Thursday, February 26, 2009
Wednesday, February 25, 2009
In an Op-Ed in this morning's Wall Street Journal, Jeremy Siegel argued that the earnings for the S&P 500 are understating actual earnings. While his entire argument can be read here, his basic premise is that Standard and Poor's calculates earnings based on each company's total earnings without taking into account their weight in the index. Siegal goes on to say that earnings should instead be calculated using each company's earnings times its weight.
While the argument may sound convincing, it doesn't really make sense. The S&P 500 is meant to represent the total value of the 500 largest companies in the US based on market cap. While a $10 million increase in a company's market cap will have a bigger impact on the stock price of Jones Apparel, which is the smallest company in the index, than it will on ExxonMobil, which is the largest company in the index, the impact on the index is the same. If the prices of all other 499 stocks remain the same, a $10 million increase in market cap for any one company has the same impact on the index regardless of the company's size.
Now let's apply this logic to earnings. Imagine you have two investments. The first is worth $1,000, and over the last year it generated $100 in income. The second investment is only worth $100, but over the last year, it had a loss of $100. Most people would probably think of their investments in the way S&P calculates the earnings for the S&P 500. You would have total investments of $1,100 ($1,000+$100) and earnings of zero ($100 profit on $1,000 investment plus $100 loss on $100 investment). Using Siegel's logic, however, your total earnings would be much better (although you would be living in la la land). Since your $100 investment is only worth one tenth of the value of the $1,000 investment, the loss from that investment would only be a tenth as much. In this case, your total earnings would be $90, as the $100 loss would only be worth $10 ($100 + $10 loss = $90).
We'll let readers decide for themselves which approach makes more sense, but before making your decision, think about the result if the returns on the two investment were reversed and the $1,000 investment had a $100 loss while the $100 investment earned $100. According to S&P methodology, your total earnings would still be $0, but under Siegel's method, you would have a total loss of $90.
Since the bear market started on October 9th, 2007, the Russell 3,000 has lost $9.58 trillion in market cap, which is more than the index's current market cap of $8.74 trillion.
Of the Russell 3,000's current members:
-- The average stock is down 53.16% during the bear market.
-- Just 4.13% of stocks in the index are up during this bear, meaning more than 95% of stocks are down.
-- A whopping 59% of stocks in the index are down more than 50%.
-- 7.3% of stocks in the index are down more than 90%, nearly twice the number that are in the black. There are more stocks down greater than 93% than there are stocks that are up.
-- 125 stocks in the index are trading for under $1/share, while just 20 are trading for more than $100/share.
-- Nearly half (46%) of the stocks in the index are trading for less than $10/share.
Below we highlight the best and worst performing stocks during the bear market that are currently in the Russell 3,000. If you're looking for relative strength names, stocks that have managed to book gains when the average stock is down more than 50% are a good place to start.
Aside from the companies that have gone out of business, 7 stocks currently in the Russell 3,000 are down more than 99% -- AIG, SPSN, FNM, FED, FRE, CHTR, and GGP. There are some big names on the list of biggest losers below. Las Vegas Sands (LVS) is down 98.26%, going from $134.95 on 10/9/07 to its current price of $2.35. Shoemaker CROCS (CROX) is down 98.08%, Ambac (ABK) is down 98.54%, Avis Budget (CAR) is down 97.91%, and Lear Corp (LEA) is down 97.76%. We couldn't fit all 205 stocks that are down 90% or more on the page, but others include Bank of America (-91.63%), General Motors (-93.71%), Citigroup (-95.3%), and Sirius XM Radio (-96.25%).
Tuesday, February 24, 2009
There have now only been two periods in the history of the S&P 500 where the index declined more than 50% from an all-time high -- 1929 and now. In the first chart below, we highlight the percentage change from the S&P 500's most recent all-time high to its current level, along with the change from the 1929 all-time high over the same number of days. Although the front-page headline in the WSJ today is "Stocks Drop to 50% of Peak," the S&P 500 was actually down 50% from its peak back in November. It just recently hit the 50% threshold again.
What is ominous about the first chart is that only four trading days separate the first time that the S&P 500 went 50% below its all-time high. Ultimately in the bear that started in 1929, the S&P 500 dropped a whopping 86.19% from its all-time high. This low occurred 679 trading days after the all-time high was reached, or about two years and nine months. The current decline has lasted one year and four months.
But by far the most depressing aspect of the 50%+ decline back in the 1930s was how long it took for the index to make a new all-time high. Following the peak in 1929, the S&P 500 went 6,251 trading days before hitting a new all-time high 25 years later.
Obviously a lot more has to happen for the market to continue lower and reach -86%, but the current declines aren't in good company.
Friday, February 20, 2009
In October 2008, we wrote an article on the market valuations and what returns we could expect from the stock market over long term. Dow was around 9000. Today we are officially in recession, GDP has seen its largest drop in 3 decades, Dow is at 8000. What can we expect from the stock market from this point on?
As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”(insert source) Over long term, the returns from stock market are determined by these factors:
1. Interest rate
Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”—Warren Buffett
2. Long Term Growth of Corporate Profitability
Although we are now in a recession, we are seeing a steep decline of corporate profitability. However, corporate profitability should reverse to its long term trend as economy stabilizes, which is around 6%. Long term growth of corporate profitability is close to long term economic growth.
3. Current Market Valuations
In the long run, stock market valuation reverses to its mean. A higher current valuation certainly results in lower long term returns in the future. On the other hand, a lower current valuation level results in a higher future long term return,
Warren Buffett’s Market Calls
Based on these factors, Warren Buffett made a few market calls in the past. In Nov. 1999, when Dow was at 11,000, a few months before the burst of dotcom bubble, stock market had gained 13% a year from 1981-1998. Warren Buffett said in a speech to friends and business leaders, “I'd like to argue that we can't come even remotely close to that 12.9... If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”
Two years after the Nov. 1999 article, when Dow was down to 9,000, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”
Nine years have passed since the publication of the article of November 22, 1999, it has been a wide and painful ride for most investors; Dow went as high as 14,000 in October 2007 and retreated painfully back to 8,000 today. Again, Warren Buffett wrote in Oct. 2008: Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”
The Sources of Investment Returns
The returns of investing in an individual stock or in the entire stock market are determined by these three factors:
1. Business growth
If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.
If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over long term, corporate earnings grow as fast as the economy itself.
Dividend is an important portion of the investment return. Dividend comes from the cash earning of a business. Everything equal, higher dividend payout ratio, in principle, result in a lower growth rate. Therefore, if a company pays out dividend while with growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.
3. Change in the market valuation
Although the value of a business does not change overnight, stock price does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual business, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.
Our backtesting has clearly showed that for individual businesses, everything else equal, lower valuations lead to higher returns.
Putting all the three factors together, the return of an investment can be estimated by the following formula:
Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)
The first two items of the equation are straightforward. The third item can be calculated if we know the beginning and the ending market ratios of the time period (T) considered. If we assumed the beginning ratio is Rb, and the ending ratio is Re, then the contribution in the change of the valuation can be calculated from this:
The investment return is thus equal to:
Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Re/Rb)(1/T)-1
This equation is actually very close to what Dr. John Hussman uses to calculate market valuations (insert source). In the past decade, he has been saying that the market has never been reasonably undervalued, and for that, he was called a “Perma Bear”.
As we discussed, the ratios here can be any commonly used ratios. However, if we use the most common ratio such as P/E, it can be misleading. This is because P/E ratio strongly depends on profit margin, which may fluctuate dramatically at different point of business cycles. To eliminate this factor, John Hussman uses Price to Peak Earnings as P/E ratio. Here we like to the ratio Warren Buffett uses, i.e. the ratio of Total Market Cap to GNP.
So what can we expect from the stock market?
From the equations we can estimate what returns we may get from the market. Currently we have an average stock dividend yield of about 3.5%. The US economy grows at about 4.7% over the past 10 years. With the Dow at 8000, we have a ratio of total market cap to GNP of about 60% (See chart below). We use the time period of 8 years to calculate the contribution of the change in market valuations, we get an estimated annualized return as the function of future valuations.
Years of Market Cycle
Estimated Annualized Return:
Future TMC/GNP Ratio
Contribution from Change of Valuation
As we can see that the future investment returns largely depend on the change of the market valuation, the overall, the chance of losing money from this point on is small if TMC/GNP stays in the range of where it has been in the past three decades, which is between 40% and 150%. Therefore being a long term investor in the current market is of reasonably low risk. If 8 years later the market valuation is the same as the current, we may expect about 8% a year, which is contributed by both the economic growth and the dividends. If the market ratio returns to the median level over the past 3 decades, we may expect more than 11% a year. If the market goes wild again, like it did in 1999, the return can be an enormous 20% a year, which is great… unless you sell out completely at that point.
Where will the market be in 8 years? GuruFocus does not want to make a prediction. But with this study we are more convinced of what Warren Buffett said in Oct. 2008: “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”
Thursday, February 19, 2009
If mishandled by the world policy establishment, this debacle is big enough to shatter the fragile banking systems of Western Europe and set off round two of our financial Götterdämmerung.
Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP.
"A failure rate of 10pc would lead to the collapse of the Austrian financial sector," reported Der Standard in Vienna. Unfortunately, that is about to happen.
The European Bank for Reconstruction and Development (EBRD) says bad debts will top 10pc and may reach 20pc. The Vienna press said Bank Austria and its Italian owner Unicredit face a "monetary Stalingrad" in the East.
Mr Pröll tried to drum up support for his rescue package from EU finance ministers in Brussels last week. The idea was scotched by Germany's Peer Steinbrück. Not our problem, he said. We'll see about that.
Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region's GDP. Good luck. The credit window has slammed shut.
Not even Russia can easily cover the $500bn dollar debts of its oligarchs while oil remains near $33 a barrel. The budget is based on Urals crude at $95. Russia has bled 36pc of its foreign reserves since August defending the rouble.
"This is the largest run on a currency in history," said Mr Jen.
In Poland, 60pc of mortgages are in Swiss francs. The zloty has just halved against the franc. Hungary, the Balkans, the Baltics, and Ukraine are all suffering variants of this story. As an act of collective folly – by lenders and borrowers – it matches America's sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not.
Almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74pc of the entire $4.9 trillion portfolio of loans to emerging markets.
They are five times more exposed to this latest bust than American or Japanese banks, and they are 50pc more leveraged (IMF data).
Spain is up to its neck in Latin America, which has belatedly joined the slump (Mexico's car output fell 51pc in January, and Brazil lost 650,000 jobs in one month). Britain and Switzerland are up to their necks in Asia.
Whether it takes months, or just weeks, the world is going to discover that Europe's financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus.
Under a "Taylor Rule" analysis, the European Central Bank already needs to cut rates to zero and then purchase bonds and Pfandbriefe on a huge scale. It is constrained by geopolitics – a German-Dutch veto – and the Maastricht Treaty.
But I digress. It is East Europe that is blowing up right now. Erik Berglof, EBRD's chief economist, told me the region may need €400bn in help to cover loans and prop up the credit system.
Europe's governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.
The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan – and Turkey next – and is fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights.
Its $16bn rescue of Ukraine has unravelled. The country – facing a 12pc contraction in GDP after the collapse of steel prices – is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia's central bank governor has declared his economy "clinically dead" after it shrank 10.5pc in the fourth quarter. Protesters have smashed the treasury and stormed parliament.
"This is much worse than the East Asia crisis in the 1990s," said Lars Christensen, at Danske Bank.
"There are accidents waiting to happen across the region, but the EU institutions don't have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU."
Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4pc in the fourth quarter.
If Deutsche Bank is correct, the economy will have shrunk by nearly 9pc before the end of this year. This is the sort of level that stokes popular revolt.
The implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU "union bonds" should the debt markets take fright at the rocketing trajectory of Italy's public debt (hitting 112pc of GDP next year, just revised up from 101pc – big change), or rescue Austria from its Habsburg adventurism.
So we watch and wait as the lethal brush fires move closer.
If one spark jumps across the eurozone line, we will have global systemic crisis within days. Are the firemen ready?
Wednesday, February 18, 2009
Beta is the most important investment opportunity in 2009 according to TOBAM, the investment manager formed from the break up of Lehman Brothers Asset Management.
"Investors have paid a premium for alpha over the last few years and as they read their investment reports in the coming weeks, they may well be asking themselves what they have been paying for," commented Yves Choueifaty, president of TOBAM.
"In 2009 the most important investment opportunities will be beta rather than alpha, so diversification should be at the top of every investors' ‘must do' list. Markets are incredibly volatile right now and strategies which spread risk cannot possibly be at a disadvantage to concentrated risk-taking."
Capturing beta efficiently is often overlooked as a path to superior investment results, according to TOBAM. There has been a trend towards non-market cap solutions and one of the more efficient approaches for beta construction is known as anti-benchmark. This uses a mathematical approach to create the ‘most diversified portfolio'.
This portfolio does not rely on historic earnings, sales or other valuation criteria to try and predict the future, rather it spreads risk more evenly across all the currently identifiable market risk factors.
TOBAM research indicated that focusing on efficient beta construction, without making big bets, is a way to achieve higher returns with less risk. Diversification is the strategy which is worth paying attention to at all times, concluded TOBAM.
The anti-benchmark strategy has been designed to offer an alternative to using market cap weighted indices as a core equity market exposure, which investors hold to capture the equity risk premium. TOBAM said it believes this risk premium is best captured by holding what investment literature refers to as a ‘well-diversified portfolio'.
Anti-benchmark is designed to be the most diversified portfolio possible for a given universe of securities and is expected to be the most efficient way to capture the higher returns available from holding equities.
The greater efficiency of anti-benchmark compared to market cap benchmarks leads over time to more return with less risk than the market cap weighted indices, concluded TOBAM.
Its research indicates that investors spend much of their time seeking new sources of alpha, when in fact expected returns over time are almost entirely driven by capturing the risk premium of their asset allocation.
Anti-benchmark does not depend on the predictions of a star fund manager or on extrapolating results in the past to predict returns in the future. The strategy provides better results by taking maximum advantage of diversification.
Tuesday, February 17, 2009
The much awaited "test" of the November lows is here for the Dow Jones Industrials Average. While this is quite depressing while it's occurring, it's a normal part of a "bottoming process" if the bottom is indeed being made. If the market holds and can bounce off of these levels over the next few days, those hoping that the lows are in will breathe a sigh of relief. If, however, this support level breaks and the market heads lower, the last three months of a "bottoming process" will be a complete waste, and the cycle will have to be repeated again once a new short-term bottom is put in.
A number of indicators are showing that the market in its current state looks much better than it did in November. We have detailed these in Bespoke Premium reports over the past few weeks, but one of them is the fact that recent declines have been concentrated in just one or two sectors. As shown below, Financials and Consumer Staples are the only two sectors that have gone down since November 20th, with Financials declining the most at -11.8%. On the other hand, four sectors are still up more than 10%, even though the market as a whole is flat. These four sectors include Consumer Discretionary, Materials, Technology, and Health Care.
Thursday, February 12, 2009
LiveLeak has caught a scary moment of previously undisclosed insight by Paul Kanjorski where he reveals some facts that have not been captured by the media previously. At 2 minutes and 20 seconds in the video below, Democratic Representative Kanjorski explains how the Federal Reserve told Congress members about a "tremendous draw-down of money market accounts in the United States, to the tune of $550 billion dollars." According to Kanjorski, this electronic transfer occurred over the period of an hour or two. And it gets worse. Kanjorski paraphrases the following disclosure by Bernanke and Paulson (emphasis added):
On Thursday (Sept 18), at 11 in the morning the Federal Reserve noticed a tremendous draw-down of money market accounts in the U.S., to the tune of $550 billion was being drawn out in the matter of an hour or two. The Treasury opened up its window to help and pumped a $105 billion in the system and quickly realized that they could not stem the tide. We were having an electronic run on the banks. They decided to close the operation, close down the money accounts and announce a guarantee of $250,000 per account so there wouldn't be further panic out there.
If they had not done that, their estimation was that by 2pm that afternoon, $5.5 trillion would have been drawn out of the money market system of the U.S., would have collapsed the entire economy of the U.S., and within 24 hours the world economy would have collapsed... It would have been the end of our economic system and our political system as we know it...
We are no better off today than we were 3 months ago because we have a decrease in the equity positions of banks because other assets are going sour by the moment.
Interestingly, Kanjorski, and likely more and more Democrats, are starting to shift to the camp that more time is needed to make a correct decision this time (which may explain Geithner's decision to postpone the "bank-rescue" announcement by one day, to Tuesday), instead of rushing into another half-baked plan. Very scary stuff.
Monday, February 09, 2009
The New York Times published an article this weekend highlighting that the current 10-year stretch that ended last month was the worst for the S&P 500 in at least the last 82 years. The Times looked at total returns for the S&P 500, and below we provide a similar analysis of the 10-year rolling price change of the Dow Jones Industrial Average going back to 1910. As shown, there have only been four other periods where the 10-year return has been negative, and three of the four periods saw returns float around the negative to flat line for quite some time. While it may have taken "buy-and-holders" a few years to end up making money if they got in early when the 10-year returns went negative, they did end up making money.
When looking at 10-year returns, however, where the market was 10 years ago is just as big of a factor as where it is now. Ten years ago, the market was just about to hit the peak of the Internet bubble, and once it burst, the 10-year return was destined to take a big hit right about now.
Below we highlight a hypothetical 10-year return chart going out to 2012 if the Dow were to stay right at its current level. As shown, the return would continue to get negative and drop all the way to -29.49% in January 2010 before finally starting to head higher. And even if the Dow stayed the same, it would end up turning positive again by late 2011, since the market had fallen so much by late 2001. If the market gets worse in the next couple of years, the 10-year returns are going to get worse. But even if the market heads sharply higher from here, the 10-year returns will still be negative to flat until we get past 2010.
Step forward, Mark Zandi of Moody’s, so that we at FT Alphaville may hail your bravery, your verve, your iconoclasm. Or at the very least, your willingness to make a bold call.
Mark Zandi believes US house prices will stabilize by the end of the year.
In a just-released survey titled “Housing in Crisis: When Will Metro Markets Recover?” (yours for just $3,995), Zandi and his team posit:
The national Case-Shiller house price index will decline by another 11% from the fourth quarter of last year for a total peak-to-trough decline of 36%.
By the end of this unprecedented downturn, house prices will have declined by double digits peak to trough in nearly 62% of the nation’s 381 metro areas. In about 10% of metro areas, price declines will exceed 30%.
So where then the green shoots of recovery? The executive summary is tantalisingly vague on details, but HousingWire reports that the Moody’s crackshots “see flattening inventories, prices coming back down to earth, and sales that are approaching stability in many markets.”
And who are we to argue with Moody’s? Oh, wait…
The head of the Blackstone Group’s fund of funds group is leaving the firm, Blackstone told investors last week.
Bruce Amlicke has resigned as chief investment officer of Blackstone Alternative Investment Management’s fund of funds division to spend more time with his family, The Wall Street Journal reports. Amlicke will remain with Blackstone for a transition period of a few months; his position will not be filled.
Amlicke has been with Blackstone since 2004, overseeing its 116-member fund of funds team.
“The extensive commute to the New York City office from his home in Connecticut and the demands of his job have weighed very heavily on Bruce and his family,” Blackstone said in a memo to clients. “As a result, he has made this important decision in order to allow him to spend much more time with his wife and children.”
In a move that could force similar changes at other money-losing hedge funds, the well-known fund manager William A. Ackman is cutting his fees and allowing investors to take what is left of their money from one of the funds he manages.
Mr. Ackman, who runs Pershing Square Capital Management, is suffering huge losses on a fund he started nearly two years ago to bet solely on the rise of the stock of the discount retailer Target Corporation.
The fund, called Pershing Square IV, is down nearly 90 percent this year, and Mr. Ackman has been feeling pressure from investors who want to take their money out. In an effort to mollify those investors, Mr. Ackman apologized for the losses in a letter sent on Sunday. He personally committed $25 million to the fund to help pay investors.
“Bottom line, PSIV has been one of the greatest disappointments of my career to date,” Mr. Ackman said in the letter. “That said, we continue to believe that we will ultimately be successful in our investment in Target.”
Those who want to withdraw what is left of their capital from the fund will be paid in March, Mr. Ackman said. About 90 percent of the investors in the Target fund are also investors in Pershing’s other hedge funds, which were down 11 percent to 13 percent at the end of last year.
For those investors, Mr. Ackman has agreed to forgo any performance fees on the other funds until he makes up for the current losses in the Target fund, according to the letter. The concessions could spur other hedge fund managers to cut their fees and increase the amount that investors can withdraw. Hedge funds typically charge customers yearly fees of 2 percent of total assets managed plus 20 percent of any profits.
Several large hedge funds, including Citadel Investment Group and Farallon Capital Management, have halted investor redemptions in certain funds after having huge losses last year.Mr. Ackman said in the letter that he was disappointed by the fund’s “dreadful performance,” adding, “I apologize profusely for the fund’s results to date.”
This chart from Deutsche Bank sums up the issue nicely. As can be seen most recently, yes, there’s been a reduction in the number of US banks reporting a tightening of credit conditions — but at the same time, demand for credit is still plummeting. In otherwords, you can take a horse to water…
Sunday, February 08, 2009
From Kiplinger's Personal Finance magazine, March 2009
Mohamed El-Erian has a vision of the economic future that may both frighten and reassure you. He sees a tectonic shift occurring, as emerging economies in Asia and elsewhere join the established powerhouses, especially the U.S. No longer will the world simply march to our beat; the U.S. will have to share leadership with emerging giants, such as China and India.
The good news is that this change in the global power structure is not altogether bad for America. El-Erian predicts that the new economic giants and other developing nations will buy more U.S. goods, easing our trade deficit and stimulating growth and jobs over time.
Now, however, we're somewhere in the middle of the journey, and it's a rocky one. Because of all these changes, El-Erian suggests in his new book, When Markets Collide (McGraw-Hill, $27.95), that investors spread their money over a wider array of assets than was once thought necessary. That means shrinking U.S. stocks to just 15% of your total portfolio (see the table on page 34 for his recommended allocations).
Unless you watch CNBC regularly, the name may not ring a bell. But El-Erian (pronounced el-AIR-e-ann) has been active in global finance for the past three decades. Born in New York City to an Egyptian father and French mother, he grew up both in the U.S. and abroad. He worked for the International Monetary Fund for 15 years, then did stints with Salomon Smith Barney and Pimco before running Harvard's endowment fund. He returned to Pimco, the bond powerhouse, in 2008. El-Erian is chief executive of Pimco as well as its co-chief investment officer (a title he shares with bond guru Bill Gross).
We caught up with El-Erian at Pimco's offices in Newport Beach, Cal. Uppermost in our mind was how Joe and Jane Investor should react to the changes going on around us now.
KIPLINGER'S: If you were writing your book right now, what would you change?
EL-ERIAN: I would deal with the way the financial landscape is being re-defined without a master plan. This has become a crisis-management phenomenon that's very reactive and changes weekly.
What does that imply?
It's inevitable that financial regulation is going to increase -- not just increase, but change the whole industry. After what we've seen recently, society will not leave unchanged a system that privatizes huge gains and socializes huge losses. Banks are being slimmed down. Bankers can still make a good living, but not as good as in the past.
Do you trust the regulators to re-regulate wisely?
No. The pendulum will probably swing too far, and it may be costly in terms of lost efficiency. I don't like that, but unfortunately, it's likely.
Why are you telling investors they need to diversify differently these days?
The traditional approach to diversification, which served us very well, went like this: Adopt a diversified portfolio, be disciplined about rebalancing the asset mix, own very well-defined types of asset classes and favor the home team because the minute you invest outside the U.S., you take on additional risk. A typical mix would then be 60% stocks and 40% bonds, and most of the stocks would be part of Standard & Poor's 500-stock index.
This approach is fatigued for several reasons. First of all, diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well. Second, it matters a great deal how you implement the asset allocation, because when the world gets bumpy, different investment types really do behave differently.
Third, consider where we're headed. We are going toward a world where the U.S. will no longer be the most dynamic part of the global economy. Because of the debt excesses of the past few years, it will be a while before the U.S. economy returns to 3% or 4% annual growth. Therefore, the wise investor asks, "Where else can I tap into sustainable growth?" To do that, you need a more global approach.
And I would add one more thing.
And that is?
Don't become hostage to historical definitions of asset classes. Be flexible, because there will be opportunities that don't fit easily into those categories.
In other words, look for the fat pitch?
Exactly. You're used to facing someone who only throws fastballs and curves. If your mind-set isn't ready for the fact that you may get a change-up, you're not going to recognize it.
What's a fat pitch today?
One such pitch is that there will be huge opportunities in infrastructure, in everything from roads to energy production to water facilities.
How can investors tap into these opportunities?
Through exchange-traded funds and mutual funds. There are several vehicles that do this and spread the risk widely. [Three ETFs that focus on this area are iShares S&P Global Infrastructure (symbol IGF), SPDR FTSE Maquarie Global Infrastructure 100 (GII) and PowerShares Emerging Market Infrastructure (PXR).] The problem with buying a few individual stocks, such as those of companies building roads in China, is that changes in Chinese law can affect you in ways that are unpredictable.
How can individuals participate in private equity -- another piece of your asset pie?
This is one of the categories that individual investors may not be able to access easily because doing so requires a very large investment upfront.
Why not buy stock in Blackstone Group or Kohlberg Capital, which are private-equity companies?
You could, but I would not. The more you get away from the underlying investments, the more undefined risk you are taking.
You also recommend that investors channel more than 10% of their assets into commodities. What is the best way?
Individuals can gain exposure to a diversified basket of commodities through mutual funds offered by firms such as Credit Suisse Asset Management, Oppenheimer and Pimco, as well as through ETFs.
What about individual stocks? Petrobras, the Brazilian company, sits on an ocean of oil.
Petrobras is a commodity-sensitive stock -- but not a commodity.
The crash in commodity prices makes this a good time to buy, doesn't it?
This would be a good time.
But will people be brave enough?
Some may not. This brings to mind the story of the rational fool. It's an experiment with a donkey that's very, very hungry. The donkey faces two piles of hay, shaped differently but equivalent in volume. Which will it choose? The donkey is aware that people are monitoring its revealed preference -- as in, don't listen to what a person says, look at what the person does. The donkey knows that by making a choice, it will indicate its preference for one of the piles of hay. But being a smart donkey, it knows that there is no difference between the two, so it cannot make a choice. Instead, it starves. It's the rational thing to do. In the same manner, investors are often frozen by indecision.
You co-manage a new mutual fund, Pimco Global Multi Asset. Is it structured along the lines of the asset mix that you suggest?
Yes, it is. We call it a three-in-one approach. Approach number one is to have an asset allocation that makes sense looking forward, given the direction the global economy is headed. The second approach is to be alert for special opportunities that arise. And the third is to manage what we call tail risk, in addition to diversification.
Is this an appropriate one-fund portfolio for an individual investor?
Yes and no. It's appropriate for a slice of your total investments -- but not all of them. Think of diversification as a matrix. You want to be invested across a broad range of asset classes. But you also want to be invested across a range of managers. Beyond a certain point, it's not more asset classes you need, but more points of view. That's why it's important to invest with an array of managers.
Which special situations is the fund invested in?
Several, including certain agency mortgage securities trading at attractive valuations. Also, we're buying the debt securities of banks that have received significant assistance from the government.
You're buying the bonds issued by the banks, but not the stock. Why?
Because the stocks get diluted every time the government comes in. This speaks to a very big issue, which is that the balance between private and public ownership is changing fundamentally. A mistake a lot of people make is to say, "Here's a company so important the government is going to give it money to keep it going, so I'm going to buy its stock."
They forget that the government becomes part owner.
Exactly. The government is very open about this. Understandably, it cites three objectives -- to stabilize the company, calm the markets and protect the taxpayer. It looks at the capital structure of a company, which includes senior debt, preferred stock and common stock, or equity. The government has not bought equity because it's too expensive, being the most junior part of the capital structure. So in the case of Fannie Mae and Freddie Mac, the government came in at the level of senior debt, and that had the effect of diluting everything below it. In the case of the banks, it came in at the level of preferred stock, which diluted the common equity. So as an investor, it really matters to you where you are in the capital structure -- the higher the better in the case of entities aided by government injections.
What are your expectations for this fund's long-term returns?
Our objective is to do better over a full market cycle than balanced funds that invest 60% in stocks and 40% in bonds. We're also conscious that doing better than this group yet delivering negative returns is not good enough. That's why we pay attention to the tail risk.
What does "tail risk" mean?
Another name for it is Armageddon protection. It's the small probability of something happening that would overwhelm everything, as is occurring right now on several fronts. An example is earthquake risk in California. If people really thought the risk of a Big One was high, no one would live there. Yet the probability, though small, exists. So it makes sense to buy earthquake insurance, if it can be bought cheaply.
If you manage this risk, why did your fund lose money in its first three weeks?
Global markets came under pressure in November, and our hedges are designed to kick in to protect against losses exceeding about 15%. The fund never got to that stage. Think of it as the deductible on your car insurance. A zero deductible is expensive. So you normally choose a higher deductible to bring the cost of insurance down. For example, at the Harvard endowment in 2006 and 2007, we bought credit-default swaps against the senior tranches of the corporate-debt index. That was a form of insurance, and it was cheap at the time.
All very good for you! But what about Joe and Jane Investor -- what's their insurance?
A financial planner can do some of these things for them. The planner's job should go beyond just asset allocation; he or she should also look to clip off the bad tail risk.
But you can also clip the tail yourself, in a less targeted fashion. Keep a cash balance that's bigger than you would have when markets are calm. If you normally keep six months of living expenses in cash, make it a bit more, so you won't have to sell assets when everyone else is selling. The critical thing about managing a bumpy journey is to never be a distressed seller.
You don't anticipate a sharp economic recovery, do you?
No. I see a saucer-shaped one. We've been driving at or slightly above the speed limit through the use of debt. I think the speed limit is going to come down on us so that the potential growth of the economy is going to go from 3% a year to 2% a year over time.
And so you don't see a robust stock market around the corner?
Correct. Lately, one of the smart trades that certain pension funds have been making is selling part of their exposure to stocks and buying high-quality corporate bonds at 8%, 10%, 12% yields. They're saying basically, "I would have been happy with an 8% return on my stocks. Now I can get that amount and be higher up in the capital structure." Remember, if you are in the sectors that are being embraced by the government, you don't want to be in common equity.
Stocks will suffer because investors, just like those pension funds, will say, "Wait a minute. I can buy the stock and have massive risk, hoping to get 8% to 10%. Or I can buy the bonds and still get 8% to 10% from the yield." Yes, you'll give up some of the potential upside of stocks, but the upside hasn't been that great recently.
Friday, February 06, 2009
Way back in August of 1979, BusinessWeek ran one of its most famous cover stories ever on "The Death of Equities." The story is widely regarded as a brilliant contrary indicator. Shortly after it ran, the market began a twenty-year bull run.
So we're taking comfort from what would otherwise be a terrifying analysis from Citi's global equity strategist Robert Buckland on the death of the "cult of equities." Neil Hume at FT Alphaville reprints the most knee-knocking bits of Buckland's note describing how investors may finally have given up on equities.
As background, what Buckland is essentially arguing is that all this talk about stocks being "cheap" is a misreading of the market. Instead of declining equity valuations demonstrating a "buy" signal, they are showing the equities market has simply died, or at least gone out of fashion. Dividend yields are still too far below bond yields to be attractive.
The problem, as Buckland sees it, is that stocks have simply stopped delivering returns that justify their volatility. We may be at the end of a very long bubble in stocks. In order to return to something like their historical yields, stocks may have to drop another 40%. That's about 500 points on the S&P.
Here's Buckland (via Alphaville):
Equities have never been particularly good at hedging inflation anyway, and now index-linked bonds can do a much better job .
Equities’ ability to match wage growth has been mixed. Increasingly mature pension funds will want to switch bonds as the moment of retirement approaches.
Defined contribution investors (where the individual takes the risk) may be less willing to tolerate volatile equity returns than the old defined benefit plans (where the employer takes the risk).
But most importantly, it is dreadful returns that will be increasingly putting investors off equities. Since the end of 1999, global equities have returned -29% compared to a +80% return from global government bonds. Not only have equity returns been dire, but the volatility has been brutal. Having two 50% bear markets in one decade is enough to test the patience of the most determined equity cultist. Just as excellent equity returns helped to promote the cult of the equity in the 1950s, so terrible returns seem to be tearing it down now.
It's not just the difference in the mechanism of investment--defined contributions and 401Ks instead of defined benefit plans. Buckland could throw in an aging population seeking more security, a crowded economy with less room for growth, increasing foreign competition for capital, a productivity boom that may have reached its apex and a slow down in technological innovation. Oh, and don't forget that investors may be turning decisively against the traditional corporate form of publicly held stocks capitalizing companies altogether, favoring new fangled limited partnerships instead.
Dividend yields are higher than treasury bond yields, of course. But they are far lower than corporate bond yeilds. So Buckland things that corporate bonds are the natural successor to equities.
There, we said it. Is the death of the cult of equities enough to signal the start of the bull market? (Note: it didn't work last time we tried this trick, so don't get too excited.)
Tuesday, February 03, 2009
After floating around the 0% level for a couple of months, yields on 1-Month and 3-Month Treasury Bills have finally started to move higher over the past few days. The 1-Month yield has moved up to 0.21% from 0.005% just last Wednesday, while the 3-Month has moved up to 0.31%. Investors fled to Treasuries from money-market funds and anything else that involved the smallest hint of risk during the fourth quarter of 2008. The fact that some of this money is now coming out of the Treasury market is a good sign. Even the 10-Year Treasury yield has risen from just above 2% at the start of the year to its current level of 2.8%.
Feb. 3 (Bloomberg) -- Eric Sprott, the Canadian money manager who last year predicted banking stocks would collapse, said the U.S. is at the beginning of an economic depression that will help gold prices more than double.
Bullion may top $2,000 an ounce in coming years amid a series of financial catastrophes, the chairman and founder of Toronto-based Sprott Asset Management Inc. said yesterday in an interview. Banks will battle to replenish capital, Treasury auctions stand the risk of failing and the moribund economy will create a dire operating outlook for many companies, he said.
“The trend is down, and there’s not one signpost that says it’s changing yet,” Sprott said yesterday from Toronto. “We’ll stand by to wait to see those, and until it does, you have to assume it gets worse.”
Sprott, who manages $4.5 billion, said in March that the world was in a “systemic financial meltdown,” a call that presaged the collapse of financial institutions including Bear Stearns & Co. and Lehman Brothers Holdings Inc. Since then, the U.S. has entered the worst economic slowdown since the Great Depression, credit markets have tightened and asset prices have dropped as companies and funds sell portfolios to raise cash.
The 81-company Standard & Poor’s 500 Financials Index has dropped 62 percent since Sprott said on March 6 he was buying bullion and gold-producers’ shares, while shorting financial- sector stocks. Gold slipped 6.3 percent during the same period.
So-called short-selling allows speculators to profit from a stock’s decline by borrowing shares, selling them to raise cash and buying them later when the price drops to repay the debt.
Betting Against Equities
Sprott now favors buying more gold stocks and bullion while selling the entire equity market short. Most at risk in the current climate are banks and discretionary consumer stocks and any companies that have debt to refinance, he said.
Sprott believes there is a chance that a U.S. Treasury auction will fail as countries use their resources to quell financial turmoil in their home markets, leaving less to help finance the world’s largest economy. That outcome will have a “catastrophic” impact, he said.
“When do people stop buying the credit of the country? That’s a tough question to answer, but it’s on a lot of people’s lips right now,” he said. “Each country has their own financial problem, so there’s no funding for anything external.”
Such concerns have driven investors to the gold market, propelling the metal higher as other commodities have slumped and helping gold-producers’ stocks almost double in the past three months.
Greenlight Capital Inc., a $5.1 billion New York-based hedge fund, has started investing in gold for the first time, while Federated Investors Inc.’s $1.3 billion Federated Market Opportunity Fund, which outperformed 99 percent of rivals last year, now counts Yamana Gold Inc. and Goldcorp Inc. among its largest investments.
Barrick Gold Corp. Chairman Peter Munk said last week he has been inundated with calls from wealthy investors seeking to buy gold to protect their capital.
“The window to raise money for gold stocks has blown open,” Sprott said. “The investing public has started to go to that one thing that they think it’s safe to invest in.”
While the bulk of the hedge fund industry suffered from drawdowns and redemptions last year, a handful of non-household funds actually generated the absolute returns that they are, by definition, after. But these under-the-radar managers say their relatively strong performances have still not won them an audience with all-important institutional investors.
Mark Ort, portfolio manager at Glazer Capital Management, says the firm gained 8.85% in 2008 on the strength of the singles and doubles that it hit in its tenth year of trading.
“Merger arbitrage is not so much about making money as it is about not losing money,” says Ort. “As long as you avoid a tremendous loss, you’re going to do okay.”
According to Ort, the fund hasn’t had any down years because it stays away from risky deals where it can’t handicap the regulatory risks or payout.
“There was a deal earlier in the year where Sirius Satellite radio merged with XM Satellite,” he said. “There was a lot of debate over whether or not that deal was going to be approved by the FCC. Ultimately, that deal closed and whoever was in it made money but we did not participate because the regulatory risk there was something we were not able to handicap.”
Ort says the firm has had a record number of marketing meetings over the past two months because investors are looking to upgrade their portfolio and is “pretty confident” with its track record that it is in a position to benefit from portfolio upgrading.
Oren Cohen, co-founder Brownstone Capital Management, also says his firm is garnering some attention from investors after returning 6.95% last year, but is still perplexed by the finicky insitutional crowd.
“Now that we’ve had a four-and-a-half year track record and we’re over $300 with a consistent approach, it’s hard for me to understand why this isn’t a fairly ideal stream of returns for pension funds,” says Cohen. “We think we should be a lot bigger.”
Greenwich, Conn.-based Highlander Partners USA, a global macro hedge fund, also has something to brag about after retuning 22% to its investors last year. The fund made its gains in the metals (precious and non-ferrous), energy, equities and currencies markets, according to James Fitzgibbon, chief investment officer.
“We caught the extraordinary rally in gold and enormous rallies in industrious metals, and we sold them out before they collapsed,” Fitzgibbon said. “We made gains in crude oil and energy being long the first half of the year and we got a sell signal and missed the entire wipeout.”
In the near term, Fitzgibbon says the fund is due for “a sell signal of a lifetime” in the long end of the curve in fixed income sometime this month or early in March and anticipates a big short-term equities rally going into the spring.
The firm is looking to ramp up its business development initiatives next month with the launch of a currency hedge fund in a managed account format for a pair of institutional investors. However, Fitzgibbon remains less-than-enthusiastic about the institutional market than his peers.
“We think that institutional investors have no idea what they want to do and they prove it all the time,” he said. “There are some very clever family offices and there are a handful of funds of funds that are also quite clever. But most of the big institutions don’t want to drill down until we’re above the $100 million mark and I think they’re really missing the boat on that.”