Talking the Talk, They will Walk the Walk

You can talk the talk. Do you walk the walk?
- Full Metal Jacket

Well it didn't take to long for things to get dicey again in Europe.  Even though Greece was restructured 3 weeks ago, and the ECB lent ~$1 Trillion of LTRO funds, bond rates in Italy and Spain are climbing higher.  On March 1, the 10 year Spanish bond was 4.87%.  Today Spanish rates hit 6%.  This is important because as the 10 year bond moves towards 7%, it means investors have lost confidence the Spain can resolve its budget deficit and make good on its debts.  7% is the line in the sand as this is when Greece, Ireland and Portugal needed bailouts.

Source: Bloomberg

Almost on cue, the ECB restarts talk about it's bond buying program.  From the Telegraph: ECB may act to bring down Spanish borrowing costs

Benoit Coeure, an executive director of the ECB, said the bank could restart its sovereign bond buying programme in a move likely to antagonize Germany but relieve a spiralling political, economic and social crisis in Spain.

Mr Coeure said that market fears over Spain were "not justified" but he added: "Will the ECB intervene? We have an instrument, the securities markets programme [SMP] which hasn't been used recently but it still exists."

Bond traders were soothed by the comments. The yield on Spain's benchmark 10-year bonds was pulled back from 6pc on Tuesday to 5.88pc, while the yield on Italy's 10-year debt also dropped marginally, to 5.54pc. 

Mr Rajoy delivered a strongly-worded speech to parliament insisting that it was "as clear as day" that Spain would not need a Greek-style bail-out.

Occasionally I'm asked how did I know things were going to blow-up in 2007.  My first clue was when the word "contained" was used by Ben Bernanke and Hank Paulson with regard to subprime mortgages.  Mike Mish Shedlock shred those claims to pieces using examples of Washington Mutual mortgages.  Another clue came from Paulson's claim that the US would not need to take over Fannie Mae and Freddie Mac.  When things are officially denied like that, watch out because it's going to happen.

Rajoy is right in that Spain will not need a Greek-style bailout - it's going to need a Spanish-style bailout because Spain's economy is more than double the size of Greece, Portugal, and Ireland combined.

We've Seen This Movie Before

The movie I refer to is how the ECB, IMF, and EU treated Greece's fiscal problems.  Currently Spain is sticking to cutting its budget though I've read that the EU wants it to raise taxes as well.  I expect to hear more about selling national assets to pay down debt.  When the ECB starts buying more Spanish bonds, then start to watch Spanish banks as they are reported to have been buying Spanish bonds using the LTRO money.  As these bonds have dropped in price, the losses to banks are building.  Worse if there is a Spanish restructuring, remember that the ECB gets paid in full while investors and banks get shellacked.

The only way Spain does not get bailed out is if it leaves the EU first.  What are the odds the politicians go that route?

And in the U.S.

The one direct affect of Spain should be falling bond rates in the U.S. as investors seek a place of refuge.  Ironically when bonds rates rose a few weeks ago, I wondered if people had forgotten that the LTRO in Europe simply bought time - it didn't solve anything.  Maybe most people thought it bought 3 years of time.  Regardless, bond rates in the U.S. should stay lower as questions about Europe and questions of the U.S.'s recovery remain in focus.

And about that U.S. recovery, it seems the best we can get is conflicting data.  What I might find humorous, if it wasn't so maddening, is how the good data took hopes of a new quantitative easing program off the table - but then unexpected bad data (in the form of the March employment numbers) immediately raised the hopes for such a program again.  The reason I, as a stay-at-home dad, find this maddening is that it resembles my two year old's temper tantrums.  Give us QE3 or watch the stock market tank.

What's worse is I see the Fed giving in as they have every time the stock market threatened to fall.  From Advisor Perspectives: Fed Intervention and the Market

I'm not the only one who sees the Fed giving in.  From Bloomberg: Gross Cuts Treasuries, Raises Mortgages in Fed Buy Bet

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., cut holdings of Treasuries last month to 32 percent, the lowest since December, and raised mortgages to the most since 2009.

Gross reduced the proportion of U.S. government and Treasury debt in the $252.4 billion Total Return Fund in March from 37 percent of assets in February, according to a report on the company’s website today.

Bill Gross, co-chief investment officer of Pacific Investment Management Co. (PIMCO), speaks during an alumni event hosted by UCLA Anderson School of Management in Beverly Hills on Nov. 17, 2011. Photographer: Andrew Harrer/Bloomberg

He raised the fund’s holdings of mortgages to 53 percent last month, the highest since June 2009, from 52 percent in February, in a bet that the Federal Reserve will buy the securities in a new round of purchases. Newport Beach, California-based Pimco doesn’t comment directly on monthly changes in its portfolio holdings.

The Fed will probably shift focus to buying mortgage securities to keep borrowing rates low when its so-called Operation Twist program ends in June, Gross said in a March 28 interview on Bloomberg Television’s “InBusiness with Margaret Brennan.”

Bill Gross successfully front ran previous Fed easing, meaning he bought treasuries and mortgages at a lower price to sell them to the Fed at a higher price.  Can it work again?  As the Fed has consistently talked the talk and walked the walk, I wouldn't bet against it.

Parting Thoughts

I've read recently that you have to trade (invest) the market you have, not the market that you want.  It made me think if I ever have invested in a market that I want.  Thinking back to when I got started in 1998, that was the final legs of the Internet bubble.  Afterwards, the Federal Reserve slashed rates so low and kept them there so long, that the housing bubble formed and kicked off the debt crisis.  Now global central banks are printing trillions in an effort to get things back to normal.

However what is normal? Looking back, it seems that all I have experienced in financial markets is managed by interest rate setting central bankers. When do bond markets finally say "enough" and start selling (thus raising interest rates)?

Perhaps what I really need to answer is what would make me sell my bond mutual funds.  Quantitative easing 3?  More Congressional stimulus? More tax cuts without offsetting spending cuts?  Maybe even no spending cuts?  More government borrowing?

As it is late, I'm going to let these questions go unanswered though I have a bunch of thoughts swirling through my head.


Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.

With that said, don’t let your investments keep you up at night. If they do keep you awake, you may be taking more risks than you are comfortable with. Talk to a professional about reallocating to less risky investments so that you can sleep. During your conversation with said professional, ask why they believe that their recommendation is less risky. If you are not convinced by their explanation, don’t invest. Remember:

1. It’s your nest egg.
2. Opportunities are easier to make up than losses.

Musings on the Market March 11

Quite often when I write, I feel like I need to say something about time horizon.  If you're a long term investor, you really don't need to focus on the daily news (except my blog of course...).  Now if you have an ADD-like complex where you have to monitor all things financial and economic, welcome to my world.  Please note though that I rarely make changes to my long term allocations based upon news events.

On the One Hand

I've been reflecting on all of the news from last week, trying to assign some importance to the news compared to the risks that I've talked about in past articles.  We saw encouraging news:

• Labor Department says 227,000 new jobs in February plus December and January were revised up by 61,000.
• Manufacturing and Service ISM numbers are still showing expansion.
• German exports increased 2.3% in January versus December.
• French industrial production increased 0.3% in January versus December.
• Greece successfully swapped it's debt.
• The Greek debt swap was called a default for credit default swaps (CDS) because of the use of collective action clauses (CAC) to bring bond holder participation to needed levels.

New jobs means that the economy is trying to recover.  Likewise, expansion in the ISM numbers also portends to an economy trying to mend itself.

The German and French reports are important because those are the largest two economies in Europe.  If there is any hope for Europe to get through its problems, its best players need to perform.

The Greek news was encouraging because finally the EU is starting to see that they have to restructure and/or default on debt in order to get through the problem.  The other positive is that the committee that rules on defaults for CDS declared a default event had occurred.  I'm not sure any bank would have ever sold another CDS contract had that not happened.  Furthermore, who would buy sovereign debt in troubled countries if they cannot hedge their risk?

On the Other Hand

There was also conflicting data:

• US productivity was down significantly for all 2011 compared to 2010. 0.4% vs. 4.1% respectively.
• Unit labor cost, which includes wages, was up 2.8%.
• The Federal Reserve is weighing a new method of easing to keep rates low.
• The Greek debt swap was called a default for credit default swaps (CDS) because of the use of collective action clauses (CAC) to bring bond holder participation to needed levels.

Declining productivity can be attributed to many things.  As employment is rising, I consider declining productivity to be the result of new workers added to payrolls - they take longer to complete their tasks.  New workers would also explain why unit labor costs are also rising. The reason this is important though is it should lead to rising prices.  Rising prices would cause the Federal Reserve to reconsider their easy monetary policy.

A little more on the Federal Reserve, I especially like how the announcement of their "new idea" came out the day before the Greek debt swap.  As any type of new easing program is widely thought of as positive, it breathed life into markets that were looking for a new hope to cling to now that the second Long Term Refinancing Operation in Europe is completed.

Another thought on easing, if things are recovering, then why do we need more?

The Greek news was also discouraging.  From John Mauldin's Thoughts from the Frontline: There Will Be Contagion (emphasis mine)

Greece itself is in free fall. The "benefits" of austerity have not become apparent, as the Greek economy saw growth rates of -0.2% in 2008, -3.3% in 2009, -3.4% in 2010, -6.9% in 2011, and...? The 4th quarter of last year saw a GDP fall of 7.5%. Do you see a trend here? The Greek economy is down by almost one-fifth in less than five years. Unemployment has risen to 20%, and 50% among young people, many of whom are leaving the country. Resentment has grown among ordinary Greeks over the austerity medicine ordered by international creditors, which has compounded the pain. Greek papers are full of stories blaming Germany for their problems. 

By any standard, what will soon be a 20% drop can be classified as a depression. There is nothing on the horizon to suggest things will turn around any time soon. The country's public debt-to-GDP ratio currently stands at 160% of nominal gross domestic product, AFTER the debt restructuring. If Greece can find someone to lend them more money, it will only get worse. 

The current agreement with the EU will not improve the economy, but require even more wage cuts, government spending cuts, and higher taxes and unemployment. The problem is that if Greece leaves the euro, those problems do not go away, they just take a different form. There is still a great deal of economic pain for Greece as a consequence of past decisions. It is sad, but there is no other choice, unless the rest of Europe or the world, through the IMF, simply gives Greece all the money they want. But then where do you stop?

As John mentions, did you see the trend of weakening GDP?  The only way for Greece to lower it's debt-to-GDP ratio is to cut spending and grow it's economy.  The growth doesn't look promising.

By the way, John's letter is worth your time to read in full. These letters are free and you can sign up at www.johnmauldin.com.

Finally, have you ever played a game where someone tried to change the rules well after that game had started?  If you have an ultra-competitive 5 year old in your midst, you are undoubtedly nodding in agreement.  The Greek debt swap was also a negative because the CACs were added to law AFTER the bond contracts were already written.  So in addition to watching the ECB get paid in full on it's bonds, investors were forced to take their losses even if they tried to hold out.

Which leads me to my next thought - what's preventing this same routine of investing in sovereign debt, having a CAC inserted into law, and then forcing a default as part of additional bail outs from being used on other countries?

So What's This Mean to Me

I honestly do not see anything that requires me to make any changes to either my Retiree Portfolio or Dollar Cost Averaging Portfolio.  Every time I see encouraging news, I start to feel like I may miss out on something in my Retiree Portfolio.  However I then remember that nothing has really changed the overall debt picture.  Yes things look good, but as I said above, if things look so good, then why is the Fed looking to ease more?  And why is the ECB lending out more money just to cover payments of previously borrowed money?

Parting Thoughts

It's spring break, and for once in Texas, I think it'll be rather nice outside.  So far, 2012 has been warmer than I remember in years past.  And we're finally getting some ugh needed rain.  Hopefully that will continue.  If you haven't been to Texas in mid-March, let me simply say that the weather is anything but predictable. I've been on fishing trips where we've gone from sunny and 80 to cloudy, rainy, windy, and in the 40s.  Definitely not predictable.

However since my kids are out of preschool, my schedule will be predictable - predictably busy.  Still I'm hoping to discuss the 100 Year Theory Chart again, which was first revealed in Market Risk, Are You Managing It?.  I hope you have a great week!


Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.

With that said, don’t let your investments keep you up at night. If they do keep you awake, you may be taking more risks than you are comfortable with. Talk to a professional about reallocating to less risky investments so that you can sleep. During your conversation with said professional, ask why they believe that their recommendation is less risky. If you are not convinced by their explanation, don’t invest. Remember:

1. It’s your nest egg.
2. Opportunities are easier to make up than losses.

How Many Bulls in this Rodeo, Clowns Want to Know

Darling you got to let me know
Should I stay or should I go?
If you say that you are mine
I'll be here till the end of time
So you got to let me know
Should I stay or should I go?
- Clash


The song above rang a bell as the S&P 500 closed today up at 1352.  Not a new high, but relatively close to the 2011 high of 1363.  The American Association of Individual Investors reports in its most recent Sentiment Survey that 52% of it's polled members are bullish, 28% are neutral, and 20% are bearish.  I also discovered that well known market bears Nouriel Roubini and David Rosenberg turned bullish recently. 

And there are reports like this one by David Kotok from Cumberland Advisors.  Initially when I read it, I looked at it as a bullish report - meaning I should have my money invested in the stock market.  (Please note that all emphasis is mine.)

So far, the Cassandras’ predictions of global collapse and failure have been proven false. Some of the most notorious bears are now turning bullish and revising their forecasts to the positive. Other “gloom and doom” holdouts are feeling the heat. We think that heat will intensify.

The key to watch is in the credit markets. Credit spreads tell a story of overwhelming liquidity being applied to the financial-system open wounds like a steroidal salve.

... 

Credit spreads are reflecting transition from worldwide recession and double-dip forecasts to gradual and improving economic outlooks around the globe. Data supports this shift in the United States, as well as in other places in the world. It will happen in portions of Europe, but not in Greece. 

... 

At the present time, our US stock market ETF portfolios remain fully invested. We are concerned about a market correction, which appears underway. It is necessary, since we have moved dramatically higher from the October selling-climax low. The upward move has been at a sustained pace. We expect this to be a correction, not a market peak. We believe the financial sector is still attractive. As it repairs, it will become even more attractive.

Truth be told, this market report ended bullish.  However the more times I read this report, the more I realized that this is a on-the-one-hand and on-the-other-hand report.  In other words, it also lists market limitations.  Going back to the report, let's look at that second paragraph again:

The key to watch is in the credit markets. Credit spreads tell a story of overwhelming liquidity being applied to the financial-system open wounds like a steroidal salve. Such treatment can alleviate interim pain. It is treatment for the symptom; it works for a while. It does not provide a permanent cure.

Liquidity is a treatment for the symptom.  Also consider:

Why have all the Cassandras been wrong? Because they ignored the power of central banks to cause credit spreads to narrow. 

Ergo, central bank liquidity has improved the credit markets. As the credit markets determine lending to everything from companies to countries, the global economic ecosystem is dependent on them functioning.  As long as credit markets are happy, global financial markets can overlook the debt crisis. Here's a summary of global central banks actions to ensure this outcome:

The G4 central banks (http://www.cumber.com/content/misc/G4_Charts.pdf) have taken the size of their collective balance sheet from $3.5 trillion to $9 trillion. That number is likely to rise. The G4 have extended duration so that the focus of their policy is not just in the overnight lending rate or in the very short term. Massive liquidity has blunted liquidity squeezes everywhere in the world.

Yet this type of intervention into the economy cannot go overlooked.  No one can tell me the market is free when $5.5 trillion has been added to system simply to keep it going.  After all, what happens when this liquidity goes away?  I don't think anyone knows for sure, but it's reasonable to speculate there could be an equal and opposite reaction to when the liquidity is added.

On to my next speculation - when will central banks pull back?  I haven't read much detail about the Great Depression.  However I have read that many armchair quarterbacks think it didn't have to last as long as it did, and they blame the Federal Reserve.  These individuals argue that the US economy started recovering in 1932/1933.  However in 1937, the Federal Reserve tightened monetary its policy, which led to a "second depression" as measured by unemployment as seen below.

Source: http://silverloc.edublogs.org/category/depressions/the-great-depression/

As Ben Bernanke is known as an expert on the Great Depression, he does not want to be known/blamed for the same mistake.  Hence, it's likely that much like Alan Greenspan left interest rates too low before the housing crisis, Ben Bernanke will also leave monetary policy too easy.  Hopefully it will end better this time than the last (though I wouldn't bet on that).  Certainly price increases (e.g. inflation) will result.  David Kotok surmises as much:

By the end of this year, the G4 central banks will have expanded their balance sheets approximately threefold during the financial crisis. The negative and inflationary results of this activity may appear in the future.

So on-the-one-hand we have central banks providing liquidity to the global economy via the credit markets.  This makes for bullish equity markets.  On-the-other-hand, doesn't this mean we have a financial system based on air and promises versus something real/substantive?   Occasionally I read about the hollowing out of the US manufacturing sector, looks like it's spread to the financial sector as well.

Still my favorite paragraph from David is this:

The biggest threat to financial-market pricing comes from periods of uncertainty, the sequence of ambiguous and conflicting views that alter investor perceptions. Uncertainty is the enemy of market pricing. Once you achieve clarity, markets adjust quickly to the new reality and move on. This will hold true in every city, county, and country. And it will apply to every banking system in the world.

One day the biggest uncertainty will be the central banks themselves as investors prophesy when they will reverse their policies.  Think about that...

I've been reading David Kotok sporadically for the last few years.  Like his previous works, this is a well thought out report.  If you can afford to spend more than 1% of your day, I encourage you to read it in full.

Is The Hockey Puck Slowing Down

Much like Wayne Gretzky's hockey play, stock markets don't trade on today's news.  They trade on perceptions of the future - skating to where the puck is going.  In the case of stock markets, the puck is earnings growth.  Lately, earnings growth is not looking good.  As FactSet reports, Estimated Q1 2012 earnings growth rate for S&P 500 falls to 0%. (emphasis mine)

The blended earnings growth rate for Q4 2011 stands at 5.5%. However, two companies account for most of the earnings growth in the S&P 500 for the quarter: Apple and AIG. If these two companies are excluded from the index, the Q4 2011 earnings growth rate for the S&P 500 drops from 5.5% to 0.8%. Comparisons to weak year-ago earnings are driving the unusually high dollar-level growth for AIG, while strong results in Q4 2011 are driving the high dollar-level growth for Apple.  

If 5.5% is the final earnings growth rate for the Q4 2011 quarter, it will mark the end of the streak of consecutive quarters of double-digit earnings growth at eight. But, it will mark the ninth straight quarter of overall earnings growth for the index. This streak might be in jeopardy in Q1 2012, however, as the estimated earnings growth for that quarter fell to 0.0% this week.

Source: FactSet

Note the contradiction between investor bullishness and estimated earnings growth.  If estimates do not turn around, the current rally will not last.

Parting Thoughts

The long-term average of bullish, neutral, and bearish investors in the AAII Sentiment Survey is 39%, 31%, and 30% respectively.  With the current reading of 52%, 28%, and 20% respectively, we can see that a lot of people are jumping into stocks thinking a new bull market is beginning.  Out of curiosity, I downloaded the survey from the S&P 500 all time high in October 2007 - Bullish 55%, Neutral 20%, Bearish 25%.

Truth be told, the fact that these numbers are close doesn't mean much.  Scanning through the years, there are a number of occurrences where the survey deviates from its long-term average.  And while the market may have fallen, it doesn't mean a major event is on the horizon.  Still don't blindly chase rewards, manage your risk.


Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.

With that said, don’t let your investments keep you up at night. If they do keep you awake, you may be taking more risks than you are comfortable with. Talk to a professional about reallocating to less risky investments so that you can sleep. During your conversation with said professional, ask why they believe that their recommendation is less risky. If you are not convinced by their explanation, don’t invest. Remember:

1. It’s your nest egg.
2. Opportunities are easier to make up than losses.