CMSms Blog - Main

Fiscal Toyota

Wed, 10 Feb 2010 05:32:13 -0500

January 31, 2010 -- This entry is my first on the eve of the release of Market Upside Down: How to Invest Profitably in a Shrinking Economy. I’m excited about it after 9 months of gestation and waiting. Although it is my third book, the birth of a new “baby” is always uplifting to the spirit.

One thing for sure: the economy, the stock market and Washington do not seem to be in a mood to celebrate. The election of the supposedly Republican Scott Brown of Massachusetts to the Senate had spin-doctors of all shades jumping and Obama vowed to freeze discretionary spending by $250 billion over 10 years (and declared other shifts in programs and rhetoric to pacify the right.)

Are you kidding? The deficit this year has swollen to $1.56 trillion, a new record. Last year’s deficit of $1.41 trillion was already the highest since WWII. How big is enough for the market to take notice of the unreality of rising debt from continuing budget deficits?

The budget “savings” (more like spending deferred until after 2012 when Obama hopes to be re-elected) are little more than a drop in the bucket. They would be less than 3% of the projected $9 trillion of additional deficits over the next 10 years even assuming they will be realized (but, like everything in Washington, don’t count the chicken until they hatch!) Anyway, the proposed spending in President Obama’s 2011 budget will make sure federal spending will keep rising for years to come. Already federal spending in 2010 will reach 25.4% of GDP. He promised spending would fall back to 23% of GDP by mid-decade. In his second term? How convenient! Even so, the share of federal spending to GDP will have reached a permanently new higher plateau.

Increasingly the government will elbow out the private sector as the dominant creator of jobs and economic incentives. The Japanese have gone through all this rising government spending and budget deficits, and look at what has happened to their economy and stock market in the last 20 years.

In the meantime, the TARP bailout watchdog warned that the federal government’s responses to the financial meltdown make it more likely that future crises will be worse. "Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," Neil Barofsky, the special inspector general for the troubled asset relief program, wrote in his latest quarterly report.

How comforting is that being in a Toyota with the accelerator stuck to the floor?

Year of the Tiger

Tue, 16 Feb 2010 02:58:13 -0500

February 16 –Today is the third day of the Year of the Tiger. Much of Asia is in slow motion and the Chinese banks have closed for a week of holidays. However, the Dow opens with a decent gain of some 60 points, more than making up for the loss on Friday. In Vancouver, excitement reigns as two Chinese ice skating pairs took the gold and silver medals, dethroning Russia, which has long dominated the sport since 1964.

Will China’s good fortune in sport carry over to the economic sphere and propel both China’s economic growth and its stock market forward in 2010, at a breath-taking pace similar to 2009? After expanding at 8.7% in 2009, China’s GDP is expected to rise by 10% in 2010. Propelling this economic expansion was a huge surge in bank lending which set a record in 2009 at CNY9.8 trillion ($1.5 trillion) and was 95.3% higher than in 2008. The real estate market also turned red hot, with property prices in Shenzen doubling while in overall China prices rose by 22% in 2009. Fearing a bubble, the government stepped in and raised bank reserve requirements by 0.5%, among other several measures aiming at cooling off the real estate market. The day before the start of the New Year, the government announced another hike of 0.5%. Although analysts expected a series of increases in reserve requirements later in the year, the pre-weekend move was unexpected and prompted a sell-off in Chinese and global stocks.

The global markets’ reaction underlined China’s predicament. Along with surges in property prices, consumer price inflation reached 1.9% in December, the highest climb in two years. However, the inflation rate eased off to 1.5% in January, surprising many analysts. Credit growth is projected to expand in 2010 still at a rapid rate of CNY7.5 trillion, smaller than in 2009, but much indicative of the ongoing glut of credit demand and how much China’s economy is dependent on credit –predominantly bank lending— and easy credit policies in order to grow. Any significant slowdown of credit expansion will surely squeeze the manufacturing and export sectors, at a time when global demand for its exports has slowed and the Western economies remain sluggish, with the risk of a double dip in the United States in the second half of the year.

China is still ruled by the imperative of fast growth. The easing of the inflation rate in January and the usual slow months after the New Year may give the People’s Bank of China enough of an excuse to be more relaxed. In this context, the unexpected year-end move in raising bank reserve requirements may be pre-emptive, rather than a warning of new rounds of tougher measures.

Who says reading the Chinese mind is easy?

A Shot Across the Bow

Wed, 24 Feb 2010 11:16:35 -0500

February 24 -- Last week the Fed presented financial markets with presumably a surprise move: it hiked the discount rate by 25 basis points to 0.75%. As explained in its press release, the action was “…intended as a further normalization of the Federal Reserve's lending facilities... not expected to lead to tighter financial conditions for households and businesses and do[es] not signal any change in the outlook for the economy or for monetary policy.” Nevertheless, bond prices fell and stocks sold off, similar to the global markets’ reaction to the action of the People’s Bank of China to tighten bank reserve requirements on the eve of the Chinese New Year.

That the markets’ subsequently recovered points to the predicament that world central banks are facing. Their wish to maintain credibility as inflation fighters, as well as, in China’s case, to prevent another bubble in the real estate sector, collides with the realities of the need for continued economic growth. As suggested by Roubini Global Economics, China has not restricted liquidity significantly, nor laid out a clear strategy to exit from the unusually easy monetary regime during the global crisis. Credit tightening is expected to be moderate, as the targeted bank lending of CNY7.5 trillion for 2010 is likely to be exceeded. The real estate sector may cool off, but prices are unlikely to collapse. Any aggressive tightening must square off the government’s desire to maintain the “active” fiscal policies and “moderately (!) loose” monetary posture in place since the end of 2008. In the meantime, exporters are adamantly opposed to significant appreciation of the Yuan, which has risen against the euro by virtue of its pegging to the dollar.

In Europe, the fiscal messes of the PIGS (Portugal, Italy, Greece, and Spain) are hardly conducive to any monetary tightening, at least until there are clear signs of an economic upsurge. On this front, the news from Germany and other countries is not yet an occasion for celebration; the drop, for the first time in 10 months, in German business confidence in February raised anew concerns about Europe’s largest economy.

In the United States, the fall of consumer confidence in February to the lowest level in 10 months, as the index of current conditions reached the lowest level in 27 years, only underlined the weakened state of consumer spending and the overloaded household balance sheets. It is thus no surprise that in today’s testimony to the Congress, Fed Chairman Ben Bernanke, citing the weak job market and low inflation, reiterated that the extraordinarily low interest rates would be in place for a long time.

Weak economic growth combined with rising debt to unsustainable record levels is a recipe for economic calamities.

However, neither the United States nor European governments appear to have effective policies for an exit strategy.

Drop Dead

Thu, 04 Mar 2010 15:40:49 -0500

March 4, 2010 – Like the proverbial Greek tragedy that is in full display in the land that lends its name, Greece’s fiscal fiasco has been conjured by the Greeks themselves. It has been long in the making and abetted by big investment banks like Goldman Sachs. Their schemes to hide debts off balance sheet pitched to governments desperate to comply with EU budget deficit rules have been widely practiced in other European countries. Yet when the chickens come home to roost and Greece faces debt defaults, the urge again is to provide bailouts. However, Greece is not the only country that has a debt time bomb on its hands –although in its case the fuse is extremely short.

My friend and Belgian-born international money manager Herve Caloen of New York-based Du Pasquier Asset Management, formerly with Scudder Stevens & Clark and Bankers Trust, has a view that I would like to share with you.

Gerald Ford to New York: Drop Dead.

Remember? Those were the days when no city was too big to fail.

In Europe, people tend to use a more nuanced vocabulary.

Last month, at an emergency summit in Brussels, Angela Merkel declared: "Greece will not be left on its own, but there are rules". Make no mistake, this is German for "Drop dead, Athens".

She then hastened to do nothing. Once credibility is restored, German banks and their French counterparts will lend Greece the money. At the proper rate.

Mr. Papandreou got the message. He was given few options. Either face the powerful union or face an Argentina-like sovereign debt default spiral. So far, he seems to have chosen the former.

The funny part is that the markets did not get it. Stock prices even rallied on the belief a bailout was coming.

Wall Street and the City of London love bailouts. Both have long ago given up any faith in capitalism. Fortunately, the Germans are reminding market participants how free markets actually work.

In the meantime, inevitably, commentators are once again predicting the end of the euro "experiment". Somehow they believe that if Greece leaves the euro, it would ignite the unravelling of Europe's greatest accomplishment.

But let's just consider Angela's only sensible option: Doing nothing.

If she does nothing, two outcomes are possible. Either the Greeks clean up their fiscal mess or they don't.

If they do, a powerful message will have been sent. German discipline prevails and the euro gains enormous credibility. Alternatively, Greece is forced to leave the euro, by market forces or by dictum. As a result, Europe loses its most backward, corrupt and insignificant member.

This decision is so easy. Spain and Portugal will get it. Ireland did not wait for Frankfurt or Berlin. They already moved aggressively, even cutting public servants' incomes.

This is very bullish for the euro. Countries in the German Union have a mechanism to enforce fiscal orthodoxy. Hence, Europe is taking the bitter pill now to avoid a protracted economic slump.

Old habits die hard, however. Attention is still focused on the PIIGS [Portugal, Italy, Ireland, Greece, Spain] countries. Or at least on the Club Med countries.

It is naturally easier to make fun of Italy than to worry about the U.K. Yet the Italian deficit is a relatively modest 5.4% of GDP, less than half its British counterpart. Or the US, for that matter.

The New York Times warns about the need to raise half a trillion dollars this year in Euroland.

Whom are we kidding? Half a trillion dollars was once a lot of money. But that was before the U.S., a smaller economy, was running a $1.5 trillion dollar annual deficit.

Here is why the dollar is at a long-term disadvantage. There is no pan-American mechanism that enforces fiscal discipline in Washington.

Back in the days when Washington acted responsibly, tough love worked marvels for New York City. Less than a decade later, New York was blooming again (no pun intended). On the other hand, postponing difficult decisions did not work for Japan.

Without a solid foundation, even Japan has been unable to grow its economy again. They are now about to enter their third lost decade. And there is still no hint of a recovery on the horizon.

As far as Greece is concerned, it is now a German province. Social unrest is inevitable. But Mr Papandreou can always try a French tactic.

Blame it on the speculators. Only twenty years ago, a French finance minister wanted all "speculators" to be guillotined.

The public loved the rhetoric.

Mornings of Sunshine

Fri, 23 Apr 2010 11:25:09 -0400

April 6, 2010 -- My mind has been full of bright thoughts in the last few weeks. I think about the possibilities of a world at peace, a strong economy with plenty of jobs for young and experienced people alike and most of all, mornings of sunshine and warm air and little kids running around. Have I too much time on my hands or gone senile? Well, my daughter is getting married to a nice young man and they make a handsome couple full of hopes and plans for their future. So, I join them in their dreams and hopes and indulge myself in these thoughts.

However, I know soon I will have to get back to reality and face up to the risks of bubbles that are brewing in the global stock markets amid forecasts of economic recoveries at breakneck speeds both at home and leading emerging markets like China. In the U.S. the strong GDP growth forecasted for the first quarter following a strong fourth quarter now have lulled many pundits to believe that the bounces fueled by temporary government jobs, stimulus measures and zero interest rate policies are here to stay. Likewise, the March employment report has been greeted with cheers by the stock market. Although payroll gains were short of expectations, quickly pundits hailed the gain of 162,000 as a sign that the labor market has turned the corner. Little mentioned were the facts that if you include the long-term unemployed and involuntary part-time workers, the under- and unemployed as percent of the labor force has reached a modern time record of 19.9%. This structural slack in the labor market is only one of many indicators, which I have discussed in Market Upside Down, of the questionable sustainability of the economic recovery. In China, a real estate bubble is well percolating that many analysts predict an end of unhappy consequences. Yet its economy is expanding at double-digit rates. I can’t help conjuring an image of an 18-wheeler hurtling down the road at 100 miles an hour. The driver, aka the Chinese government, is well aware of the risks. However, it is quite reluctant to apply the necessary monetary brakes for fear of crashing the property market, which has been leading the Chinese economic rebound, as well as its economy at large. Will the steamroller slow down gently or come crashing to everyone’s professed surprise?

Surprises déjà vu

Mon, 10 May 2010 08:54:57 -0400

May 7, 2010 – “Confidence may be replaced by recognition and fear of even darker days ahead. Without confidence and optimism, the values of the stock certificates will simply evaporate.“

I wrote those words more than six months ago for the introduction to Market Upside Down. In the last few days, as throngs of Greeks took to the streets –as they have done in the past for causes noble or otherwise-- to protest their government’s spending cuts, newspapers screamed out with such headlines as “U.S. markets plunge,” or “Greece fuels fears of contagion in the U.S.”

In one week of chaotic trading, the Dow Jones Industrial Average gave up all the gain that it had painstakingly built up since the beginning of the year. Such has been the typical reaction of markets advancing on mere confidence and optimism. One gentle push and the house of cards unravels.

For in the scheme of the world economy, Greece is a small country. Its GDP is about one-tenth of Germany’s, and is little more than half the size of the retirees’ state of Florida’s. Yet, “Wall Street panics as Greece protests flare,” As PIMCO’s Bill Gross said, “Up until last week there was this confidence that nothing could upset the apple cart as long as the economy and job growth was positive. Now, fear is back in play.”

Sure, the sell-offs in the U.S. stock market (and equities worldwide) reflect the concern that the debt cancer of Greece will spread to the other PIIGS countries. The top 10 U.S. banks account for 96% of the debt exposure to Greece, Ireland, Portugal and Spain, according to Barclays Capital, but their holdings amount to only $176 billion. The Bank of America disclosed that it had $193 million in exposure to Greece's sovereign debt, and $1.1 billion in non-sovereign debt to the country as of March 31. Though not a trivial amount, this sum is only one-third of the Bank’s 2010 first quarter’s profit. Yet, in the last five days, BAC dropped over 10%, twice the Dow Jones’ loss.

Of course, these figures are mere pittance when compared with the trillions of dollars in debt that U.S. banks hold in defunct U.S. residential and commercial mortgages. Add to these amounts the mountain of debt the U.S. government has been piling up. Deutsche Bank estimated that the public debt-to-GDP ratio of the United States would top 100% to reach 133% by 2020, the same as Greece’s 130% currently.

What will happen upon recognition that the U.S., and other countries such as the U.K. and France, are heading down the path Greece (and Japan in the last 20 years) have been traveling?

Manic Depressive

Mon, 31 May 2010 13:15:19 -0400

May 31, 2010 – “Sell in May and go away,” so goes the adage about stock market doldrums in summer. Better to sell in May and wait for better market conditions comes fall.

Let’s hope the cooler weather will drive away the manic depressive state of the equity market seen this month.

Starting with promises on the first trading day of May, and poised to make new highs since the rally started in March last year, the market’s follow-up was hardly more disappointing. In subsequent days, early advances on openings quickly reversed, and gains on one day were erased the next. The debt crisis in Greece was the first to be fingered for the violent moves, followed by rumors of massive trading errors on May 6 that were supposed to prompt the Dow to lose 1,000 points in a matter of minutes. Yet the market found little comfort in the $1 trillion EU bailout for the benefits of the spendthrift Greeks and lack of evidence for the alleged trading mistakes. By the last trading day, the loss in May had wiped out all the Dow’s gain since the year’s beginning, and turned the year’s gain of 7.4% at the high into a loss of 2.8%. year-to-date.

In fact, investors who bought into equities since October last year amid urgings of pundits who proclaimed the return of bull markets have seen their investment gains, if any, disappear –in the midst of unprecedented uncertainty about the European debt crisis and its global contagion. To further stir up the boiling pot, emerging markets from China to India weakened as their economies slowed down in response to actual or threats of monetary and credit tightening.

The prospects of economic growth in the U.S. are hardly brighter. Going into the second half, the effects of various stimulus measures are fading, with second half growth expected to taper off to 1-2%, from 3.0% in Q1, which was revised down from 3.2%. The reported unemployment rate –already understating the severity of the depressed state of the labor market with rising discouraged and part-time workers—has bounced back up to 9.7%. Statistics on income and spending showed spending growth has outpaced growth of income, but now spending was slowing down. Consumer spending in April was flat, compared to forecasts of 0.1% rise, after six straight monthly increases.

In the meantime, year-on-year CPI ex. food and energy continued to decelerate from the cyclical peak in 2007. Since December 2008, core CPI has been increasing at less than 2%; in April, it rose at 1%. Money supply has also been decelerating. Rising at 10.2% in December 2008, M2 has been accelerating at less than 2% since March 2010. Commodity prices have also weakened. Backing off from the high in January, the Thomson Reuters/Jefferies CRB Index has lost 13.3% since then.

Where are strong economic growth rates, higher commodity prices, accelerating money velocity, and fast growing foreign markets to provide tailwinds for the equity market? No wonder Ben Bernanke has kept Fed funds rate at near zero, despite calls for tightening among some of his colleagues on the Board of Governors. The debt crisis in Europe is another nail in the coffin for any near-term possibility of a U.S. rate hike.

However, will zero Fed funds rates cure the de/disinflation disease that has plagued the Japanese for decades and is germinating in the U.S.?

Deflation, Debt and Budget Deficits

Tue, 22 Jun 2010 15:23:46 -0400

June 22 – It is difficult to think of the U.S. experiencing a deflationary cycle like in the 1929 depression, or a la Japan in the last two decades, with its devastating impacts on economic growth and wealth of the nation.

However, as I noted in the previous entry Manic Depressive, CPI ex. food and energy has been decelerating. Since December 2008, core CPI has risen at less than 2% year-on-year. A small pick-up toward the end of 2009 with the approaching Christmas season gave way to a rise of only 1.48% in January 2010, from 1.8% in the preceding December. Last month, it rose only 0.97%, slipping from 1% in April*. This rate is well below the Fed’s informal target of 1.5% to 2%, while interest rates are at near-zero and, according to some, the equity market is in a bull run, presumably because the economic recovery is viewed to be on track.

CPI rose at a declining rate that averaged 1.6% between 2003 and 2004, in the aftermath of the 2000 to 2002 recession. However, as the economic recovery gained momentum, core CPI again climbed at 2.3% on average between 2005 and 2007.

This time, it is different. Economic growth is expected to slow down significantly in 2010-2011 as the fiscal stimulus or AARA (American Reinvestment and Recovery Act of 2009) turned into a drag on the economy starting in the second half this year. Many economists are now fearful of increasing chances of a double dip recession, especially after the big drop in retail sales last month. Even Fed Chairman Bernanke has sounded a cautious note: “My best guess is that we’ll have a continued recovery, but it won’t feel terrific.”

An economic slowdown or double dip will do little to reverse the march toward deflation.

Under these conditions, it is peculiar that last week in a WSJ piece, the former Fed Chairman Alan Greenspan, the champion of easy money and bank deregulation that brought on the boom-bust cycle in the last decade, joined the born-again deficit hawks in calling for cutting the Federal budget deficits.

On the eve of Greece’s debt implosion, Greenspan called for “a tectonic shift in fiscal policy” in the U.S. as well as most of the rest of the developed economies. It would be “none too soon,” he said. He warned that “[d]espite the surge in federal debt to the public during the past 18 months—to $8.6 trillion from $5.5 trillion—inflation and long-term interest rates, the typical symptoms of fiscal excess, have remained remarkably subdued. This is regrettable, because it is fostering a sense of complacency that can have dire consequences.” He noted that “[i]t is little comfort that the dollar is still the least worst of the major fiat currencies. But the inexorable rise in the price of gold [i.e., the decline of the dollar in terms of gold] indicates a large number of investors are seeking a safe haven beyond fiat currencies.”

A consequence of persistent deficits is higher long-term interest rates, and “the Treasury would have to pay much higher interest rates to market its newly issued [debt] securities.” And “we cannot count on foreigners to finance our current account deficit indefinitely.” Greenspan pointed out that “long-term rate increases can emerge with unexpected suddenness.” Already the market has priced 10-year Treasury notes as riskier than indebtedness of large corporations; evidenced by the narrowing of the swap spread of such durations to a minus 13 basis points, from a positive 77 basis points as recent as September 2008; the so-called “canary in the coal mine.”

All of these are sound warnings, as I had discussed at length and warned in Market upside Down. In the introduction to the book, I wrote, ‘When the next crisis comes, where will the U.S. and its citizens find the resources to combat and recover? Except that the Federal Reserve may crank up the printing press at full speed. But the global markets have a way to express their displeasure, through soaring interest rates, the dollar’s collapse and sell-offs of stocks prices. By the time the next crisis rears its head, when the effects of “the massive shots in the arm” [through fiscal deficits] have worn off, the pain and patience of real people may reach the nadir. Confidence may be replaced by recognition and fear of even darker days ahead. Without confidence and optimism, the values of the stock certificates will simply evaporate.”

Curiously, Greenspan dismissed concerns of the contracting effects of fiscal cuts on the economy. “I believe the fears of budget contraction inducing a renewed decline of economic activity are misplaced.” Really?

The list of the ailments infecting the economy is lengthy. From high unemployment rate and record numbers of the long-term unemployed to the distressed housing market and commercial real estate, from depressed personal savings which have hovered at the bottom despite much hype about improved savings rates, to the low rates of capacity utilization that have languished near the worst levels experienced in the 1973-75 and 1981-82 recessions, there is no bright spot except hiring by the Federal government. Additionally, transfer payments have risen to a record level of 18.2% of personal income.

So, how is that budget cuts would not further depress the economy?

Unfortunately, as I pointed out in Market Upside Down, the United States is facing two imperatives: one is the need to cut debt; the other is the need to borrow more in order to stimulate economic growth. Since private sector balance sheets are already over-leveraged, only the Federal government is creditworthy –that is, at least until the credit rating agencies decide to act on their warnings and downgrade U.S. Treasuries’ credit-risk-free privileged status.

At the same time, as I observed last year, “[t]he [Federal] government should find its budget deficits and record debt load make it difficult if not impossible to get a trillion dollars here, another there for bailout and stimulus spending.” The debt crisis facing PIIGS and the rising volume of the deficit-cutting chorus joined by luminaries such as Alan Greenspan and the newly elected British Prime Minister David Cameron only spotlight the precarious position the U.S. has found itself trapped in.

How the U.S. as a nation and the world’s largest and dominant economy works itself out of this morass will determine the future of a generation to come –possibly across the entire globe.

*Note: GDP price deflator has been dropping off sharply with the first quarter 2010 registered at only 0.5%, far below the norms during the 2003-2007 expansion.

The Money Manager's Trapeze -- Book Review

Wed, 07 Jul 2010 21:17:14 -0400

July 6, 2010 – A review of Market Upside Down by Madan Sabnavis in Businessworld.

The Money Manager’s Trapeze -- Vinh Q. Tran focuses on how to preserve capital value while lowering risk factors to earn money when the markets are “upside down”.

Predicting the future is hazardous, besieged as it is with mistaken signs and distorted rear view mirrors, made foggier with the passage of time and emotion. These words of Vinh Q. Tran summarise the substance of his book as he guides investors into doing the right thing with their money even in the wrong times.

In Market Upside Down, Tran’s attention is directed primarily to those who may be saving for post-retirement and would like to preserve their capital value and earn something above it. More importantly, they would like to lower their risk as much as possible. The focus is, hence, on how to earn money when the markets are “upside down”.

Tran manoeuvres your thought process through the beta curves (market risk exposure) and alphas (excess returns over the market adjusted for beta) to warn us against some common fallacies that we make while investing. A rising market is a no-brainer because you would gain at some time.

But Tran believes that this will not always hold if the downward cycles last longer — which is uncertain — and one gets caught at this time when searching for liquidity. Tran gives his version of the financial crisis, and feels the resuscitation packages have not taught us our lessons, and institutions may be engendering a new one.

This, combined with the fact the hegemony of the US dollar is eroded, means things could change drastically anytime. This view may change today in light of the Greek and Euro crisis where the dollar has once again become important, albeit by default.

Tran’s suggestion is that those who rely on stockmarkets after retirement should not enter the market as ‘strategists’ thinking the ‘bull run’ has begun. In the past cycle after the tech rally, the Dow had returned to the start after a sharp fall of 44 per cent. So, the concept of mean reverting can catch the investor in this trap.

Tran’s analysis of US markets shakes the shibboleths that have been held sacred. The first of them is that one cannot take the position that one can never lose in the long run, as the period is not defined. This is a major blow for your investment advisor who makes such a loose statement.

The second is the theory that stockmarkets are an inflation hedge. It works only in half the number of observed cycles, which shatters the image that has been held all along.

The third myth is that cost averaging yields optimal results. This debunks our own concept of systematic investment plans. This is quite a revelation that can leave the small investor wondering what to do as we are told that SIPs are the way out for an apprehensive investor.

The fourth myth broken is that risk and return go together. This questions the basis of the wisdom spewed in textbooks that correlates the two in terms of a trade-off. And the fifth one is an even greater blow to the theory of finance: VaR (value at risk) does not work as the Dow has recorded losses of 30 per cent or more very often. This comes as a shocker for the normal curve and its theories.

Further, few funds have a beta substantially lower than or greater than one, and few really outperform the market. We need to watch the regular analysts’ reports more closely to look beyond those numbers when they talk of the fund beating the market.

Finally, believing that the market is mean reverting could be an error as the time points can never be known.

In that case, how much should we put in stocks? One option is to think of how much of our wealth are we willing to lose. Now, just double it and put it in stocks. Another idea is to simply subtract our age from 100 and keep that proportion in stocks. These thumb rules are worth pursuing.

Tran suggests that we follow the policy of absolute return strategy where we diversify across equities, bonds, commodities, etc. in relation to our age profile. While this is again common-sense, the book should be viewed more as a reminder of moving towards ‘sanity’ while “we try and discern the contours of a vague outline”.

The book is recommended for all those who are attracted by the benefits of the market — often reiterated by our investment advisors. But reading this twice may make a first timer remain on the periphery of the market.

Author's Details:
Vinh Q. Tran has worked as a money manager for Morgan Stanley, Bank of America and Aetna Life and Casualty for 20 years. He has taught advanced investment as adjunct professor of finance at New York University’s Stern School of Business, and is the author of Evaluating Hedge Fund Performance. Tran holds a Ph.D. and MBA in finance from George Washington University.

Sabnavis is chief economist at CARE Ratings

(This story was published in Businessworld Issue Dated 28-06-2010)

Source: http://www.businessworld.in/bw/2010_06_19_The_Money_Managers_Trapez.html

Stocks, Double Dip, and Deflation

Fri, 16 Jul 2010 15:46:22 -0400

July 16, 2010 – The stock market has been experiencing severe mood swings, going up and down from one day to the next. After reaching the highest levels since the bottom last March, the key market indices crashed into bear market territories in May and June upon discovery of the not-so-secret fiscal mess of the PIIGS countries. (It took video shots of street protests, bank burning, and people killed for global equity markets to notice that Greece has long been insolvent!) Since then, stocks have alternated between strong rallies and sharp declines, cheered on by pundits on public TV, and beat-the-estimates earnings announcements of market favorites like Apple, only to feel depressed by lousy economic statistics, as if the bleak economic outlook is a surprise.

To be fair, what else is there for pundits to say to attract stock buyers? After all, credit is cheap, (if you can get it and only big banks have ready access to it for their proprietary trading, courtesy of the Fed), bond yields are near all-time lows, and Fed funds are virtually zero. “It’s the liquidity, stupid!” as it was often said about Japanese stocks in the late 1980s when no other explanation would make sense. Besides, dividend yields are high; at its low points in June, dividend yields on S&P 500 exceeded 2%, beating 5-year Treasuries. The bank stocks did even better, surpassing the 4% yields on 30-year Treasury bonds. Only if you can lock in the dividend yields! (That, you can do with bonds, but not with stocks, which can lose value. How comes this crucial detail is never apparent?)

So for now, big players can make millions (change that to “b” like in “billions”) and if the economy hits a wall as widely expected in the second half, well, it can be dealt with later; they can always sell out at the drop of a hat if things go bad. (Will retirees, savers, and long-term investors get out of the stampede in time, and avoid being crushed as they had been in 2008?) On this, they have a booster in none other than Fed Chairman Bernanke. In a June testimony to the House Budget Committee, the Chairman confidently stated "[t]he economy ... appears to be on track to continue to expand through this year and next."

Let us all hope the Chairman’s confidence is justified. Our futures depend on it.

Unfortunately, earnings news is not that rosy and economic statistics continue to deteriorate and the odds of a double dip increase with every piece of economic news.

After bidding up prices for a week in anticipation of strong earnings, stocks tumbled badly today, losing 2%, with earnings from Google, Bank of America, and others falling short of expectations. The Dow now teetered on the brink of the key 10,000 level and the 300-day moving average.

Bad news on the economic front continues to pile on, though largely has been much shrugged off by the market –“Stocks are in a bull run,” so say a number of strategists. Retail sales, a key barometer of consumer spending which accounts for two-thirds of the economy, fell in June for the second time in a row. The Michigan consumer sentiment index slumped in July to the lowest level in a year.

It is not difficult to understand why consumers are not in a good mood. The unemployment rate hovers just under 10% with little prospect of improving. If anything, this indicator understates the severe weakness of the labor market for it does not account for the record and increasing number of part-time workers and the discouraged who are not counted as participating in the labor force. At the same time, consumer wealth has shrunk with declining stocks and house prices, amid mountains of debt at the household, state, and Federal levels.

But the bad news can get worse. In previous comments, I have pointed out to the continuing decline of the inflation rate, whether measured by the Consumer Price Index or other ways. In June, CPI declined 0.1%, month-on-month, for the third time in a row. Year-on-year, it rose a mere 1.1%. Since the beginning of the year, CPI less food and energy has been below the Fed’s informal target of between 1.5% and 2.0%. Last three months, this index has dipped below 1%. Other inflation indicators pretty much tell the same story. GDP deflator has languished at 0.6% last three quarters. The core deflator of Personal Consumption Expenditure market prices (less food and energy) has been falling off the last few months. Rises in PPI have softened. The Reuters/Jefferies CRB index has also trending down since the beginning of the year.

What does all this mean? Paul Krugman in his piece Trending Toward Inflation in last Sunday NYT says “…deflation isn’t some distant possibility — it’s already here by some measures, not far off by others.” “The United States and Europe are heading toward--and Japan already suffers from--deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins,” John Makin of the American Enterprise Institute said in his July piece “The Rising Threat of Deflation.”

Anyone who is in doubt about the devastating effects of deflation needs only to look at Japan and its stock index Nikkei 225 in the last twenty years, which has come down from 38,916 to below 9,500 currently.

Unfortunately, as Makin observed in the same article, policy makers are ignoring deflation risks. Along the same lines of my June 22 comments, he said, “The G20’s newfound embrace of fiscal stringency only adds to the extant deflation pressure.”

Volatility Uninterrupted

Tue, 03 Aug 2010 09:43:23 -0400

August 3 – The temperature soared to oppressive levels but stocks enjoyed a great month. In July, the S&P 500 surged 7%. Except for the bounces from the March 2009 bottom, it has been years since the market saw such elevated returns. A casual observer could understandably conclude that all is well on the mend for the economy.

Even the spate of statistics pointing to a weak recovery and increasing odds of a double dip and deflation has so far failed to stop the rally. To top it off, equities staged a strong gain of over 2% on the first trading day of August, riding on the falling dollar, higher energy prices and strong price action from Europe. Aiding the upbeat tone, the ISM index showed a larger-than-expected gain for July.

However, trading volume was low on this day, only 7.6 billion shares, well below last year’s estimated average daily average of 9.6 billion.

When the market is thin with traders and money managers taking vacation from the heat of summer, a bit of good news can go a long way to cause exaggerated moves –and vice versa. Remember losses of almost 10% in the last two weeks of June? In the words of one strategist, it has been a “meat grinder”; before the August 2 run, the S&P 500 barely broke even for the year.

Soon the earnings season will be over and the stock market will have to deal with the economic reality of weak growth, high unemployment and rising fiscal imbalances at state as well as federal levels.

Already the economic recovery has been sub-par. After growing at a revised 3.7% in the first quarter, GDP growth has slowed to 2.4% in the second, well below the 6% average in past recoveries. We now know that the recession was worse than had been reported, knocking 4.1% off GDP between December 2007 and March 2009. By now, if the recovery were similar to previous averages, GDP should have already well surpassed the 2007 peak; but it is still 1% below. With the stimulus program fading away, the economy may slip back into a recession in the second half as some fear. As former Fed Chairman Alan Greenspan put it, “We’re in a pause in a recovery, a modest recovery, but a pause in the modest recovery feels like a quasi- recession.” Consumers seemed to feel the same way. The Michigan Consumer Sentiment Index was down sharply in July, to 67.8 from 76.0 in June, wiping out all the gain recorded since last July. The Expectations Index dropped to the lowest level since the market bottom in March last year. It is no wonder that consumers have reined in their purchases. In the first quarter, consumer spending rose at a faster pace than the growth in income. It then screeched to a halt in the second quarter, registering no growth. In June, income also was flat, the weakest showing in nine months.

This economic outlook will not be enough to drive equities to sustainably higher levels.

GDP statistics also reinforced what the Consumer Price Index has been telling us for months: inflation has been slowing to dangerous levels. As reported by the Bureau of Economic Analysis, the price index for domestic purchases rose only 0.1% in the second quarter, versus 2.1% in the first. Excluding food and energy, the core price index increased 0.9%, decelerating from 1.6% in the first quarter. A slowing economy can only increase the deflationary pressures.

Equity markets will not react kindly to the convergence of these headwinds: Weak economy in a deflationary spiral.

That’s why it is imperative that the Fed retains its zero rate policy for a long time to come, coupled with other measures to keep pumping liquidity into the system. The question is, Will these measures be enough to avert a Japanese-style economic malaise?

Oblivion Is Bliss

Sun, 15 Aug 2010 18:00:09 -0400

August 15 – After strong rallies of over 2% on the first trading day of August, major stock indices have managed to retain their gains, riding through the miserable July payroll reports, and turning the S&P 500 from a loss into a gain of 0.5% year-to-date. Yet, the labor statistics again highlighted the bleak employment outlook and continuing lack of jobs for the rising ranks of the unemployed. Overall, the nation lost 131,000 non-farm jobs in July, with 202,000 cut in government payroll. The loss of 48 thousand jobs in state and local governments surprised economists. The gains in private sector jobs of 71 thousand were pitiful, just a bit over half of what is needed to keep pace with population growth; to reduce unemployment the U.S. needs to gain at least 200,000 jobs a month consistently.

The poor payroll reports surprised even optimistic economists. “No question about it, the three-month average of adding 50,000 jobs is disappointing versus almost anybody’s expectations,” said Robert J. Barbera, chief economist of Mount Lucas Management, who has said that the economy is on track for sustained recovery. “And certainly it’s less than half of what you need to keep things stable.”

Fear, however, has come back to the stock market the last few days. Bullish sentiment and optimism came to face with the economic reality American consumers and the unemployed have felt in their lives and their guts for many months: This is not the economic recovery and strong growth market pundits have been broadcasting.

On Wednesday, the Dow lost 265 points, after dropping one-half percent the previous day; and losses kept up through the week after meek attempts to rally. Now the major indices looked at a loss of over 3% year-to-date.

Unpalatable news –not that they were surprises. What else could be expected? – suddenly converged and drew attention to what “is going to be a long slog,” as phrased by David H. Resler, chief U.S. economist of Nomura Securities International. After giving signals of its sagging confidence in a robust recovery earlier this year --“The pace of recovery in output and employment has slowed in recent months…” – the Fed showed “a feeling of panic”, as an economist put it, in its announcement on Tuesday that the proceeds from its huge portfolio of mortgage bonds will be used to buy long-term Treasury bonds. With interest rates at virtually zero, the Fed now has little leeway to stimulate the economy; the only resort is printing money, or putting more politely, quantitative easing.

Now that the most authoritative forecaster of economic growth –and guardian of the economy-- has said it, Wall Street began to once again pay attention to the stream of bad economic news coming from different directions, from faltering American exports to retail sales. In June, the trade deficits jumped 18.8% from May, rising to $49.9 billion, with exports slipping and imports increasing. Retail sales looked better on the surface, gaining 0.4% in July; but excluding autos and gasoline, retail sales went down 0.1%, disappointing economists who had predicted 0.5% overall gains and 0.2% rise, excluding gasoline and autos.

Abroad, China, the engine of global economic growth, is showing signs of slowing down after its GDP advanced at the break-neck pace of 11.1% annualized in the first half. Although Chinese growth is still forecasted to continue strong, signs of slackening are showing in retail sales, imports, and fixed asset investments. Bank lending also has begun to taper off, being reduced to Rmb533 billion ($79billion) last month, from Rmb603 billion ($89 billion) in June. Growth of money supply has also declined, to 17.6% year-on-year, from 18.5% in June.

At the same time, the Bank of England marked down its forecast of 2010 growth to 3% from 3.5% only a couple of months earlier. Citing softening business and consumer sentiment, the Bank’s governor hinted at expanding the economic stimulus package to support the British economy. The Euro zone economies also are feared to slow again in 2010 H2 driven by austerity measures in Germany, budget cuts in France and persistent weak growth in Spain, Italy and others.

So, in lock step with the S&P 500’s loss of 2.8% on Wednesday, the Eurotoxx blue chip index gave up 2.6%.

The Japanese Nikkei dropped 2.7%, raising the year-to-date loss to more than 12%. After a two-decade decline, it looks like Japanese stocks are facing another wasted year.

Fleeing the Market?

Tue, 31 Aug 2010 12:04:58 -0400

August 31, 2010 – In a stunning reversal, investors have been taking money out of stock mutual funds! Is that so? In a recent front page article, the New York Times headlined “In Striking Shift, Investors Flee Stock Market.”

Citing data from the Investment Company Institute, the article observed, “Investors withdrew a staggering $33.12 billion from domestic stock market in the first seven months of this year.” It went on, “Renewed economic uncertainty is testing Americans’ generation-long love affair with the stock market.” “Small investors are ‘losing their appetite for risk,’” a well known strategist chimed in, as quoted in the article.

Not so fast. Concurrent with taking money out of domestic equity funds, individual investors have re-entered foreign stock markets, starting in April 2009, right after the market bottom in March. Since then investors have steadily upped their ante in foreign equities, except for an outflow of $5.6 billion in May this year, according to the Investment Company Institute. For the first quarter of 2009, investors withdrew $16.6 billion from foreign stock funds after an outflow of $82.5 billion in 2008. But money came back to foreign markets, with an inflow of $47.3 billion during the last nine months of 2009, and $28.4 billion so far this year, through the week of August 18.

The inflows into foreign equities were not large enough to offset the outflows from domestic stock funds, but close. Net inflows into foreign stock funds in 2009 were $30.7 billion, v. net withdrawals of $39.5 billion from domestic funds, leaving a much more modest net redemption from equities of $8.8 billion. Same thing so far in 2010. Net equity redemption came to $10.2 billion, consisting of a net withdrawal of $36.7 billion from domestic funds and additions of $28.4 billion into foreign equities.

The shift into foreign equities is unlikely to do much to help investors if another market crash is to occur. In 2008, the MSCI Barra USA index lost -38.6%; not a small number by any means. But the MSCI EU Index (which includes the Euro zone countries) dropped -49.8%; MSCI Emerging Markets crashed with a loss of -54.5%. The World Index excluding the U.S. tumbled by -45.2%. So far this year the EU index fared poorly versus the U.S., losing -13.8% v. -5.9%, respectively. Emerging Markets’ losses have been modest, -1.7%, but few investors have much in these markets.

These results should not be surprising to any market participant. In the tech bust of 2000, more money was lost from foreign markets than U.S. stocks. Foreign markets may perform better than U.S. stocks at times, but diversification with foreign stocks has not turned out to be an effective way to reduce risks.

This is because foreign equities have been shown, as I did in Market Upside Down, to be more volatile than the U.S. equity market.

If you are “losing appetite for risk,” you don’t flee U.S. stocks and move into foreign equities.

Also historically, foreign markets were highly correlated to the U.S. In the last four years, as an illustration, the MSCI World ex. USA Index has a 0.98 correlation with the U.S. (If this figure is 1.0, the two markets would move in perfect unison.) The correlation between the U.S. and the EU is 0.97. The Emerging Markets Index is 0.79 correlated to the U.S., hardly inductive as a diversification strategy to reduce risks.

Thus, if the U.S. market is to tank, foreign markets will likely follow and exacerbate investors’ losses.

So, why did individual investors run from U.S. stocks?

The flows data indicated that they became wary of the U.S. stock market, by withdrawing from domestic equity funds. Instead, they put money in bond funds. Inflows into bond funds were $205 billion this year through August 18. This is more than two times of the 2007 inflows and one-third more than the average during 2008 and 2009. (In 2008, additions to bond funds were relatively small, possibly because investors were preoccupied with problems in the stock markets globally and uncertain about the safety of bond mutual funds, probably as a result of the Reserve Money Fund collapse.)

Investors have been handsomely rewarded by these moves. The Barclay Aggregate Bond index returned 7.6% this year through August 30. If investors have ignored the pundits’ advice to stay away from U.S. Treasuries because of inflation threats, and instead plowed their money into long-term Treasury bonds, the reward for their independent thinking would be even much bigger; the Barclay Treasury 10-20 Year Index returned 17.55% through August 30. In contrast, the S&P 500 total return was a loss of -4.66%.

The hunt for return is alive and well, even though investors are becoming wary of the potential losses in the U.S. stock market. And rightfully so.

The Fed Reflates the Economy

Wed, 15 Dec 2010 21:29:46 -0500

December 15, 2010 – On November 3, the Fed announced after its policy setting Federal Open Market Committee meeting that it was launching the second phase of quantitative easing, with purchases of up to $600 billion in Treasury bonds through the first half of 20111.

Although QE2, as it is referred to, is much less than the first round of $1.75 trillion between 2009 and 2010, the Fed’s latest move came to immediate criticism from all circles.

Apart from the tenth District Federal Reserve Bank President Thomas Hoenig who dissented, Governor Kevin Warsh warned of “significant risks” including the potential of leading to excessive inflation. He also doubted the program would create “significant” or “durable benefits” for the economy. Comments from European capitals were particularly harsh. "What the U.S. accuses China of doing, the U.S.A. is doing by different means," said German Finance Minister Wolfgang Schaeuble. French Finance Minister Christine Lagarde said in an interview with the Wall Street Journal a couple of days later that the fresh quantitative easing would inevitably result in an appreciation of the euro.

Brazilian Finance Minister Guido Mantega called the Fed's policy "an error." "It is doubtful the Fed decision will produce any results," he predicted. "Throwing money out of a helicopter doesn't do any good," Mr. Mantega dryly commented.

China was also angry. "Many countries are worried about the impact of the policy on their economies," Vice Foreign Minister Cui Tiankai, China's top G-20 negotiator, told a news briefing in Beijing. "It would be appropriate for someone to step forward and give us an explanation,” he demanded. Chinese central bank adviser Xia Bin called the Fed move "uncontrolled" money printing.

China’s credit rating agency Dagong Global Credit Rating Group, which began rating sovereign debt in July, and vied to be an alternative to Standard & Poor's Corp., Moody's Investors Service and Fitch Ratings, downgraded U.S. debt to A+ from AA . The Chinese agency has ranked China’s government debt higher than that of the U.S. and Japan. This time, it cited "Serious defects in the United States economic development and management model [which] will lead to the long-term recession of its national economy, fundamentally lowering the national solvency” as reasons for the downgrade.

On Wall Street, bond traders also reacted strongly, pushing 10-year Treasury rates from 2.53% on November 4 to 3.5% as of yesterday. However, in the foreign exchange market, the euro weakened sharply, from the high of $1.428 to as low as $1.297 at the end of November, a continuous decline of over 9%. The dollar also rallied against the yen, from ¥80.5 to ¥84.2 during the same period. Both currency and bond traders apparently anticipated stronger economic growth in the U.S., enhancing the value of the dollar while pushing bond yields up.

The real yield on 10-year inflation-indexed Treasury bonds, TIPS, also surged higher, from 0.44% on November 4, to 1.1% currently, reflecting higher inflation expectations.

Higher inflation is what the economy needs!

A scholar of the Great Depression, Chairman Ben Bernanke has been particularly concerned about the deflationary spiral that would cause the economy to collapse like in 1929, or worse, to slip into a prolonged malaise like Japan since 1990.

As experienced in Japan, once the deflationary psychology has set in, it becomes extremely difficult to reverse, through fiscal stimulus, zero interest rate policy, or money printing. After the peak in December 1989, the Japanese stock market has been steadily declining while its economy continued in the doldrums. Delayed actions to stimulate the economy by the Japanese government, fiscally and monetarily, have turned out to be too late to have much effect on its economy. In the meantime, the unemployment rate rose substantially, years of CPI deflation ensued, and its national debt has soared to twice the size of its economy.

As hopes of a Japanese recovery seemed to be fading during this summer, after three straight quarters of GDP expansion, amid a stronger yen and the expiration of government subsidies, the Japanese government stepped in, throwing a double lifeline to the economy. In August, the central bank unveiled a new six-month low interest loan program to financial institutions, increasing the pool of such funds available to banks to $355 billion. The government also launched a new economic stimulus package worth $10.9 billion.

The financial markets appeared to be under-whelmed by these measures, however. "There seems to be a sense of fatalism," noted a report by Macquarie Securities. "The BOJ continues to play the same old game of making incremental, but ultimately meaningless policy change, in response to political pressure."

Well aware of the need for “national policy responses [to be] forceful, timely, and mutually reinforcing,” at the Fed's annual conference in August, Chairman Bernanke said the Fed “will do all that it can to ensure continuation of the economic recovery…” The Fed has “policy options for the future should the recovery falter or inflation decline further,” including additional purchases of long-term debt securities, he continued.

On November 19, at the Sixth ECB Central Banking Conference in Frankfurt, he defended QE2, saying, “the [Federal Open Market] Committee seeks to support the economic recovery, promote a faster pace of job creation, and reduce the risk of a further decline in inflation that would prove damaging to the recovery.” “Importantly, the Committee remains unwaveringly committed to price stability and does not seek inflation above the level of 2 percent or a bit less that most FOMC participants see as consistent with the Federal Reserve's mandate,” the Chairman continued.

The Chairman has followed up on his words, and the financial markets are giving him the benefit of the doubt.