Why the Euro Bailouts Might Not Work…

To sound clichéd, pictures are worth a thousand words.  And these pictures from Boston.com speak to why the Euro is still in trouble. 

They capture the protests taking place in Greece, Italy, Spain, and Portugal.  These pictures seem to indicate the protests in Europe are substantially more intense than anything we see in the states.  Further, they indicate why any “solution” or “fix” to the problem is met with skepticism.

Any bailout or EU external funding is wrought with conditions, namely budget targets.  The only way is to get to said targets is to make cuts in benefits (spending) or raise taxes.  The thing about this austerity (deficit-cutting by lowering spending) is that the people tend not to like it.  And when they don’t like it you have protests and/or riots like we can see in those pictures. 

In short, the political situation in the Eurozone may not allow for any agreed upon framework to take place.  The fallout is anyone’s guess.  Again, this points to the difficulties of having a fractured monetary and fiscal union.  

Why is Gold Attractive?

There are a handful of reasons, but I want to highlight one – real interest rates are really, really low.  The real interest rate is what you get once inflation is taken into account.  For example, the interest rate is 4% and inflation is 1.5% the real rate is 2.5% (note: actual equation is not as straightforward, thus real rate shown is for the sake of simplicity).  So why does this matter?

One of the drawbacks of holding gold is that you are paid nothing when you purchase it.  If I hold a bond, for instance, I am paid an interest rate bi-annually for providing my capital.  On the other hand, if I hold gold, not only I am not paid for providing capital, but it costs me capital to hold it (e.g. a safe).

Today the real interest rate on a 10 year bond (10 year yield taking into account 10 year inflation expectations) is at roughly .20%, close to an all-time low.  In fact, real rates have been trending down for a long time.  During that time, gold has increased in value.  The negative correlation, while moderate, is pretty clear:

The negative correlation picks up as real yields fall for a sustained period, although interestingly is uncorrelated when real yields drop below 1.  That maybe indicates something else drives prices as the benefit from a low opportunity cost of holding gold is being reduced. 

Past performance is no guarantee of future results.

Where to Get Yield

I was recently in a group where we were outlining discussion topics for an upcoming conference.  Without fail someone knew someone would mention “generating income in the low interest rate environment”. 

I say without fail because this is always, always, always brought up in settings like this.  I will say however, the conversation has evolved from “what will we do about impending hyperinflation and interest rates rising 1000% overnight” to “how can retirees live off their portfolio income”.

That doesn't mean the conversation isn't worth having.  It is and it’s very important.  However, the one thing that always gets short shrift in the conversation – risk – is equally important.  The idea here is simple – want more yield?  Take on more risk.

This is not to say taking on more risk in order to generate more income isn't the correct decision.  It might be the case; however, the investor needs to realize that there is no free lunch. 

Further, given that rates are extremely low, I could argue the risk is heightened as capital is misallocated.  For example, negative yields on Treasury bonds push more investors into High Yield bonds in a search for yield (remember the extended low rates after Tech bubble). 

This capital flow forces yields down, perhaps well below their fair value.  As a result, if/when interest rates normalize and/or liquidity is less abundant capital could flow the opposite direction, which would force up interest rates on higher yielding assets and lower their value.

I’d like to remind you, this is not a comment on what assets an investor should hold or where interest rates will go, but rather a general discussion about simply this fact: if you want to generate more yield, be sure you realize you are very likely taking on more risk.

What if China Sells All of Our Bonds?

I get these occasionally, “we owe money to China” or “what if China sells off all of our bonds”.

I think the first part is much more complicated than simply “we owe money to China” and can explained walking through why China owes Treasuries:

1. We buy goods from China ABC Co.
2. Before we buy we need to covert dollars to Yuan (CNY), so we sell USD and buy Yuan for the transaction
3. Ultimately the above transaction arrives on the currency market and puts downward pressure on USD
4. We are net importers of Chinese goods; as a result there should be more supply of USD relative to CNY, lowering the value of USD/CNY. 
5. Except there is no downward pressure because China’s Central Bank intervenes and buys those dollars
6. So now what does their Central Bank do now?  They obviously want USD or wouldn’t have purchased it, so they invest in the safest USD asset around – Treasuries.  

That is probably an oversimplification, but what I am getting at is that we “owe” China money due to trade.  Would they sell our bonds?  I don’t know, maybe.  So what?

1. If they are selling, someone is buying.  Given where interest rates are there is plenty of demand. 
2. This would put downward pressure on USD, making our exports more competitive.
3. Given their large holdings of Treasuries, why would China have a “fire sale”?  It would crush exports to their largest (or second largest) customer and harm their own central bank balance sheet.
• Note #1 assumes this is done more orderly than just dumping all $1.5t or so Treasuries on the market.

Again, this is an oversimplification and I am certainly missing a few steps.  Further, I will admit this is above my pay grade.  I am just trying to outline that it is much more complicated than “we owe China” and if they do sell our bonds it could yield positive benefits to our exports.

Presidential Race

First, this blog is non-partisan for a variety of reasons.  Second, this is not a partisan post; I just want to bring to light observations on the Presidential race.

One of my favorite “news” sites is Drudge Report mainly because it’s totally headline driven, contains some very good pop culture links, and funny pictures.  I also frequent the NYT.  What appears clear to me is that in national polls Obama and Romney seem tied.

Where it gets interesting is the Intrade betting markets, where Obama is more heavily favored with Romney making ground.  Intrade problems aside, why the disconnect?  The election isn’t decided by the popular vote but by the Electoral College.

Econbrowser did a nice job of laying this out drawing on Real Clear Politics and Intrade numbers.  I again liked to look at the Intrade map, which outlines Electoral College bets on each state.  It’s a nice to play with the math and see the different outcomes.

The one conclusion I came to, and as Econbrowser pointed out, Ohio is really the only state that matters.  I took it one step further and put together a chart of the Obama values (higher = more likely to win) since September 1, when contract volume picked up:

The correlation is almost 1, which advances the theory “as Ohio goes, the election goes”, or whatever it is they say.

Does Iran’s Hyperinflation Mean for Everyone Else?

I have no clear idea, however…

Historically, incidences of hyperinflation result in high levels of social unrest – protesting, rioting, anger, regime change, etc.  This makes total sense; if the masses can’t afford food they get mad and such conditions are ripe for mobs and rioting.

As Walter Kurtz points out, “The only question now is who will be the target of people's rage and desperation this time.”  Will it at be at the regime, the West, or another group?

I want to look at the former (the regime), mainly because the latter two don’t totally change the current dynamic.  In fact, the only two other hyperinflations this century involved Zimbabwe and North Korea.  To my knowledge neither experienced regime change (Note: I think Zimbabwe does have some joint power agreement) and the discourse regarding either country has not really changed.  Still, I should note that both economies are much smaller than Iran.

The whole reason I started on this Iran post (aside from brining attention to it) is to think about the impact of social unrest and possible regime change.  I am not sure what the conventional wisdom is on an Iranian regime change, but even though they are the most destructive actor in the world arena, I think at least in the short-term it would not be a positive geopolitical event:

1. I believe that in most cases those with power, especially in extractive governments, want to stay in power and will do what it takes to do so.  As a result, saber rattling now may turn into action if the regime feels threatened.
• The analogy may be of an angry pit bull that’s cornered and probably has only one move left.
2. Who fills the power vacuum?  See Libya and Egypt.
3. Contagion to the rest of region.  As I look at a map, Saudi Arabia would essentially be surrounded by social unrest.
4. Rising oil prices could tip the world into recession again at a time of high fragility.

Caveat: I am painting this with the broadest of brushes here and shooting from the hip. There could be some important cultural, social, religious, etc. details of which I am unaware, which could derail my hypothesis.

Still the risk is important to consider, especially since we could be at an inflection point.  “Turmoil in the middle east” is always an investment risk.  Seriously, if you find a list of market threats that doesn’t list, or that hasn’t listed that in the past 6 years, please forward it to me. 

So to conclude, while the past couple posts have drifted into world affairs, I believe that what is happening in Iran is at the very least a thought when considering asset allocation going forward, especially given the current state of affairs. 

Iran Economic Collapse

I tend to avoid watching the news and focus the bulk of my reading to aggregators or sources outside traditional media for a variety of reasons.  I am going to presume that many are not that Iran is, or could be, on the brink of an economic collapse as I haven’t really heard it discussed.

Regardless, I have seen an explosion of Iran related articles and blog posts over the past few weeks (I believe it started with The Atlantic) and here are some facts:

• Iran’s monthly inflation is roughly 70%.  This is considered hyperinflation based on a widely accepted definition (> 50% a month).
• This means prices double in 40 days.
• $1 bought you 24,600 Rials (Iran’s currency) on 09/24 in Iran’s Black Market.  On October 2^nd  39,000 Rials is what you got for $1.  The Rial is least valued currency in the world relative to USD.  The official value is 12,260 Rials for a dollar.
• Sanctions began in Summer 2010: since then the Rial has depreciated 70%+ vs. USD and the monthly inflation rate has risen to 70% from 0.70%. 

And why they are having hyperinflation:

1. Iran is heavily dependent on oil exports.  The sanctions are de facto do business with Iran (mid 20s in comparative size) or do business with the US (largest economy in the world).  Thus, production takes a hit while currency in the system stays the same or increases.  Less production + more currency = less demand and greater supply of currency = inflation.
• Simplistically, if an economy produces $100 worth of goods and has currency supply $102 then overnight only has $50 worth of goods there are now $50 less of output to soak up the currency.  As a result, the excess currency goes to purchase the remaining $50 of goods, pushing up prices.
2. As #1 happens, whoever is holding Rials wants to convert those to something with a store of value – USD.  But since the USD is essentially cut off from Iran, the supply of USDs fall rapidly as people begin converting the Rial ASAP.  This reinforces #1.

So what is happening now?

• Hoarding.  Buying goods now instead of later before the price goes up.
• Rioting.  If you can’t buy bread for your family, what else can you do?
• Withholding of goods.  Why sell today when tomorrow’s price will be higher?
• More black markets.  If you want the USD why go to central bank when a guy in alleyway will give you 3x that?
• Outlawing exchange.  Prices rising, currency collapsing, so try and prevent USD demand to prop up Rial.

So now what?  Next post I will touch on this.

OMT. Part III

Outright Monetary Transactions (OMTs) were announced on September 6^th, so what is the plan:

1. ECB buying bonds up to a maturity of 1 to 3 years on the secondary market with new Euros
2. Purchases will only occur in countries who request help from the EFSF/ESFSM (and subsequent ESM) bailout funds, which purchase debt on the primary market)
3. Purchases are conditional on reform programme
4. Purchases stop if country no longer needs help or if don’t comply with the agreed to conditions
5. No exact amount of purchases will be outlined and determined by ECB governing council
6. Purchases will be sterilized fully (e.g. buy Spanish bonds with ECB reserves and then sell German bonds, making reserves in system neutral and lowering inflation risk), TBD
7. No yield caps
8. Not senior to other bond holders

Here is what I think the result will be.  This is what I sent internally relatively verbatim on September 6^th, after the announcement:

The plan goal is to save the Euro - preventing runs on countries that investors feel may leave.  In other words, capital flows out of Spanish banks because as yields on Spanish debt rise, which is a result of banks not bidding on Spain's debt due to default concerns, depositors are nervous they will get a devalued Peseta (i.e. the new Spanish currency). 

As of now, the market is on board as yields in the periphery sank.  In fact, Spain's 10-year was under 6 for the first time since May.  It should be noted though that this happened the last two times the ECB announced a bond buying program only for yields to shoot higher.  However, longer-term is another issue. 

The two keys are "unlimited" and "conditions".  The first would appear to be a bazooka, if investors believe the quantity is unlimited then default is off the table and there would be no reason for capital to flee banks.  I think this would hold true, even if you buy longer dated bonds (5 year bonds eventually have a maturity less than 3 years).  Still, conditionality will ultimately decide this thing. 

For instance, say Spain requests EFSF and subsequently is involved OMT on the condition they keep their deficit at 3% GDP and insist on spending cuts.  Such austerity could actually cause the deficit to rise and/or could be politically unpopular as the economy shrinks further.  At which point, Spain can't keep up the conditions, then what?  Maybe it doesn't matter, as Spain will then have leverage - destroying the Euro and hurting the ECB balance sheet (now full of Spanish bonds).  But if it does and the ECB stops the funding once the conditions aren't met, then it could mean the end of the Euro. 

In short, a Euro breakup is off the table (maybe sans Greece) for now, but it’s much of the same – kicking the can down the road.  At least IMO; however, the plan does seem to have more firepower.

OMT. Part II

In my last post I outlined why I think interest rates were rising, absent from that was a discussion on what monetary policy can do to prevent bank runs, help the economy, and assist in keeping public interest rates low:

1. As defaults happen, central banks can lower interest rates (increasing liquidity, interbank lending, etc), engage in asset purchases (e.g. quantitative easing), act as the lender of last resort, etc.  All of these tools help prevent runs on the bank. 
2. Further, expansionary central bank tools should in theory should encourage banks to lend, stimulating the economy.  It also lowers the value of the currency and creates inflation.  The former helps exports and competitiveness, while the latter helps inflate away debt (as opposed to default).
3. A central bank can create money out of thin air.  It can also require banks to bid on Treasury auctions (as in the US).  As a result the central bank can set interest rates on public debt if need be.

The problem in the EU is that each country is not in control of its own currency, they are subject to the ECB.  Thus, while the US can do all the above, Spain for instance is beholden to the ECB.  This is why I believe their interest rates on public debt were rising…

There was no guarantee the ECB will create the reserves if need be to purchase public debt (e.g. the ECB will purchase or will have banks purchase public debt), as a result the government is revenue constrained to what it can procure in tax revenue and what it can finance in the market.  As tax revenues fall, the likelihood of default increases, which in turn causes the market to push up interest rates, and again increases the likelihood of default, so goes the circle…

Again, the contrast here is that the market realizes the Fed can dare it to sell the Treasury bonds.  The Fed has endless reserves to do so in order to keep interest rates where they want to (see QE3).  The countries in the EU can’t create their own reserves and thus are dependent on the ECB to do so.

OMT. Part I

These blog posts eventually lead to the Outright Monetary Transactions (OMTs), which was recently announced by the ECB.

First, I think it’s important to get a refresher on the problems in Europe.  I am going to use Spain as an example. 

1. Countries like Spain ran up large debts earlier in the decade, which was a boom to asset prices and growth. 
2. Thus, as capital began to leave Spain asset prices began to fall.  And so started a negative feedback loop – lower asset prices, capital flees, resulting in lower asset prices, more capital flight, etc.
3. This puts Spanish banks in a bad spot as their assets decrease in value and their funding sources dry up.  This results in a pullback in lending.
4. So back to point 1, growth was also dependent on credit, which is now being taken away.  As a result, growth stalls.  Again this creates another negative feedback loop – lower growth, less lending, resulting in lower growth, thus less lending, etc.
5. The combination of 2 and 4 lead to private defaults and exacerbates the fall in asset prices and growth.  Further, it puts the banks at risk.
6. This also leads to a collapse in tax revenues, a massive increase in stabilizers (i.e. the social safety net), a possible bailout of the financial system, and thus a ballooning of the public deficit to GDP.  This in turn causes interest rates to rise.
7. Rising interest rates create a self-fulfilling prophecy.  Higher interest payments = higher deficit = higher interest rates.  This continues until a breaking point when interest rates are too high and governments default.  
8. Simultaneous to #1, foreign capital is being pulled out of banks (i.e. “a run on the bank”) as the probability of public default rises.  This is because after the default deposits will be in the new local currency, which will be devalued relative to the Euro.
9. Number 8 exacerbates the problem of interest rates rising, as the reserves used to pay off public debt being to dwindle.

If you read the above and thought “this sounds a lot like the US” you would be correct… up until number 6.  So why aren’t we seeing the same sort of interest rate problem as Spain?  The most basic reason is that a key ingredient in the above is missing – monetary policy (the Fed and ECB).  

In Retrospect, What Did QE1 and QE2 Bring?

Again, I hope to get to some economic charts shortly, but for now let’s focus on asset prices.  The Big Picture posted some great charts on the previous QEs and Operation Twist (OT) and how various asset classes reacted.  Since I am not sure if I can post them (please check out the link), here is summary:

• Yields.  It’s interesting that yields rise after QEs.  They do drop drastically before QEs though.  Markets are basically buying the rumor and selling the news.  The same could be said about OT, while yields have gone lower it wasn’t until earlier this year.  I don’t think it was coincidence QE3 rumors started then.  I can’t see a divergence between the 10 and 30 year.
• Stocks.  Equity prices did rise rather nicely.  However, it does appear that there is a near-term pullback in prices at first.    Again, it appears investors start buying QE before it even happens.
• Commodities.  Prices rise pretty much throughout QE and on the rumor.  Like equities, there appears to be a selloff at the launch before a nice move higher.  

Also, from those charts I took a look at some numbers and came up with the following chart:

One thing that jumped out was that stocks and oil didn’t have as big a jump after QE2 as they did in Q1.  This would be concerning now given that the QE3 has already seen about the same rise.  Still, the highs and lows are relatively subjective.  Further, maybe the open-ended nature or current economic conditions would generate higher returns than QE2.

Gold and commodities appear to have the most upside, as rose by close to the same amount both QEs and have barely got off the ground this round.

QE3 – A Quick Thought

On September 13^th the Fed statement was extremely accommodative.  Here are some highlights:

1. Extending language "exceptionally low … federal funds rate are likely to be warranted at least through mid-2015"
2. New round of QE to MBS (not Treasuries) & rolling maturing MBS from previous asset purchases "purchasing additional agency mortgage-backed securities at a pace of $40 billion per month... maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities... increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year"
3. Extending operation twist "continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June"
4. Asset purchases appear open-ended (as opposed to a set $ amount) "outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability". 
5. Fed officials also upgraded their economic forecasts significantly.

So that was the announcement.  The takeaways?

• There also isn't a consensus this is actually economically stimulative.  I myself wonder how will lowering already low mortgage rates will help stimulate demand?  I will post on this shortly after I look into some data.
• Even if it doesn’t help the economy, does that mean QE is meaningless?  No.  If it follows the past QEs stocks and commodities should have a nice go of it.
• So if we assume it doesn’t help the economy, how can it help stocks?  Multiple expansion. 
• One measure of stock value is Price/Earnings.  So if Price is $100 and Earnings are $10 then P/E = 10.  If we assume QE doesn’t affect the economy then earnings stay at $10, but QE does help a stock’s P goes to $110.  The P/E is now 11, however fundamentals remain unchanged.  
• The open ended comment essentially assures Treasury yields shouldn't have a large move up and volatility in that market should be muted.
• Treasury and agency spreads should narrow further.
• The Fed won't be tightening until there is a dramatic change in the economic data.  
• Is the Fed now out of bullets?

In my next post, I want to touch on what happened to various asset prices the last two times we have QE.

Apple to Consume Cable?

The headline might be a bit much, especially the inevitability.  Still I got to thinking after reading this article on Apple.  I instantly thought cable will be dead over time. 

First, for those who aren’t familiar with Apple TV is a small box that hooks up to your TV.  From that you can order movies off of iTunes, watch shows from Hulu, stream NetFlix movies, view anything like photos or movies from any computer in the house,  and other features.  My brother has it, and I can attest it’s very smooth, clean, and easy to use.  So why will it end cable?

• Who likes their cable operator?  It’s overpriced; you pay $200 a month and watch three channels.  Rarely do you find anything worth watching.  The customer service is awful.  Everyone seems to think they have the worst cable company.
• With Apple TV you wouldn’t deal with any cable company and only buy the box once. 
• The business model is not consumer friendly.  Most of it is all or nothing and you pay for channels you don’t need.  For example, if the Oprah Channel costs Time Warner $1 per subscriber I am incurring that cost even if I don’t watch that channel.
• With Apple TV you would only pay for what you wanted, at least how it is currently set up.
• You can stream a lot of shows now on your computer.  You can even stream Bloomberg TV all day live.  This adds cheap alternatives at a fraction of the cost.
• Streaming will be easy to wrap into an Apple TV and it only costs $100 at the onset for the box.
• The marketplace is evolving.  Record companies, cell phone manufacturers, hardware, software, publishers, etc.  industries that all changed because Apple innovated while others didn’t. 
• Do you think Apple or cable companies will be quicker to innovate or set the marketplace?  Further, Apple products at the very least tend to be the most user friendly, efficient, clean, and glitch free of any on the market.  I have a Samsung Blue-Ray player that cost $150 and offers similar features to that of Apple TV, but it is a pain to use.

Will this happen overnight?  No, it might not even happen at all.  However, when I look at the landscape cable seems like easy pickings for Apple.  While I admit Apple TV isn’t there yet to overcome cable, in time it should evolve.  When that happens, I know I won’t be purchasing cable.

Where we are at now, US Economy

With the massive amount of data available it can be hard to get a grasp on what is going on.  I tend to look more at the big picture and trends, as opposed to the data points.  So here it goes:

• GDP growth is slow – 2% for Q1 and 1.70% for Q2 (revised up today).  Year end estimates are in the 2% range.
• Employment isn’t good.  But hey, doesn’t look like mass layoffs are coming up soon either.
• Housing starts have bottomed and are in an uptrend.  Maybe even prices (?) have bottomed.  Just don’t expect a massive V recovery in either.  
• Real income growth is weak and still below the 2008 peak.
• Retail sales were up, but that was after a decline.  It’s not clear whether the trend will move down, sideways, or reverse back to up. 
• Industrial production continues to expand and is in an uptrend.   The ISM Index indicates a slight contraction. 

So the bad news is I wouldn’t expect a massive jump in GDP.  None of the above metrics (or any others) seems to indicate that.  This is because employment is terrible and income growth is weak.  Without higher incomes, there is less demand; less demand equals lower revenues, which in turn leads to lower employment.  This is why I am opposed to deficit reduction now.

On the plus side, nothing appears to be rolling over.  Retail sales were close, but the most recent jump at the very least gave pause to its recent moves down.  Hopefully this actually reverses the trend going forward.  Housing is now a tailwind as opposed to a headwind.  And manufacturing, while not roaring, is chugging along.

Ultimately, this is indicative of a slow growth economy, but not one that is cratering or in recession; although, the latter is more semantics at this point than anything.    

What to Do About a Higher CAPE?

In my last post I pointed out that from a longer term valuation standpoint the market isn’t a screaming long-term buy.  Before we get into how investors can navigate the secular bear market trend, here are some caveats with CAPE:

• Not very reliable over the short term.
• Given the above, low CAPE can go lower and high CAPE higher (i.e. can’t time the market with it).
• It’s only one measure.
• Innovation could alter the secular trend.

I am still under the assumption that the secular trend we are in is bearish.  That doesn’t mean ditch your stocks now; however, there are things you can do:

• Temper your expectations:  an annualized return of roughly 10% to 15% is going to be tough to achieve.
• Linear is dead:  the relative linear movement of equities from 1982 to 1999 is probably not coming back for awhile.   It is likely to return, but not until the secular bear cycle runs its course.  So expect the choppiness to continue.
• Risk On, Risk Off:   this isn’t to say go from 100% cash to 100% stocks at the drop of a hat, but take profits when you can and rebalance when needed.  Further, it wouldn’t hurt to dial risk back when markets get frothy.
• Have a plan on the downside: be aware of the trend: this seems obvious, but today it can be easy to get caught up in the news and confuse noise with signals.
• Preserve capital:  this one is the key.  Don’t suffer catastrophic losses.
• Stay up the quality chain:  similar to the above, but this way when the market moves down you don’t catch all of the downside.
• Diversify PROPERLY:  realize that asset class correlations tend to be closer to 1 and -1 right now and can change quickly.  Further, past correlations don’t mean that future correlations will hold.

  

Stocks for the Long Run…

If valuation levels are correct.  This isn’t anything new or complicated, investing in stocks when they are overvalued will likely yield a lower return over the long-run then when stocks are undervalued.  

There are various levels to measure this.  For this post I will look at Dr. Shiller’s Cyclically Adjusted Price to Earnings ratio (CAPE).  This widely utilized methodology calculates the inflation adjusted price of the S&P 500 divided by the prior 10-year mean of inflation-adjusted earnings.  In short, it is a measure of long-term valuation.

So where are we now?  These CAPE charts indicate: 

• We have a ways to go before we launch our next secular bull market (i.e. we are still in a secular bear market).
• CAPE moves in downtrends and uptrends, we are in a downtrend.
• Thus, CAPE should contract further (higher earnings combined with lower or stagnant equity price levels) before the next great long term buying opportunity presents itself.

Recently I read a study, which highlights the strong correlation between CAPE and forward equity returns – the longer the time horizon, the greater the correlation.  This is true not only in our market, but other markets (developed and emerging, though less tight in emerging).

This doesn’t mean you should avoid stocks altogether, in fact in the short-term CAPE isn’t reliable at all.  I just think it’s important to highlight the secular bear cycle we are in and that future will probably present better long term buying opportunities for equities than right now.

TARP “An Abysmal Failure”

Those were the words of Neil Barofsky (appointed by Bush, registered Democrat), former special inspector general for TARP, in a recent interview with Yahoo! Finance.  Here is the video:

And here are some key takeaways:

• Banks could dictate terms of their own bailout
• No difference between the Bush administration and the Obama administration
• Most of blame goes to executive branch, and thus Treasury (again both parties)
•  Program was intended to restore lending, help homeowners, but nothing in program to compel the banks to do so 
• Geithner essentially acknowledged that the program was to allow banks to soften the blow and extend the foreclosure process
• Government just looked the other way in the face of misconduct
• Accounting tricks and spin have essentially showed TARP is a gain, but losses were still less than expected
• Further, the above “gain” doesn’t take into account all other bailouts
• It did help prevent financial Armageddon, but did little in the way of helping the broader economy and households, which is the reason why Congress passed TARP in the first place

In hindsight without the world on the brink of returning to a hunter-gatherer society it’s much easier to criticize the program.  It was really scary in the Fall of 2008.  I admit that.  Further, I will concede I don’t think Paulson, Bernanke, Geithner, etc. created this massive wealth transfer out of malice.

Having said that, I think Barofsky is correct – consumers are still over leveraged, unemployment is high, consumption is weak, growth is slow, etc.  While all are improving, none are indicative of a robust economy.  There could have been a better way to handle TARP (e.g. controlled bankruptcy, greater controls) and if there wasn’t, why wasn’t there?

Ultimately I think TARP is another example of treating the symptoms and not the disease.  The banks were in trouble because they made excessive loans to consumers who were leveraged to the gills.  The economy won’t feel any better until the consumers repair their balance sheets.  TARP, monetary easing, and other policies have done little to address that.

HT to Big Picture for alerting me to the video.

Here is Barofsky’s book.

Takes From “Fooling Some People All of the Time”

A friend pointed me to the book Fooling Some People All of the Time by David Einhorn, president of the hedge fund Greenlight Capital.  The book details Einhorn’s short position in Allied Capital. At first I was hesitant to read it because most of my reading is more macro than micro (as you could probably tell from this blog).  However, it turned out to be a great read and even read more like fiction.

Einhorn goes into detail why he took the position (egregious accounting, loan fraud, ponzi scheme), how the position played out (longer than he anticipated, same Allied practices continued), his struggles along the way (SEC accusations, phone records stolen, ad hominem attacks), and what ultimately happened (he was right, made a lot of money).  Rather than write a book report, I figured I would highlight some of my key takeaways:

1. Trust Yourself.  Executives, analysts, journalists, regulators all failed shareholders.
2. Short Selling is Good.  I always thought this, but if you have beef with it this book is worth the read to see why it's good.  Essentially short sellers help uncover what everyone else (again, executives, analysts, journalists, regulators) fail to see.  There are other reasons why short selling is good for markets, but won’t get into detail.  Just know Spain banning short selling won’t work.
3. When a Company Attacks Short Sellers, Bet on the Latter.  Again, this is something I have thought for awhile.  First, why would a company who has nothing to hide attack shorts?  Ultimately they know the market price will reflect the value, if anything it gives executives a chance to load up on cheaper shares.  Shorts don’t bankrupt a company or lead it to have bad business practices, the company does.  It’d be like blaming the doctor for the diagnosis.
4. Trading Stocks is Hard.  The amount of research Einhorn did on this one company is astounding.  Just know when you buy an individual stock, the person selling it you is probably very astute. 
5. Markets Aren’t Efficient.  This is obvious.  If markets were efficient Einhorn couldn’t have made any money as Allied would have been priced under $5.

Those were just the first five that came to mind.  I have some more, but will leave it at that.  Anyway, it’s an entertaining, although at times frustrating given the lack of concern against Allied’s practices, story.

Here is a link to the book.  Also note, Einhorn and Greenlight donated $7m to charity from trading profits on Allied.

A Note on Unemployment

The employment picture is a huge economic headwind.  That is why each report gets so much attention.  Lack of employment = continued weak demand.  If the employment situation improves, consumption should pick, balance sheets will heal faster, the economy will improve, and then you get a positive feedback loop.  With that in mind, let’s take a look at the most recent report…

The Good:

• We added 163k jobs
• Better than consensus (100k forecast)
• The stock market appeared to like the number
• Indicates we aren't in a recession

The Bad:

• Other aspects of the report were more negative
• Unemployment actually rose to 8.30%
• U6, a broader range of unemployment rose to 15%
• Revisions in prior months and seasonality 

What it Means:

Nothing.  While I just said the report gets attention, it’s one report.  The trends remain not good and the employment picture is still poor.  Calculated Risk has some fantastic graphs that illustrate this:

• Deepest job loss and slowest job recovery in Post WWII recessions (here)
• Long-term unemployment, while decreasing, is still elevated (here)
• Note, if this doesn’t decrease it could indicate a more secular employment problem
• People ages 25 to 54 are underemployed relative to prior levels (here)
• People still aren’t participating in the labor force as they have in the past (here)

So to conclude, it’s good we are moving in a positive direction, continuing to heal, and seemingly not in a recession as of now.  Still, the report is not a game changer and does not augment the underlying key theme – the employment situation as a whole is weak.

Focus on the trends, not one reading.

Investors Mistakes – Part III - My Additions

My last few posts outlined Barry Ritholtz’s 10 investor mistakes and Robert Seawright’s 10 Most Common Behavioral Biases.  I gave a brief description and then provided a solution to avoiding such errors.  Today I cover some errors not mentioned by the last two authors.

1. Political Trades – an investor makes an investment or trade based on his or her own political views or that of a commentator.  Solution:  Avoid these investments all together.  An easy way to spot one is the association of a political party or politician to reason why investment ABC will move up or down.  That isn’t to say geopolitical events don’t move markets, they do.  But look for analysis with data, not vague political diatribes.
2. All or None – this is similar to Rithotlz’s #3 (being your own worst enemy), but often times investors will get bullish and want to move all into stocks and/or bearish and move all into cash.  Such large moves can drastically increase the chances of being right or wrong and alter the longer-term risk/reward profile of the portfolio.  Solution:  Have a game plan.  Make moves in ranges, particularly on the downside.  If you get nervous, take a % away from equities and move into bonds, but try not to alter your whole portfolio.  Even better, have a plan on the way down with different sell points, hedged investments, moving up in quality, stop losses, etc.
3. Ignoring Liquidity – not realizing the importance of having your capital locked up in investments that don’t trade daily.  Solution:  Not all illiquid investments are bad, but make sure you realize that your assets will be tied up and for how long.  A hedge fund probably has greater liquidity than CRE, but both will have capital tie ups, for example.  Further, make sure you know the underlying investments, as this has bearing on the nature of the liquidity.  In the last downturn, some of these investments, which were supposed to provide quarterly liquidity couldn’t perform due to the nature of their holdings.   
4. Investing in What You Don’t Understand – deploying capital to investments (now investments with a higher yield are all the rage) that are confusing and/or complicated to the investors.   Solution:  Don’t get it?  Don’t buy it.  If you can’t answer the questions how much risk am I taking for the return and what the investment does to produce said returns, then chances are the investment isn’t for you.  It doesn’t make the investment bad, but it just increases your risk that it won’t perform as expected in any number of economic scenarios.  A rule of thumb - the more complicated the higher the seller compensation, so watch the soft costs, they dig deeply into return.
5. Ambiguous to Time Horizon – investing in inappropriate asset classes based on time horizon.  Need money in a year?  Don’t invest in stocks.  Solution:  Figure out what you need from your savings and investments over the next few years and earmark assets for those purchases.  A lack of liquidity can also be measured by selling your assets at a loss when you need the cash. Making sure your time horizon matches your asset mix can help alleviate that issue.

I have 5 more, which I will get to at some point down the road.

Investors Mistakes – Part II - Behavior Biases

My last post outlined Barry Ritholtz’s 10 investor mistakes and then provided some solutions.  In this post, I will focus on cognitive errors investors make.

I recently read an article entitled “Investors’ 10 Most Common Behavioral Biases” by Robert Seawright.  I really think behavioral finance aspects of investing are vastly overlooked, especially when it comes to Modern Portfolio Theory and a total set it and forget it allocation.  Below, I summarize the list and suggest possible ways to correct such biases:

1. Confirmation Bias – get to the conclusion first and then find facts to support it.  Solution:  Seek out information that runs contrary to your current opinions and conclusions.
2. Optimism Bias – you believe you are less at risk of experiencing a negative than everyone else.  Solution:  Focus on the capital you have at risk.
3. Loss Aversion – losses feel much worse than gains feel good leading to poor investment decisions (note: this conflicts with number 2 and as the author states “we tend to make bold forecasts but timid choices”).  Solution:  Have a plan in place in the event you start to experience losses.
4. Self-Serving Bias – good things happen because of you, bad things are someone else’s fault.  Solution:  Be humble regarding gains, owe a part of it to dumb luck, have a plan on the way down so losses are in your hands.
5. The Planning Fallacy – we overrate our own abilities, underestimate the process, and overestimate the gains.  Solution:  Have an objective look at the risk/return profile of your investments, realize the future won’t replicate the past, and be cognizant of hedging costs.
6. Choice Paralysis – too many choices lead to decision paralysis.  Solution:  Reduce the number of your investment holdings and focus on asset class over managers.
7. Herding – herd behavior.  Solution:  Be cognizant of the herd, but don’t follow it without a logical reason.  Realize investment managers also follow herd behavior (e.g. they get hammered less if they are wrong when everyone else is, but are hammered harder if they are wrong when the herd is right).
8. We Prefer Stories to Analysis – people tend to prefer a narrative to data: it’s easier to understand.  Solution:  Analyze data, look for trends, and make objective decisions based facts, not stories.
9. Recency Bias – extrapolate recent events into the future indefinitely.  Solution:  Filter noise and look for signals.  Generally, ignore most analysts.
10. The Bias-Blind Spot – not recognizing we have cognitive deficiencies.  Solution:  Read the attached article and this blog post. 

Next up, my own additions to the last two posts.

Investor Mistakes – Part I – Conventional Mistakes

Recently there has been a wave of good articles outlining investor mistakes.  As a result I thought I would outline the two pieces I read and then in a separate post, add my own.

The first piece is from Barry Ritholtz entitled “Investors’ 10 most common mistakes”.  I present my Ritholtz’s mistakes and then suggest a solution:

1. High fees – over time fees can be a big drag on returns.  Solution:  Seek out investment managers with lower fees, ask for transparency, and avoid complicated investments with higher fees.
2. Reaching for yield – picking investments based on what they kick out in income.  Solution:  Always keep an eye on the risk vs. return trade off. This has been a common and BIG mistake by many investors in the last five years investing in CDO’s and like securities.  On the equity side look for quality, not yield.
3. Your own worst enemy – making investment decisions based on emotion.  Solution:  I like Mr. Ritholtz’s solution, if you need to “feed the beast” do so with a small amount of capital so as not to sabotage your portfolio.
4. Mutual funds vs. ETFs – mutual funds charge higher fees than ETFs.  Solution:  Be diligent in your active management selection and use ETFs as a foundation in your portfolio.  Anywhere from 15 to 30% of active managers have outperformed the indexes, depending on the asset class.
5. Asset allocation vs. stock picking – how you allocate to asset classes matters more than security selection.  Solution:  Give a greater weight to what asset classes you are in, paying particular attention to risky assets and realizing in times of crisis or euphoria they move together making security selection inconsequential.
6. Passive vs. active – most active managers struggle to beat the passive benchmark given fees.  Solution:  Similar to #4.  Again, thoroughly comb through active managers, know their strategy, be aware of fees, check their performance, and, most importantly, make sure qualitative factors are in place for repeatable success.  DON’T CHASE RETURNS!
7. Not understating the long cycle – markets move in secular cycles.  Solution:  Be cognizant of what is going on currently; however, never lose sight of the secular trend.  Realize strategies that work in bull cycles won’t necessarily work in bear cycles and vice versa.  Additionally, realize that bull market runs exist in secular bear markets and vice versa.
8. Cognitive errors – we suffer from many cognitive deficiencies which can present themselves when we invest.  Solution:  Too much to cover in a couple of sentences. I will expound on behavioral mistakes more in my next post. 
9. Past performance and future returns – chasing the hot money and not taking into account qualitative factors.  Solution:  Know the managers you are investing in and whether the past performance is replicable, luck, or more on beta (asset class performance) than alpha (security performance).  Don’t chase purely based on performance!
10. Get what you pay for – paying for advice or services you can DIY and/or finding the right people.  Solution:  Seek credible trustworthy referral sources. Interview several advisors and determine what you get for what you pay. Most importantly make sure it feels like you can develop the chemistry required for a successful relationship.   

Up next, various cognitive errors we make.

Europe Again & Again & Again – Part III, Some DIY Tips

Given all the news that comes out of Europe, I figured it would be a good idea to provide readers with a quick way to find easy to read news stories and then see how markets react. 

First, here is some good source material from the NYT.  I choose Spain and Italy given they are the rage right now. The pages are set up rather nicely, with a summary of all relevant information at the top, followed by the newest NYT articles on the bottom:

• Greece
• Spain

Next, when a new piece of information comes out how will the markets react?   I like to follow the yield on government bonds.  Bloomberg provide 10-Year yields and I picked three of the riskier Euro nations and then Germany as a way to compare:

• Greece
• Spain
• Italy
• Germany

Basically if things in Europe are worsening riskier Euro nations will have their yields rising and Germany should have its yield falling (note: this might not hold in the remote worst care scenario). 

There is also Intrade to see a market prediction on a county leaving the Euro.  Without getting into detail, essentially just look at the % chance.

There are obviously many more places to mine for data.  I think these are the most basic and direct. 

One thing to note, it appears the trend is that markets are reacting less and less favorably after every “positive” announcement.  To me this indicates markets aren’t buying what Europe is selling.  Again, as I mentioned in my previous post, I don’t think this will happen until Germany backs substantial systemic change. 

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development – basically banks will now be able to borrow directly from the ECB, not their own Central Bank.

This is bigger than any news out of the EU in awhile.  While the restructuring I think is needed, it is certainly a step in the right direction:

1. A step toward UNITY.  This is key, all countries need to start moving together, not apart.
2. By recapitalizing the banks directly through the ECB, the risk of the worst case scenario credit crisis scenario (bank runs) appears to be reduced, although not eliminated.  

Europe Again & Again – Part II, Too Much of Nothing New: What to Expect

When I say “nothing new” I mean anything that isn’t a total restructuring of the Euro.  This should be approached with either new rules/institutions (e.g. Eurobonds, EU backstop, etc.) or with a change in members (e.g. weaker members leave, Euro disbands, etc.).   Status quo will not do - something new, something systematic is required if some semblance of the Eurozone is to survive.

What does not constitute something new is what I outlined in my last post – Spanish bank bailout, and  a Greek coalition to stay in the Euro.  These are stop gap measures that will only kick the can down the road.  The market apparently agrees.

So if Europe continues to kick the can down the road what should we expect?  More of the same from late last summer to now:

• Downward pressure on the Euro vs. Dollar (i.e. the Dollar continues to strengthen versus the Euro, making your European vacations cheaper and our exports more expensive)
• Steep VIX futures curve
• The VIX is a forward looking volatility measure.  The steep curve implies the market expects volatility to be greater in the future than it is now.
• Upward trend in yields of weaker EU countries (Greece,  Spain,  Italy)
• Downward trend in German yields
• Low Treasury yields
• Choppy equity market, perhaps range bound

How long with this continue? I am not quite sure, but I would think the above trends will probably hold until there is a resolution one way or another.   That isn’t to say there won’t be movements against the trends whenever some news comes out, just that over the course of “kicking the can down the road” they will persist. 

The ball is in Germany’s court.

Update:  I wrote this a few weeks ago, but since then there has been a relatively big (well bigger) development – basically banks will now be able to borrow directly from the ECB, not their own Central Bank.

I will comment more on this in my last post of this 3 part series.