The Financial Crisis: Seven Lessons to Incorporate into Client Relationships

The global financial crisis of 2008–2009 exacted a hefty toll on all those who suffered through it: from devastating investment losses to a pervasive loss of trust. The Great Recession, as it is now known, forced many financial advisers to reevaluate long-held investment approaches and to reconsider ways in which they communicated with clients.

We’ve all heard the saying that those who fail to learn from history are doomed to repeat it. So what are some of the key lessons financial advisers can learn from the crisis?

G. Scott Clemons, CFA, chief investment strategist at Brown Brothers Harriman, spoke at the recent High Net Worth and Family Wealth Conference hosted by CFA Society Philadelphia and outlined seven take-aways in his keynote presentation, “Incorporating the Financial Lessons of 2008 into Client Relationships.”

1. Passive investing is not riskless investing.

Clemons declared there “is no such thing as passive investing” and urged advisers to rethink the dichotomy of active versus passive investing.

“An investor in a passive index fund over the past 13 years got roughly 0% return, but the price tag for that was a huge amount of volatility,” he said. “The overwhelming human temptation, even if you are using a passive vehicle, is to sell at the troughs when the pain gets too much to bear and then buy closer in to the peaks.”

Clemons’ point was that, at its root, a passive investment is a price-momentum strategy.

As he explained: “Think about what a passive investment is: Let’s take the S&P 500 index, it’s a capitalization weighted index — shares outstanding times the price of those shares. That determines how big the company is in the index, which determines how much of the company in the index one has to buy. So as the share price goes up, the capitalization goes up, the more the index fund has to buy, which means there is more pressure on the price, which means the capitalization goes up, so, see where I’m going with this? What in reality is happening with a passive investment is a price-momentum strategy. “

While this worked in the 1980s and 1990s, Clemons said, “the reminder of the last decade is that price momentum works on the downside as well.”

He again encouraged advisers to try and break away from the dichotomy of active versus passive. “Passive seems to imply safety, activity seems to imply risk,” he said. “We know that’s not true, but subconsciously when we talk to our clients that connotation of those words is still very much there.”

2. The conventional definition of risk is wrong.

“Risk is not volatility. Period,” Clemons told delegates. “I’ve been advising individual clients and families for over 20 years now, and I’ve never met a single individual or family who shared that definition of risk. The wittier of them would say, ‘I like the upside volatility, I liked the volatility from 2009 to date. I’ll take more of that please. I just don’t want the downside volatility.’”

For most investors, he explained, risk is a concept that he or she might do irreparable damage to their capital; that they may lose money and not be able to get it back.

Reflecting on his own conversations with clients, Clemons noted that what is actually taking place is an exercise in asset liability matching.

“So as an investor — as an individual, as a family — you have assets that can be measured financially. You also have liabilities. Some of those liabilities are discrete (mortgage payments, rental payments, tuition payments, healthcare payments). Some of those liabilities, however, are very vague. They are ambiguous, they are lifestyle. ‘I would like to retire to a certain place. I would like to travel in a certain way. I would like to collect art.’ Those aspirational liabilities are still there nonetheless. So you’ve got assets, you’ve got liabilities, and the whole investment exercise is matching those assets and liabilities.”

If you buy into this framework, he added, then risk is the idea that assets and liabilities don’t match. “We [at Brown Brothers Harriman] spend a lot of time with our clients talking about the liability side of the balance sheet, because unless I thoroughly understand the liability side of the balance sheet, how can I possibly put together an asset side of the balance sheet, asset allocation, that has an idea of successfully managing what that liability stream is down the road?”

3. Relative returns are close to meaningless.

Clemons noted the financial services industry has done a very good job training clients to believe that success and failure are defined by how well an investment portfolio (and hence the adviser) performs relative to a benchmark.

“I defy the belief that in a market that is down 50%, when you lose 40% of your client’s money, somehow that’s success,” he scoffed. “It doesn’t work if the ultimate objective is asset liability matching.”

Clemons went on to propose a bifurcated definition of success, one that acknowledges that investment advisers have to compare performance to something. “Ultimately the objective of investment wealth management is preservation and growth of your client’s wealth, and in that order,” he said. “Yes, still use the relevant benchmark, but keep in mind there is a very real absolute measure, an economic measure if you will, that relates back to the idea of asset liability matching.”

4. There is a difference between wealth and money.

The difference is purchasing power. In other words, inflation.

Clemons said that when he talks to clients or industry gatherings, he sometimes gets blank stares when he mentions inflation, given that it is around 2% (a number he disputes).

“If you think about your own bucket of consumption, it just doesn’t seem like a 2% number, it seems higher than that,” he said. “If what I am worried about is that there is inflation on the liability side of my balance sheet, the inflation rate I need to hedge is not CPI, it’s your idiosyncratic rate of inflation, which is probably higher in most cases.”

But what if the number is right, and 2% is right rate of inflation? Is this still something advisers and clients should worry about? The answer is yes.

“We’re all familiar with the miracle of compound interest,” Clemons explained. “Inflation is simply that dynamic shifted into reverse. It’s the evil twin. It is how a great fortune at even a modest inflation rate can diminish in purchasing power over time. Graphically, $1 million at a 2% inflation rate, if that were to remain the case over 25 years, you would lose close to 40% of the purchasing power. The higher the rate of inflation goes, the more damaging it is. So when we talk to our clients about matching assets and liabilities, and we look at the liability side of the balance sheet, and we talk about the inflation on that side of the balance sheet, inflation is front and center. And when we think about the kind of money that they may need down the road to support a future lifestyle, retirement, philanthropy, whatever it is, I try very hard, I don’t always succeed, to not even use the word money, but to use the word wealth because there is a difference between the two, and that difference is inflation.”

5. The role of cash as a call option is under appreciated.

There is a debate, Clemons noted, about whether or not cash plays a role in a portfolio. “Most asset allocation policies and most asset allocation approaches look at cash and say, ‘This is an asset in today’s market that has a rate of return that is pretty much zero, and when you take into account inflation, the return is actually negative so it really doesn’t play a role in a portfolio. Why would you hold cash in a portfolio?’”

He believes, however, that there is another role that cash plays. “I’ve begun thinking about it in terms of an optionality value, and cash is a call option on future downside volatility in, if you will, riskier asset classes,” Clemons said.

He thinks of cash as “dry powder on the sidelines” that can be deployed when needed but noted that this approach requires contrarian investment thinking, patience, and an ability to look long-term for an extended period.

6. Strategic versus tactical asset allocation is a false dichotomy.

Strategic allocation, Clemons said, is generally defined as “long term, patient, thoughtful, conservative, value based most of the time,” while tactical allocation “is more price-driven, more momentum-driven, more technical.” The issue is that those two approaches tend to be on opposite sides of the spectrum — and yet sometimes strategic decisions appear to be tactical decisions.

He related the firm’s experience during 2008–2010, when there were a lot of strategic changes, or what the firm thought of as strategic changes. Clemons said he started to hear from clients who wanted to know if something had changed, because they were not used to seeing this many changes in a portfolio. This prompted some introspection. “We said, ‘We’re not doing anything different, we are still very long-term, patient, value-based investors.’ But of course you know how to solve that paradox: being, long-term, patient, value-based investors in a period of heightened price volatility gives you more opportunities to act strategically. Just it looks tactical.”

Clemons noted that Brown Brothers Harriman is trying to break the dichotomy by using a different word: replacing strategic and tactical with “dynamic.”

“You may say that’s just semantics, and you’re probably right, but there is such a connotation, and in some cases even negative baggage to tactical asset allocation, of trying to dance between the rain drops. The strategy we employ is still very much a value-based strategy, but when the market gives us more frequent opportunities to employ that strategy we will dynamically do so.”

7. Modern portfolio theory requires a generalization.

Clemons believes the limitations of modern portfolio theory have been laid bare and offered a real-world analog by way of explanation: Albert Einstin, a grantee of theResearch Corporation for Science Advancement, which funds innovative scientific research. (Clemons is on the board.)

As Clemons told the story, “In 1905 Einstein developed a special, or specific, theory of relativity, it had severe constraints wrapped around it, and it didn’t really cause a ripple in the scientific community. He continued to work on it, and by 1916 published a general theory of relativity, and since that day we have seen the world through different eyes. And the difference was he generalized away the constraints. I think that what we have in modern portfolio theory is a specific theory, a theory that is severely constrained by some constraints that work on paper and work in theory but don’t necessarily work in the real world. It is a theory that begs to be generalized.”

Modern portfolio theory, he said, posits certain assumptions that the experience of the past decade have called into serious question. Namely, that:

• Risk is equivalent to volatility;
• Correlations between asset classes are static;
• A risk-free asset exists, is readily identifiable, and is agreed upon by investors;
• Markets are frictionless;
• Markets are efficient (to some degree);
• Investors act rationally; and
• The future will resemble or echo the past.

Clemons noted that while this final point is not necessarily part of the theory itself, he sees a lot of it in practice. And, if the financial crisis has taught us anything, it is that there needs to be a more thorough assessment of both theory and practice — and how the two intersect.

Reading Pessimism in the Market for Bonds

“Certificates of Confiscation.”

Three decades ago, that was what some people said bonds really were. The interest the bond paid would not be enough, they said, to offset the declining value of dollars as inflation added up. The “real” — after-inflation — bond yield would be negative.

That was just as the great bull market in bonds began. Bonds were great investments, and the bond bears turned out to have been dead wrong.

Now we have come full circle. The government is selling bonds that are absolutely, positively guaranteed to not pay enough to offset inflation over the coming years. It is even possible that someone who bought a new Treasury security that will be issued on Monday will end up getting fewer dollars back than he or she invested — interest and principal combined — between now and when the bond matures in 2017.

The securities are inflation-protected Treasury notes. If inflation ticks up significantly over the coming years, investors will get back more dollars than originally invested. But not enough to come close to keeping up with inflation. If there is no inflation, they will get back less than they invested.

When those securities were auctioned last week, buyers agreed to accept a real yield of negative 1.496 percent. It takes a lot of pessimism — about the economy and the future of the United States — to think an investment certain to lose money is an investment worth making.

The great bear market in bonds, both corporates and governments, lasted 35 years, from 1946 to 1981. The bull market lasted about 30 years. A new bear market almost certainly has begun.

If that is true, those seeking a little income now by going out the yield curve will come to rue the decision. They will get the promised interest, but as market interest rates rise, the price of those bonds will decline and decline and decline.

On Oct. 26, 1981, which can be dated as the bottom of the great bond bear market, the yield on 30-year Treasury bonds rose to 15.21 percent. On that date, a Treasury bond issued in 1970 and scheduled to mature in 2000 was quoted at less than 56 percent of face value. It had a coupon of 7.875 percent, but that was not deemed enough to compensate investors for the risk.

At market extremes, it is often worth analyzing what has to be true for a given investment to be a good, or bad, value. Back in 1981, you had to assume that inflation would not only remain in double digits for decades, but that it would also continue to rise, for a newly issued Treasury bond to turn out to be a bad investment. Yet many investors assumed it would be. After all, a lot of people on Wall Street in 1981 could not remember a time when bonds were good investments.

A few weeks before rates peaked, Seth Glickenhaus, an experienced bond trader and head of Glickenhaus & Company, an investment advisory firm, spoke the conventional wisdom when he said, “Anyone who buys a bond today to hold for more than five years is out of his mind.”

Michael Gavin, the head of United States asset allocation for Barclays, pointed out this month that over the past 30 years an investor who stayed invested in American, or British, 10-year government bonds would have earned more than 5 percent a year over inflation.

“It does not require advanced market math to understand that returns like these are no longer remotely plausible,” he wrote. “But they say that fish don’t know that they live in water — until they are removed from it — and we wonder if some of the many market participants whose entire professional experience has been conditioned by the financial backdrop created by the bond market rally might underestimate some consequences of its termination.”

Even if rates stay where they are for the next five years, and investors collect the interest coupons, he said, “bonds will be transformed from wealth creators into wealth destroyers.”

Or at least they will be unless there is severe deflation. For that is the only situation that will allow today’s new long-term bonds to turn into good investments.

Is that possible? To think it is likely, you pretty much have to assume that economic growth is a thing of the past in both the United States and Europe. It is not an optimistic outlook.

James Grant, the editor of Grant’s Interest Rate Observer — and a bear on bonds for some time — argues there are parallels between 1981 and now, at least in conventional wisdom. “Central banks are harmless, said the bond bears in 1981; in a social democracy, inflation is ineradicable,” he writes in the current issue of his publication. “Central bankers are harmless, charge the bond bulls of 2012; in an overleveraged economy, inflation is unachievable.”

One reason bond yields are so low now — at least in markets like Britain and the United States — is the fact that after the Greek fiasco investors have come to fear default more than currency depreciation. That had led to a rush to default-proof bonds, which means bonds issued by countries that can print the currency they borrowed. (It may be that Treasuries will not always be default-proof because a Tea Party-influenced Congress will refuse to allow the government to pay its bills. But so far markets assume the politicians will not be that stupid.)

It is interesting to look at the relationship of stocks and bonds when the bond market is near extremes in valuation. Those moments tend to come when economic uncertainty is high and fears are widespread. In the past, such fears have proved to be wrong.

In 1946, there was a consensus among many economists that a new depression was likely. After all, the 1930s depression did not end until armies put unemployed people to work. Now that the war was over and armies were shrinking, would not the economy retreat again?

Bond prices turned down — and yields up — in the spring of 1946. Stocks sold off that fall, and it was not until 1950 that the stock market got back to where it was when the bond bear market began.

Then stocks enjoyed a phenomenal period. One reason interest rates were rising was that economic growth presented good investment opportunities. The stock market was a very good place to put money throughout the 1950s and into the mid-1960s, occasional recessions and bear markets notwithstanding.

During the last 10 or 15 years of the bond bear market, however, the stock market gyrated but went nowhere. In 1981, as the bond bear market was ending, the Dow Jones industrial average was lower than it had been 15 years earlier. The economy was in recession and optimism was hard to find. There was a consensus that the United States had lost its competitive edge and could not compete with Japan. Share prices did not hit bottom until the summer of 1982.

But in 1982 the golden age of American stock and bond markets began. For nearly two decades, both were usually good places to invest, and the United States economy did well. But the technology stock bubble’s bursting in 2000 signaled an end to an era in the stock market. A share of Fidelity Magellan — one of the most successful mutual funds of the 1980s and 1990s — is now worth less than a share was worth 13 years ago.

As 2012 ends, pessimism is high. Some economists talk of a prolonged period without economic growth in the industrialized world, as the United States and Europe fail to compete with China and India. Investors find a bond guaranteed to lose value — but not to lose all value — to be worth buying.

It is no wonder that major corporations now are issuing long-term bonds even though they don’t appear to have any need for the money. As economic growth picks up in coming years, those companies will appear to have been prescient. The buyers, on the other hand, will seem to have been as foolish as were those who disdained bonds 30 years ago.

Gundlach’s High-Conviction Investment Idea

Count Jeffrey Gundlach among those who expect Japan’s currency to collapse because it can’t service its debt.  Japan’s challenges may parallel those that the US faces, and Gundlach feels strongly that they have created a compelling investment opportunity.
Speaking a day before Federal Reserve Chairman Bernanke announced that the Fed would step up its quantitative easing policies, Gundlach warned investors that such efforts would have diminishing returns.  Near-zero interest rates and an expansion of the Fed’s balance sheet won’t boost asset returns, he said, and they don’t address the fiscal imbalances our country faces.
“We’re in this predicament owing to a simple fact,” Gundlach said. “The United States has been spending more than 50% more than it’s been taking in in taxes. “ Addressing the budget deficit will be costly, he added, and an “instant recession” will ensue if deficits are reined in too quickly.
In Japan’s case, meanwhile, Gundlach said quantitative easing will have far more insidious effects – most notably, debasement of the yen – and that creates opportunities for investors.
Gundlach, the founder and chief investment officer of Los Angeles-based Doubleline Capital, spoke to investors in a conference call on December 11. The slides from his presentation are available here.
I’ll discuss Gundlach’s high-conviction investment idea in more detail, but first let’s review his assessment of the economic landscape – including the fiscal cliff – and his outlook for Japan, which may prove to foreshadow the fate of the US economy.
A challenged US economy
“Clearly, people don’t want to see the economy contract very substantially next year,” Gundlach said.  “But, as I’ve said for several years now, addressing the budget deficit equals economic weakness and headwinds, and perhaps if it’s addressed aggressively, that’s just instant recession.”
Gundlach was very skeptical that progress would be made to avert the fiscal cliff, much less toward addressing the larger deficit issues.   The fiscal cliff negotiations have been unable to bridge gaps as small as $70 to $80 billion annually in tax increases, he said, which does not bode well for addressing the $1.3 trillion deficit.
“Ultimately, you must balance the budget,” he said.  “To do that, you have so much more work to do than this tiny little issue about 2% of the population.”
Lack of progress on the fiscal cliff has impeded growth, according to Gundlach, by delaying businesses’ decisions about spending.  Confidence among corporate leaders has “plummeted,” he said, since reaching a fairly high level in the first part of 2011, and the data show that purchases of equipment, software and other goods have been very slow lately.
Higher taxes are likely, according to Gundlach.  He warned that other states may follow the example set by California in the recent election; it raised taxes by 30%, retroactively, on its wealthiest citizens.  He also said that more granular tax brackets were probable, such as additional brackets at $500,000 or $1,000,000.

“It’s possible that taxes on the very wealthy in America could go very, very substantially higher, because there really is no resistance to raising taxes on the wealthy,” he said.
At the other extreme, Gundlach said that most of the jobs gained in the current recovery have been  low-wage.  As a consequence, he said, median household income has fallen in real terms since 2000, and in nominal terms it is below its 2008 peak. 
Labor-force participation has spiked for workers over age 75, who have seen their wealth depleted and can no longer live off their savings, Gundlach said.  Their incomes have grown slightly, but the economic hardship is worse for the younger generation.  Unemployment among teenagers has increased sharply, making it extremely difficult for them to get jobs, he said.
The message from Japan
The two-decade miasma of slow growth and fiscal imbalances that Japan has endured are a cautionary backdrop for US policymakers as they grapple with these challenges.  Gundlach had not discussed Japan in previous conference calls, but this time he drew a number of parallels between its situation and the US’s.
Gundlach’s analysis of Japan closely resembled that articulated by the hedge-fund manager Kyle Bass in a talk a month ago at a University of Virginia conference.
With debt more than double its GDP, Japan is far more indebted than the US and still headed in the wrong direction.  According to Gundlach, Japan’s debt has increased by half its GDP in just the last four years.
“Government spending, of course, is what’s responsible,” he said, and presented the data below showing the persistent rise of quarterly spending:

Japan’s rising imports – exacerbated most recently by demand for new, foreign energy sources since the 2011 tsunami and nuclear disaster – have created a trade deficit, Gundlach said.  Its aging population is further depressing Japan’s current account, he added, forcing it to engage in increasingly aggressive monetary policies.
“Japan should be watched for moving into an inflationary exercise,” he said.  Japan is out of policy tools, according to Gundlach, and will “embark first on an exercise in debasement in an attempt to create inflation.”
Japan may still have room to lower its interest rates, since, unlike in the US, real rates remain positive in Japan. 
The potential for lower interest rates carries a message for those who expect high-dividend stocks to outperform bonds.  Gundlach noted that, at the end of 2009, Japanese stocks had higher yields than Japanese government bonds.  Yet, those bonds have outperformed stocks since then.  Gundlach did not predict the same outcome for US investors, but he said there’s “no guarantee that just because a certain stock portfolio might have a higher dividend it would outperform even a government bond portfolio.”

A high-conviction investment idea
One of Gundlach’s “most high-conviction investment ideas” stems from his assessment of Japan’s economy.  The likelihood that Japan will ease monetary policy means that investors should short the yen versus the dollar – or even the euro – he said.
Those investors should also go long the Japanese stock market, which is something that Gundlach has not previously recommended.  Debasement, he reasoned, would spur exports and benefit Japanese industries.
“I wouldn’t be surprised if the Nikkei, which has risen about 10% or so from its low just a month ago, found its way higher by a couple or even three thousand points during the year 2013,” he said.
Gundlach also noted other investment opportunities, for which his degree of conviction was somewhat lower.
The Shanghai is cheap, he said, particularly relative to the S&P.  It would serve as a good hedge against the possibility of a “disaster” in the global economy, or it would do well if inflationary policies lead to broad market rallies.
Investors should be careful with emerging markets until food prices stop rising, Gundlach said, because in those economies food is an exceptionally large part of the average household’s budget.
Gold has generally fared well during this era of global quantitative easing, Gundlach said, a relationship that he considers “fairly convincing and fairly logical.”  “If you’re thinking of QE forever and QE on a coordinated basis coming more and more,” he said, you should favor gold over stocks.
In the US, Gundlach said, Fed purchases of mortgages have made prices in the non-agency market “incredibly unattractive,” and he is looking at “certain other sectors that are less affected by the negatives” of the Fed’s program.
Gundlach said he has been negative on mortgage REITs for the last several months, since it became evident that Fed activity would lead to increased prepayments on the underlying securities.  He expects dividends to be cut on REITs, which would cause prices to decrease.
Interest rates have bottomed in the US, Gundlach said, reiterating comments from his previous conference call.  The bottom for the 10-year Treasury note was 1.39% on July 24. Volatility in the fixed-income markets was low in 2012, but he expects it to pick up next year.
Nor will interest rates in the US move sharply higher.  Gundlach said the Fed could keep interest rates low for an indefinite period of time, through open-market purchases of bonds.  He said the Fed would continue to expand its balance sheet in 2013.
Gundlach said he expects the return on Doubleline’s Total Return Fund (DBLTX) for 2012 to end up slightly more than the 8% to 9% he forecast at the beginning of this year.  For next year, he said he hopes the fund will return 6%.

Greek bond bet pays off for hedge fund (Third Pt)

©EPA

One of the world’s most prominent hedge funds is sitting on a $500m profit after making a bet that Greece would not be forced to leave the eurozone, bucking the trend in a difficult year for the industry.

Third Point, headed by the billionaire US investor Dan Loeb, tendered the majority of a $1bn position in Greek government bonds, built up only months earlier, as part of a landmark debt buyback deal by Athens on Monday, according to people familiar with the firm.

The windfall marks out the New York-based firm as one of the few hedge fund managers to have profited from the eurozone crisis. Standard & Poor’s, the rating agency, raised its assessment of Greece’s sovereign debt by several notches on Tuesday, citing the eurozone’s “strong determination” to keep the country inside the common currency area.

Mr Loeb is one of only a handful of hedge fund titans to have made big returns this year. The $2tn hedge fund industry – made famous by investors such as George Soros, who bet against the British pound and “broke the Bank of England” on Black Wednesday in 1992 – has struggled to find its confidence after two years of lacklustre returns.

John Paulson, the hedge fund manager who correctly called the US housing crash, has been among those wrongfooted. Mr Paulson has seen his bets on a US economic recovery and a deterioration in the health of Germany’s bonds both unravel. Since 2010 his flagship fund has lost more than 60 per cent of its value.

Audacious bets in Greek bonds, which have made a handful of managers huge amounts this year, have been a rare exception to the industry’s record. Third Point is the largest hedge fund holder of Greek bonds, according to traders.

The Greek government swapped holdings of its own debt for notes issued by one of the eurozone’s rescue facilities at a value of 34 cents on the euro. Third Point had scooped up holdings of Greek debt earlier this year for just 17 cents on the euro.

The firm has also retained a sizeable position in Greek debt because Mr Loeb believes there could still be a long way for the bonds to rally further next year. Analysts at the firm believe the bonds could rally by a further 40 per cent.

A spokesperson for Third Point, which manages assets of $10bn, declined to comment on the trade.

Third Point has made its investors a 20 per cent return so far this year, compared with 4.9 per cent for the average hedge fund.

Mr Loeb, who has earned a fearsome reputation in the investment world for penning acerbic, but acutely observed public letters to those he disagrees with – from recalcitrant corporate board members to President Barack Obama – is one of the US’s most successful hedge fund managers.

Mr Loeb, who turned 51 on Tuesday, has recently moved the focus of his firm away from shareholder activism towards making bets across a range of asset classes. The fund has been particularly active in Europe in recent years.

Third Point began buying up Greek bonds after profiting from a rally in Portuguese debt at the beginning of the year. Analysts from the fund have kept close tabs on Greek politicians and advisers and have been in ongoing discussions with the Greek government.

Jeff Gundlach: Investors Should Hold Cash

On how to trade this environment:

"I think that investors should be looking for lower prices on most risk assets in these developed countries with the exception of Japan... investors should be looking for the potential inflationary consequences of all this money printing exercise and the place to look for that is Japan."


On whether investors should get more disciplined and look at fundamentals:

"The fundamentals are always important but it does get trumped by policy decisions when policy decisions are so radical as has been the case in recent years…There seems to be diminishing returns on the various rounds of quantitative easing. It's almost like a half-life of a radioactive particle. The first quantitative easing brought 50%, the second brought a little more than half of that, the third half again, the fourth less than half again. It just seems that the idea of a Pavlovian reaction when you see quantitative easing that you should go out and buy risk assets--it has worked four times, but it doesn't seem like you are getting much bang for your buck any more…I would point out that gold, for example, hasn't done much of anything in the last couple of rounds of quantitative easing. It seems that the fundamentals are starting to exert themselves more powerfully against the backdrop of endless quantitative easing, so it's possible that the market support is close to finding its limit. This is why I think that investors should be holding cash and buying risk assets at lower prices once the fundamentals assert themselves."


On where to put money now:

"You've got to survive with virtually no return if that's the way you look at things. I actually recommend that for many investors. I think the small amount of money that you might make by trying to push it here as we get closer and closer to the end game where this thing might tail out--the amount of money you might make will be dwarfed by the amount of money you might lose when things reprice lower. Put it another way, if you just stay in cash and earn a small return or stay in a low risk investment and earn a middling single digit return--the money you might be able to make as we move into late 2013 or early 2014 with repricing, the amount of money you might make if you are able to deploy the money at that point will make all the difference. People always want investments to go up like a line…That's just not reality. You make 80% of your money in 20% of the time in investing and you have to be patient…I see some values in some of these foreign markets. I don't see a lot of value in the U.S. stock market and I think you have to play it safe in the U.S. bond market with funds that are really dedicated to having low volatility." 

Read more: http://www.marketfolly.com/2012/12/jeff-gundlach-investors-should-hold-cash.html#ixzz2FhIVM1Io

Fed’s $4 Trillion Rescue Helps Hedge Fund as Savers Hurt

Deepak Narula’s mortgage-bond fund is up 39 percent this year. George Sanchez’s monthly annuity payout is down 41 percent.

The near-zero interest rate the Federal Reserve charges financial firms, as well as securities purchases that will balloon the central bank’sbalance sheet to almost $4 trillion next year, have made it easier for Narula’s $1.6 billion fund to thrive and more difficult for Sanchez, a former college library director, to enjoy retirement.

Chairman Ben S. Bernanke’s efforts to energize the U.S. economy since 2008 have been credited with rousing the housing market from a six-year funk, lowering the jobless rate and putting more money in the pockets of both mortgage lenders and borrowers. At the same time, Fed policy has been blamed for starving money-savers of income and boosting certain asset prices, widening the gap between the rich and the rest of the country, said Joseph E. Stiglitz, the Nobel Prize-winning Columbia University economist.

“Monetary policy has been indirectly, surreptitiously helping the top and hurting the bottom,” Stiglitz said.

Fed officials declined to comment for this story on whether their policies exacerbated inequality, said Barbara Hagenbaugh, a spokeswoman for the U.S. central bank. Bernanke said last year that the Fed aims “strictly to do what’s in the interest of the broad public.”

He said last week that the policies are intended to “try and create a stronger economy, more jobs, so that folks across the country, including places like the one where I grew up, will have more opportunity to have better lives for themselves.” Bernanke was raised in Dillon, South Carolina, population 6,745.

Divergent Paths

Since the end of the 18-month recession in June 2009, people like Narula and Sanchez have followed divergent economic paths. Earnings rose 5.5 percent last year for the 1.2 million households whose incomes put them in the top 1 percent of the U.S., according to estimates from the U.S. Census Bureau. At the same time, income fell 1.7 percent for the 97 million households in the bottom 80 percent -- those making less than $101,583.

After two rounds of asset purchases totaling $2.3 trillion through June 2011, the central bank began so-called QE3 in September. QE stands for “quantitative easing,” in which the Fed buys securities to channel cash into the financial system.

The goal is to stimulate spending and boost lending, which is meant to generate more jobs. Bernanke said last week the central bank will purchase $85 billion of assets a month next year “to increase the near-term momentum of the economy.” That would bring its balance sheet to almost $4 trillion, up from $924 billion on Sept. 10, 2008, the week before the collapse of investment bank Lehman Brothers Holdings Inc. deepened the recession.

Commodity Speculation

The Fed’s mortgage-securities purchases have bolstered demand, and the possibility of profit, for fund managers such as Narula. Hedge funds that handle mortgage securities have a 20 percent gain on average this year, according to data compiled by Bloomberg. The fund run by Narula, founder of New York-based Metacapital Management LP, is beating that at 39 percent through Dec. 14, according to an e-mail obtained by Bloomberg News. Narula declined to comment.

With money gained from Fed securities purchases, investors speculated on the future prices of commodities, helping to drive up food and energy prices for consumers, said John Gnuschke, director of the Sparks Bureau of Business & Economic Research at the University of Memphis in Tennessee.

After rising and falling independently for decades, prices for stocks and commodities rose “in lockstep” from 2008 through 2011, when the central bank conducted its first series of securities purchases, said Ruchir Sharma, head of emerging market equities and global macro at Morgan Stanley Investment Management in New York.

Higher Prices

Twenty-two of the 24 commodities in the S&P GSCI Commodity Spot Index have gained since the recession ended in June 2009, with only natural gas and cocoa lagging. Corn more than doubled in price even before this year’s drought sent values soaring. Heating oil is up 77 percent and wheat 58 percent. That means higher energy and food prices for consumers like Arlene McGuirk.

“Prices are ridiculous,” said McGuirk, a 65-year-old in Sterling, Massachusetts, who, like Sanchez, supplements a fixed income with a diminished annuity. “People who say there’s no inflation never go grocery shopping.”

Inflation has been lower in the 41 months since the recession ended than it was before. The Consumer Price Index climbed 7.6 percent since June 2009, the federal Bureau of Labor Statistics said. That compares with an 11.8 percent rise in the 41 months before the downturn.

‘Excess Money’

Commodity prices are trading above their value according to supply and demand, Sharma said. “The increase is because of excess money,” he said.

Not everyone agrees. Growing demand in emerging countries, including China, helps explain commodity price increases, said Chris Rupkey, chief financial economist for Bank of Tokyo- Mitsubishi UFJ Ltd. in New York.

Still, Sharma said the situation reflects the limits of the Fed’s main tool for influencing the economy -- controlling the amount of money in the financial system.

“You can print all the money you want but you can’t control where it will end up,” he said. “It ends up in the commodities sector and benefitting the wrong people.”

While higher commodities prices can also fuel economic growth, that effect is undercut by the fact that the U.S. is a net importer of commodities, Stiglitz said.

Sheik’s Share

“It’s redistribution from consumers to owners of these resources, from a car owner to a sheik,” he said. The negative consequences fall hardest on low-income people, who spend a higher percentage of their income on food and fuel than better- off people, Sharma said.

Gasoline prices are 23 percent higher than they were in June 2009, according to the American Automobile Association.

In the view of Bank of Tokyo-Mitsubishi’s Rupkey, the bigger Fed-related issue is the comparatively paltry return savers get -- a result of the Fed’s decision to hold near zero the interest rate it charges banks. This week marks the fourth anniversary of ZIRP, the zero interest rate policy, which hurts Sanchez and others who have their savings in interest-bearing accounts to keep the principal safe, Rupkey said.

Sanchez, a 65-year-old former director of library services at LIM College in New York, teaches part-time at the Fashion Institute of Technology to make ends meet.

Unaffordable Retirement

“I couldn’t afford to retire full-time,” said Sanchez, who lives in Manhattan. “I have some money in fixed income and it doesn’t make much money. And I have some money in cash and that doesn’t make any money at all.”

Sanchez said that when he first started an annuity in 2005, his interest rate was 5.25 percent. Now it’s 2 percent, he said. That means that instead of getting a monthly payout of $700, he gets $413.

“The downside of the current monetary policy is that it is corrupting financial decision-making and requiring folks to take a little more risk than perhaps is proper,” said Roy M. Whitehead, chief executive officer of Washington Federal Inc., a Seattle thrift. “We’re penalizing those who behaved well during the time leading up to the financial crisis. It doesn’t seem fair.”

With the Fed’s lending rate at 0.25 percent, JPMorgan Chase & Co. (JPM), which leads U.S. banks with $1.14 trillion in deposits, offers to pay0.01 percent annual yield on savings accounts of less than $10,000.

Withdrawal Fee

Charlotte, North Carolina-based Bank of America, the second-biggest in deposits with $1.06 trillion, offers the same rate on the same deposit amount. Three withdrawals a month are free, according to the bank’s website. After that, the bank charges $3 per withdrawal.

Anne Pace, a Bank of America spokeswoman, declined to comment. Jennifer Zuccarelli, a spokeswoman for New York-based JPMorgan Chase, did not respond to requests for comment.

Bernanke said this month that the zero-rate policy will continue into 2015.

“The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time,” the Fed chairman said in an October speech to the Economic Club of Indiana. “If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again.”

Four-Year Low

The U.S. jobless rate fell to 7.7 percent last month, the lowest in four years, according to the Bureau of Labor Statistics. The rate hasn’t dipped below 7 percent since November 2008. The central bank said on Dec. 12 for the first time that rates will stay low “at least as long” as the jobless rate remains above 6.5 percent and Fed economists project inflation of no more than 2.5 percent one or two years in the future.

“The losers in monetary policy are the savers,” Rupkey said. “Their rates are at zero for four years with the promise of two-and-a-half more years of zero rates. There’s little hope for the savers out there.”

Mortgage borrowers, on the other hand, have never had it better. Bob Miller, who bought a 2,100-square-foot condo in Greenwich, Connecticut, in September for $680,000, got a 3.5 percent rate on his mortgage. After a 20 percent down payment and not counting taxes and maintenance fees, his monthly bill would be $2,443. At the 18.25 percent rate he paid for his first house 30 years ago, payments would have been $8,309.

Super Bowl

The difference helped Miller, 57, and his wife, now empty- nesters, pay for re-carpeting and painting their new place, which overlooks a pond where they plan to take their 3-year-old granddaughter to feed the ducks. Miller is also in the market for a big-screen, high-definition television.

“I’m going to watch my New York Giants repeat as Super Bowl champions and then I’ll watch the Yankees in the summer,” said Miller, who leases commercial space for a living.

The Fed’s rate pushed 30-year mortgage-borrowing costs to 3.31 percent last month, the lowest in history, according to Freddie Mac, the government mortgage buyer. At the same time, U.S. home prices have risen 7 percent so far this year after losing 35 percent from their July 2006 peak, according to the S&P Case-Shiller Home Price Index.

Low rates have sparked a boom of home-loan refinancings. The Mortgage Bankers Association expects $1.7 trillion of mortgages to be written this year, the most since 2009. About 71 percent will be refinancings, the group says, up from 46 percent in 2008.

Seven-Year Wait

Not everyone can take advantage. Damian Bertain is one of the 4 million Americans who went through foreclosure in the last 3½ years, according to RealtyTrac Inc. Bertain, a broadband technician who works out of Suddenlink Communications’s Eureka, California, office, quit paying his mortgage, lost his home and filed for bankruptcy after a divorce from his wife of 12 years that was finalized earlier this year. He was forced, at the age of 39, with joint custody of three children, to live with his parents.

Borrowers must wait as much as four years following a bankruptcy to qualify for a Fannie Mae-guaranteed mortgage, according to the U.S. agency’s guidelines. A seven-year wait is required after a foreclosure, or three years with documented extenuating circumstances, such as a job loss.

The house in Fortuna, California, that Bertain bought for $522,000 in 2006 was sold out of foreclosure last year by Bank of America for $244,000, he said.

Starting Over

“I have to start over and rebuild my credit and that’s definitely frustrating,” said Bertain.

Borrowers whose credit was wrecked during the housing bust are going to have difficulty despite the Fed’s efforts, Eric S. Rosengren, president of the Federal Reserve Bank of Boston, said in a Dec. 3 presentation in New York.

“Does it work perfectly? No,” he said of keeping interest rates at rock bottom. “Does it work better than not doing it? Definitely. You have to weigh the costs and the benefits. I think so far the benefits have outweighed the costs.”

Not all the benefits go to the borrower. Mortgage lenders are able to profit from the sale of their home loans to the Fed, said Rael Gorelick, co-founder and principal of Charlotte, North Carolina-based Gorelick Brothers Capital LLC, which invests in mortgage funds. The central bank buys mortgage-backed securities at a 2.5 percent yield, meaning the banks make the difference between that and the prevailing home-loan interest rate, he said. That’s about 1 percentage point on every loan that ends up on the Fed balance sheet.

Making Money

“The mortgage banking people are making a ton of money, they just don’t want anybody to know about it,” said Paul J. Miller Jr., a bank analyst at FBR Capital Markets Corp. in Arlington, Virginia. Critics could cast the Fed’s asset purchases as another back-door bailout of the big banks, Miller said, though bank profits will decline once the Fed-fueled refinancing boom is over.

The largest residential lenders are San Francisco-based Wells Fargo & Co. (WFC), with about one-third of the market, and JPMorgan Chase.

Wells Fargo said 72 percent of the mortgage applications it received in the third quarter were for refinancings, up from 39 percent in the same period in 2008, the last before QE began. The bank said it received $188 billion in applications, more than double the $83 billion in the three months ending September 2008. Spokesman Ancel Martinez declined to comment.

‘Getting Crushed’

The boon for the banks rankles David A. Stockman, a former Michigan congressman and director of the U.S. Office of Management and Budget under President Ronald Reagan.

“The Federal Reserve is in the tank for Wall Street,” said Stockman, who headed auto-parts maker Collins & Aikman Corp. “That’s why the 1 percent are thriving on financial speculation while savers, workers and retirees are getting crushed by zero interest rates and inflationary food and energy costs. It’s damn unfair, and it doesn’t work either.”

Bernanke said last week that it’s important to remember the real people with real troubles behind the economic statistics tracked by the central bank.

“It’s very important to try to keep in mind the reality of unemployment, of foreclosure, of weak wage growth, etc.,” Bernanke said. “So we always try to do that.”

10 comforting charts

There are plenty of things to worry about these days. The fiscal cliff negotiations and the likelihood of higher taxes on capital and small businesses; the Federal Reserve's massively expansive monetary policy; the recession in the Eurozone; the lingering threat of sovereign defaults; the political deterioration in the Middle East; the prospect of trillion-dollar federal deficits for as far as the eye can see; the gigantic unfunded liabilities of U.S. entitlement programs; the recent decline in industrial production in most developed economies; the slowdown in Chinese growth; the rising regulatory burdens; the onset of ObamaCare; the very weak U.S. dollar; the relatively tepid growth of the U.S. economy; and the huge gap between current and potential growth. 

But all is not lost, and the end of the world is not imminent. Here's a collection of 10 charts that tell a story of an economy that continues to improve on the margin. They don't point to any big growth revival, but neither do they point to an imminent recession. At the very least they are comforting.

Housing starts are up 60% from early last year, and up 22% in the past 12 months. 

Building permits typically lead starts, and they are up 27% in the past year. The future of residential construction looks very bright.

Architecture billings typically lead construction spending by 9-12 months. A majority of the firms surveyed for this index in November reported increased billings activity. The future of nonresidential construction looks better than at any time in the past 5 years.

Industrial metals prices are good indicators of global economic activity. Although they are down from recent highs, they are still orders of magnitude higher than they were 10 years ago, and they are up 113% from their Great Recession lows. At the very least, these prices tells us that global economic activity remains relatively strong.

We all know that the Eurozone is in a recession and that growth prospects are miserable. Yet Eurozone equity prices are up 26% from last year's low. This is not necessarily a sign of strength, but it does suggest at the very least that the situation in Europe is not as bad as many had feared. After all, prices today are about the same as they were in late 1997, 15 years ago! U.S. equity prices have fared better, but still, they have made zero progress in the past 12 years, despite the fact that after-tax corporate profits have more than doubled since then. My take is that equity prices are moving higher because things are not as bad as they market had feared; markets have been priced to a recession, but instead we continue to see that growth is positive albeit disappointingly weak.

Credit Default Swap spreads show no signs of any fundamental deterioration in the economy. Indeed, they are about as low as they have been since the recovery started. They are still elevated by historical standards, but on the margin they are telling us that conditions are improving.

The implied volatility of equity options—the Vix Index—is still somewhat elevated relative to what we would expect to see in "normal" times, but it is far below the levels registered at times of crisis. At the very least, this is telling us that the "fiscal cliff" negotiations are not a do-or-die event for the U.S. economy. Not good, but not bad either.

Swap spreads are very important indicators of financial market health and systemic risk, and have proven to be good leading indicators of economic strength. The very low level of swap spreads today is a reflection of very healthy liquidity conditions and very low systemic risk. It would therefore be very surprising for the economy to dip into a recession.

Inflation is neither too low nor too high. This chart shows the quarterly annualized change in the GDP deflator, the broadest measure of inflation in the U.S. economy. Year over year inflation is running a bit less than 2%, regardless of the measure you wish to use.

The pace of jobs growth is very disappointing, to be sure, but employment around the world, as well as in the U.S., continues to expand. Slow growth is much better than contraction.