Blind Men, Elephants and Europe

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?

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?

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

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

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?

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?

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.