So You Want To Invest in the Emerging Markets

The Close of the Chinese Stock Market on Monday*

*photo courtesy of the Christian Science Monitor

China surprised investors and the financial world yesterday by cutting interest rates.

The cut - which is the first rate reduction since 2008 - is a clear sign that Chinese officials are more concerned about flagging economic growth than possible inflationary pressures.

Is this the beginning of an opportunity in emerging market equity markets?

The emerging markets have generally lagged the U.S. market this year. China's stock market, for example, is off about -1.1% year-to-date versus a rise of +4.7% for the U.S. market, according to Merrill Lynch.

However, if the Chinese central bank is adding monetary stimulus, might not some of the liquidity flow into the equity markets?

Well, it could be, in my opinion, and we are taking a hard look at all of the emerging markets, including China.

But I must confess that I was a little unsettled by what happened in the Chinese stock market earlier this week.

June 4 represented the 20th anniversary of the Tiananmen Square unrising.  For many Chinese, the brutal reaction of the Chinese government to the protest movement remains a very ugly memory.


So what happened in the Chinese stock market on this Monday, June 4?


Here's the report from Reuters:

The Shanghai stock market fell a bizarre 64.89 points on Monday, the anniversary of the bloody crackdown on protesters in Tiananmen Square on June 4, 1989, or 6-4-89.

 

In another twist, the Shanghai Composite Index .SSEC opened at 2346.98 points on the 23rd anniversary of the killings. The numbers 46.98 could be read as June 4, 1989, backwards.

If getting the index to settle on those figures through trades can be ruled out, could the trading system itself have been hacked?

http://www.reuters.com/article/2012/06/04/us-china-stocks-tiananmen-idUSBRE8530F720120604



Now, the Reuters story quoted several officials and experts that essentially said that it would have been exceedingly difficult for anyone to manipulate the indexes to achieve such a coincidental outcome.  And they're probably right.


But the fact that the possibility of a market manipulation event could have taken place on Monday is enough to give one pause.

A Salve for the Facebook IPO Debacle

Yesterday I wrote about my dismay with how the recent IPO for Facebook was handled.

It's not only that the stock is off by almost one-third since May 18, when Facebook first came public.

After all, despite yesterday's strong rally, the stock market has been struggling in recent weeks. 

No, in my opinion, the real problem is that the public has apparently been played for a sap.

The big institutions were quietly warned by company management about some disquieting news in Facebook's mobile search advertising, so they backed away from buying shares.

Senior management at Facebook and most of its original investors took advantage of the hype to sell even more shares that they had originally indicated, thus creating the image (fairly or not) that they knew that Facebook was overvalued at the initial offering price.

The only group not informed about the company's apparent slowdown in advertising revenue was the general public, which eagerly snapped up whatever shares were available and now feel abused.

Lawsuits are now flying around, as would be expected.  Nasdaq announced this morning that it is setting aside $40 million to cover the operational issues that arose during the day of the Facebook IPO.  There are also indications that the underwriters will be facing their own legal issues, not to mention senior management.

I don't have any issue with company founders realizing some profits.  Facebook has obviously been a fabulous success, and potentially could be an internet powerhouse for years to come.

It would be naive to not expect that largest shareholders of Facebook not look to monetize at least a portion of their private holdings at the best possible price.  Moreover, no one had to buy shares of the company - investors were hoping to make a large profit, which in this case has not happened so far at least.

But still: It would be nice if some of the people that reaped hundreds of millions - if not billions, in the case of Mark Zuckerberg - gave at least some signal that they felt that the recent drop in stock price was not warranted.

Just think:  if senior management of Facebook announced that they were taking some of their personal funds to buy shares in the open market, imagine the signal that would send.

Unlikely? You bet.  But there is some precedent.

Here's a story that comes from Robert Cringely's book written in 1996 called Accident Empires: How the Boys of Silicon Valley Make Their Millions, Battle Foreign Competition, and Still Can't Get A Date.

As you can tell from the title, Cringely's book is an amusing yet terrifically insightful book about the tech industry in the 1980's.  Public Television also did a mini-series based on his book titled "Triumph of the Nerds".

In any event, Cringely tells a story about Steve Ballmer, who in the late 1980's was a senior executive behind Bill Gates at Microsoft (Ballmer has since ascended to the CEO spot).   Here's an excerpt:

The Age of Microsoft dates, I believe, from a moment in 1989, when executive vice-president Steve Ballmer borrowed some money.  Prior to that moment, Microsoft had all the elements necessary for global digital dominance except the will to make it happen.  Ballmer's mortgage signified that there was finally a will to go with the way...

{Based on what he was seeing}, Ballmer took a chance.  He borrowed everything he could against his Microsoft stock, stock options, and his every other possession.  In all, Ballmer was able to borrow $50 million and he used every cent to buy more Microsoft shares...

There's something about betting every penny you have in the world that helps with focus, and Microsoft has been very focused during the 1990's.  As a result, Steve Ballmer is now Microsoft's third billionaire, joining Bill Gates and Paul Allen.  His shares have increased in value by twenty times since 1989.

I love Ballmer's story from two aspects.

First, it is rare to find anyone that believes enough in his company and its future to borrow everything to buy more shares as Ballmer did.  I have often wondered whether I would have done the same if I had been at Microsoft in the late 1980's - I doubt it.

And second, it sent a very powerful message to the stock market, which is why I think that Facebook should at least consider doing the same today.

The Trouble With Facebook

Slightly more than two weeks after it went public, Facebook shares closed yesterday at just under $26 a share, or -32% below where the deal was priced on May 18.

This is a debacle any way you look at it.

True, IPO's are typically priced to extract the maximum amount of capital for the company, but underwriters also try to get a little "juice" for investors as well.

For example, when Apple went public, it was met with a frenzied response, and the stock soared in value in the first days of trading.  Here's how one website describes it:

By late 1980, Apple Computer had been a private company for three years.  Apple’s partners decided to take their company to Wall Street and put Apple on the stock market, making it a publicly-held company. 

At the company’s Initial Public Offering (IPO) on December 12, 1980, Apple shares were offered to the general public at a price of $14 each.  At the opening bell, the stock was priced $22 and sold all 4.6 million shares within minutes.

Apple’s stock offering had generated more capital than Ford Motor’s had in 1956 and instantly created about 300 millionaires – more than any company in history up to that point. In its first day of trading Apple closed at $29, giving the company a market valuation of $1.778 billion.  


http://www.pophistorydig.com/?tag=apple-computer-ipo

The problem with the Facebook offering is not that the stock has not done well - after all, the market in general has been struggling in recent days - but rather investors have gotten the very strong impression that the general investing public has once again been played for a sap.

Remember that the Facebook was originally supposed to be priced at $28 a share.  Then, after the company hit the road and investor interest was near maniac levels, they raised the offering price to $38 a share.

In the meantime, however, there have been several reports that Facebook officials were quietly telling large institutional investors that sales and earnings had slowed in the second quarter as mobile advertising has not yet met expectations.

Thus the big institutional players backed away from the deal, and allowed the unknowing general public to buy shares at unsustainably high levels.

Now, it could still all work out - most Facebook shareholders have not yet sold, so the losses are still mostly on paper, as Ron Lieber pointed out in the New York Times last weekend:

But it is investors who may be making the biggest mistake by drawing all the wrong conclusions. Facebook’s I.P.O. was not a failure for Facebook, given the pile of money the company raised from willing buyers. Investors have lost nothing so far except on paper, save for those people who didn’t consider the fact that the stock might actually go down and then sold out of panic or because they felt somehow cheated when the thing didn’t pop. 

http://www.nytimes.com/2012/06/02/your-money/stocks-and-bonds/how-to-pick-stocks-after-facebooks-ipo.html?_r=1&nl=your-money&emc=edit_my_20120604 

I think what really bothers me is the investors - who have become largely disillusioned with the stock market over the past decade - now have even more evidence to suggest that the market is a "rigged game", where only a few insiders make any real money.

Stocks in my opinion continue to be the only change that legitimate investors have to make any money in the next few years.  Government policies have pushed interest rates on bonds to multi-generational lows, and offer very little investment value.  Investors should be selling bonds in favor of stocks, but they're not.

But ugly episodes like the Facebook IPO give investors yet another reason to stay with bonds.

I have a suggestion as to how this could solved, which I will post tomorrow.
 

Here's One Big Reason That U.S. Treasury Rates Are So Low

Yesterday's FT Alphaville (the blog for the Financial Times) carried an interesting piece on the Treasury holdings of the Federal Reserve.

The piece quoted extensively from a research noted written by Torsten Slok of Deutsche Bank (DB also was the source of the chart shown above).

Here's what Mr. Slok wrote:

In addition, central banks (Fed, ECB, BoE, BoJ) buying government bonds has lowered supply of risk-free bonds real money managers can buy (for example, the Fed currently holds 30% of all 5-10 year U.S. Treasuries outstanding).

http://ftalphaville.ft.com/blog/2012/06/04/1027301/will-rates-stay-low-qe-or-no/

Think of that:  nearly a third of all of the Treasury debt trading in the public markets that has maturities in the 5 to 10 year area is being held by our central bank, and not investors.

While there is no doubt that times are uncertain, and the fate of the euro very much in question, but still:

Where would interest rates be if the Fed were not intervening?

I wrote last week that I felt that the Fed should at least consider selling a portion of the $1.6 trillion in Treasury holdings currently on its balance sheet.

Here's an excerpt from what I wrote:

...ever since the first quantitative easing program began, the Fed has been under intense political pressure to demonstrate how it could exit the capital markets without disrupting the economy.

If the Fed sold, say, $100 billion of its position, it would provide a tangible demonstration of just how our central bank could reduce its bond holdings. ..

...extremely low interest rates are a penalty on savers as well as the nation's financial institutions.  It would seem to me that it is no one's interest to have longer maturity interest rates continue to plunge lower.

..selling some of its bond position would remove the element of the "Bernanke put" that is present in today's market.  Currently most investors and bond traders assume that if the economy showed any signs of plunging lower that the Fed would intervene in the markets again.

Selling bonds today would in essence tell the markets that the Fed's purchase of bonds since the financial crisis of 2008 was only a temporary policy decision, and that it is now looking forward to resuming its role as the Steward of our Banking System.


http://randomglenings.blogspot.com/2012/06/should-fed-be-selling-some-of-its-bonds.html?spref=bl

After looking at the chart shown above, I still believe the Fed should reconsider its current position.

Treasury Yields Now At 200 Year Lows

The 10 year Treasury note is now yielding slightly more than 1.5%.

According to Strategist Michael Hartnett at Merrill Lynch, Treasury yields are now at 200 year lows, breaking the old record set in November 1945.

Despite the record low level of interest rates, there seems little abatement in the appetite for fixed income securities.

Anecdotal evidence further suggests that Wall Street's fixed income community has its most exposure to interest rates this year (i.e., they are betting on a further decline in rates).

Equities, meanwhile, remain unloved and unwanted.  The bullish sentiments that seemed so prevalent just a couple of months ago are now long gone, even though corporate earnings estimates continue to be raised.

Here's how Larry Summers, former US Treasury secretary and Harvard president, described the credit markets this morning:

...consider the remarkable level of interest rates in much of the industrialized world. The U.S. government can borrow in nominal terms at about 0.5 percent for five years, 1.5 percent for 10 years, and 2.5 percent for 30 years. Rates are considerably lower in Germany, and still lower in Japan.

Even more remarkable are the interest rates on inflation-protected bonds. In real terms, the world is prepared to pay the U.S. more than 100 basis points to store its money for five years and more than 50 basis points for 10 years. Maturities would have to reach more than 20 years before the interest rates on indexed bonds becomes positive. Again, real rates are even lower in Germany and Japan. Remarkably, the UK borrowed money last week for 50 years at a real rate of 4 basis points.

http://blogs.reuters.com/lawrencesummers/2012/06/03/breaking-the-negative-feedback-loop/

(Summers goes on to suggest that governments increase their borrowings and invest in projects that will lead to more job growth.  While this might make economic sense, it seems unlikely that governments will increase deficits at this point in the political cycle, in my opinion.)

Stock markets, meanwhile, continue to get rocked around the market.

Friday's stock market action was ugly in the aftermath of a disappointing jobs report. Global equities have now lost all of the gains achieved in the first quarter of this year, as Nigel Tupper of Merrill Lynch reported on Friday:


In May, the MSCI AC World Index (-9.3%) experienced the 10th worst month on
record (since 1988) as investors focused on the impact of Greece possibly leaving the Euro, the approaching “fiscal cliff” in the US, and weaker economic data from China.


Global equities are now down -0.5% year-to-date.

As is often the case during negative return months, the USA fell the least (-6.4%) while Asia Pac ex-Japan (-10.9%) and Emerging Markets (-11.7%)
underperformed the index. Europe (-13.0%) performed the worst while Japan
(-9.0%) fell in line with global averages.

 http://rcr.ml.com/Archive/11172915.pdf?w=dglen%40bpbtc.com&q=kRxwQ!Xvd!X0ib6L3iZ3gg&__gda__=1338820641_17a2a0e58c8b632c4117b12d2c29d406


Interestingly, Thomas Lee at JP Morgan suggests that the market may have misinterpreted the May payroll figures.

While the headline number for payroll growth was well below expectations (+69K vs. +150K consensus expectations), Mr. Lee argues that the non-adjusted growth in payrolls was much better than perceived.

On a non-seasonally adjusted basis, the U.S. added roughly +800K, which is one of the best reports since 1999.  The culprit, according to Mr. Lee, is the seasonal adjustments that the Labor Department used:

The May change of 800k is one of the best since 1999 for the "establishment"
survey (corporations) and at 732k for the "household" survey is the
BEST since 1999. Think about it…we are talking about the best number
since 1999, yet the May 2012 payrolls figure SEASONALLY
ADJUSTED is one of the worst since 1999.


Still, in a world where investors sell first, and analyze later, it makes little difference whether Mr. Lee's logic is correct.

Warren Buffett famously said that the way to make money in the markets is to "Be greedy when others are fearful, and fearful when others are greedy".

Are we now at one of those times?

Should the Fed Be Selling Some of Its Bonds Now?

source:  Bianco Research

Yields on U.S. Treasury obligations continued to plunge lower yesterday.  As of this morning, the 10-year Treasury note is yielding a paltry 1.54%.

Should the Fed take advantage of the apparent insatiable appetite for U.S. government debt to start reducing its $1.2 trillion bond position?

Nearly all of the Fed's purchases under its so-called quantitative easing programs were done when interest rates were much higher.  While its intervention policies were obviously done for economic reasons, and not investment, there is no denying the fact that the Fed's bond portfolio now has huge capital gains, since bond prices rise as interest rates fall.

Now, I realize that this is unlikely to happen.  The Fed's accumulation of government debt over the past several years was done in an effort to spur economic growth.

With housing just beginning to show signs of revival, and other economic indications indicating tepid growth, it seems politically unlikely that Chairman Bernanke would start to sell some of the Fed's holdings, which could lead to higher interest rates.

But I think he should, for three reasons.

First, ever since the first quantitative easing program began, the Fed has been under intense political pressure to demonstrate how it could exit the capital markets without disrupting the economy.

If the Fed sold, say, $100 billion of its position, it would provide a tangible demonstration of just how our central bank could reduce its bond holdings.

True, a large sale of bonds might temporarily push interest rates slightly higher, but it would also relieve some of the intense buying pressure currently present in the Treasury market.

Put another way: If Treasury yields rose to, say, 1.75% from 1.55% today does anyone really believe the economy would be affected?


Second, extremely low interest rates are a penalty on savers as well as the nation's financial institutions.  It would seem to me that it is no one's interest to have longer maturity interest rates continue to plunge lower.

And, third, selling some of its bond position would remove the element of the "Bernanke put" that is present in today's market.  Currently most investors and bond traders assume that if the economy showed any signs of plunging lower that the Fed would intervene in the markets again.

Selling bonds today would in essence tell the markets that the Fed's purchase of bonds since the financial crisis of 2008 was only a temporary policy decision, and that it is now looking forward to resuming its role as the Steward of our Banking System.

The Quiet Panic

The last time interest rates on U.S. Treasury obligations were as low as they were are today was 1946.

You probably don't remember 1946*:  Harry Truman was President, and the global economies were just beginning to recover from World War II.

Bond yields were low in this country largely because there was very little to either buy or invest in. 

American business was slowly converting back to peacetime production, but there were still widespread shortages of basic consumer goods.

U.S. bond yields had been kept low for a variety of reasons, but the patriotic calls to buy savings bonds to fund our war effort provided a huge reservoir of funding for the government at very low interest rates.

In a society awash in idle cash, banks had little need for funds, as loan demand continued to be sluggish. In 1946, many major banks were actually charging a fee to depositors, i.e. negative interest rates.

And as for stocks:  Scarred by the stock market crash of 1929, and the subsequent horrific decade of the 1930's, the response of most citizens to stocks was: fugetaboutit.

So now, 66 years, U.S. bonds yields are back to incredibly low levels last seen in my parents' generation.  The 10 year Treasury this morning yields 1.6%.

If it is any consolation, our bonds offer a better deal than many other countries.  German government 10 year notes offer a yield of 1.27%, while Japan's 10 year yields 0.8%.

We all know the reasons:  the fate of the euro zone remains in balance while Europe's leaders bicker about solutions.  Yields on government debt may be low, but at least you are assured of getting your principal back at some point.

There's a couple of aspects of the current situation that puzzle me.

First, if the world is really coming to an end, why are gold prices tumbling?

Gold has traditionally been the safe haven of choice throughout history, yet the recent tumble of gold and other commodities would suggest that something else is going on.

According to Reuters, May marks the biggest decline in gold prices in 30 years:

The precious metal is down more than 6 percent so far this month, its biggest May loss since a near 10 percent fall in 1982. The metal is also set to post a fourth consecutive monthly loss for the first time since January 2000.

While the possibility of a fresh round of monetary easing in the United States and demand for alternatives to the beleaguered euro could lift gold, confidence in the metal remains weak.

http://www.reuters.com/article/2012/05/31/us-markets-precious-idUSBRE8390RW20120531


The second paradox is the difference between what the world's bond markets are saying:

"Panic!  Sell Everything! Safety is All!"

and what corporations are actually seeing in their day-to-day business operations:

"Thing Aren't that Bad! Europe is Better than Expected! Earnings Estimates should be increased!"

Yesterday, for example, I went to hear management of Air Products, one of the world's major producers of industrial gases that are used in manufacturing around the world. They too indicated that their businesses are around the world are doing just fine; the only pocket of weakness, interestingly, is in their technology area.

So there's a Quiet Panic going on right now, but it seems to be mostly confined to the credit markets.

*I don't remember 1946 either - I was born 11 years later.