Ramblings of a Portfolio Manager--The Perfect Trifecta?
It should be no news to investors that, since July, the US capital markets have been held hostage by political and economic events unfolding in Europe. One cannot pick up a publication above a child’s pop-up book without reading about the political machinations in Greece and Italy and the struggles of French and German ministers, along with the ECB and IMF, to staunch the tide of debt defaults and ensuing continental recession. And our markets seem to move dramatically on every utterance by any European “official” however minor. For nearly 4 months now, the US capital markets have been the dog wagged by the Euro-tail. In fact, a recent study showed a 70+% correlation between US and European equities, nearly twice the long-run average. Should this be and how long can the trend continue? We see three reasons why the trend may be soon to end.
We are now at the tail end of earnings season in the US. Remember, this was a very low expectations season as many analysts had factored in the “Euro effect” into their numbers. Estimates were that 2011 S&P earnings could drop by as much as 25%, especially given that the depths of the European crisis occurred largely in the third quarter. Instead, US companies continued their long run of beating estimates with over 75% of companies doing so, right in line with the trend for the last eight quarters. S&P earnings estimates for the year barely budged. And as far as forward guidance from Management, it was not so robust as in past quarters, given the uncertainty in Europe, however 2012 S&P earnings have been revised down less than 3%. Hardly the stuff of economic Armageddon that has been predicted. In fact, the S&P500 is now trading at over 3 multiple points below its long run average. Yet this past season was the least talked about earnings reporting period probably in history as the financial press focused all their attention on Europe. Had Europe not existed, equity markets in this country would surely be much higher just on the back of earnings alone.
Also largely ignored by the talking heads was China. For over a year now economists have been wringing their hands over China’s monetary tightening policy, aimed at curtailing the real estate boom in that country. The fear was that China could not engineer a soft landing in the broader economy and would slip into recession, dragging the rest of the world with it. In the last few weeks, however, we’ve received data out of China that their braking efforts have been effective with inflation slowing while the economy continued expansion at a fairly robust pace. In fact, the Chinese have now stopped their string of interest rate and reserve hikes, signaling an end to their tightening policy and there is now talk of reducing the reserve requirements on banks, clearly an easing move. In fact, data shows that Chinese bank lending has risen substantially over the last two months, a sign that banks, at least, believe that the tightening cycle is at an end and a period of easing may lie ahead. Of course, that would good for world economies and, by proxy, world equity markets.
Finally, though the doomsayers may posit otherwise, the Europeans are, in fact, moving aggressively to fix their problems. No, with 17 sovereign entities to work in harmony, they cannot implement changes as fast as we did TARP in this country but it is clear that France and Germany are taking the lead to move things ahead. Does anyone doubt that Merkel and Sarkozy pulled a Luca Brazi on the Greek Prime Minister over the referendum? You can bet they will do that with Berlusconi as well if needed. While the issues in Europe will be worked out over months if not years, eventually they will fade from the front pages. That factor, along with China easing and record low interest rates and P/Es in this country, could just be the perfect trifecta for a significant market rally.
Monday, November 7, 2011
Monday, August 22, 2011
Ramblings of a Portfolio Manager
What to Expect From Jackson Hole
This Friday Chairman Ben Bernanke will speak at the Federal Reserve’s annual symposium in Jackson Hole, Wyoming.
Last year, Bernanke hinted that the Fed might embark on a second round of asset purchases to bolster the recovery, dubbed QE2. That speech kicked off a 28 percent rally in the Standard & Poor’s 500 Index of stocks that ended in a three-year high on April 29th.
At the last Fed meeting policy makers pledged to keep their benchmark interest rate near zero until at least mid-2013 and also said they “discussed the range of policy tools” available, giving hope that they may add to their record stimulus. That signaled that a QE3 might be on the table.
The whole world will be watching Bernanke’s speech, so if he chooses not to say very much, the global markets are sure to be disappointed. Though many market observers deny we will get a QE3, still there is hope among many that one will be forthcoming in some form.
Predictions are that Bernanke will suggest that the central bank will lengthen the average maturity for its $2.86 trillion of assets, which would help bring down long-term interest rates. The yield on the benchmark 10-year Treasury note dropped as low as 2.062 percent on Aug. 19 in New York, according to Bloomberg Bond Trader prices. Yields have fallen to record lows since the Fed announced its rate pledge on Aug. 9.
At the Fed’s last meeting Federal Reserve Bank presidents Charles Plosser of Philadelphia, Richard Fisher of Dallas and Narayana Kocherlakota of Minneapolis all voted against the Fed’s decision to keep the target for the federal funds rate at zero to 0.25 percent until at least mid-2013. Plosser and Fisher both said last week the pledge won’t help spur growth. The last time three policy makers dissented was in November 1992.
The central bank has kept the rate on overnight loans among banks near zero since December 2008. It also purchased $1.7 trillion of Treasury and mortgage debt between December 2008 and March 2010, and the $600 billion of Treasuries from November through June. The result was a temporary rise in risk assets but economic growth and job creation remains moribund.
Despite what many market watchers believe, the Fed is not out of bullets yet. Bernanke told Congress on July 13 the Fed does have stimulus options; these include buying additional securities, increasing the average maturity of its bond portfolio, lowering the interest rate on excess reserves and pledging to keep its balance sheet near a record high for a longer period of time.
When he foreshadowed the Federal Open Market Committee’s Aug. 9 decision to hold interest rates near record lows, the S&P 500 Index climbed 7.6 percent between Aug. 8 and Aug. 15. Unfortunately, it has since fallen 6.7 percent since amid concerns that U.S and global economic growth are faltering. Still, the Fed got a pretty good response to its decision, so they may deploy one or more of their remaining tricks.
The bond market seems to be already is pricing in an expectation that the Fed will announce new purchases of $500 billion to $600 billion, and investors looking for confirmation in Bernanke’s Jackson Hole speech may be disappointed.
The cost of living in the U.S. accelerated at an annual pace of 1.8 percent in July, excluding food and energy costs, which are typically more volatile. The gain was the largest in more than a year, according to Labor Department data released Aug. 18. That signals that, at least, QE2 was successful in staving off deflation.
However, the economy grew at a weaker-than-projected 1.3 percent annual pace in the second quarter, the Commerce Department said July 29, and growth in the prior quarter slowed to 0.4 percent, the weakest three-month period since the recovery began June 2009, suggesting that QE2 did little for the economy.
Morgan Stanley analysts have cut their estimate for expansion worldwide this year to 3.9 percent from a previous prediction of 4.2 percent. Part of the reason was “the drama” around lifting the U.S. debt ceiling, which helped depress financial markets and erode business and consumer confidence, the analysts said in a report last week.
Bernanke would have to overcome internal opposition to additional measures after his rate pledge led to the three dissents. There is less agreement this year among FOMC members that further easing is needed than there was a year ago when Bernanke spoke out. That suggests that the Fed chairman won’t hint at additional measures in Jackson Hole.
Still, Bernanke’s has shown he is willing to swim against the tide of dissent among the Governors in his decision to pursue the rate pledge with or without the full support of his fellow policy makers. So we the markets may get some, even if little comfort, this week.
This Friday Chairman Ben Bernanke will speak at the Federal Reserve’s annual symposium in Jackson Hole, Wyoming.
Last year, Bernanke hinted that the Fed might embark on a second round of asset purchases to bolster the recovery, dubbed QE2. That speech kicked off a 28 percent rally in the Standard & Poor’s 500 Index of stocks that ended in a three-year high on April 29th.
At the last Fed meeting policy makers pledged to keep their benchmark interest rate near zero until at least mid-2013 and also said they “discussed the range of policy tools” available, giving hope that they may add to their record stimulus. That signaled that a QE3 might be on the table.
The whole world will be watching Bernanke’s speech, so if he chooses not to say very much, the global markets are sure to be disappointed. Though many market observers deny we will get a QE3, still there is hope among many that one will be forthcoming in some form.
Predictions are that Bernanke will suggest that the central bank will lengthen the average maturity for its $2.86 trillion of assets, which would help bring down long-term interest rates. The yield on the benchmark 10-year Treasury note dropped as low as 2.062 percent on Aug. 19 in New York, according to Bloomberg Bond Trader prices. Yields have fallen to record lows since the Fed announced its rate pledge on Aug. 9.
At the Fed’s last meeting Federal Reserve Bank presidents Charles Plosser of Philadelphia, Richard Fisher of Dallas and Narayana Kocherlakota of Minneapolis all voted against the Fed’s decision to keep the target for the federal funds rate at zero to 0.25 percent until at least mid-2013. Plosser and Fisher both said last week the pledge won’t help spur growth. The last time three policy makers dissented was in November 1992.
The central bank has kept the rate on overnight loans among banks near zero since December 2008. It also purchased $1.7 trillion of Treasury and mortgage debt between December 2008 and March 2010, and the $600 billion of Treasuries from November through June. The result was a temporary rise in risk assets but economic growth and job creation remains moribund.
Despite what many market watchers believe, the Fed is not out of bullets yet. Bernanke told Congress on July 13 the Fed does have stimulus options; these include buying additional securities, increasing the average maturity of its bond portfolio, lowering the interest rate on excess reserves and pledging to keep its balance sheet near a record high for a longer period of time.
When he foreshadowed the Federal Open Market Committee’s Aug. 9 decision to hold interest rates near record lows, the S&P 500 Index climbed 7.6 percent between Aug. 8 and Aug. 15. Unfortunately, it has since fallen 6.7 percent since amid concerns that U.S and global economic growth are faltering. Still, the Fed got a pretty good response to its decision, so they may deploy one or more of their remaining tricks.
The bond market seems to be already is pricing in an expectation that the Fed will announce new purchases of $500 billion to $600 billion, and investors looking for confirmation in Bernanke’s Jackson Hole speech may be disappointed.
The cost of living in the U.S. accelerated at an annual pace of 1.8 percent in July, excluding food and energy costs, which are typically more volatile. The gain was the largest in more than a year, according to Labor Department data released Aug. 18. That signals that, at least, QE2 was successful in staving off deflation.
However, the economy grew at a weaker-than-projected 1.3 percent annual pace in the second quarter, the Commerce Department said July 29, and growth in the prior quarter slowed to 0.4 percent, the weakest three-month period since the recovery began June 2009, suggesting that QE2 did little for the economy.
Morgan Stanley analysts have cut their estimate for expansion worldwide this year to 3.9 percent from a previous prediction of 4.2 percent. Part of the reason was “the drama” around lifting the U.S. debt ceiling, which helped depress financial markets and erode business and consumer confidence, the analysts said in a report last week.
Bernanke would have to overcome internal opposition to additional measures after his rate pledge led to the three dissents. There is less agreement this year among FOMC members that further easing is needed than there was a year ago when Bernanke spoke out. That suggests that the Fed chairman won’t hint at additional measures in Jackson Hole.
Still, Bernanke’s has shown he is willing to swim against the tide of dissent among the Governors in his decision to pursue the rate pledge with or without the full support of his fellow policy makers. So we the markets may get some, even if little comfort, this week.
Monday, August 15, 2011
Ramblings of a Portfolio Manager
Ramblings of a Portfolio Manager—This is NOT 2008!
It feels awful out there…trust us, we know. We’ve cancelled all summer plans to remain in the office to mind this market even though with 500 point Dow swings it is difficult to know exactly what to do, if anything (we wonder why Obama and the EU leaders haven’t done the same, instead choosing to put lotion on each others’ backs in some exotic warm locale). With volatility like this it is easy to make a mistake so we monitor, take advantage of dislocations and try to understand where things are headed. For many investors, however, it's easy to draw parallels between this market and 2008 and there from comes the volatility we are seeing. We don’t believe this period in the worlds’ economies or markets is anything like 2008 (or 1974 for that matter) and there are a number of indicators that tell us otherwise.
For example, if we look at the 2Yr USD Swap Spread chart below Courtesy of Bloomberg (a measure of fear over the financial health of banks)– it is clear that professionals in the global credit markets (as opposed to the retail investor in the US Treasury markets) do not believe this is 2008 all over again. The current 2 year USD Swap Spread, which ballooned to nearly 170 bps in the fall 2008, still hovers at a slightly elevated 29bps—it’s hardly a blip in the chart. We aren’t even where we were at the end of 2010 in terms of fear regarding the financial system. Remember, 2008 was all about the fear of every US Financial Institution being insolvent and/or under-capitalized. And we did have real defaults... remember CIT? That was true credit risk.
At the moment what it appears is that we are dealing with is a global sovereign/currency crisis, which requires large-scale solutions: Eurozone fiscal unity; Chinese participation in the EFSF, etc. Of course, some economists are talking about the possibility of breaking up the Euro, however, even the Germans (who get almost 40% of their GDP from exports) are vitally aware of the implications of operating once again under the Deutsche Mark. If we do some overly simple math we see that Germany can easily lose as much as €300Bln in exports every year if that were to happen. Compare that to their current peripheral contribution to Europe? It makes it look like peanuts. In any case, if Greece, Portugal and Spain collapse; then Germany is already on the hook. And the there are the German, French, Italian banks -- no one wants to see this happen and they aren’t going to let it.
We hear rumors daily—for example, on Thursday some small unknown Chinese bank supposedly stopped doing business with SocGen—it was false and certainly benefitted the rumor monger as it dropped the futures 200 points alone in just 10 minutes (of course the futures recovered and we had a nice day—hope he/she lost his/her shirt)—but most of these are just plain false. Yet while many of these fears/rumors are unfounded, the volatility they create is not helping to improve trading liquidity. Furthermore, the liquidity that the Central Banks are pumping into the markets is losing its benefits as investors take it for granted. It is clear that the global economy is slowing, and risk is being re-priced. But that doesn’t mean one cannot make money in stocks. In fact, as we have all seen over the last 3 years, the pendulum can over swing both ways until sanity prevails. At the moment, we believe risk is being overpriced and will return to normal slowly but in short order.
The good news is that right now our markets are functioning: $10Bln in new corporate bonds priced last week alone as companies took advantage of negative real interest rates to clean up their balance sheets. That's an important data point. It means that investors still have cash to put to work and issuers can still come to market. It also means that Corporate America is getting healthier and while dislocations such as negative real rates can persist for a time, the bond markets and, most likely the equity markets, have overreacted and we are due for a reversal. This morning Japan reported much better than expected GDP. And we have only seen upward revisions to S&P 500 earnings projections since earnings season. No, this is not 2008 although it may feel like it. We suggest you turn off the financial news, enjoy your summer vacation and let the capital markets quiet down and sort themselves out. They always do—even post 2008.
It feels awful out there…trust us, we know. We’ve cancelled all summer plans to remain in the office to mind this market even though with 500 point Dow swings it is difficult to know exactly what to do, if anything (we wonder why Obama and the EU leaders haven’t done the same, instead choosing to put lotion on each others’ backs in some exotic warm locale). With volatility like this it is easy to make a mistake so we monitor, take advantage of dislocations and try to understand where things are headed. For many investors, however, it's easy to draw parallels between this market and 2008 and there from comes the volatility we are seeing. We don’t believe this period in the worlds’ economies or markets is anything like 2008 (or 1974 for that matter) and there are a number of indicators that tell us otherwise.
For example, if we look at the 2Yr USD Swap Spread chart below Courtesy of Bloomberg (a measure of fear over the financial health of banks)– it is clear that professionals in the global credit markets (as opposed to the retail investor in the US Treasury markets) do not believe this is 2008 all over again. The current 2 year USD Swap Spread, which ballooned to nearly 170 bps in the fall 2008, still hovers at a slightly elevated 29bps—it’s hardly a blip in the chart. We aren’t even where we were at the end of 2010 in terms of fear regarding the financial system. Remember, 2008 was all about the fear of every US Financial Institution being insolvent and/or under-capitalized. And we did have real defaults... remember CIT? That was true credit risk.
At the moment what it appears is that we are dealing with is a global sovereign/currency crisis, which requires large-scale solutions: Eurozone fiscal unity; Chinese participation in the EFSF, etc. Of course, some economists are talking about the possibility of breaking up the Euro, however, even the Germans (who get almost 40% of their GDP from exports) are vitally aware of the implications of operating once again under the Deutsche Mark. If we do some overly simple math we see that Germany can easily lose as much as €300Bln in exports every year if that were to happen. Compare that to their current peripheral contribution to Europe? It makes it look like peanuts. In any case, if Greece, Portugal and Spain collapse; then Germany is already on the hook. And the there are the German, French, Italian banks -- no one wants to see this happen and they aren’t going to let it.
We hear rumors daily—for example, on Thursday some small unknown Chinese bank supposedly stopped doing business with SocGen—it was false and certainly benefitted the rumor monger as it dropped the futures 200 points alone in just 10 minutes (of course the futures recovered and we had a nice day—hope he/she lost his/her shirt)—but most of these are just plain false. Yet while many of these fears/rumors are unfounded, the volatility they create is not helping to improve trading liquidity. Furthermore, the liquidity that the Central Banks are pumping into the markets is losing its benefits as investors take it for granted. It is clear that the global economy is slowing, and risk is being re-priced. But that doesn’t mean one cannot make money in stocks. In fact, as we have all seen over the last 3 years, the pendulum can over swing both ways until sanity prevails. At the moment, we believe risk is being overpriced and will return to normal slowly but in short order.
The good news is that right now our markets are functioning: $10Bln in new corporate bonds priced last week alone as companies took advantage of negative real interest rates to clean up their balance sheets. That's an important data point. It means that investors still have cash to put to work and issuers can still come to market. It also means that Corporate America is getting healthier and while dislocations such as negative real rates can persist for a time, the bond markets and, most likely the equity markets, have overreacted and we are due for a reversal. This morning Japan reported much better than expected GDP. And we have only seen upward revisions to S&P 500 earnings projections since earnings season. No, this is not 2008 although it may feel like it. We suggest you turn off the financial news, enjoy your summer vacation and let the capital markets quiet down and sort themselves out. They always do—even post 2008.
Monday, August 8, 2011
Ramblings of a Portfolio Manager
Dear Investor:
After Last week’s market turmoil you no doubt are scared and rethinking what crazed decision ever lead you to invest in stocks in the first place. That’s only natural. You’re also probably going to be watching all the Financial TV pundits over the weekend, from Nouriel Roubini, telling us Armageddon is just around the corner to Warren Buffett, waving his little American flag singing “buy buy buy.” How can you make sense of all this rhetoric and jargon? Where were these geniuses’ 2000 Dow points higher?
We thought long and hard about what to write this week but in doing so we ran across this week’s Barron’s piece on the week gone by. Now, we all know Barron’s can be a fairly bearish publication but we found a surprising amount of bullishness in what they had to say. So rather than cobble together something on our own, we reprint here, in part, an article from that publication we thought accurately paralleled our thoughts. Full credit to Barron’s and the author for the piece, we take no credit other than finding it online at midnight last night and seeing that the article is both sober and balanced.
Barron's(8/8) Attention, Shoppers. It's Time To Buy
12:10 AM Eastern Daylight Time Aug 06, 2011
(From BARRON'S)
By Andrew Bary
After the recent plunge in major global markets, U.S. stocks look attractive. The benchmark Standard & Poor's 500 index trades for little more than 12 times projected 2011 profits, one of the lowest price/earnings ratios in a generation. The Dow Jones Industrial Average has a similar P/E -- 11.6 times this year's estimated earnings. Its dividend yield of 2.62% exceeds the depressed 2.56% yield on the 10-year Treasury note, another rare occurrence. This isn't the1970s, when P/E ratios were low but inflation and interest rates were high. Investors are worried about different problems: a weakening domestic economy, Europe's debt mess, political dysfunction in Washington and a massive and seemingly intractable federal budget deficit. Yet American corporations rarely have been in better shape, with generally robust profits and balance sheets flush with more than $1 trillion in cash. Analysts are loath to predict when the sell-off, which began July 22, might end, but many say they see stocks ending the year higher. If the S&P 500 merely gets back to its 2011 peak, set in April, the index would rise 14%. "The economy is doing well enough to keep earnings rising and bring some bullishness back to the stock market," says Jim Paulsen, investment strategist at Wells Capital Management.
Investors have been rattled by the swift pace of the sell-off, in which the S&P 500 fell more than 10% in 10 trading sessions. This marks only the fourth such decline in a bull market since the end of World War II. The other three 10% drops occurred in late 1974, October 1997 (during the Asian crisis) and August 1998 (after the collapse of the hedge fund Long-Term Capital Management). The good news is that the market rallied an average of 18% in the ensuing three months after each of those three setbacks, according to J.P. Morgan strategist Thomas Lee. Stocks might be near a bottom after a week of selling. The Dow finished Friday at 11,444.61, up 60.93 points in a volatile session but down 5.8% for the week. Most of the damage occurred Thursday, when the average fell 512 points, or 4.3%, its biggest point drop since late 2008. The industrials are down 1.2% for the year; they were up 10.7% at their April peak. The S&P 500 ended the week at 1,199.38, off 7.2% for the five days and 4.6% for the year. The situation is worse overseas, as the table nearby shows. The Euro Stoxx 50 index is down 15% this year, Japan's Nikkei is off 9% and formerly once-hot Brazilian stocks are down 24%. Every major European market except Switzerland has a P/E below 10, and European stocks yield an average of 4%. Closer to home, the top 50 U.S. banks trade on average at around book value. They have been cheaper only twice in the past 25 years-during the deep recession of 1990 and the 2009 financial crisis. Both those times were major buying opportunities, and today, notes RBC Capital Markets analyst Gerard Cassidy, the industry's fundamentals are improving. At 37.60 a share, J.P. Morgan Chase (ticker: JPM) trades below book value and for under eight times projected 2011 profits. The stock yields 2.7%, which is likely is going higher. Citigroup (C), at 33.44, is down 29% this year and trades for less than 75% of book value of $48.75. Tangible book is a conservative measure of shareholder equity that excludes goodwill and other intangible assets stemming from acquisitions. Goldman Sachs (GS), at 125.18, trades just above tangible book, and Morgan Stanley (MS), at 20.02, changes hands below tangible book of $26.97. A wobbly global economy poses risks for big financials, but the industry's capital levels are appreciably higher than in 2008 and leverage is lower. It will be tough for most big financial companies to earn 15%-plus returns on equity in the coming years-a performance that was common before 2008-given higher mandated capital levels. But the stocks are priced for single-digit returns or worse. Drug stocks, normally defensive, haven't done a lot to protect investors lately. Pfizer (PFE), at 17.49, trades for around eight times estimated 2011 profits, while Merck (MRK), at 31.71, has a similar P/E ratio. Both yield more than 4.5%.Government pressure on drug-cost reimbursements could escalate around the world, but that concern seems captured in drug stocks' low valuations. Technology companies have more exposure to Europe than other stock-market sectors, but they also have excellent balance sheets and low price/earnings multiples. Microsoft (MSFT), at 25.68, trades for nine times estimated earnings for the fiscal year ending next June. Its P/E, excluding net cash and investments of $6 a share, is under eight. Intel (INTC), at 20.79, trades for nine times projected 2011 profits and yields 4%, while Hewlett-Packard (HPQ), at 32.63 fetches less than seven times current-year profits. Apple (AAPL) the market's premier mega-cap growth stock, at 373.62, trades for 14 times what it is likely to earn in the fiscal year ending September. Excluding $80 a share in cash and investments, its P/E is closer to 10. In the energy sector, many investors prefer exploration plays and oil-service stocks, but the best value could lie in industry giants like ExxonMobil (XOM) and Chevron (CVX). At 74.82, Exxon trades for under nine times projected 2011 profits and yields 2.5%, while Chevron, at 97.61, has a P/E of just seven based on estimated 2011 net. It yields 3.2%. The recent drop in U.S. oil prices to $87 a barrel from $100 could pressure profits, but the stocks look to be discounting far lower oil and gas prices. The prospect of cuts in the Pentagon budget has crunched defense stocks. Northrop Grumman (NOC), for instance, now trades at 55.49, down from 70 in early July, and sports a P/E of eight. It yields 3.6%. Lockheed Martin (LMT), another major contractor, trades for 72.82, or 9.7 times earnings, and yields 4%. Gold has been a bright spot, rising $36 an ounce last week to $1,663.80. The metal is up 17% so far this year. Gold is shining because investors fear that the U.S. government will continue to pursue policies-notably zero-percent rates and massive fiscal deficits-that will further debase the dollar and spark inflation. Gold remains an "underowned" asset class with few individuals and institutions with a sizable weighting, which could mean more buying. While gold has gained, major producers have lagged. The leading miner, Barrick Gold (ABX), is down 14% this year to 45.86, and trades for just 10 times estimated 2011 profits. Gold bugs weren't happy that Barrick paid up to buy a major copper miner earlier this year, diluting its exposure to gold. There is rumored to have been heavy selling of Barrick by some institutional investors in recent months. Even so, Barrick has rarely had such a low P/E and its profits have a lot of leverage to gold prices. Berkshire Hathaway (BRKA) is a financial Fort Knox, with one of the strongest balance sheets among huge companies. Its shares have been no safe haven, falling11% this year to $107,300, or just 1.1 times book value. Berkshire looks inexpensive with a price/book ratio that has rarely been lower in recent decades. Its earnings power has never been better. Berkshire CEO Warren Buffett has been cool to stock buybacks -- the company has repurchased virtually no stock since he took over in 1965 -- but he ought to consider a buyback rather than paying cash for another major acquisition, given Berkshire's low valuation. Stocks had a tough summer in 2010 as the S&P 500 dropped 15% from its spring high to a low of about 1,050 in late August. That proved to be a buying opportunity as Federal Reserve Chairman Ben Bernanke came to the rescue with a new credit-easing program, known as QE2. By the end of 2010, stocks had risen 20% from their August lows. While the Fed is more reluctant to begin a fresh asset-buying plan this year, stocks look even cheaper than they were last summer. Historically, it has been good to buy the stock market when its trades around 10 times earnings. Barring global financial mayhem, investors with a modicum of patience should do well. Stocks could be the best asset class in the world.
After Last week’s market turmoil you no doubt are scared and rethinking what crazed decision ever lead you to invest in stocks in the first place. That’s only natural. You’re also probably going to be watching all the Financial TV pundits over the weekend, from Nouriel Roubini, telling us Armageddon is just around the corner to Warren Buffett, waving his little American flag singing “buy buy buy.” How can you make sense of all this rhetoric and jargon? Where were these geniuses’ 2000 Dow points higher?
We thought long and hard about what to write this week but in doing so we ran across this week’s Barron’s piece on the week gone by. Now, we all know Barron’s can be a fairly bearish publication but we found a surprising amount of bullishness in what they had to say. So rather than cobble together something on our own, we reprint here, in part, an article from that publication we thought accurately paralleled our thoughts. Full credit to Barron’s and the author for the piece, we take no credit other than finding it online at midnight last night and seeing that the article is both sober and balanced.
Barron's(8/8) Attention, Shoppers. It's Time To Buy
12:10 AM Eastern Daylight Time Aug 06, 2011
(From BARRON'S)
By Andrew Bary
After the recent plunge in major global markets, U.S. stocks look attractive. The benchmark Standard & Poor's 500 index trades for little more than 12 times projected 2011 profits, one of the lowest price/earnings ratios in a generation. The Dow Jones Industrial Average has a similar P/E -- 11.6 times this year's estimated earnings. Its dividend yield of 2.62% exceeds the depressed 2.56% yield on the 10-year Treasury note, another rare occurrence. This isn't the1970s, when P/E ratios were low but inflation and interest rates were high. Investors are worried about different problems: a weakening domestic economy, Europe's debt mess, political dysfunction in Washington and a massive and seemingly intractable federal budget deficit. Yet American corporations rarely have been in better shape, with generally robust profits and balance sheets flush with more than $1 trillion in cash. Analysts are loath to predict when the sell-off, which began July 22, might end, but many say they see stocks ending the year higher. If the S&P 500 merely gets back to its 2011 peak, set in April, the index would rise 14%. "The economy is doing well enough to keep earnings rising and bring some bullishness back to the stock market," says Jim Paulsen, investment strategist at Wells Capital Management.
Investors have been rattled by the swift pace of the sell-off, in which the S&P 500 fell more than 10% in 10 trading sessions. This marks only the fourth such decline in a bull market since the end of World War II. The other three 10% drops occurred in late 1974, October 1997 (during the Asian crisis) and August 1998 (after the collapse of the hedge fund Long-Term Capital Management). The good news is that the market rallied an average of 18% in the ensuing three months after each of those three setbacks, according to J.P. Morgan strategist Thomas Lee. Stocks might be near a bottom after a week of selling. The Dow finished Friday at 11,444.61, up 60.93 points in a volatile session but down 5.8% for the week. Most of the damage occurred Thursday, when the average fell 512 points, or 4.3%, its biggest point drop since late 2008. The industrials are down 1.2% for the year; they were up 10.7% at their April peak. The S&P 500 ended the week at 1,199.38, off 7.2% for the five days and 4.6% for the year. The situation is worse overseas, as the table nearby shows. The Euro Stoxx 50 index is down 15% this year, Japan's Nikkei is off 9% and formerly once-hot Brazilian stocks are down 24%. Every major European market except Switzerland has a P/E below 10, and European stocks yield an average of 4%. Closer to home, the top 50 U.S. banks trade on average at around book value. They have been cheaper only twice in the past 25 years-during the deep recession of 1990 and the 2009 financial crisis. Both those times were major buying opportunities, and today, notes RBC Capital Markets analyst Gerard Cassidy, the industry's fundamentals are improving. At 37.60 a share, J.P. Morgan Chase (ticker: JPM) trades below book value and for under eight times projected 2011 profits. The stock yields 2.7%, which is likely is going higher. Citigroup (C), at 33.44, is down 29% this year and trades for less than 75% of book value of $48.75. Tangible book is a conservative measure of shareholder equity that excludes goodwill and other intangible assets stemming from acquisitions. Goldman Sachs (GS), at 125.18, trades just above tangible book, and Morgan Stanley (MS), at 20.02, changes hands below tangible book of $26.97. A wobbly global economy poses risks for big financials, but the industry's capital levels are appreciably higher than in 2008 and leverage is lower. It will be tough for most big financial companies to earn 15%-plus returns on equity in the coming years-a performance that was common before 2008-given higher mandated capital levels. But the stocks are priced for single-digit returns or worse. Drug stocks, normally defensive, haven't done a lot to protect investors lately. Pfizer (PFE), at 17.49, trades for around eight times estimated 2011 profits, while Merck (MRK), at 31.71, has a similar P/E ratio. Both yield more than 4.5%.Government pressure on drug-cost reimbursements could escalate around the world, but that concern seems captured in drug stocks' low valuations. Technology companies have more exposure to Europe than other stock-market sectors, but they also have excellent balance sheets and low price/earnings multiples. Microsoft (MSFT), at 25.68, trades for nine times estimated earnings for the fiscal year ending next June. Its P/E, excluding net cash and investments of $6 a share, is under eight. Intel (INTC), at 20.79, trades for nine times projected 2011 profits and yields 4%, while Hewlett-Packard (HPQ), at 32.63 fetches less than seven times current-year profits. Apple (AAPL) the market's premier mega-cap growth stock, at 373.62, trades for 14 times what it is likely to earn in the fiscal year ending September. Excluding $80 a share in cash and investments, its P/E is closer to 10. In the energy sector, many investors prefer exploration plays and oil-service stocks, but the best value could lie in industry giants like ExxonMobil (XOM) and Chevron (CVX). At 74.82, Exxon trades for under nine times projected 2011 profits and yields 2.5%, while Chevron, at 97.61, has a P/E of just seven based on estimated 2011 net. It yields 3.2%. The recent drop in U.S. oil prices to $87 a barrel from $100 could pressure profits, but the stocks look to be discounting far lower oil and gas prices. The prospect of cuts in the Pentagon budget has crunched defense stocks. Northrop Grumman (NOC), for instance, now trades at 55.49, down from 70 in early July, and sports a P/E of eight. It yields 3.6%. Lockheed Martin (LMT), another major contractor, trades for 72.82, or 9.7 times earnings, and yields 4%. Gold has been a bright spot, rising $36 an ounce last week to $1,663.80. The metal is up 17% so far this year. Gold is shining because investors fear that the U.S. government will continue to pursue policies-notably zero-percent rates and massive fiscal deficits-that will further debase the dollar and spark inflation. Gold remains an "underowned" asset class with few individuals and institutions with a sizable weighting, which could mean more buying. While gold has gained, major producers have lagged. The leading miner, Barrick Gold (ABX), is down 14% this year to 45.86, and trades for just 10 times estimated 2011 profits. Gold bugs weren't happy that Barrick paid up to buy a major copper miner earlier this year, diluting its exposure to gold. There is rumored to have been heavy selling of Barrick by some institutional investors in recent months. Even so, Barrick has rarely had such a low P/E and its profits have a lot of leverage to gold prices. Berkshire Hathaway (BRKA) is a financial Fort Knox, with one of the strongest balance sheets among huge companies. Its shares have been no safe haven, falling11% this year to $107,300, or just 1.1 times book value. Berkshire looks inexpensive with a price/book ratio that has rarely been lower in recent decades. Its earnings power has never been better. Berkshire CEO Warren Buffett has been cool to stock buybacks -- the company has repurchased virtually no stock since he took over in 1965 -- but he ought to consider a buyback rather than paying cash for another major acquisition, given Berkshire's low valuation. Stocks had a tough summer in 2010 as the S&P 500 dropped 15% from its spring high to a low of about 1,050 in late August. That proved to be a buying opportunity as Federal Reserve Chairman Ben Bernanke came to the rescue with a new credit-easing program, known as QE2. By the end of 2010, stocks had risen 20% from their August lows. While the Fed is more reluctant to begin a fresh asset-buying plan this year, stocks look even cheaper than they were last summer. Historically, it has been good to buy the stock market when its trades around 10 times earnings. Barring global financial mayhem, investors with a modicum of patience should do well. Stocks could be the best asset class in the world.
Tuesday, July 19, 2011
Ramblings of a Portfolio Manager
Will We Get a Budget Deal and What Will Be Left of the Economy When We Do?
We don’t have to bring everyone up to speed on the current status of the budget/debt ceiling negotiations going on in Washington. Suffice to say that each side remains intractable on their respective positions with Obama shuttling back and forth proposing noble but clearly unpassable “deals” in order to save face for the elections next year. Meanwhile, our Treasury Secretary and Federal Reserve Chairman alike continue to warn the parties not to play a game of Chicken with our debt rating and, ultimately our economy, backed up by rating agencies who, though discredited over the past few years, still carry weight when it comes to existing contracts and indentures and, ultimately, the interest rate paid by the entities they rate.
While all of this makes for a good side show and the current yield on the long bonds suggests that the markets expect a deal to be done to avoid default before the August 2nd deadline, missing from the popular headlines is what the negotiations themselves may be doing to the economy, in a sense making any “deal” moot by the time it becomes passed. Few noticed that several small rating agencies have actually become proactive and have already dropped our debt rating one notch. Moody’s and S&P, however, are the 800 lb. gorillas to whom everyone pays attention and whose ratings are written into bond indentures across corporate America. Still, what those smaller firms say and said are telling. Being proactive, they looked at whatever a potential deal might be and what the ongoing negations have been doing to corporate behavior in the months leading up to that deal. What they arrived at makes total sense and is a good basis for their downgrades. Corporate heads watch CNBC too and the growing sense that the “deal” will come to the wire and be much less than is what is really needed to get this Country on the right track for the next decade, let alone to the next election, is, once again, causing great uncertainty. In fact, this Administration’s legacy will be the uncertainty they have caused with business given all their regulations, policy shifts and new spending programs. That uncertainty has hampered hiring since Obama took office and, just as it looked as though, perhaps, Companies were about to try to forge ahead no matter, around comes another bout of uncertainty—the outcome of the budget talks.
What CEO, who’s debt is tied to LIBOR, Prime or, gasp, Treasuries, is going to make capital spending and hiring plans not knowing what rates he/she will be paying on that debt in 3 weeks? To do anything, frankly, would be irresponsible. Everyone was shocked at the poor employment numbers released in early July but they made total sense—Corporate America is frozen in its expansion plans pending the outcome of the “great deal.” And this time, we cant just blame the Obama administration—the Republicans are as much at fault for the deadlock and the uncertainty it is causing. Now everyone is looking toward the August release. We can almost guarantee they will be as bad if not worse than those released in July, as company’s sat on the sidelines in wait and see mode. Meanwhile, many municipalities , who’s debt payments are tied to the rate on US Treasuries, are making contingency plans should the negotiations go past August 2nd or should the promised downgrades occur. Geithner and Bernanke were’t kidding when they said the outcome of a default will be disasterous. Our 9.2% unemployment rate will balloon as Federal, State and Municipal employees are let go in droves after a default. Bottom line, those little rating agencies looked ahead and saw the damage the current gridlock is already doing to the economy and, knowing a weakened economy cannot pay its debts as well as a strong one, did the right thing and did their downgrades.
So what to do? Frankly, we do expect a deal and a very small one at that, one that cuts spending over a lengthy period of time. Will such a deal be good enough for the rating agencies? We hope so. If that deal is accepted by Moody’s and S&P and we retain our rating, then we expect a nice market rally. Why? Because such a deal is yet more can kicking and preserves current spending and tax levels, items deemed important in helping the US get back on its feet. As for rates, well they may even rise on hopes of a future recovery. Still, we wonder what might be if the dolts who we elected actually get together and come up with some meaningful cuts. The markets are willing to assign higher multiples to unleveraged companies and the same holds true for the economy as a whole. A $4-$6trillion cut might provide the leverage reduction the markets seek and produce an even bigger rally. We doubt we’ll ever see such a deal but for now a deal, any deal, that raises the debt ceiling and staves off the rating agencies, will be good for the equity markets. We hope the markets are clever enough to see the poor employment numbers we will see in August are a direct result of the uncertainty factor. If they can get past that fact, we may rally right to year end. Just expect many more Mylanta days, as we have been seeing, before that occurs.
We don’t have to bring everyone up to speed on the current status of the budget/debt ceiling negotiations going on in Washington. Suffice to say that each side remains intractable on their respective positions with Obama shuttling back and forth proposing noble but clearly unpassable “deals” in order to save face for the elections next year. Meanwhile, our Treasury Secretary and Federal Reserve Chairman alike continue to warn the parties not to play a game of Chicken with our debt rating and, ultimately our economy, backed up by rating agencies who, though discredited over the past few years, still carry weight when it comes to existing contracts and indentures and, ultimately, the interest rate paid by the entities they rate.
While all of this makes for a good side show and the current yield on the long bonds suggests that the markets expect a deal to be done to avoid default before the August 2nd deadline, missing from the popular headlines is what the negotiations themselves may be doing to the economy, in a sense making any “deal” moot by the time it becomes passed. Few noticed that several small rating agencies have actually become proactive and have already dropped our debt rating one notch. Moody’s and S&P, however, are the 800 lb. gorillas to whom everyone pays attention and whose ratings are written into bond indentures across corporate America. Still, what those smaller firms say and said are telling. Being proactive, they looked at whatever a potential deal might be and what the ongoing negations have been doing to corporate behavior in the months leading up to that deal. What they arrived at makes total sense and is a good basis for their downgrades. Corporate heads watch CNBC too and the growing sense that the “deal” will come to the wire and be much less than is what is really needed to get this Country on the right track for the next decade, let alone to the next election, is, once again, causing great uncertainty. In fact, this Administration’s legacy will be the uncertainty they have caused with business given all their regulations, policy shifts and new spending programs. That uncertainty has hampered hiring since Obama took office and, just as it looked as though, perhaps, Companies were about to try to forge ahead no matter, around comes another bout of uncertainty—the outcome of the budget talks.
What CEO, who’s debt is tied to LIBOR, Prime or, gasp, Treasuries, is going to make capital spending and hiring plans not knowing what rates he/she will be paying on that debt in 3 weeks? To do anything, frankly, would be irresponsible. Everyone was shocked at the poor employment numbers released in early July but they made total sense—Corporate America is frozen in its expansion plans pending the outcome of the “great deal.” And this time, we cant just blame the Obama administration—the Republicans are as much at fault for the deadlock and the uncertainty it is causing. Now everyone is looking toward the August release. We can almost guarantee they will be as bad if not worse than those released in July, as company’s sat on the sidelines in wait and see mode. Meanwhile, many municipalities , who’s debt payments are tied to the rate on US Treasuries, are making contingency plans should the negotiations go past August 2nd or should the promised downgrades occur. Geithner and Bernanke were’t kidding when they said the outcome of a default will be disasterous. Our 9.2% unemployment rate will balloon as Federal, State and Municipal employees are let go in droves after a default. Bottom line, those little rating agencies looked ahead and saw the damage the current gridlock is already doing to the economy and, knowing a weakened economy cannot pay its debts as well as a strong one, did the right thing and did their downgrades.
So what to do? Frankly, we do expect a deal and a very small one at that, one that cuts spending over a lengthy period of time. Will such a deal be good enough for the rating agencies? We hope so. If that deal is accepted by Moody’s and S&P and we retain our rating, then we expect a nice market rally. Why? Because such a deal is yet more can kicking and preserves current spending and tax levels, items deemed important in helping the US get back on its feet. As for rates, well they may even rise on hopes of a future recovery. Still, we wonder what might be if the dolts who we elected actually get together and come up with some meaningful cuts. The markets are willing to assign higher multiples to unleveraged companies and the same holds true for the economy as a whole. A $4-$6trillion cut might provide the leverage reduction the markets seek and produce an even bigger rally. We doubt we’ll ever see such a deal but for now a deal, any deal, that raises the debt ceiling and staves off the rating agencies, will be good for the equity markets. We hope the markets are clever enough to see the poor employment numbers we will see in August are a direct result of the uncertainty factor. If they can get past that fact, we may rally right to year end. Just expect many more Mylanta days, as we have been seeing, before that occurs.
Monday, July 11, 2011
Ramblings of a Portfolio Manager
Here We Go Again?
We awoke early this morning to find futures for markets around the world, including our own, sharply lower, while many Asian markets had already closed deeply in the red. The cause: a trifecta of yet another Southern European debt-laden country nearing a crisis—in this case Italy, the apparent breakdown in debt reduction talks between Obama and the US Congress over the weekend, and, most likely, some carry over from the poor jobs report in the US on Friday. US bond yields, which were heading higher after the strong PMI numbers we received here last week, are back below 3% for the 10-year Treasuries. In short, just about everything that made the markets rally off their bottom in late June—the resolution of the crisis in Greek debt, optimism over a debt deal in the US and a promising ADP jobs report, seem to have been undone since last Friday morning. This, of course, begs the question, are we going right back to our June lows this time quicker than the sickening 6 week slide that got us there? We don’t think so.
Let’s look rationally at each piece of news, one at a time. First, as for Italy, this is no Greece. Yes, it is a much larger market but it is also much different in its behavior toward austerity. We note that the Italians have already put in place some severe austerity programs voluntarily and have already taken steps to reduce their sovereign debt. The IMF has already agreed to backstop Italy and there will be no anxiety-riddled days of waiting on a vote from the Italian Government on a vote to accept the aid and the conditions that go with it. In addition, the situation in Italy is not new news but that doesn’t seem to matter these days. Any weakness on the “Italian Affair” will most likely be a buying opportunity.
As for the spending and debt reduction talks here at home, it did indeed look like Obama had struck a promising $4trillion deal with Congress last week and the markets liked that. Over the weekend, however, old biases crept back in from each side with the republicans backing away over tax hikes for the “wealthy” and our good friend Nancy Pelosi backtracking on any kind of cuts in entitlements. Both of these items were part of each side’s give and take that would have made a $4trillion deal work. Obama has yet to give up on his ambition plan, as it would have been somewhat of an election-enhancing coupe for him, however it looks more likely that a plan with cuts have the size will be what we get. In any case, both sides have made noise about contingency plans on raising the debt ceiling so that should not be a concern, even if they do bring it down to the wire. Furthermore, sad as it may be, a $2trillion deal would actually be better for the US economy as it would include smaller tax and spending cuts. Yes, it does kick the can further down the road but it would be a good start and one that hopefully keeps rates at home and the value of the dollar low, both of which will only continue to benefit the US economy.
Finally, we can’t discount the lousy jobs report we got Friday morning. There was little in that report that was encouraging for employment prospects in the US. We do note, however, that the Monster Employment Index, released the same day, was +3.5%, its best showing since early 2008, prior to the financial crises. Unlike the Government’s data, which is backward looking, this index is real-time data from employers regarding their intent to take on more employees. The ADP report, which is being ridiculed of late do to its apparent “inaccuracy”, is also real-time from a broad swath of employers. In many ways, it is more up to date and accurate than the government’s data. Remember, if the economists are correct about the idea of a temporary slowdown thanks to Japan and oil, that fact would have been captured in the June data, which it apparently was. In sum, we believe the July employment data will be much better, but we will have to wait for that to see. One thing is for sure, with such weak data, there is now more pressure on the Fed to implement a QE3 style program. Look for a softening tone from some of the Fed governors and certainly no talk of liquidity withdrawal for the conceivable future.
So, should we be concerned or is this a buying opportunity. Ultimately, we believe all three issues will be resolved or seen for what they are—temporary—but despite the recent rally the markets are nervous so we may see some weakness over the next few days. The key will be what companies say during their conference calls. So far, the few that have reported have “beat and raised” meaning they see the current slowdown as temporary. Bellwether Alcoa reports tonight and that may well set the tone for what we hear going forward. With its costs falling and prices for its products rising, we think that report will be good and, perhaps, just what this nervous market needs to hear.
We awoke early this morning to find futures for markets around the world, including our own, sharply lower, while many Asian markets had already closed deeply in the red. The cause: a trifecta of yet another Southern European debt-laden country nearing a crisis—in this case Italy, the apparent breakdown in debt reduction talks between Obama and the US Congress over the weekend, and, most likely, some carry over from the poor jobs report in the US on Friday. US bond yields, which were heading higher after the strong PMI numbers we received here last week, are back below 3% for the 10-year Treasuries. In short, just about everything that made the markets rally off their bottom in late June—the resolution of the crisis in Greek debt, optimism over a debt deal in the US and a promising ADP jobs report, seem to have been undone since last Friday morning. This, of course, begs the question, are we going right back to our June lows this time quicker than the sickening 6 week slide that got us there? We don’t think so.
Let’s look rationally at each piece of news, one at a time. First, as for Italy, this is no Greece. Yes, it is a much larger market but it is also much different in its behavior toward austerity. We note that the Italians have already put in place some severe austerity programs voluntarily and have already taken steps to reduce their sovereign debt. The IMF has already agreed to backstop Italy and there will be no anxiety-riddled days of waiting on a vote from the Italian Government on a vote to accept the aid and the conditions that go with it. In addition, the situation in Italy is not new news but that doesn’t seem to matter these days. Any weakness on the “Italian Affair” will most likely be a buying opportunity.
As for the spending and debt reduction talks here at home, it did indeed look like Obama had struck a promising $4trillion deal with Congress last week and the markets liked that. Over the weekend, however, old biases crept back in from each side with the republicans backing away over tax hikes for the “wealthy” and our good friend Nancy Pelosi backtracking on any kind of cuts in entitlements. Both of these items were part of each side’s give and take that would have made a $4trillion deal work. Obama has yet to give up on his ambition plan, as it would have been somewhat of an election-enhancing coupe for him, however it looks more likely that a plan with cuts have the size will be what we get. In any case, both sides have made noise about contingency plans on raising the debt ceiling so that should not be a concern, even if they do bring it down to the wire. Furthermore, sad as it may be, a $2trillion deal would actually be better for the US economy as it would include smaller tax and spending cuts. Yes, it does kick the can further down the road but it would be a good start and one that hopefully keeps rates at home and the value of the dollar low, both of which will only continue to benefit the US economy.
Finally, we can’t discount the lousy jobs report we got Friday morning. There was little in that report that was encouraging for employment prospects in the US. We do note, however, that the Monster Employment Index, released the same day, was +3.5%, its best showing since early 2008, prior to the financial crises. Unlike the Government’s data, which is backward looking, this index is real-time data from employers regarding their intent to take on more employees. The ADP report, which is being ridiculed of late do to its apparent “inaccuracy”, is also real-time from a broad swath of employers. In many ways, it is more up to date and accurate than the government’s data. Remember, if the economists are correct about the idea of a temporary slowdown thanks to Japan and oil, that fact would have been captured in the June data, which it apparently was. In sum, we believe the July employment data will be much better, but we will have to wait for that to see. One thing is for sure, with such weak data, there is now more pressure on the Fed to implement a QE3 style program. Look for a softening tone from some of the Fed governors and certainly no talk of liquidity withdrawal for the conceivable future.
So, should we be concerned or is this a buying opportunity. Ultimately, we believe all three issues will be resolved or seen for what they are—temporary—but despite the recent rally the markets are nervous so we may see some weakness over the next few days. The key will be what companies say during their conference calls. So far, the few that have reported have “beat and raised” meaning they see the current slowdown as temporary. Bellwether Alcoa reports tonight and that may well set the tone for what we hear going forward. With its costs falling and prices for its products rising, we think that report will be good and, perhaps, just what this nervous market needs to hear.
Monday, June 27, 2011
Ramblings of a Portfolio Manager
Is QE2 Really Dead?
With Greece back in the headlines—and we’ve said quite enough on that subject--we thought we’d take the opportunity to talk a little about one of the other of the myriad concerns the US equity markets have been focused upon over the last two months—the coming end to QE2. Very few government actions have been so well telegraphed to the markets yet the equity, currency and bond markets have been roiling over the last two months as they fight to determine what, if anything, will be the exact effect of the end of the Federal Reserve’s program to support bond prices and keep interest rates and the dollar low with the purchase of US Treasuries.
QE2’s goal was to support asset prices through the purchase of $600 billion of US Government debt issues. The hope was that higher asset (equity, bond) prices would lead to the wealth effect among consumers and businesses alike, spurring spending and, eventually, production and hiring. Whether the program was a success or not remains to be seen. Of late we have received some fairly weak economic data from the US, including employment, which has called into doubt the efficacy of the program. Our thesis is that the effects of QE2 have a lag and that the full impact of higher asset prices and easy money has yet to kick in and be seen in US economic data. In the meantime, economic data, as it always is coming out of a recession, has been lumpy causing many to declare the program a failure. We choose to wait and see. In the meantime, while economists fret over the pending end to QE2 and the apparent lack of a successor, they ignore one very important artifact of the program from the outset—the Fed, now the largest owner of US Treasuries, is earning some decent interest rates on its purchases. In fact, the Fed’s balance sheet now stands at close to $2.9 trillion. With Fed Chairman Ben Bernanke declaring that it will be some time before the Federal Reserve begins to unload its considerable holdings in Treasuries, some pretty sizable interest payments will be hitting the Fed’s income statement. What will they do with all that money?
On June 22 the Fed concluded its monthly Open Market Committee meeting and Bernanke gave a rare press interview shortly thereafter. The takeaway for the markets, as we saw in equity price actions that day and the next, was that there would be no QE3, something many traders and economists alike were hoping for to continue to support asset prices. What was largely ignored, however, is that the Fed said on June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. Given the size of its balance sheet, that could mean purchases (reinvestment) of as much as $300 billion of government debt over the next 12 months without adding any additional money to the financial system. That means that the central bank will continue buying Treasuries to keep market rates down as the economy slows. And those purchases will continue to support demand at bond auctions while Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion. So not only is the Fed maintaining its accommodative stance, it is, in effect, launching into an unofficial QE2.5—something the markets have yet to focus upon.
Of the Fed’s bond holdings, a total of $112.1 billion will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account. Just replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac. Estimates are that $10 billion to $16 billion will mature each month, depending on the pace of prepayments. That is yet more liquidity that will be reinvested into the system if the Fed decides to keep its balance sheet size the same, as it has openly declared.
Helping the Fed with its low interest rate policy has been the flight to quality by investors in the face of European debt concerns. Treasury 10-year yields fell to the lowest since Dec. 1 last week, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent. And so far there’s been no lack of demand for government securities even as US Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
Most economists don’t expect that the Fed will raise its zero to 0.25 percent interest target rate for overnight loans between banks until the first quarter of next year. At his June 22 conference, Bernanke declared that the inflationary pressures we saw earlier this year are abating, in his opinion, and yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation, up only modestly from the 1.5 percentage points the way back in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. That suggests the first interest rate hike may be well into next year—beyond Q1
Bottom line: the asset purchases the Fed must make, even if they occur on a smaller scale, over the next year still continues the strategy that the Fed was trying to accomplish in the first place. That means that even with the end of QE2, the liquidity flow and its fundamental impact will remain intact for some time to come. So even though the market is going through a correction in anticipation of QE2’s demise, we may very well see the resumption of the liquidity driven rally.
With Greece back in the headlines—and we’ve said quite enough on that subject--we thought we’d take the opportunity to talk a little about one of the other of the myriad concerns the US equity markets have been focused upon over the last two months—the coming end to QE2. Very few government actions have been so well telegraphed to the markets yet the equity, currency and bond markets have been roiling over the last two months as they fight to determine what, if anything, will be the exact effect of the end of the Federal Reserve’s program to support bond prices and keep interest rates and the dollar low with the purchase of US Treasuries.
QE2’s goal was to support asset prices through the purchase of $600 billion of US Government debt issues. The hope was that higher asset (equity, bond) prices would lead to the wealth effect among consumers and businesses alike, spurring spending and, eventually, production and hiring. Whether the program was a success or not remains to be seen. Of late we have received some fairly weak economic data from the US, including employment, which has called into doubt the efficacy of the program. Our thesis is that the effects of QE2 have a lag and that the full impact of higher asset prices and easy money has yet to kick in and be seen in US economic data. In the meantime, economic data, as it always is coming out of a recession, has been lumpy causing many to declare the program a failure. We choose to wait and see. In the meantime, while economists fret over the pending end to QE2 and the apparent lack of a successor, they ignore one very important artifact of the program from the outset—the Fed, now the largest owner of US Treasuries, is earning some decent interest rates on its purchases. In fact, the Fed’s balance sheet now stands at close to $2.9 trillion. With Fed Chairman Ben Bernanke declaring that it will be some time before the Federal Reserve begins to unload its considerable holdings in Treasuries, some pretty sizable interest payments will be hitting the Fed’s income statement. What will they do with all that money?
On June 22 the Fed concluded its monthly Open Market Committee meeting and Bernanke gave a rare press interview shortly thereafter. The takeaway for the markets, as we saw in equity price actions that day and the next, was that there would be no QE3, something many traders and economists alike were hoping for to continue to support asset prices. What was largely ignored, however, is that the Fed said on June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. Given the size of its balance sheet, that could mean purchases (reinvestment) of as much as $300 billion of government debt over the next 12 months without adding any additional money to the financial system. That means that the central bank will continue buying Treasuries to keep market rates down as the economy slows. And those purchases will continue to support demand at bond auctions while Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion. So not only is the Fed maintaining its accommodative stance, it is, in effect, launching into an unofficial QE2.5—something the markets have yet to focus upon.
Of the Fed’s bond holdings, a total of $112.1 billion will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account. Just replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac. Estimates are that $10 billion to $16 billion will mature each month, depending on the pace of prepayments. That is yet more liquidity that will be reinvested into the system if the Fed decides to keep its balance sheet size the same, as it has openly declared.
Helping the Fed with its low interest rate policy has been the flight to quality by investors in the face of European debt concerns. Treasury 10-year yields fell to the lowest since Dec. 1 last week, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent. And so far there’s been no lack of demand for government securities even as US Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
Most economists don’t expect that the Fed will raise its zero to 0.25 percent interest target rate for overnight loans between banks until the first quarter of next year. At his June 22 conference, Bernanke declared that the inflationary pressures we saw earlier this year are abating, in his opinion, and yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation, up only modestly from the 1.5 percentage points the way back in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. That suggests the first interest rate hike may be well into next year—beyond Q1
Bottom line: the asset purchases the Fed must make, even if they occur on a smaller scale, over the next year still continues the strategy that the Fed was trying to accomplish in the first place. That means that even with the end of QE2, the liquidity flow and its fundamental impact will remain intact for some time to come. So even though the market is going through a correction in anticipation of QE2’s demise, we may very well see the resumption of the liquidity driven rally.
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