

S.& P. also counts declarations of extra dividends, but does not keep track of whether such dividends are higher or lower than the company paid the previous year. Those figures are excluded from the calculations.

In 2009, just 778 companies announced either increases or resumptions of payouts, the smallest number since S.& P. began keeping track of the figures in 1955. The previous low was 786 in 1958, another recession year and the only previous year when the number of negative moves came close to the number of positive ones.

Similarly, the number of negative moves in 2009, at 804, was the highest ever, surpassing the 738 figure of 1958.

On a quarterly basis, the first three months of 2009 were the worst of this cycle, with 64 percent of dividend announcements being negative. But that figure fell a little short of the record of 67 percent, set in the second quarter of 1958.

The stock market hit bottom in March 2009, at a time when there was talk of a new Great Depression. In that one month, a record 144 companies announced reductions in or eliminations of dividends. Before the current cycle, that total had topped 100 in only one other month, May 1958. But the number surpassed 100 in five of the six months from November 2008 through April 2009.

The sheer rapidity of the plunge could provide an indication that the dividend recovery will be faster than many expect. It is possible that some companies made cuts fearing much worse conditions than actually arrived, and will therefore be able to raise payouts even without much improvement in business.

"After the Flood" - Excerpts from My Fourth Quarter Letter

After the Flood

Stocks dropped relentlessly during the first two months of last year. In just the first 68 days of 2009, the S&P 500 plummeted -25%. Then, in one of the most remarkable capital markets turnarounds in US history, stocks soared by +65% in the next 10 months, and the market wound up the year posting solid gains.

The reasons for the turnaround are varied, of course, but to my mind the most important factor was the Federal Reserve. Led by Chairman Bernanke, the Fed unleashed a torrent of liquidity into the financial system in a series of innovative and creative techniques. Among their efforts were the so-called “quantitative easing” measures which drove mortgage rates lower and stabilized the housing market.

So far, so good. Only problem is: what does the Fed do now?

Nearly all are in agreement that the US central bank will need to gradually withdraw its support from the financial markets. It is neither sustainable nor desirable for the US government to be the sole supplier of credit and financial support. Moreover, once the economy begins to show signs of real improvement, the welcome flood of monetary stimulus that the Fed provided last year could lead to significant inflationary pressures.

Some would argue that the bond market is already anticipating higher inflation through the recent upward move in longer term interest rates. Although the posted federal funds rate remains 0% - 0.25%, longer maturity US Treasury yields have moved from 2.5% to 3.8% in the last 12 months, despite Fed protestations that they will be keeping rates low for the foreseeable future.

In short, the economy is improving, and the financial system has been pulled back from the brink of disaster, largely helped by the Fed’s flood of money into the system last year. The challenge for 2010, then, will be to find the optimal investment balance in a world where Fed- provided liquidity is receding from the market.

Consensus earnings estimates for 2010 call for S&P earnings to be up +24% for the year, followed by a +21% rise in 2011. Low interest rates and rising earnings estimates typically lead to good stock market performance, so we would seem poised for a another positive year. Stock sectors that we currently think are attractive include health care; technology; energy; and utilities. We are more cautious on the consumer discretionary area, especially after the strong move that retail stocks made at the end of last year.

Risks to stocks lie mostly in the credit market, as they have for the past two years. If the Fed moves too aggressively to remove its stimulus, for example, the economy could falter, causing earnings to fall short of current expectations.

By the way, in my opinion, I would be careful to simply assume that longer maturity bonds are risky at this juncture. The overwhelming consensus of investment managers seems to be that interest rates are headed higher, which could mean that all of the “bad news” is already in bond prices. Moreover, one only has to look across the Pacific Ocean to Japan to see an example of a country where a financial crisis lead to 20 years of low (below 2%) interest rates.

My New Blog: “Random Glenings”

I recently started a blog (http://randomglenings.blogspot.com/) where I publish various articles that may be useful in thinking about today’s investing issues. I will also be including various financial planning articles, including thoughts on such topics as Roth IRA’s and discussions on changes in the estate tax laws.

I hope you will have the chance to take a look at it. Please do not hesitate to let me know if you have any suggestions to make the site more useful.

Good Interview with Bill Gross from Pimco in Time Magazine

Tuesday, Jan. 05, 2010

Pimco's Bill Gross Sees 2010 as Year of Reckoning

By John Curran

Pimco managing director Bill Gross not only oversees the world's biggest bond fund, his views often sway markets. In a late December interview with TIME's John Curran, Gross pointed to the second half of 2010 as a period when investors large and small will reckon with a new reality of poor economic growth and a Federal Reserve that is hard pressed to offer much help.

TIME: Where do you see the economy going over the next 6 to 12 months?
Bill Gross: The economy should be relatively strong in the first half of 2010 then weaken in the second half. That's not to say we'll return to recession but we'll see weakness as opposed to a continuation of what will probably be a decent first half.

What will make the first half of 2010 so good?
The first half will be dominated by government stimulus and by inventory accumulation or a lack of [inventory] liquidation among businesses. I expect nothing from consumer [spending] and nothing really from housing or really any of the standard cyclical leading sectors. It's hard to put a number on GDP growth rates, but let's say 4% in the first half and then 2% in the second half, which would basically call for some additional help.

You're talking about a second shot of federal stimulus?
Yes, something else is probably needed if the [government's] thrust is really reducing unemployment below double digits and re-normalizing the economy.

What does this say about the Federal Reserve's hopes to start pulling its added liquidity out of the markets, either by raising short-term rates or just getting out of buying bonds, which has been keeping long rates low?
I think the Fed's statements suggest that they really want to exit in some fashion from the buying program. The first step in that direction, logically, would be to stop buying and our sense is that they're at least going to try that. But based on our forecasts for the second half of the year they may have to re-initiate it, and that will be difficult to do once they stop because it then becomes a political hot potato.

All that said, I think they'll stop buying mortgage agency securities, and the trillion-and-a-half dollar check that's been written over the past 9 to 12 months basically disappears. It's significant from the standpoint of interest rates and interest rate spreads in certain sectors. And I would even go so far as to say it might be a mistake.

Because they might have to restart the buying program later?
Yes, I think the Fed wonders about this as well. But you have to understand that the Fed's probably under political pressure — such as the hearings for new regulation of the Fed, the growing public unease about the supersized Fed balance sheet, etc.. The Fed's expanded balance sheet is not something that I consider to be a problem, but I think the market does — and so the Fed will probably be working in the direction of pulling some of the liquidity out of the marketplace. They won't sell — it's a near impossibility to unload what they've purchased over past 12 months. But they'll at least stop buying.

Won't that put upward pressure on interest rates?
I think it will. I mean the mortgage market would be your first place to look in terms of something that's overvalued that would become normalized. Nobody knows what the Fed's buying is worth — we think about half a percentage point on rates, but we don't know.

But secondly, there's a ripple affect. Just speaking about Pimco's general portfolio strategy, we've sold our agency mortgage securities, Fannie and Freddie, in the billions to the willing check of the Fed. They're buying a trillion dollars of them, or have over the past 9-12 months, and so we sold them a lot of ours. Now, what did we do with the money? We bought Treasuries, we bought corporate bonds, and so the bond markets in general have benefited, as have stocks because this available money effectively flows through the capital markets. So it's a trillion-and-a-half dollar check that won't be there as the Fed withdraws from the market. How that affects the markets, I just don't know. I'm not eagerly anticipating the answer, but I think it holds some surprises in 2010, not just in mortgage securities but stocks as well. We could miss the money, put it that way.

Given your scenario of weakness later in 2010, will there be a premium on safety, like Treasury bonds and notes?
I'd be careful about this continuing assumption that U.S. Treasuries are the place to go. There are a number of reasons to have doubts about Treasuries, not just because of America's sovereign risk but also from the standpoint of an over-owned currency [the dollar]. Add onto those concerns the comments from Chinese authorities and others. They that haven't said they're up to their neck in Treasuries, but you know they're getting close.

So maybe cash becomes the best asset class of 2010?
I'm not being wishy-washy here but cash doesn't earn anything. There's the Will Rogers quote about being more concerned about the return of your money, but you also have to be concerned about the return on your money and there's nothing [being paid] by cash and Treasury bills. At Pimco we would probably try and substitute for our Treasuries with sovereign bonds of potentially higher quality. Germany looks interesting to us. Germany has problems, but it's in a much better budget situation than the U.S. because of a constitutional amendment three months ago that forces a balanced budget in four years.

Given all the crosscurrents, what will the investor's world like in the years ahead?
In a new "normal" world growth will be half of what it was, profit growth will be half of what it was and returns on almost all assets — including bonds — will be half of what we've grown used to. Further, the U.S. economy and other [developed] economies have provided as a whole 7% to 9% returns over the past 10, 20 years, and investors got used to that. That's one of the reasons why states and pension funds with the long-term liabilities matched to expectations for double-digit types of returns are facing problems; now they are suddenly having to come to grips with the potential reality of half-sized returns. I think increasingly in 2010 the market will begin to adjust to that.

Meaning...?
Over the past six to nine months, the 60% pop off the bottom not just for stocks but for high-yield bonds, etc., is indicative of a return in perspective to the old normal as opposed to the new normal. We think that 2010 will be tempered, and that doesn't mean bear markets but it does mean a growing realization that we have a lot of problems and the markets aren't necessarily priced for it.

Would a second federal stimulus package improve your outlook?
It would help the economy and if applied through Fed programs in terms of outright purchases of assets, yes, I think it would help the markets. I do sort of expect another stimulus program in 2010 at some point but it can't be a big one because the American public and indeed the rest of the world is increasingly demanding some type of fiscal discipline.

Stock Market Technical Picture

Mary Ann Bartels from Merrill Lynch is one of my favorite market technicians. She has had a pretty good track record of calling market trends, so I thought her view of the coming few months was interesting:

A new year brings new forecasts
The S&P 500 spent most of November and December within a 3% trading range, which has been resolved to the upside. The importance of this breakout is that there is little resistance above 1120. The NYSE advance-decline line has confirmed the breakout and long-term price momentum is positive with the market above the 15-month moving average. Volume is neutral. The indicator that has called the tactical turns in the market extremely well is the 10-day TRIN trading index, which enters 2010 bullish with an oversold reading. So our call for a correction of the larger uptrend has proven premature. In the near term more gains are likely with first resistance targets at 1200-1230, though we expect a choppy rotational market in 2010.

Possible headwinds in 2010 causing volatility and rotation
Below we identify six events/themes that are more out of consensus and that may impact the market throughout 2010. Here are six items on our watch list:

1. US 10-year Treasury yields break out from a head and shoulders bottom and reach 55.50%, creating possible competition for stocks.
2. Crude oil breaks above $83 targeting a move to $100. A move like this is positive for energy stocks but could prove taxing to consumers.
3. We are in a congressional election year along with a "0" year under the Decennial Pattern. Both cycles have proven very volatile for the market.

4. Sentiment is shifting quickly - the bears are gone for both the professionals and individuals. We still likely need more bulls before sentiment becomes a problem for the market. Further gains in the market may bring in the bulls.
5. The relative price trend for Financials is still negative and needs to be watched. However, Financials enter 2010 oversold with a very large increase in short interest, particularly in Diversified Financials.
6. Volatility overall may be more active in 2010. The VIX index has declined nearly 80% from its peak and the ML MOVE index (a measure of Treasury yield curve volatility) has declined 70%. In the near term the VIX could fall to 16-15, but the risk from these levels appears higher.

Mega-cap multinationals still favored
We believe leadership is within the mega-cap multinationals, which incorporates most S&P sectors. Technology, in particular, remains strong. If this strategy proves correct the broad market breadth move should eventually narrow.

Levels to watch
S&P 500 resistance is 1200-1230. Prior resistance now becomes support at 1120-1100. Our forecast range for the S&P for 2010 was 1250-1325 and remains unchanged.

Big Oil Continues to Move Into Natural Gas

Last month Exxon bought XTO, a large player in the "unconventional" natural gas field. Yesterday's announcement that Total was investing in a portion of Chesapeake's shale gas fields continues the trend of the large integrated oil producers towards natural gas.

The advantages of natural gas - clean burning, large US availability - have significant appeal to the large integrated oil companies that have struggled with replacing reserves.

Total in $2.25bn gas deal with Chesapeake

Posted by Gwen Robinson on Jan 05 05:06.

Total on Monday became the third big European energy company to buy into Chesapeake Energy’s US shale gas assets. The French oil producer will pay up to $2.25bn for 25% of Chesapeake’s assets in Texas Barnett Shale, $800m of it in cash and the rest by funding 60% of the project’s costs over the next 5-6 years. BP of the UK and Norway’s Statoil in the past 18 months signed similar deals with Chesapeake. Analysts said the deal’s price – $63,000 per barrel of current production – was in line with recent deals.

Using Covered Call Strategy to Produce More Income

In Saturday's Wall Street Journal there was an article about older investors writing calls on equity positions to produce more income:

http://online.wsj.com/article/SB10001424052748703916304574632312919184046.html

I have never been a fan of this strategy. It works great in steady-to-up market environments - and stock prices are moving in a range or trending higher - but can really be painful when markets move south.

In some ways, writing calls without some sort of downside protection is a little like selling house insurance. If the house stays intact, you pocket the premium, and all seems well. However, if significant damage occurs, and you have to pay out to cover damages, all of the "gains" realized from selling insurance are lost.

There are several areas in the equity markets that still appear to offer reasonable income opportunities without significant downside risk. I would include stocks of regulated utility companies high on this list. Other possibilities would include large integrated oil company stocks (e.g. BP, or Chevron) and consumer staples companies (e.g General Mills). These companies can offer some income as well the potential for growth in the years to come.

I would also not ignore longer intermediate corporate bond alternatives. I realize that interest rates have begun to move higher, but I still do not believe that we are facing significantly higher interest rates for at least a few years.

More on the Fed and the Yield Curve

From this AM's Clusterstock blog (and, I promise, no more yield curve posts this week!)

Warren Buffett - "A Year of Investing Dangerously"

Warren Buffett, of course, is easily the best investor of our generation, if not all-time. This article - which appeared in the December 12, 2009, Wall Street Journal is a worthwhile read.

One key "takeaway" is that sometimes the best investments are the ones you don't make. Buffett avoided alot of potential disasters over the last year (e.g., Lehman Brothers) while picking up some terrific deals (e.g. Goldman Sachs) in the same industry.

http://online.wsj.com/article/SB126056572135687829.html