Bogle's Outlook for the Market

Bud Fox: So, let's start with your outlook for the market. Let's start with equities, and talk about what your expectations are and how you arrive at them?

Bogle: Well, I've been using this kind of system, if you will, ever since the early 1990s, when I forecasted returns for the 1990s, and it's very simple, and it is extremely helpful, because I divide market returns into two categories--investment return and speculative return.
Investment return is a dividend yield on the day you buy into the market, and to that is added earnings growth that follows. So, today, the dividend yield is around 2%, and I think we can look forward to 5% in earnings growth--nothing is guaranteed, but basically there is nominal growth, and the country is going to be growing like that rate, I think, nominally. And so that would be a 7% investment return or fundamental return.
Bud Fox: Bonds: I am guessing you are less sanguine, about the bond market.
Bogle: Wait a minute to talk about bonds, to finish the stocks, because stock returns are also affected by speculative return, and speculative return is the amount of dollars, the number of dollars, people will pay for a dollar of earnings. So, for example, in 1980, they paid $10 for a dollar of earnings, a price/earnings multiple so-called. In 1990, it doubled to $20. It had added 7% to the return in the 1980s, and then that 20 times earnings in 1990 went to 40 times essentially in 1999, and added, doubling again, another 7%.
So you know the investment return is going to be fairly stable. You know the initial dividend yield, exactly what it is, and so the question is, will P/Es go up or down by the end of the decade, I don't do this for shorter periods … there just isn't many merit in shorter periods.
The fact of the matter is, at 40 times earnings the market is unsustainable. Could we double again? We'd have to repeat those 7% annual returns additions, and it would have to go to 80 times, and the market can do anything …, but 80 times is pushing your luck.
Bud Fox: So at current valuation levels...
Bogle: My basic guess, and it's hard, very hard to guess--first, we don't even know what the current P/E is. There are so many different ways of looking at it: 10-year average, 5-year average, last year's earnings, next year's earnings. A big one is operating earnings versus reported earnings. Operating earnings are before all those charges that companies have; reported earnings after them, and I prefer reported. But something like 16 is probably the P/E that we're at today, rationally looked at.
And I would expect that's not going to go up a lot or down a lot in the next 10 years. So I'm just going to call out arbitrarily, zero. So 7% would be my outlook for stocks.
Bonds is a similar system, except there is no speculative return over 10 years, because a 10-year bond matures in 10 years; you get back the par value. There is no growth in earnings or in appreciation in the value of the bond, so you rest entirely on the interest coupon.
So, today, if you look at a 10-year Treasury bond, for example, at 1.6%--a hypothetic 1.6%--that's going to be your return in the next 10 years. Now, I don't think many people are going to be satisfied with that, and you can increase that return by taking a little more risk--investment-grade corporates, longer maturities, this is kind of a short-intermediate maturity, today, for 10 years, and you can go out to the 12- to 15-year range without getting into real volatility of a 25- to 30-year bond.
So, if you could get a 2.5% return or 3% return on bonds today, that would be the return for the next 10 years. Today's yield is the 10-year return, and the correlation between those two numbers is an incredible 91%, but of course, it has to be. It comports with your ideas of logic.
Bud Fox: How about your inflation expectations? What sort of inflation should investors be baking into their assumptions?
Bogle: I'm using 2.5%. I don't know, and the reason I'm a little bit different from Bill Gross in a lot of ways, but in this way, he gives you real returns, and it's always unclear with him where the return is coming from. I give you the nominal return, and then I basically say, you take your choice on the inflation rate and that will give you a real return. But I think you should be using something like 2.5%, and that would take that nominal return of 7% down to 4.5%, and the nominal return on bonds down to almost zero. So, you'd have about a 2% nominal return on the balanced portfolio, real
.

Hedge Funds Correlation with S&P 500 Extremely High: BAML

The performance of hedge funds remained strongly coordinated with the S&P 500 (INDEX.INX), despite its under-performance, according to Mary Ann Bartels, analyst at Bank of America Corp (NYSE:BAC) Merrill Lynch.

The one-year correlation of hedge funds with S&P 500 (INDEX.INX) is still high, at 82 percent in September 2012, compared with the historical average of 30 percent. Last year, the one-year correlation of hedge funds with the S&P 500 reached as high as 98 percent.

Bartels said, “The drop in correlation comes with a staggering underperformance relative to the S&P 500. The question remains: are there too many hedge funds chasing too few returns?”

Based on the latest BofAML Hedge Fund Monitor, in September hedge funds increased by 51 percent, while the S&P 500 climbed by 2.42 percent in September. Long/short equity funds posted the best performance last month, with a 0.96 percent growth. Event driven funds rose by 0.85 percent, while short biased funds declined by 1.34 percent.

According to Bartels, the figure showed that market neutral funds bought market exposure to 4 percent net long, from 1 percent net short. The market exposure of equity long/short funds surged from 19 percent to 22 percent net long.

Macros sold the S&P 500 (INDEX.INX), commodities, and emerging market exposures, and bought the NASDAQ 100, EAFE exposures, and 10-year Treasuries, while partially covering their US dollar shorts.

Based on data from the Commodity Futures Trading Commission, large equities speculators purchased S&P 500, but sold Russell 2000 and NASDAQ 100 futures. Speculators in agriculture sold corn, wheat, and soybeans; metals speculators purchased gold, silver, platinum, and remained flat on palladium; while energy speculators bought heating oil, but remained flat on crude, natural gas, and gasoline.

Interest rate speculators sold 2-year and 10-year Treasuries, but bought 30-year Treasuries. Meanwhile, Forex speculators added the U.S. dollar and euro in their shorts, and sold the Japanese yen.

In a related report, a study from Infovest 21 found the average allocation of 26 public pension funds that allocated approximately $1 billion to hedge funds was 7.4 percent of their total assets in FY2012.

The figure showed that pension funds allocations in their total assets increased from 6.5 percent during the past four years since 2009, while their allocations declined from 46.9 percent to 41.3 percent. The pension funds’ allocation to fixed incomealso decreased from 25.9 percent in FY 2009 to 21.8 percent in FY2012.

In a previous report, New Jersey State Senator Shirley Turner introduced a bill, prohibiting state pension and annuity funds from investing in any hedge fund or derivatives contracts. Pension funds are “woefully, severely underfunded because we haven’t made regular deposits for 15 years,” according to the Sen. Turner.

She emphasized that it is wrong for pension funds to “to make up for those skipped payments by gambling on an aggressive, high-risk investment strategy.”

Sen. Turner added, “It is high-risk, high-reward, but so far the hedge funds the state has invested in have not returned the 8.2% that they had anticipated—this past year they’ve only returned 2.9%.”

Furthermore, she pointed out that pension funds cannot gamble with retirees’ money, and their investments in hedge funds should stop because it is dangerous
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Junk bonds, bubbles and Goldilocks

BofA Merrill Lynch's Michael Hartnett put together this chart of what he calls "bubble-like" inflows to high yield ("junk") bond funds in 2012:

It's obviously been a remarkable year for high yield bond demand, boosted by extremely low U.S. Treasury rates (and the Fed's promise to keep things that way) along with global macro concerns that leave investors skeptical of equities.

If you look at returns on high yield bonds as a class, they are good, but not that stellar year to date - here's HYG, the most popular junk bond ETF, in 2012:

HYG data by YCharts

In the longer view of HYG, you see the discrepancy from Hartnett's inflows chart - 2009 saw a huge jump in value despite much lower inflows to the sector:

HYG data by YCharts

Why hasn't 2012 seen a similar, or even greater rise in HYG value? One factor, as Ben Levisohn points out, could be that the ETF was overpriced at the beginning of the year. But there's also been plenty of supply to sop up investors' demand. The FT reports

a nearly fourfold rise in “junk” bond issuance from the same [Q3] quarter last year to $109bn, as companies normally forced to pay closer to 9 per cent over the past decade tried to lock in substantially cheaper rates. “With risk-free rates around the world so close to zero, investors have been willing to take on a lot more credit risk to get a higher yield,” says Mathew Cestar, head of leveraged finance in Europe at Credit Suisse. “Corporates have been rushing to borrow.”

So what could go wrong here? As always with bonds, there are two main risks: default risk (the corporations you loan to don't pay you back) and interest rate risk (rates rise everywhere, making your junk bond yield less attractive). Here's IndexUniverse's Spencer Bogart on the former:

If macroeconomic conditions play out in a doomsday scenario, defaults in the junk bond market could spike dramatically and cause investors to demand higher yield in a heightened risk-off environment. Another important note on default risk is that issuers of low-rated debt may overextend themselves in good times. Consequently, they face a higher risk of default when the economic environment turns negative.

And on interest rate risk:

if the Federal Reserve reneges on its commitment to suppress long-term rates, investors who were previously deterred by negative real rates may find their way back to the relative safety of Treasurys. As money flows back into Treasurys, demand for junk bonds wanes, and investors demand a greater premium over the rate offered by risk-free Treasurys.

But as the economy remains in a state of long-term repair, the Fed appears unlikely to renege. So junk bond investors (and corporate borrowers) are betting on things continuing in this Golilocks-like  'not too hot, not too cold' state - corporations (even weaker ones that need to pay high borrowing rates) generally able to produce the cash flows to pay back their reasonable debt levels, within an tepid economy that requires low interest rates from monetary policymakers.

But if either one of those assumptions proves untrue sometime in the near future, watch out in junk bond land. Goldie won't eat if the porridge is cold, or with a burned tongue.  Keep that in mind if you're tempted to join her high yield bond party.

Managed Futures: still the Better Diversifier?

A decade ago, Cass Business School Professor Harry M. Kat wrote a paper entitled Managed Futures and Hedge Funds: A Match Made in Heaven. In the paper Kat studied the impact of adding managed futures to traditional bond/stock portfolio allocations.
In comparison to hedge funds, Kat found that:

Apart from their lower expected returns, managed futures appear to be more effective diversifiers than hedge funds.

This is obviously an interesting paper but it starts to date; and blog reader Tom Rollinger from Sunrise Capital had the good idea to update the numbers in his paper entitled Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven.
Quite a lot has happened since 2002. In the markets in general and the alternative investment space in particular. So checking how Kat’s findings have held up was an obviously interesting follow-up. A sort of “out-of-sample” testing.
In the paper, Rollinger applies the same methodology used by Kat to measure the effect of adding managed futures to the traditional portfolios, then combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios.

First: a Managed Futures Definition

Trend followers, CTAs and managed futures are terms usually used inter-changeably, and Rollinger establishes this (emphasis mine):

Managed futures traders are commonly referred to as “Commodity Trading Advisors” or “CTAs” [...]
somewhat misleading since CTAs are not restricted to trading only commodity futures. [...]
Moreover many investors generically say “managed futures” or “CTAs” when they more precisely mean “systematic CTAs who employ trend following strategies”. This paper focuses on CTAs utilizing systematic trend following strategies.

The index used by Rollinger for Managed Futures is the Barclay Systematic Traders Index. The other asset classes are represented by:
- Bonds: Barclays U.S. Aggregate Bond Index
- Stocks: S&P 500 Total Return Index
- Hedge Funds: HFRI Fund Weighted Composite Index
This is different from Kat’s data/choice of indices but Rollinger shows in his Appendix B that for the period covered by Kat (June 1994–May 2001), the results “closely resemble” the original when using these different indexes.

Results of the “out-of-sample” test, a decade after Kat

Both papers simulate different portfolio allocations between the “traditional” 50/50 Bond/Stock portfolio and the “alternatives”, either Managed Futures, Hedge Funds or combination of both. The impact on the return distribution can then be observed.
It seems that the findings have stayed very similar since Kat published his paper. Adding managed futures to stocks and bonds helps more and quicker than do hedge funds, and do not bring on the negative side effect from hedge funds – increased tail risk.
From Rollinger’s paper (emphasis on Kat’s quote mine):

Managed futures have continued to be very valuable diversifiers. Throughout our analysis, and similar to Kat, we found that adding managed futures to portfolios of stocks and bonds reduced portfolio standard deviation to a greater degree and more quickly than did hedge funds alone, and without the undesirable side effects on skewness and kurtosis.
[...]
As the contribution to alternatives increases, all four moments of the return distribution benefit:
1) Mean return increases
2) Standard deviation decreases
3) Skewness increases
4) Kurtosis decreases
Overall, our analysis is best summarized by the following quote from Dr. Kat (regarding his own findings almost 10 years ago): “Investing in managed futures can improve the overall risk profile of a portfolio far beyond what can be achieved with hedge funds alone“.

The Papers

Here is a link to Kat’s original paper on SSRN:
Managed Futures and Hedge Funds: A Match Made in Heaven
Its abstract:

In this paper we study the possible role of managed futures in portfolios of stocks, bonds and hedge funds. We find that allocating to managed futures allow investors to achieve a very substantial degree of overall risk reduction at limited costs. Apart from their lower expected return, managed futures appear to be more effective diversifiers than hedge funds. Adding managed futures to a portfolio of stocks and bonds will reduce that portfolio’s standard deviation more and quicker than hedge funds will, and without the undesirable side-effects on skewness and kurtosis. Overall portfolio standard deviation can be reduced further by combining both hedge funds and managed futures with stocks and bonds. As long as at least 45-50% of the alternatives allocation is allocated to managed futures, this again will not have any negative side-effects on skewness and kurtosis.

And here is the link to Rollinger’s paper:
Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven
Abstract:

In November 2002, Cass Business School Professor Harry M. Kat, Ph.D. began to circulate a Working Paper entitled Managed Futures and Hedge Funds: A Match Made in Heaven. The Journal of Investment Management subsequently published the paper in the First Quarter of 2004. In the paper, Kat noted that while adding hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility, it also produced an undesired side effect — increased tail risk (lower skew and higher kurtosis). He went on to analyze the effects of adding managed futures to the traditional portfolios, and then of combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios. He found that managed futures were better diversifiers than hedge funds; that they reduced the portfolio’s volatility to a greater degree and more quickly than did hedge funds, and without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with the traditional portfolios. Kat’s original period of study was June 1994–May 2001. In this paper, we revisit and update Kat’s original work. Using similar data for the period June 2001–December 2011, we find that his observations continue to hold true more than 10 years later. During the subsequent 101⁄2 years, a highly volatile period that included separate stock market drawdowns of 36% and 56%, managed futures have continued to provide more effective and more valuable diversification for portfolios of stocks and bonds than have hedge funds.

I have just noticed Attain have also written up a piece comparing both papers. You can read more on their site:
Between kat and rollinger: blending managed futures and hedge funds

Around the world

When it comes to advice for the financial markets, there is a reason why the majority of people in this business lose money consistently, while only a handful are successful and make a profit on a consistent basis. These clowns come on TV channels like Bloomberg and CNBC and they all sound the same. I think I always say this to you, but I'll repeat it again: when it comes to financial advice, the best thing to do is to do your own research and run your own investments. It is basic advice, but it is very, very important. That way you lose your own money if you make mistakes, or if you do your homework and have a little luck, you make your own profits. Listening to financial "gurus / bloggers / experts / traders" who think they know everything, for the majority of time is a complete waste, and this includes me too. 

I can be just as wrong as the common man on the street. As a matter of fact, because I spend a large amount of time in front of the computer reading, researching and studying all of this "stuff", the common man on the street probably knows a lot more about the economy than I do. I am talking about the common man that runs a business and isn't brainwashed by all these financial reports we read daily. That is because visiting local restaurants and night clubs, or just asking various taxi drivers how business is going can tell you a lot more than government statistics - which are all phoney anyway. And on that note, I can give you advice on what I see in the market place today and what I am doing with my money, but in the end I am no better than you or anyone else, so read as much as you can from as many people as you can and in the end, always think clearly by yourself. 

On the stock market...

So when it comes to stock prices I can tell you my view: every man and his dog is optimistic, positive, strongly invested and quite complacent. That to me is a cocktail of trouble! Let me explain...

Source: Short Side Of Long

Investors today are positive about corporate profits and earnings moving even higher than right now. They are also positive about corporate margins expanding even further (see the first chart above). But... let me tell you that earnings are already at record highs and so are corporate margins. No one ever got rich buying stocks when profit margins were at or close to all time highs. Notice that all the best investment opportunities and major market bottoms occurred when margins collapsed, like in 1974, 1982, 2002 and 2009 etc etc. When margins are depressed and earnings have collapsed due to a recession, stocks offer a great entry point and you get to catch the whole recovery. When you hear a lot of opinions regarding how positive fundamental picture is because "profits are at record highs" - that type of a parrot talk can usually be heard from all financial advisors and "gurus / experts" on TV near the peak of the stock market. Look at the chart above and see how profit margins peaked during the 2006/07 period. Now focus on the chart below:

Source: JP Morgan / Barry Ritholtz

Notice that from 2002 to 2007, the US Stock marked gained 100% and it did it during a huge credit boom, housing boom, Chinese boom, commodity boom and manufacturing boom. In 2006 and 2007, the world was in tip top shape and every analyst would have told you that things will continue into the blue skies… almost forever. And that was precisely when the market peaked out, just as the profit margins started to decline. Fast forward to today and the market has now gained 113% in even less time, rising even more rapidly and yet profit margins are at all time record high. That means, it is not probable that they will go even higher and most likely will do the opposite and mean revert downwards. Remember in capitalism, profit margins always mean revert. Currently, the market is driven by central bank's printing money and stimulating financial assets. This has forced a lot of speculation into the market, and yet constantly market participants argue that "there is a lot of cash on the sidelines" and that "funds are underinvested". Let me tell you that the market doesn't gain 113% in three years because everyone is underinvested and there is cash on the sidelines. How the hell did it get there, all by itself?

Source: Short Side Of Long

Furthermore, the majority of investors are now optimistic on stocks and have "made some profits" (as you yourself said in the email) after an almost vertical rally in recent months. But away from the short term, what really surprises me today is the way the majority are strongly invested, quite complacent and not worried about anything. Notice that the US stock market has rallied over 110% in the space of three and half years from its lows in March 2009. The time to be an optimist has long passed. It was wise to be one back in late 2008 and early 2009, when profit margins and earnings collapsed. Back than, retail investors as well as "mum and pop" investors held large amount of cash on the sideline due to fear (chart above shows cash levels reached over 40% of the portfolio on average). 

Today everybody is an optimist, even the bears are slightly invested, but the stock market rally of 110% plus has largely discounted the majority of good news such as record profits and record profit margins. Today, these same investors hold very small amounts of cash on the sideline due to greed, herding and being over exposed (chart above shows cash levels are now at 18% of the portfolio on average). You will notice that whenever cash levels drop, stocks tend to correct almost always. At the same time, when retail investors sell stocks and raise cash… now that is when it is the best time to invest. That is when you will see me excited. As I always say, you are either a contrarian or a casualty. Warren Buffet could tell you a thing or two regarding the sentiment and the chart above: "Attempt to be fearful when others are greedy and to be greedy only when others are fearful" ~ Warren Buffet

On the Precious Metals...

So the question is, if the stock market is not a good place to invest right now, could Gold or Silver present opportunities? Last time we talked, I told you that I wasn't doing anything. The reason for that has not changed. Europe is still a mess and Greece or even Spain is heading towards a default of some type that will shock the system similar to 2008. I know that almost everyone doesn't hold that opinion anymore, but I still do. I also didn't do anything because I remain fully invested in Precious Metals, including Silver. That means I rather not buy extra than is necessary and overexpose myself. Nevertheless, Silver has rallied from $26 to $35 from the middle of August towards the end of September, which is an impressive 35%. So since I am fully invested in this asset and the majority of my clients money is held there, my fund is up rather handsomely for the year (so far). 

Source: Deutsche Bank

Obviously, if Silver falls so will my performance. As wise men say, good times never last forever, so I understand that the recent rally has been a too far, too quick type of a move and could correct slightly in the coming weeks and months. But, regardless of what happens in a few months from here, I believe Gold and Silver will go much much higher in the next few years and I remain a long term investor in this asset class. During a bull market or a boom, the best thing to do is to exercise patience. Besides, when I look at an average portfolio of an investment fund, I notice that stocks are commonly about 37%, bonds are even higher at 49% (bond bubble anyone?), money markets (aka cash levels) are currently at 9% - which I already stated is extremely and dangerously low for an overbought stock market, and finally Gold is only at 1% of exposure. This makes me think that Gold is not in a bubble as investors are still largely under-exposed to this asset class. When I hear constant chatter on Bloomberg and CNBC from these so called "gurus" on how funds now hold 10% or 20% of their money in Gold, that is when I will become worried… and if and when Gold prices go high rapidly, I will most likely sell out. That is because, almost everybody will be super-bullish at that point.

Source: Merrill Lynch / Ann Bartels Technicals

Regarding your question about technicals of Gold, an investment friend in the Merrill Lynch technical team, who sends me regular newsletters regarding asset price movements, also talks about the resistance of $1,800 for Gold and how the price will rally once it "breaks" above that level. They also talk about Gold moving towards $3,000 in the next several quarters or years, according to their chart. I don't really know what to tell you in the short term. Short term market movements are like gambling and probability. It could go up, but it might not. It seems to be that a lot of investors are focused on these "technical levels" anticipating a breakout… the same levels you discussed in your email. In my experience, I've learned that it is not wise to focus on things that everyone else focuses on, because usually markets surprise and do something completely different. And it has also come to my attention, that in the near term, investors are too optimistic about Gold and Silver.

Source: Short Side Of Long

The retail crowd seems to have positioned for this breakout and a lot of speculation and hot money has flown into Gold recently. The chart above shows physical holdings in the major ETF trading product have exploded, so take note that whenever a majority rush into something, it is never wise to buy and the same goes for Gold. I'm also fortunate to read a few newsletters from various investment banks and also individual traders. Technical guys who run these "shorter term" publications are all anticipating a breakout above $1,800 and are decently positioned for it.

I am not saying Gold cannot move higher, all I am saying is that personally I would not buy right here right now. I'd rather wait for a pullback or wait for a setup where the retail investors sell Gold so I can "buy when others are fearful" as Mr Buffett himself wisely stated. You see, Gold has good fundamentals and reasons to why it is rising (unlike the stock market). As central banks print money, maybe even more investors will rush in and Gold might not even pullback. After all, my long term view is that Gold will go much higher. So while I am not selling my Precious Metals due to a good long term outlook, I am also refraining from buying today and tomorrow, due to the short term "froth and heat" in the market.

If I miss the move, then I miss the move… no big deal. There is always another opportunity and that is one thing I've learned in this game. Another chance is just around the corner. Same goes for Silver, as Silver follows Gold rather closely, but just with larger downswings and larger upswings. If I had to buy one of the two, I'd rather buy Silver because it is cheaper on a historical basis. Silver is still 30% below its all time peak of $50, while Gold is very close to new all time highs. That makes me think that Silver has some catching up to do. Therefore, holding both with the longer term view is still fine in my opinion.

On the Economy and Australian real estate...

Finally, read my recent blog post, which argues that we are now on the edge of a global rescission (link here). When I look at Asia, it has been the powerhouse of the recent recovery out of the 2008 recession. However, their export volume is now declining, which signals to me that their customers - which are US and Europe - are showing signs of a slowdown and weak demand.

Source: Merrill Lynch

This has also been true when we look at global economic barometers like Crude Oil or the price of Copper, both of which are struggling. Let us not forget that marginal demand for these industrial commodities comes from the Asian expansion and growth. Greece barely consumes Copper or Oil, so when the price declines it is because something is not well with China, even though those clowns on TV constantly keep saying Eurozone this and Eurozone that, blaming a small tiny economy like Greece for the world's problems.

Source: Bloomberg

I got a Standard Chartered research note the other day, which covers Chinese Copper inventories in various ports near the South / East side of the country. There is idle stockpiles of copper everywhere and it keeps building up. This is a sign that economic activity is very low and slow in certain areas, because Copper is used in almost all building processes, as you probably know yourself. As all prices move on the premise of demand and supply, whenever demand decreases and supply increases, that tends to be the mortal enemy of future price action. When activity slows and the economy stalls, inventories build up and prices decline. Iron Ore inventories at Chinese ports are also through the roof too.

The Iron Ore fundamentals of demand and supply are even worse as prices have crashed recently. As you know well, Iron Ore is a main component of steel making and Australia's main export commodity. At the same time, China is the biggest producer of steel in the world, and therefore Australia's No 1 customer.

The Australian trade balance has now turned into a deficit as the mining boom slows further. That means, Australia is once again importing more goods and services than it is exporting. This weakens capital as it slowly leaves the country and it could most likely weaken the currency too. The slowdown will surely affect the economy. I also happen to think that government revenues will now fall, which could mean higher taxes for us, as the government will need to raise more money elsewhere. All in all, it does not signal great things ahead for the overvalued and overhyped Australian housing bubble.

You might already know that I am rather negative on this asset class and a hold a friendly bet over drinks and dinner, with a close family friend, who's family owns and manages a large private commercial and residential property trust in Australia in excess of $100 million dollars. He believes that Australia real estate prices will move sideways and do not have large downside risks. I hope for the sake of everyone in Australia that he is right. Furthermore, I am also quite aware that certain "experts" out of local investment banks, are now talking about how a mining boom end, signals a housing boom re-start (link here). 

Source: Trading Economics / Short Side Of Long

I personally do not think so and quite honestly, I think such thinking is slightly nuts (as in crazy). Australia has not had a recession for 21 years, while normal business cycles tend to last between 5 to 8 years. As we all should know, recessions are common reoccurrence for the economy to clean itself out and remove excesses. It just makes me think that excesses that have been built into the Australian economy are rather large these days, because it has not been cleaned out for 21 years, just the same way as a normal residence or a home would be rather dirty if it has not been cleaned out for 21 years, as well.

I am quite convinced that once a recession occurs, Australia real estate could drop more than 20% from peak to trough. The level of mortgage debt Australians hold is now much larger than in 2006 when the US housing market turned south. And let me tell you that soon enough, our unemployment rate will also start to rise. So the question is, will this debt be serviceable? Since I believe we are in for a mean reverting outcome, just like US profit margins, it is only a matter of time until the "the lucky country" takes a turn for the worse. Finally, I found this quite amusing and something that usually gets published at the top of economic growth:

Source: Amazon Books

"There's no better place to be during economic turbulence than Australia. Brilliant in a bust, we've learnt to use our brains in a boom. Despite a lingering inability to acknowledge our achievements at home, the rest of the world asks: how did we get it right?"

The housing market deal of a lifetime

This chart of the yield on current coupon FNMA collateral and 10-yr Treasury yields, and the spread between the two, is good evidence that the Fed has finally managed to distort market pricing. MBS spreads are now almost zero—implying that FNMA MBS are as rock-solid and as attractive as Treasuries. Which of course they aren't. Mortgage-backed securities have nasty characteristics that Treasuries don't: when yields fall, their duration shortens (because homeowners can prepay their mortgages), and when yields rise, their duration extends (nobody will ever want to prepay a 30-yr mortgage with a 3% rate). That's called negative convexity, and that's one big reason why MBS yields are almost always higher than Treasury yields. Investors require an extra yield on MBS to compensate for their erratic cash flow risk. Not to mention, of course, that they don't have an explicit U.S. government guarantee.

If MBS spreads remain near zero, then 30-yr fixed rate conforming mortgages (orange line in the first chart above) could fall to 2.25%. (Over the past 15 years, the average spread between FNMA collateral and 30-yr conforming mortgages has been about 60 bps, which when added to today's 10-yr yield of 1.62%, gives you an idea of just how low conforming mortgage rates could go.) At that outstanding, almost unimaginable level, everyone who doesn't own a home should be willing to stand in line outside a bank for however long it takes to qualify for a mortgage, and then turn around and buy just about any home on the market. The Fed has succeeded in creating the housing market's biggest "blue plate special" of all time. Come and get it! A once in a lifetime opportunity to lock up unbelievably low fixed-rate financing and buy a home at a price that's not going to last much longer.

The one thing standing in the way of what should be a stampede of new home buyers is that it's not so easy to qualify for a loan. Banks have been loaded to the gills with reserves, and thus able to make an almost unlimited number of new loans, but they haven't—because they are still very risk-averse. You need 20% down to qualify, and your credit scores need to be good, and your employment solid. Not everyone can qualify, and many can't.

Regardless, this is a situation that can't last for very long. When market prices are distorted artificially, powerful arbitrage forces are set in motion. Large institutional investors are going to want to sell their MBS holdings at what could be record-setting high prices. Yields going forward are paltry, downside risk is enormous, and upside potential is extremely limited. The Fed's promise to buy $40 billion per month of MBS could be swamped by the decision of money managers to lighten up on their MBS holdings, which are measured in the many trillions of dollars. In other words, the big decline in MBS yields could quickly reverse, because the Fed can't permanently distort the yield on a market that is many trillions of dollars in size by buying a paltry $40 billion per month.

Meanwhile, those who can get loans are going to be putting that money to work in the housing market, and that's one reason why prices are firming in many parts of the country. The new mentality: buy now, before prices go higher. (Banks with tons of REO on their books will be thinking: no rush to sell now, maybe prices will go higher. Homeowners who are currently underwater will be thinking: maybe I can hold out a little bit longer and things will get better. It all adds up to less selling pressure and more buying pressure and the outcome can only be higher prices.)

And of course, banks are at some point going to be relaxing their lending standards. If they don't do it on their own initiative, then you can bet some politician is going to figure out a way to force them to. There is a precedent for this sort of thing in the U.S., after all, and that's one reason we got the housing market bubble.

QE3 and interesting stats on Gold

Given that Fed­er­al Reserve Chair­man Ben "Heli­copter Make it Rain Dol­lar Bills" Bernanke just announced QE3 (quan­ti­ta­tive eas­ing) that sent the price of gold high­er, we were sent an inter­est­ing info­graph­ic with some facts on every­one's favorite pre­cious metal.

For years now, we've high­light­ed how many promi­nent hedge fund man­agers have owned gold in some capac­i­ty (either phys­i­cal­ly, or via prox­ies like exchange trad­ed funds GLD orIAU).

John Paul­son start­ed a gold fund as a bet against the US dollar.  Oth­ers bought gold as an uncer­tain­ty hedge.  Green­light Cap­i­tal's David Ein­horn con­tin­ues to own gold as a top hold­ing.  And Third Point's Dan Loeb con­tin­ues to own gold as his 2nd largest posi­tion. 

Here's some notable recent facts about gold: 



- Cur­rent mar­ket value of all gold is $8 tril­lion 



- All avail­able gold is equal to approx­i­mate­ly half of the pub­lic debt of the USA



- US gold reserves amount to 77% of the nation­al for­eign exchange reserves



- China's gold reserves account for only 1.8% of its total reserves 



- Annu­al gold con­sump­tion for invest­ment: 1,640 tonnes (about 50 mil­lion gold coins) 





And here's the info­graph­ic: 

The magnitude of the mess we're in

By George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor

Sometimes a few facts tell important stories. The American economy now is full of facts that tell stories that you really don't want, but need, to hear.

Where are we now?

Did you know that annual spending by the federal government now exceeds the 2007 level by about $1 trillion? With a slow economy, revenues are little changed. The result is an unprecedented string of federal budget deficits, $1.4 trillion in 2009, $1.3 trillion in 2010, $1.3 trillion in 2011, and another $1.2 trillion on the way this year. The four-year increase in borrowing amounts to $55,000 per U.S. household.

The amount of debt is one thing. The burden of interest payments is another. The Treasury now has a preponderance of its debt issued in very short-term durations, to take advantage of low short-term interest rates. It must frequently refinance this debt which, when added to the current deficit, means Treasury must raise $4 trillion this year alone. So the debt burden will explode when interest rates go up.

The government has to get the money to finance its spending by taxing or borrowing. While it might be tempting to conclude that we can just tax upper-income people, did you know that the U.S. income tax system is already very progressive? The top 1% pay 37% of all income taxes and 50% pay none.

Did you know that, during the last fiscal year, around three-quarters of the deficit was financed by the Federal Reserve? Foreign governments accounted for most of the rest, as American citizens' and institutions' purchases and sales netted to about zero. The Fed now owns one in six dollars of the national debt, the largest percentage of GDP in history, larger than even at the end of World War II.

The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself. It determines the interest rate by declaring what it will pay on reserve balances at the Fed without regard for the supply and demand of money. By replacing large decentralized markets with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended economic consequences.

Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process? To pay for quantitative easing—the purchase of government debt, mortgage-backed securities, etc.—the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. These reserve balances have exploded to $1.5 trillion from $8 billion in September 2008.

The Fed now pays 0.25% interest on reserves it holds. So the Fed is paying the banks almost $4 billion a year. If interest rates rise to 2%, and the Federal Reserve raises the rate it pays on reserves correspondingly, the payment rises to $30 billion a year. Would Congress appropriate that kind of money to give—not lend—to banks?

The Fed's policy of keeping interest rates so low for so long means that the real rate (after accounting for inflation) is negative, thereby cutting significantly the real income of those who have saved for retirement over their lifetime.

The Consumer Financial Protection Bureau is also being financed by the Federal Reserve rather than by appropriations, severing the checks and balances needed for good government. And the Fed's Operation Twist, buying long-term and selling short-term debt, is substituting for the Treasury's traditional debt management.

This large expansion of reserves creates two-sided risks. If it is not unwound, the reserves could pour into the economy, causing inflation. In that event, the Fed will have effectively turned the government debt and mortgage-backed securities it purchased into money that will have an explosive impact. If reserves are unwound too quickly, banks may find it hard to adjust and pull back on loans. Unwinding would be hard to manage now, but will become ever harder the more the balance sheet rises.

The issue is not merely how much we spend, but how wisely, how effectively. Did you know that the federal government had 46 separate job-training programs? Yet a 47th for green jobs was added, and the success rate was so poor that the Department of Labor inspector general said it should be shut down. We need to get much better results from current programs, serving a more carefully targeted set of people with more effective programs that increase their opportunities.

Did you know that funding for federal regulatory agencies and their employment levels are at all-time highs? In 2010, the number of Federal Register pages devoted to proposed new rules broke its previous all-time record for the second consecutive year. It's up by 25% compared to 2008. These regulations alone will impose large costs and create heightened uncertainty for business and especially small business.

This is all bad enough, but where we are headed is even worse.

President Obama's budget will raise the federal debt-to-GDP ratio to 80.4% in two years, about double its level at the end of 2008, and a larger percentage point increase than Greece from the end of 2008 to the beginning of this year.

Under the president's budget, for example, the debt expands rapidly to $18.8 trillion from $10.8 trillion in 10 years. The interest costs alone will reach $743 billion a year, more than we are currently spending on Social Security, Medicare or national defense, even under the benign assumption of no inflationary increase or adverse bond-market reaction. For every one percentage point increase in interest rates above this projection, interest costs rise by more than $100 billion, more than current spending on veterans' health and the National Institutes of Health combined.

Worse, the unfunded long-run liabilities of Social Security, Medicare and Medicaid add tens of trillions of dollars to the debt, mostly due to rising real benefits per beneficiary. Before long, all the government will be able to do is finance the debt and pay pension and medical benefits. This spending will crowd out all other necessary government functions.

What does this spending and debt mean in the long run if it is not controlled? One result will be ever-higher income and payroll taxes on all taxpayers that will reach over 80% at the top and 70% for many middle-income working couples.

Did you know that the federal government used the bankruptcy of two auto companies to transfer money that belonged to debt holders such as pension funds and paid it to friendly labor unions? This greatly increased uncertainty about creditor rights under bankruptcy law.

The Fed is adding to the uncertainty of current policy. Quantitative easing as a policy tool is very hard to manage. Traders speculate whether and when the Fed will intervene next. The Fed can intervene without limit in any credit market—not only mortgage-backed securities but also securities backed by automobile loans or student loans. This raises questions about why an independent agency of government should have this power.

When businesses and households confront large-scale uncertainty, they tend to wait for more clarity to emerge before making major commitments to spend, invest and hire. Right now, they confront a mountain of regulatory uncertainty and a fiscal cliff that, if unattended, means a sharp increase in taxes and a sharp decline in spending bound to have adverse effect on the economy. Are you surprised that so much cash is waiting on the sidelines?

What's at stake?

We cannot count on problems elsewhere in the world to make Treasury securities a safe haven forever. We risk eventually losing the privilege and great benefit of lower interest rates from the dollar's role as the global reserve currency. In short, we risk passing an economic, fiscal and financial point of no return.

Suppose you were offered the job of Treasury secretary a few months from now. Would you accept? You would confront problems that are so daunting even Alexander Hamilton would have trouble preserving the full faith and credit of the United States. Our first Treasury secretary famously argued that one of a nation's greatest assets is its ability to issue debt, especially in a crisis. We needed to honor our Revolutionary War debt, he said, because the debt "foreign and domestic, was the price of liberty."

History has reconfirmed Hamilton's wisdom. As historian John Steele Gordon has written, our nation's ability to issue debt helped preserve the Union in the 1860s and defeat totalitarian governments in the 1940s. Today, government officials are issuing debt to finance pet projects and payoffs to interest groups, not some vital, let alone existential, national purpose.

The problems are close to being unmanageable now. If we stay on the current path, they will wind up being completely unmanageable, culminating in an unwelcome explosion and crisis.

The fixes are blindingly obvious. Economic theory, empirical studies and historical experience teach that the solutions are the lowest possible tax rates on the broadest base, sufficient to fund the necessary functions of government on balance over the business cycle; sound monetary policy; trade liberalization; spending control and entitlement reform; and regulatory, litigation and education reform. The need is clear. Why wait for disaster? The future is now.

The authors are senior fellows at Stanford University's Hoover Institution. They have served in various federal government policy positions in the Treasury Department, the Office of Management and Budget and the Council of Economic Advisers.

A version of this article appeared September 17, 2012, on page A19 in the U.S. edition of The Wall Street Journal, with the headline: The Magnitude of the Mess We're In.

Sell everything and buy stocks

We give up. We’re throwing in the towel and recommending everyone sell their managed futures investments and put it all in the stock market. Ok, not really, but can we really ignore this rally anymore. It is almost begging people to sell everything and get involved.

But would you recommend that to anybody in their right mind? Would anyone in their right mind do that?  Given the internet bubble burst, financial crisis, flash crash, and so on;  most people we talk to believe a 50% allocation to the stock market is heavy these days. Yet the market goes onwards and upwards.

Whether it is because of just this malaise towards stocks, or because of the hundreds of billions pumped into the U.S. system by Bernanke & Co. – the U.S. stock market has been the best thing going for investors since March of 2009.

While most of us were (smartly) preparing our portfolios for the next leg down in the crash, for the incredible volatility when China’s economy slowed, for the contagion in Europe when countries there started falling like dominoes – the U.S. stock market has laughed it off, returning to the highs attained before the financial crisis.

DISCLAIMER: PAST PERFORMANCES IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. HERE AND THROUGHOUT THIS PIECE, US STOCKS = S&P 500 TOTAL RETURN, BONDS = CITIWORLD BOND INDEX, MANAGED FUTURES = DOW JONES CREDIT SUISSE BROAD MANAGED FUTURES SUBINDEX. FINANACIAL INDICES ARE IMPERFECT PROXIES FOR ASSET CLASS PERFORMANCE.

But, again, does anyone really trust these past 3.5 years? Does anyone really think the next 3.5 years will be that good for stocks? 

Where do we go from here?

Most people we talk to sure don’t think this is a permanent up move in the stock market (perhaps in and of itself an argument for it to continue).  The common thread is the thought that prices have just come too far too quickly since the 2009 bottom.

We decided to take a look at just how far that is – analyzing the S&P 500’s return since March 2009, or 43 months ago, versus all the previous 43 month periods back to the 1950s. You can see in the chart below that this rally is quickly becoming one of the most impressive of our time. But, you can also see that the last times we were up in this area were in Aug/Sep of 1987 (yeah, that 1987, the one where stocks lost 21% in a day), and in the summer of 1999, right before the internet bubble burst and the Nasdaq fell over -70%.

Does this mean doom is upon us and these levels signal a sharp sell off right around the corner? Not likely. The market could stay elevated at these levels for quite some time. Indeed, the S& P spent 15 out of 26 months at a rolling 43 month return of over 100% during 1997, 1998, and 1999. However, the differences between now and then are well documented. Then, we had an investor driven bubble in the midst of a growing economy and near full employment. Now, it's a government fueled bubble in the midst of a flat to shrinking economy with hefty unemployment.

Relative Performance

Most investors we talk to feel like they missed this stock rally. They tell us how it seemed to risky to get in at the lows in 2009, had come to far too fast to get in during 2010, looked like the world was ending in 2011, and how it would just be chasing at this point… after missing all the other entry points. While they weren’t plowing into stocks because of the perceived risks, many investors were adding protection to their portfolios in the form of non correlated alternative investments such as managed futures.

But this isn’t just about stock market performance, it is also about how managed futures have performed during the up move; and while the stock market was gaining back everything it lost and then some during the financial crisis – managed futures, generally speaking, were not keeping up on a relative basis.

We saw above that the S&P has outperformed the DJCS managed futures index by xxx% since March 2009 – but what is a normal amount of overperformance (after all, we should expect some outperformance of stocks on a pure return basis – given they are roughly 4 times as volatile as the managed futures index).

To explore this, we charted the cumulative return of the S&P 500 total return index with the DJCS managed futures index back to 1994 and highlighted the periods of maximum differences between the two. 

You will see stocks running clear and away better than managed futures from 1994 through 1999, with a max difference in cumulative performance of 242% right before the internet bubble burst and managed futures clawed back the bulk of that difference.

From that crisis period, stocks again started their more aggressive rise, outpacing managed futures for 4.3 years from roughly 2003 through 2007 until peaking at a difference of 182% before the financial crisis hit and brought stocks all the way below managed futures on a cumulative basis since 1994.

DISCLAIMER: PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. FINANCIAL INDICES ARE IMPERFECT PROXIES FOR ASSET CLASSES.

Which brings us to the current 3.3 year run up period for stocks, where they have again pried open a significant spread over managed futures, being about 127% better right now than managed futures since 1994.

What do we see in all of this? A pattern of sorts, whereby U.S. stocks outperform managed futures for a 3 to 5 years, followed by a sharp downturn where managed futures catch up, followed by another "expansion" of the spread by stocks into another downturn/convergence, and so on.  Ignoring the current period, the previous two saw an average stock expansion period of 4.8 years and an average max divergence of 212%.

Does that mean this current stock outperformance over managed futures has another 1.5 years and 80% to go? If that’s the case, then you may want to heed our sarcastic advice at the beginning of this piece and ditch your managed futures for a long stock portfolio.  

Or does it mean stocks have put in the bulk of any outperformance over managed futures both in terms of cumulative return (130% out of 200%?) and time (3.3 out of 4.8 years) since the last cross over in performance, and a reversion to the mean is due? Remind us to give the real stock buy signal next time the stock and managed futures equity lines converge...

Or, lastly – does it mean nothing… (always a distinct possibility, but less fun to talk about) and both stocks and managed futures will continue to do what they do independent of one another?

The Managed Futures Seat Belt

Whatever it means, this boom time for stock investors and flat period for managed futures investors has caused more than a few investors to start asking some difficult questions (despite managed futures continuing to add to total assets under management and stock mutual funds continuing to bleed assets).

You see, the sale made to investors was, and the sale still made to this day; is something along the lines of, "You need managed futures in the portfolio to protect against another 2008 type environment.  You need managed futures as a seat belt of sorts to protect against an accident."

Now, we’ve been as guilty as anyone at making that “seat belt” claim and espousing the benefits of managed futures during crisis periods such as 2008. But the thing is – the entire rest of the world is essentially setup to keep the markets from having such crisis periods.  Just think of currency interventions, QE1-3, changes to accounting rules to mask bank losses, bans on short selling, and so on. 

But, the question being asked more and more by those invested in managed futures and seeing the big underperformance of managed futures versus the stock market is a variation of, "What have you done for me lately?" Investors want to know what they're supposed to do in the space until the next big outperformance period comes along. They realized the need for protection against another crisis, but that crisis hasn’t come, and despite all apparent evidence to the contrary, still isn’t here. The question on many investors’ minds is what can this "seat belt" investment do for me when there is no crash imminent. Do I take it off and risk crashing through the windshield? Or maybe I just shift it around a little bit to make it more comfortable (likely lessening its safety profile a bit)?

In short, investors want the crisis period performance of managed futures – but they don’t want to just sit around during non-crisis times – they want returns during those times, too!

Crisis Period vs Absolute Returns

Nobody ever said clients have to have rational expectations. Sure, it helps people in our business if they do, but you can’t blame investors for wanting their cake and eat it, too. In this case, many investors are sick of waiting for the next crisis for performance out of their managed futures portfolio, and want some performance out of it now. They don’t care if the program they are invested in is the largest in the world with 100 phDs on staff and did great in 2008. Most would rather trade in that pedigree for performance in 2009 and here in 2012.

And there are plenty of programs which fit the bill, having done well historically and  doing well during the past 3.5 years when stocks have outperformed the managed futures index. Give us a call to find out which programs our specialists have been recommending to some clients who are looking for performance in the non-crisis period, not just when another 2008 comes.

That is one important point to consider – all of the stats and discussion above centers around the imperfect managed futures index, which we believe to be a good snapshot of the asset class, but a snapshot nonetheless.  The index is also comprised mainly of trend following and multi-strategy type programs which have the long volatility, crisis period performance profile most have come to expect out of managed futures.

Not represented meaningfully in the main managed futures indices are Ag traders, spread traders, short term CTAs, and specialty CTAs dealing exclusively in markets like meats or softs. And wouldn’t you know it – these are the type of programs which have, generally speaking, outperformed the managed futures indices since 2008. These are the types of programs not waiting for the next 2008 – they are giving it a go at earning a decent return right now, in 2012.

But like all things in life, such programs come with a cost, and the question we ask such customers looking at these alternative managed futures strategies… are you willing to forego some of the crisis period performance managed futures is known for in return for some "absolute returns." It isn’t always an either/or proposition, but more often than not – if you want returns during non crisis periods, you are less likely to get the positive returns in the crisis periods. That which makes money in crisis periods is less likely to also be able to make money when volatility is falling and there is no crisis.

So look yourself in the mirror and ask what you want out of your managed futures portfolio. Crisis period performance or Absolute Returns. Your answer may open up new opportunities for you to consider. 

IMPORTANT RISK DISCLOSURE

The Investor Sentiment Wheel

Sell Side Consensus Indicator

August -- Another Bad Month for Dividend Stocks

The average stock in the S&P 500 gained just over 3% in August.  But there was a pretty big discrepency in performance between high yielders and low or no yielders.  Below we have broken the S&P 500 into deciles (10 groups of 50 stocks each) based on dividend yield.  We then calculated the average performance of the stocks in each decile during the month of August.  As shown, the decile of the highest yielding S&P 500 stocks rose an average of just 0.62% in August.  Conversely, S&P 500 stocks that pay no dividend rose an average of 5.45%!  A few months ago, investors couldn't get enough of high dividend payers.  Now they want nothing to do with them.