Are Euroblock Problems Already Reflected In Market Prices?

I mentioned the "The Cyrano Principle" in my blog post yesterday.

Veteran market strategist Laszlo Birinyi discussed The Cyrano Principle in last weekend's New York Times. The idea, as Mr. Birinyi was quoted saying, is:

"If the problem is as obvious as the nose on your face, the chance are the everyone else knows it, too" The markets, he said, are very good at digesting this news and adapting to it. Sooner or later, he says, "unless there is some truly dramatic surprise - and not just something the market is well aware of" - stock will resume what he expects to be a long run higher.

http://www.nytimes.com/2011/06/19/your-money/stocks-and-bonds/19stra.html?scp=2&sq=jeff%20sommer&st=cse

Which brings me to the current buzz about Greece and the euro block.

I don't know which way the Greek parliament will go today - the discussion of austerity measures has brought widespread protests among the Greek populace, who seem to like getting lots of benefits paid for by foreign creditors (no fools, these Greeks) - but I really don't think it is going to make that much different in the markets.

Moreover, I would also bet that the Greeks can continue to thumb their collective noses at the rest of Europe for the very simple reason that a Greek default would hurt the rest of Europe more than it would hurt Greece.

Jeremy Warner had a good column about the situation in last Friday's London Telegraph. Here's Mr. Warner's observation:

Give us the money, the Greeks can say, or we’ll pull the whole house down with us. As Europe’s policy elite is only too painfully aware, the cost of refusing is likely to be infinitely greater than that of coughing up, however politically unpalatable it might seem to the solvent north. Neither the IMF nor the eurozone can afford to let Greece go.

Mr. Warner goes on to write that a Greek default would inevitably lead to defaults by Ireland and Portugal, followed possibly by even Spain. And in the papers today there are several articles discussing the idea that the real problem in euro land awaits in Italy.

http://www.telegraph.co.uk/finance/comment/jeremy-warner/8581092/Greeces-ace-card-help-us-or-well-take-you-all-down.html

In short, I keep looking for events that don't seem to be already widely discounted in current market prices, and so far am coming up short.

Or, put another way, when billions of dollars are flooding in 2-year Treasury notes yielding 0.38%, it is hard to say that the world isn't already well aware of the financial storms raging in Europe right now.

Laszlo Birinyi and "The Cyrano Principle"

There was a good column by Jeff Sommer in yesterday's New York Times about the current market environment.

The mood of investors has changed dramatically in the last couple of months, and no wonder. The fiscal crisis in Greece is threatening the euro zone. Unemployment remains stubbornly high. Recent US economic data has shown an economy that is slowing, and there are more worries that the collapse in housing is going to lead to a second recession.

With the federal government worried about a $14 trillion cumulative budget shortfall, it seems very unlikely that we will see any fiscal stimulative package any time soon.

Oh, and it is also unlikely that the Fed will be doing another round of quantitative easing, given the prevailing political mood in Washington.

But, as the article notes, maybe all of this already in the current stock market prices.

The piece quotes veteran market strategist Laszlo Birinyi about the market. Mr. Birinyi views the recent market pullback as simply a correction in a secular bull market, and believes that investors should be adding to stocks, not reducing.

Here's Mr. Birinyi on something he calls "The Cyrano Principle":

As for Mr. Birinyi, he cites what he calls “the Cyrano Principle”: “If the problem is as obvious as the nose on your face, the chances are that everyone else knows it, too.” The markets, he said, are very good at digesting this news and adapting to it. Sooner or later, he says, “unless there is some truly dramatic surprise — and not just something the market is well aware of” — stocks will resume what he expects to be a long run higher.

Stocks Haven’t Fallen That Much, Despite Recurring Worries - NYTimes.com

I agree with his view. Yes, I know the data is soft, but markets typically get walloped by unforeseen events, not those that are so widely broadcast as today's financial woes.

And then there's this: At a time when investors are still piling into Treasurys yielding well below 1% (on shorter maturities), stocks on many measures are very cheap. Here's a piece from this morning's Bloomberg:

Analysts are boosting profit forecasts even with the global economy showing signs of weakness. S&P 500 earnings may rise to $99.61 a share in 2011 from $84.58 last year and $61.52 in 2009, according to data compiled by Bloomberg. That’s an increase from the forecast of $95.37 on Jan. 3 and $98.70 on April 29, the data show.

Should stocks stay at current prices and the analyst prediction come true, the S&P 500 would trade at 12.8 times income on Dec. 31, the lowest level since 1985 except for the six months after Lehman Brothers Holdings Inc.’s bankruptcy in September 2008 and nine months in the late 1980s, according to Bloomberg data. Companies in the S&P 500 are forecast to earn $24.31 this quarter, up from $24.16 at the start of April.

http://www.bloomberg.com/news/2011-06-19/stocks-cheapest-in-two-decades-as-s-p-500-falls-with-earnings-climbing-18-.html

Now, to be sure, Wall Street might be too optimistic. Merrill's US quantitative strategist Savita Subramanian has noted a worrisome divergence between rising analysts' forecast and a more cautious corporate management tone. For this reason Ms. Subramanian is less optimistic on stocks than, say, Mr. Birinyi.

But still: How much "bad news" is already in stock prices?

The Rise and Fall of Fannie Mae

About 20 years ago, while I was employed at the investment firm Scudder, Stevens & Clark, I developed and marketed several mortgage-backed securities funds targeted at Japanese institutional investors.

This was a terrific experience for me. The funds were a success, and performance was very good. In addition, for a period of about 8 years or so, I had the chance to go to Japan two or three times a year to meet with investors.

Two of the funds I marketed were sponsored by Fannie Mae. Fannie was an important part of our marketing story, since most international investors knew Fannie.

Foreign investors assumed that Fannie Mae carried the implicit backing of our government. And, of course, this proved to be the case a couple of years ago, when the U.S. government bailed out both Fannie and Freddie Mac.

I was very impressed with the people I worked with from Fannie. They were very smart, and worked long hours. In addition, investors in Fannie Mae enjoyed terrific returns, since the stock was one of the best performers in the 1990's.

The head of Fannnie Mae during those years was David Maxwell. Mr. Maxwell embodied all of the qualities that I admired about Fannie Mae: smart, driven, and very skeptical of Wall Street.

Here's what author Jim Collins wrote about Maxwell in 2003 in Fortune Magazine's profile of the 10 Greatest CEO's:

No. 7 David Maxwell turned a turnaround into art

Fannie Mae was losing $1 million a day when he arrived--"an opportunity to make [it] into a great company."

In 1981, as the stock of Chrysler hit an all-time low, America was beginning its enthrallment with the man hired to save it. Lee Iacocca would soon be a national icon--bestselling author, star of more than 80 commercials, and everyone's image of a turnaround artist.

That same year, as the stock of Fannie Mae hit an all-time low, a different executive was hired to save the deeply troubled mortgage lender. David Maxwell would not become a national icon--nor even a recognizable name. Yet by the time both men retired in the early 1990s, Maxwell's Fannie Mae had beat the stock market at a rate more than twice that attained by Chrysler under Iacocca.

More inspired than inspiring, more diligent than dazzling, Maxwell took a burning house and not only saved it but built it into a cathedral. Some steps, such as selling off $10 billion in unprofitable mortgages, were classic fireman stuff. But his deepest genius was to frame the rebuilding around a mission: strengthening America's social fabric by democratizing home ownership. If Fannie Mae did its job well, people traditionally excluded from owning homes --minorities, immigrants, single-parent families--could more easily claim their part of the American dream. If turnaround is an art, Maxwell was its Michelangelo.

http://money.cnn.com/magazines/fortune/fortune_archive/2003/07/21/346095/index.htm

Unfortunately, when David Maxwell retired in 1991, he was succeeded by James Johnson, formerly head of Lehman Brothers.

In my opinion, Johnson was everything that Maxwell was not. He epitomized what Main Street thinks of Wall Street: very political, slick, and wildly overcompensated for his efforts.

We all know what happened. Fannie Mae transformed from one of the most successful government programs ever to a massive government headache requiring hundreds of billions of bailout money from the government.

David Brooks had a column in the New York Times this morning titled "Who is James Johnson?" He discusses Mr. Johnson's role in what has turned out to be one of the largest financial debacle's in our country's history. Here's an excerpt:

The Fannie Mae scandal has gotten relatively little media attention because many of the participants are still powerful, admired and well connected. But Gretchen Morgenson, a Times colleague, and the financial analyst Joshua Rosner have rectified that, writing “Reckless Endangerment,” a brave book that exposes the affair in clear and gripping form.

The story centers around James Johnson, a Democratic sage with a raft of prestigious connections. Appointed as chief executive of Fannie Mae in 1991, Johnson started an aggressive effort to expand homeownership.

Back then, Fannie Mae could raise money at low interest rates because the federal government implicitly guaranteed its debt. In 1995, according to the Congressional Budget Office, this implied guarantee netted the agency $7 billion. Instead of using that money to help buyers, Johnson and other executives kept $2.1 billion for themselves and their shareholders. They used it to further the cause — expanding their clout, their salaries and their bonuses. They did the things that every special-interest group does to advance its interests.

Who Is James Johnson? - NYTimes.com

I wasn't going to buy "Reckless Endangerment", since I feel like I have already relived the last decade enough.

But I think I might now, if only to read about how a company that I deeply admired was perverted and ultimately destroyed by a group of insiders.

Two Views on Asset Allocation

This is a very difficult time for investors to figure out how to position their portfolios.

Low interest rates are the main culprit. Throughout most of my 30 year career, bonds offered a safe, albeit boring, alternative to riskier asset classes.

You weren't going to get rich buying bonds, but you could be assured of steady returns and principal stability, which obviously appeals to many people.

But no longer.

In the wake of the latest eurozone crisis, Treasury bond yields have once again moved sharply lower. Two year Treasury notes now offer a unappealing 0.38% yield to investors, which is about half of the yield of a year ago. Even 10-year Treasurys are now yielding 2.92% at this writing.

Most high quality corporate and municipal bond yields have moved sharply lower as well.

In my opinion, with rates so low, it is hard to make a strong investment case for bonds for all but the most gloomy investor. Bonds can still play an important role in asset allocation, but with the full recognition that their primary role is principal protection, not total return.

I say this for a couple of reasons.

First, today's rates offer little inflation protection. True, there seems to be little signs of inflationary pressures today, but who knows how long this will last?

Second, if rates tick up only modestly from today's levels, the total return (price change + coupon) from a bond portfolio will turn negative. Of course, this will not matter if you are not planning to sell a bond prior - but will you really be happy looking at your portfolio of bonds that are priced below cost for the next few years?

We had a spirited discussion yesterday at our Investment Policy Committee here at the bank about asset allocation. As you might expect, there was a wide range of opinions.

Several people disagreed with me. They point to recent economic data as a sign of slowdown in the U.S. economy; in such an environment, high quality bonds should proper.

Bond bulls also point to the problems in the eurozone. If the Greek contagion spreads, the euro block could be threatened. In addition, the financial sector will be hit hard, since they are large holders of bonds denominated in euros. Dollar-denominated assets should prosper in such a scenario.

I understand all of that, but I still think that the odds favor dividend-paying stocks.

So, too, does Bill Gross of Pimco. Here's a excerpt from a recent article, along with the link:

Pacific Investment Management Co. (Pimco) managing director Bill Gross is perhaps the nation’s foremost bond guy, but he says investors looking for real returns should turn to consistent dividend-paying stocks like Coca-Cola, Johnson & Johnson or electric utilities rather than U.S. Treasuries.

In remarks made during Wednesday’s opening session of the Morningstar investment conference in Chicago, Gross echoed themes he recently wrote in his monthly investment commentary for Pimco, the Newport Beach, Calif.-based money manager with $1.3 trillion in assets

Specifically, he noted the Federal Reserve has kept interest rates lower than they should be in hopes of inflating the economy and boosting riskier asset classes, such as stocks. That’s been a boon for the latter but hasn’t translated into success for the former. Meanwhile, much of the Treasury yield curve wallows in negative territory compared with expected future inflation.

That means Treasury investors “are getting their pockets picked,” Gross told the audience.

http://www.fa-mag.com/fa-news/7643-gross-pitches-dividend-stocks.html

Why Buy A Home Now If Prices Are Going to Continue to Fall?

Robert Shiller had a good article last weekend in the New York Times about the role that future price expectations might have on overall economic activity, particularly as it relates to housing.

Shiller, of course, is the Yale professor who famously wrote the book Irrational Exuberance in 2000, which correctly forecast the popping of the technology stock bubble.

He then turned his attention to the housing market, and together with Karl Case of Wellesley College came up with the Case-Shiller index of housing prices that is now widely followed.

Shiller has also been prescient about the future course of housing a few years ago, and even wrote a bearish chapter on housing in one of subsequent editions of Irrational Exuberance.

Dr. Shiller was in the news last week with the forecast that housing prices could decline -25% from current levels.

He subsequently backpedaled somewhat on this forecast - noting that predicting the trend of housing prices was like trying to predict the weather - but I think the point remains that he is more bearish on housing than most economists.

That said, many surveys of people actually involved in the business of building and selling houses are more in line with Professor Shiller.

For example, Diana Olick of CNBC posted a tweet on Twitter that indicated that a recent survey of home builder sentiment reached lows not seen since February 2009.

The problem is largely expectations rather than fundamentals. Low mortgage rates and falling house prices has driven affordability of buying a new home to levels where, on a purely financial basis, it makes more sense to buy than rent.

Yet no one wants to buy and watch the value of their new home drop by another 10% or 20%. Or, put another way, the expectation of lower future home prices has become a major impediment to any improvement in housing.

This is the point that Shiller made last Sunday:

Even for people who have other reasons to buy a house, there may be little urgency to do so. Our 2011 survey found that the median expectation for home price appreciation next year is just 1 percent. So it won’t be surprising if new home sales remain abysmally low and few jobs are created in the hard-hit construction industry. And it shouldn’t be a shock if the personal savings rate stays at around 5 percent, as it has recently, up from around 1 percent in 2005. This would mean that consumer spending will not drive a strong recovery.


The Sickness Beneath the Slump - Economic View - NYTimes.com

Hopefully he is wrong in his bearish sentiment, but given his track record it's hard to bet against Robert Shiller.

Pop Quiz: Which Portfolio Has More Risk?

Here's the question: Based on historic data since 1950, which portfolio mix has a greater risk:

Choice A: 70% Stocks/20% Bonds/10% Cash

Choice B: 0% Stocks/90% Bonds/10%

The answer can be found at the end of this post.

I was at a Global Quantitative Strategy conference yesterday sponsored by Merrill Lynch. It was a very interesting day, with speakers focused on a variety of topics.

Simply put, the idea behind quantitative analysis is to use data-driven, computer analyses to find market opportunities. One goal that practitioners of quantitative analysis is to try to remove emotions from their investment activities.

I won't go into everything that was discussed yesterday, but will try to touch on a few of the presentations over the next few days.

The first speaker yesterday was Nicholas Barberis, a professor from the Yale School of Management whose specialty is behavioral finance.

Behavioral finance has become a "hot" area in investment management, since it attempts to incorporate how psychology can impact investment decisions.

Professor Barberis pointed out that most of us focus on the risk of events that have a fairly small likelihood of actually happening. Some of us suffer from the fear of flying, even though millions fly each year without incident. We demand vaccines or preventative measures for illnesses that have only the remotest chance of occurring.

In investing, most conversations I have with investors focus on the possibility of a repeat of the 2008 stock market meltdown, when the S&P declined by more than -30%. However, if you go back to 1926, there have been just 11 years that the stock market has declined by more than -10%.

Or, put another way, in 87% of the years since 1926 the stock market has either gained or experienced a small decline. Only 3 of the last 84 years (4%) of the years had declines that were of the magnitude of 2008.

And yet most investors I speak to these days are more focused on the risk of stocks than bonds, even though bond yields are historically very low.

So the Answer to the Pop Quiz, based on Ned Davis Research data:

Choice A has a negative return 23% of the time over the last 60 years. On average, the return of the 70% stock/30% fixed portfolio has been +15%.

But here's the surprise. Choice B - the all bond portfolio - has had a negative return 25% of the time (or slightly higher than the portfolio skewed towards stocks) but the average annual return has been slightly less than +10%, or nearly 1/3 lower than the portfolio having stocks.

Put another way, the all-fixed portfolio had more risk, and lower returns, than the equity portfolio.

So if you chose Choice A, consider yourself rational.

Telco Woes Continue: "Voice Will Be Free"

Unlike my current unease with the financial sector - which I view as more of a tactical opinion - I have not been a fan of the large telecommunications companies for many years, despite their generous dividend yields.

My view point on the sector was originally established almost 11 years ago, after attending a talk by John Chambers, CEO of Cisco. At the time, Mr. Chambers announced that "Voice will be free."

Chambers was referring to the inexorable decline in the costs of making telephone calls the the consumer.

Subsequent events have proven him right. Most wireless plans, for example, offer free long-distance calls during the evening and weekends. You can now make international calls on Skype for a fraction of what a traditional carrier would cost.

The problem that most telcos face is that a large portion of their profits come from the traditional wireline business.

For example, according to Bernstein analyst Craig Moffett, while only about17% of the revenue at AT&T comes from residential wireline, about 40% of AT&T's EBITDA came from the same source.

The same is roughly true at Verizon; 21% of Verizon's revenue, but 57% of EBITDA, comes from residential wireline.

Why is this a problem? Well, the wireline business is sinking like a stone. According to Moffett, residential access lines have cumulatively declined by 53% since the end of 2000, or around the time that I heard John Chambers's pronouncement.

In 2005, 7% of U.S. households had "cut the cord", and did not have a wireline phone in their home; today, just 5 years later, this figure has reached of 27% households in the U.S.

So how are the telcos earning their money? Well, one way has been charging for data transfer, or texting. And now this is under attack, as yesterday's Wall Street Journal pointed out:

Text traffic will come under more pressure in the months ahead. This week, Apple Inc. showed off an application that will allow iPhone and iPad owners to bypass carriers and send text messages over the Internet to other people with Apple devices.

Read more: http://online.wsj.com/article/SB10001424052702304778304576373860513481364.html#ixzz1OspMjKt5

The article goes on to note that numerous other servers are finding ways to offer consumers faster and cheaper ways to communicate with their cellphones.

In short, while I might be worried about the financial sector in the short term, I think that the secular decline for large telecommunications in this country is firmly in place.