Why must the US Stock Market be a slave to the US Dollar?
Lately, one cannot help but turn on a business news channel and hear, at least a dozen times during the broadcast day, a report on the US Dollar Index (USDX) and its real-time impact on stock prices. More often than not we are presented with an intraday chart of the USDX versus the S&P 500, which explains with near perfect reliability why stocks have strengthened or weakened in the last few moments—always the inverse of the immediate movement of the dollar versus a basket of currencies. We hear and read about this relationship so often now that, in fact, that most newer market participants take it for granted that US equities must always be negatively correlated to the value of the US dollar versus other currencies, a fact that is certain to turn this relationship into a self-fulfilling prophecy for the short run. But does this need to be and has it been so in the past?
The USDX is an index of the value of the US Dollar versus the exchange rates of six major world currencies: the Euro, Japanese Yen, Canadian Dollar, British Pound, Swedish Krona and Swiss Franc. The index started in 1973 and was revised in 2000 with the creation of the Euro. It began with a base of 100 and all movements of the Dollar versus that basket of currencies is relative to this base, so a value of 125 would mean that the U.S. dollar increased in value by 25% since 1973. The index reached a high of over 120 in 2002 and since that time has been in a more or less steady decline. Over the last year the index has declined from a high around 88 during March 2009, at the height of Market fear when the dollar was sought as a safe haven, to a low of 74 in November of 2009. Since November, however, the index has rebounded to around 80 as hopes of a US interest rate rise, combined with a safe haven move on fears of a Greek default, have bid up the Dollar. Over this recent period the Dollar has indeed shown a nearly perfect negative correlation to US stock prices with a coefficient of -0.81 for 2009 and -1.0 (perfect negative relationship) for the last 12 months, meaning US stocks have moved almost in lock step with the dollar but in the opposite direction.
This correlation is atypical, however, and historically a strong dollar was seen as an indicator of a healthy and strong US stock market. A little history: From 1995 to 2000, both the Dollar and the US markets rallied, a positive correlation. From 2000 to 2002, the US markets suffered a big decline and so did the Dollar, also a positive correlation. From 2003 through 2004, however, the markets rallied while the Dollar lost, a negative correlation. In 2005, the Market was fairly flat and the Dollar rose while in 2006, the Market rallied and the Dollar lost. In 2007, the US Market gained but the Dollar suffered a big decline and in 2008, the Dollar initially lost ground while the Market rose slightly but then spiked late in the year when the financial crisis hit and the dollar became a safe haven while the Market sank. The results of this longer term analysis is that the USDX and US equity markets actually have a weak but positive correlation of about +0.35.
So why has the dollar been a strong negative driver of stock prices over the last 18 months? The answer has to do with the absolute level of interest rates in the US. With the drastic Fed easing cycle US rates are near zero and global investors seeking higher returns have been borrowing in dollars to invest in higher yielding instruments such as stocks and commodities--the so called carry trade--leading to a strong inverse relationship between the S&P 500 and the USDX. We’ve seen this pattern before and perhaps there is a history lesson there. In 2004 we also saw a large inverse relationship between the S&P and the Dollar with a correlation coefficient of -0.71. The Dollar Index fell 7% that year while the S&P gained 9%. Back then, as today, interest rates were extremely low during a Fed easing period that led to a Fed Funds target rate of 1%. At the end of the cycle, as the Fed began to raise rates on a strengthen economy, the relationship weakened and as the economy picked up the strength was enough to keep the stock market rising, even with a rising dollar. The current environment feels a lot like the end of 2003 and we suspect that, with Bernanke at the helm of the Fed, future rate rises will be measured enough to allow continued strong economic expansion in the face of rising rates. If that is the case, then history tells us that further gains for both the Dollar and US markets lie ahead.
Monday, March 1, 2010
Monday, February 22, 2010
Rambings of a Portfolio Manager
Lesson’s from earnings season
Fourth quarter 2009 earnings reporting season is winding down and so far, with 84% of S&P 500 companies reporting, the results have been fairly impressive. According to Thomson Reuters, of the companies that have reported 72% have beaten earnings expectations, 10% met expectations and 18% missed. This result is much better than the historical average of 60% beating analyst’s estimates. Revenues, which have consistently underperformed expectations coming out of 2008’s massive decline, actually surpassed expectations with 71%of companies beating and 29% missing estimates (no revenue reports matched expectations but, of course, that’s somewhat spurious as companies manage to EPS but revenues are harder to manipulate). Earnings growth year-over-year was a whopping 212%, but that was off a very low, recessionary base. Still, for all of 2010, earnings are expected to rise 27% from 2009 levels. All of this positive news, however, was greeted in most cases by selling. Why?
As usual, Alcoa kicked off earnings season with its report, the first of the Dow components to do so. Expectations were high for the company, given what the stock and the price of its underlying commodity had done since the March lows. While Alcoa’s revenues beat expectations investors, however, were disappointed as Alcoa delivered weaker than expected earnings and guidance due to higher costs, something that has not been an issue for reporting companies since Q4 2008. This put the Market on edge and set the stage for a round of “sell on the news” reactions to all future earnings reports, both good and bad. If Alco set the stage, Intel’s report was the catalyst for this trend as the company’s much better than expected report and guidance was greeted with a 3% stock decline and after Intel, the stock of virtually every other reporting company suffered the same fate. Had the whisper numbers (i.e. expectations) gotten ahead of underlying fundamentals? Did the market come too far too fast, as many disgruntled bears claimed? Actually, we believe that some really bad timing on the calendar had much to do with the price action seen during the past reporting season. First, we are into a new year, meaning that funds with big profits in positions from the March lows were more willing to sell and book a taxable gain than they were at the end of last year. The fact that the Bush capital gains tax cuts are due to expire at the end of this year certainly exacerbated this behavior. Secondly, there was the Scott Brown election, the results of which we received two days before Intel reported. President Obama’s attack on the banks, launched the next day in response to that defeat in Massachusetts, put a market already nervous from Alcoa’s report further on edge and started new talk about a potential government-induced double dip recession. The final straw was China’s mandate to its major banks to curb lending, released concurrent with Obama’s speech, which further raised concerns of a double-dip based on a slowing China, if not a business unfriendly US government. Timing is everything and in late January we got a confluence of unfortunately bad news.
Frankly, we’re not concerned by the price action following recent earnings reports and view this as a temporary, short-term trend. Gains that were taken in January and early February are now booked and remaining holders seem to be comfortable waiting for long-term capital gains status. Already we see that the Market is pricing in the risks of China’s actions and Obama, perhaps in reaction to the polls, is looking very much like he is moving toward the center ala Bill Clinton. The combination of the above is probably the reason for the Market’s rally since February 8th. As earnings and economic data continue to come in better than expected, we see a moderation and reversal of the sell on the earnings news trend. If that’s the case, then the Market may be ready to continue its move higher over the next quarter.
Fourth quarter 2009 earnings reporting season is winding down and so far, with 84% of S&P 500 companies reporting, the results have been fairly impressive. According to Thomson Reuters, of the companies that have reported 72% have beaten earnings expectations, 10% met expectations and 18% missed. This result is much better than the historical average of 60% beating analyst’s estimates. Revenues, which have consistently underperformed expectations coming out of 2008’s massive decline, actually surpassed expectations with 71%of companies beating and 29% missing estimates (no revenue reports matched expectations but, of course, that’s somewhat spurious as companies manage to EPS but revenues are harder to manipulate). Earnings growth year-over-year was a whopping 212%, but that was off a very low, recessionary base. Still, for all of 2010, earnings are expected to rise 27% from 2009 levels. All of this positive news, however, was greeted in most cases by selling. Why?
As usual, Alcoa kicked off earnings season with its report, the first of the Dow components to do so. Expectations were high for the company, given what the stock and the price of its underlying commodity had done since the March lows. While Alcoa’s revenues beat expectations investors, however, were disappointed as Alcoa delivered weaker than expected earnings and guidance due to higher costs, something that has not been an issue for reporting companies since Q4 2008. This put the Market on edge and set the stage for a round of “sell on the news” reactions to all future earnings reports, both good and bad. If Alco set the stage, Intel’s report was the catalyst for this trend as the company’s much better than expected report and guidance was greeted with a 3% stock decline and after Intel, the stock of virtually every other reporting company suffered the same fate. Had the whisper numbers (i.e. expectations) gotten ahead of underlying fundamentals? Did the market come too far too fast, as many disgruntled bears claimed? Actually, we believe that some really bad timing on the calendar had much to do with the price action seen during the past reporting season. First, we are into a new year, meaning that funds with big profits in positions from the March lows were more willing to sell and book a taxable gain than they were at the end of last year. The fact that the Bush capital gains tax cuts are due to expire at the end of this year certainly exacerbated this behavior. Secondly, there was the Scott Brown election, the results of which we received two days before Intel reported. President Obama’s attack on the banks, launched the next day in response to that defeat in Massachusetts, put a market already nervous from Alcoa’s report further on edge and started new talk about a potential government-induced double dip recession. The final straw was China’s mandate to its major banks to curb lending, released concurrent with Obama’s speech, which further raised concerns of a double-dip based on a slowing China, if not a business unfriendly US government. Timing is everything and in late January we got a confluence of unfortunately bad news.
Frankly, we’re not concerned by the price action following recent earnings reports and view this as a temporary, short-term trend. Gains that were taken in January and early February are now booked and remaining holders seem to be comfortable waiting for long-term capital gains status. Already we see that the Market is pricing in the risks of China’s actions and Obama, perhaps in reaction to the polls, is looking very much like he is moving toward the center ala Bill Clinton. The combination of the above is probably the reason for the Market’s rally since February 8th. As earnings and economic data continue to come in better than expected, we see a moderation and reversal of the sell on the earnings news trend. If that’s the case, then the Market may be ready to continue its move higher over the next quarter.
Tuesday, February 16, 2010
Ramblings of a Portfolio Manager
Let it Snow, Let it Snow, Let it Snow!
The US equity markets just completed their first positive week in five, a welcome relief to most investors but to the dismay of our TV repairman, who was Bentley shopping after we put a series of Diet Coke cans through the screen in vain assassination attempts on the” gurus” postulating that the market is selling off simply because we are 60-70% off the March lows, which we now need to retest according to their detailed analyses (assuming they are holding the chart correct side up). After a strong start followed by much volatility, the indexes are now slightly in positive territory for the month. The recent rally, which began Tuesday after the Dow closed below 10,000 for the first time since November, startled many market watchers who had no idea whence it emanated. Was it the prospect of a resolution to the Greek debt crisis? The strong US economic data hitting the tape daily? A benign CPI in China? Toyota finally recalling their Camry and Prius models? Yes. A more compelling argument, however, is that Washington was deep under two successive snow storms, which had the effect of suppressing any and all toxic rhetoric on the airwaves. No news is good news!
So where are we now? After our “well deserved” sell-off the major US equity averages are all down about 3% year to date. From their January 19th closing high to their February 8th closing low, most indexes lost about 8% or more. Only the Russell 2000 came close to the “classic correction” number of 10%, having fallen 9.7% between those dates. When one looks at the intraday highs and lows, however, the numbers are a little more drastic and in line with guru expectations, with the Russell correcting nearly 11%, the Dow and S&P dropping about 9% and the NASDAQ losing about 10%. So there you go! Correction meted out, weathered and now over, right? Frankly, in our opinion, this is all just number manipulation. Take the Shanghai Composite, for instance--that index was up over 90% from its November ’08 bottom yet it is down in line with US equity indexes during its “correction,” which began at the same time. Is that enough, too little or too much? Heck if we know. Stocks have no memory of their historical trading prices--just ask anyone who owned Cisco Systems or Nortel in 1999--and, collectively, these indexes are comprised of stocks. So, just as it is nonsense to preach the need for a correction after some random amount of upside from a bottom, it is irrational to suggest that any pre-determined percentage move to the downside during that correction is appropriate and to be expected.
We like to think like the fundamental portfolio managers we are and look at the indexes as individual securities, with financial performance expectations and multiples placed by the market on those expectations. Like a stock, the price of an index is determined by a multiple—e.g. price/earnings-- and that what the multiple is measuring—e.g. earnings, sales, book value and cash flow. For portfolio managers, the denominator--earnings, sales, book value, etc.--is fairly easy to calculate and even forecast. The numerator or Price, however, is what we all want to know so it is the multiple (of earnings, book value, etc.) that fundamental portfolio managers spend most of their time trying to solve.
In the case of the S&P 500, the current Price/Book Value multiple is 2.1x , the Price/Sales is 1.14 and the Price/Cash Flow is 10.0x. All of these are well below their pre-2008 10-year averages and near the lows hit over that same period. The Price/Earnings multiple on 12-month trailing earnings is 18.1x, near the high for the pre-2008 decade, but it is only 14.2x on forward (2010) expected earnings, at the lower end seen during that same period. What’s going on? Market multiples are all about sentiment and sentiment is based on expectations of growth. The higher the expected growth (in earnings, book value, etc.), the more the Market is willing to pay for the future in today’s dollars and, thus, the higher the P/E, P/B, etc. In 2009 S&P earnings per share dropped to $68.6, and for 2010 they are expected to be about $75.8, a level last seen at the end of 2005, when the index was trading over 200 points (19%) higher than it is now. The Market, always looking ahead, is willing to pay a higher multiple on what it perceives as “trough” earnings in 2009, expecting higher growth in 2010 and beyond, yet the S&P is not even at the multiples or level where it began 2005. Why not?
In 2011 S&P 500 companies are projected to earn $87.6 per share, roughly equal to what they earned in 2006, their highest level ever. The index at that time was trading over 350 points higher than today. Obviously, the Market saw something in2005- 2006 that gave it more reason to be optimistic and assign higher multiples than it is now. Was it higher expected near-term earnings growth? Not if you believe 2011 numbers. Was it a lower interest rate environment than we have now? Doubtful, given that we are at zero for the foreseeable future and even a series of rate hikes wouldn’t get us to where we were in 2005 or 2006. So why was the Market willing to pay more then for the future than today? There are multiple (pun intended) factors. To be sure there is the uncertainty discount that the current administration carries with it. Whatever history thinks of Bush/Greenspan the truth is that they were seen then as infinitely more business friendly than Obama/Bernanke are now. Then there is the fear factor, carried over from the near meltdown of 2008, which we did not have in 2005 and which recent sovereign events have rekindled. Like someone who has jumped into an icy pool once, investors will be slow to renter the same water as quickly the second time around. Also to be considered is the diminution of the Pax Americana premium, something that will continue as sovereign entities like China and the EU (don’t laugh!) assert their ascendancy in the world. Finally, there is the enormous debt that the Obama administration is piling on, raising the risk level of the US economy vis-à-vis its competitors. This last one is ironic as the Market is almost always willing to pay more for unlevered vs. levered companies due to their lower risk, yet as the Obama administration swaps private debt for public the Market is ascribing the same, if not higher, level of risk to the now less-levered companies in the S&P as it did before—all due to the leveraging up of the US government.
For stocks to go higher in the near term we will need multiple expansion and for that to occur some of the above concerns need to be alleviated in investors’ minds. We believe that the fear factor will dissipate over time and that the American premium will wax and wane with our perceived relative position in the world. The risk discount from the current administration and government borrowing, however, can only diminish if we get perceived stability and fiscal control out of Washington. The Bush administration spent like drunken sailors and Obama, despite his proclivity to blame everything on that policy, is only ramping it up. Perhaps, if we are lucky, the mid-term elections will do more than reduce the power of the anti-business lobby—hopefully, voters will send a message that they have learned their lesson with debt and now it’s Congress’ turn to learn as well. If that happens, then S&P 1400 and Dow 14000 will not be far away.
The US equity markets just completed their first positive week in five, a welcome relief to most investors but to the dismay of our TV repairman, who was Bentley shopping after we put a series of Diet Coke cans through the screen in vain assassination attempts on the” gurus” postulating that the market is selling off simply because we are 60-70% off the March lows, which we now need to retest according to their detailed analyses (assuming they are holding the chart correct side up). After a strong start followed by much volatility, the indexes are now slightly in positive territory for the month. The recent rally, which began Tuesday after the Dow closed below 10,000 for the first time since November, startled many market watchers who had no idea whence it emanated. Was it the prospect of a resolution to the Greek debt crisis? The strong US economic data hitting the tape daily? A benign CPI in China? Toyota finally recalling their Camry and Prius models? Yes. A more compelling argument, however, is that Washington was deep under two successive snow storms, which had the effect of suppressing any and all toxic rhetoric on the airwaves. No news is good news!
So where are we now? After our “well deserved” sell-off the major US equity averages are all down about 3% year to date. From their January 19th closing high to their February 8th closing low, most indexes lost about 8% or more. Only the Russell 2000 came close to the “classic correction” number of 10%, having fallen 9.7% between those dates. When one looks at the intraday highs and lows, however, the numbers are a little more drastic and in line with guru expectations, with the Russell correcting nearly 11%, the Dow and S&P dropping about 9% and the NASDAQ losing about 10%. So there you go! Correction meted out, weathered and now over, right? Frankly, in our opinion, this is all just number manipulation. Take the Shanghai Composite, for instance--that index was up over 90% from its November ’08 bottom yet it is down in line with US equity indexes during its “correction,” which began at the same time. Is that enough, too little or too much? Heck if we know. Stocks have no memory of their historical trading prices--just ask anyone who owned Cisco Systems or Nortel in 1999--and, collectively, these indexes are comprised of stocks. So, just as it is nonsense to preach the need for a correction after some random amount of upside from a bottom, it is irrational to suggest that any pre-determined percentage move to the downside during that correction is appropriate and to be expected.
We like to think like the fundamental portfolio managers we are and look at the indexes as individual securities, with financial performance expectations and multiples placed by the market on those expectations. Like a stock, the price of an index is determined by a multiple—e.g. price/earnings-- and that what the multiple is measuring—e.g. earnings, sales, book value and cash flow. For portfolio managers, the denominator--earnings, sales, book value, etc.--is fairly easy to calculate and even forecast. The numerator or Price, however, is what we all want to know so it is the multiple (of earnings, book value, etc.) that fundamental portfolio managers spend most of their time trying to solve.
In the case of the S&P 500, the current Price/Book Value multiple is 2.1x , the Price/Sales is 1.14 and the Price/Cash Flow is 10.0x. All of these are well below their pre-2008 10-year averages and near the lows hit over that same period. The Price/Earnings multiple on 12-month trailing earnings is 18.1x, near the high for the pre-2008 decade, but it is only 14.2x on forward (2010) expected earnings, at the lower end seen during that same period. What’s going on? Market multiples are all about sentiment and sentiment is based on expectations of growth. The higher the expected growth (in earnings, book value, etc.), the more the Market is willing to pay for the future in today’s dollars and, thus, the higher the P/E, P/B, etc. In 2009 S&P earnings per share dropped to $68.6, and for 2010 they are expected to be about $75.8, a level last seen at the end of 2005, when the index was trading over 200 points (19%) higher than it is now. The Market, always looking ahead, is willing to pay a higher multiple on what it perceives as “trough” earnings in 2009, expecting higher growth in 2010 and beyond, yet the S&P is not even at the multiples or level where it began 2005. Why not?
In 2011 S&P 500 companies are projected to earn $87.6 per share, roughly equal to what they earned in 2006, their highest level ever. The index at that time was trading over 350 points higher than today. Obviously, the Market saw something in2005- 2006 that gave it more reason to be optimistic and assign higher multiples than it is now. Was it higher expected near-term earnings growth? Not if you believe 2011 numbers. Was it a lower interest rate environment than we have now? Doubtful, given that we are at zero for the foreseeable future and even a series of rate hikes wouldn’t get us to where we were in 2005 or 2006. So why was the Market willing to pay more then for the future than today? There are multiple (pun intended) factors. To be sure there is the uncertainty discount that the current administration carries with it. Whatever history thinks of Bush/Greenspan the truth is that they were seen then as infinitely more business friendly than Obama/Bernanke are now. Then there is the fear factor, carried over from the near meltdown of 2008, which we did not have in 2005 and which recent sovereign events have rekindled. Like someone who has jumped into an icy pool once, investors will be slow to renter the same water as quickly the second time around. Also to be considered is the diminution of the Pax Americana premium, something that will continue as sovereign entities like China and the EU (don’t laugh!) assert their ascendancy in the world. Finally, there is the enormous debt that the Obama administration is piling on, raising the risk level of the US economy vis-à-vis its competitors. This last one is ironic as the Market is almost always willing to pay more for unlevered vs. levered companies due to their lower risk, yet as the Obama administration swaps private debt for public the Market is ascribing the same, if not higher, level of risk to the now less-levered companies in the S&P as it did before—all due to the leveraging up of the US government.
For stocks to go higher in the near term we will need multiple expansion and for that to occur some of the above concerns need to be alleviated in investors’ minds. We believe that the fear factor will dissipate over time and that the American premium will wax and wane with our perceived relative position in the world. The risk discount from the current administration and government borrowing, however, can only diminish if we get perceived stability and fiscal control out of Washington. The Bush administration spent like drunken sailors and Obama, despite his proclivity to blame everything on that policy, is only ramping it up. Perhaps, if we are lucky, the mid-term elections will do more than reduce the power of the anti-business lobby—hopefully, voters will send a message that they have learned their lesson with debt and now it’s Congress’ turn to learn as well. If that happens, then S&P 1400 and Dow 14000 will not be far away.
Monday, February 8, 2010
Ramblings of a Portfolio Manager 2-8-2010
Bulls Bears & PIGS
The old saying on Wall Street goes bulls and bears will always make money but pigs will get slaughtered. The “pigs” in this little proverb refers the living, sty-resident type and is meant to represent greedy investors, who never succeed by being “hoggish.” The soothe-sayers of old who came up with the adage certainly could not have envisioned that one day the modern day PIGS, Portugal, Ireland, Greece and Spain, would make it a truism. After a dismal market month in January, February’s strong start was abruptly halted by the twin specters of continued debt trouble in Greece and, by extension, Spain.
To put things in perspective, Greece is a country of 11 million people and represents approximately 2% of the combined GDP of the EU. New York City, with a GDP 3x larger, could kick its butt in a rumble. Spain, on the other hand, has a GDP slightly larger than NYC, approaching that of California, with a population of 45 million, slightly less than California and New York City combined. A Sovereign default by Spain would certainly cause a big ripple across the world financial markets and the fear of the Greek contagion spreading to the other PIGS is what rocked world markets last week. By comparison, the tiny Emirate of Dubai, which caused a minor tempest in the markets last fall, is about 13% the size of Greece in GDP.
The possibility of a default by Greece cannot be dismissed. Greece’s total debt stands at over 120% of GDP as compared to California’s indebtedness at 7% and unlike the UAE, EU charter prevents member countries from coming to neighboring states’ financial aid. Any rescue of Greece would have to come from the EU as a whole, possibly in the form of a bond offering, the proceeds of which would be shared with Greece. So far, EU ministers have rejected the prospect of a bailout, as has China, now the World’s lender of last resort. But as we pointed out, Greece is very small and so that begs the question how would Greece bring down Spain? According to the Bank for International Settlements, the majority of Greek Sovereign and private debt is held by French, Swiss and German banks. So a Greek default wouldn’t necessarily harm financial institutions in Spain, however much of the same macroeconomic woes that afflict Greece are also hitting Spain, who’s debt load as a percentage of GDP is a also high, at 66%, and who’s budget deficit is comparable at 9.7% versus 13% in Greece. The sentiment is that if it could happen to one Mediterranean state, it could happen to others (including Portugal) and that fear is hanging over the Spanish currency and thus its bond market, causing the Government to cancel a planned note offering last week.
So is this the buying opportunity that retail investors have been waiting for since the March 6th bottom? Perhaps a lesson from history is in order. The Arab oil embargo of the mid 70’s led to the Latin American debt crisis of ’75-’82, when many countries could not pay the high debt incurred from years of fruitless infrastructure projects. While that crisis played itself out, the US equity markets experienced the “lost decade” of little or no progression. To be sure, much of that lost decade can be attributed to problems at home, also caused by the oil shock, but the LatAm crisis certainly played out on the equities of large US multinational banks and fears of Sovereign default weighed on the US equity markets at the end of the decade. With the resolution of the crisis in 1982, however, the US equity markets staged a stunning decade-long rally although some of that rally could be attributed to the election of Ronald Regan as US President and his subsequent implementation of supply side economics. A more recent and closer analogy is the “Asian Contagion” of 1997, which began with the collapse of the Thai Baht and the subsequent inability of that country to meet its debt obligations. The contagion spread across other South East Asian countries, many of which had Debt/GDP ratios over 100%, as their currencies and stock markets became significantly devalued by global fear. The crisis was eventually resolved by the IMF, which created a series of rescue packages (bailouts) to enable the affected countries to avoid default, tying the aid to promises of drastic economic reforms at the recipient countries. During that contagion the US equity market at first took a dive in mid-1998 but soon recovered and the S&P 500 ended the year up nearly 30%.
In our opinion PIGS issue will eventually be resolved by the coordinated efforts of the EU with some IMF and foreign assistance but that while it works its way through the markets will remain volatile. We are reminded that for half of its time as a Sovereign entity (200 years) Greece has been in default on its debt. So what we are witnessing here has been seen before. Ultimately, we believe that this will present an excellent opportunity to get back into the equity markets and look for the resolution as the catalyst.
The old saying on Wall Street goes bulls and bears will always make money but pigs will get slaughtered. The “pigs” in this little proverb refers the living, sty-resident type and is meant to represent greedy investors, who never succeed by being “hoggish.” The soothe-sayers of old who came up with the adage certainly could not have envisioned that one day the modern day PIGS, Portugal, Ireland, Greece and Spain, would make it a truism. After a dismal market month in January, February’s strong start was abruptly halted by the twin specters of continued debt trouble in Greece and, by extension, Spain.
To put things in perspective, Greece is a country of 11 million people and represents approximately 2% of the combined GDP of the EU. New York City, with a GDP 3x larger, could kick its butt in a rumble. Spain, on the other hand, has a GDP slightly larger than NYC, approaching that of California, with a population of 45 million, slightly less than California and New York City combined. A Sovereign default by Spain would certainly cause a big ripple across the world financial markets and the fear of the Greek contagion spreading to the other PIGS is what rocked world markets last week. By comparison, the tiny Emirate of Dubai, which caused a minor tempest in the markets last fall, is about 13% the size of Greece in GDP.
The possibility of a default by Greece cannot be dismissed. Greece’s total debt stands at over 120% of GDP as compared to California’s indebtedness at 7% and unlike the UAE, EU charter prevents member countries from coming to neighboring states’ financial aid. Any rescue of Greece would have to come from the EU as a whole, possibly in the form of a bond offering, the proceeds of which would be shared with Greece. So far, EU ministers have rejected the prospect of a bailout, as has China, now the World’s lender of last resort. But as we pointed out, Greece is very small and so that begs the question how would Greece bring down Spain? According to the Bank for International Settlements, the majority of Greek Sovereign and private debt is held by French, Swiss and German banks. So a Greek default wouldn’t necessarily harm financial institutions in Spain, however much of the same macroeconomic woes that afflict Greece are also hitting Spain, who’s debt load as a percentage of GDP is a also high, at 66%, and who’s budget deficit is comparable at 9.7% versus 13% in Greece. The sentiment is that if it could happen to one Mediterranean state, it could happen to others (including Portugal) and that fear is hanging over the Spanish currency and thus its bond market, causing the Government to cancel a planned note offering last week.
So is this the buying opportunity that retail investors have been waiting for since the March 6th bottom? Perhaps a lesson from history is in order. The Arab oil embargo of the mid 70’s led to the Latin American debt crisis of ’75-’82, when many countries could not pay the high debt incurred from years of fruitless infrastructure projects. While that crisis played itself out, the US equity markets experienced the “lost decade” of little or no progression. To be sure, much of that lost decade can be attributed to problems at home, also caused by the oil shock, but the LatAm crisis certainly played out on the equities of large US multinational banks and fears of Sovereign default weighed on the US equity markets at the end of the decade. With the resolution of the crisis in 1982, however, the US equity markets staged a stunning decade-long rally although some of that rally could be attributed to the election of Ronald Regan as US President and his subsequent implementation of supply side economics. A more recent and closer analogy is the “Asian Contagion” of 1997, which began with the collapse of the Thai Baht and the subsequent inability of that country to meet its debt obligations. The contagion spread across other South East Asian countries, many of which had Debt/GDP ratios over 100%, as their currencies and stock markets became significantly devalued by global fear. The crisis was eventually resolved by the IMF, which created a series of rescue packages (bailouts) to enable the affected countries to avoid default, tying the aid to promises of drastic economic reforms at the recipient countries. During that contagion the US equity market at first took a dive in mid-1998 but soon recovered and the S&P 500 ended the year up nearly 30%.
In our opinion PIGS issue will eventually be resolved by the coordinated efforts of the EU with some IMF and foreign assistance but that while it works its way through the markets will remain volatile. We are reminded that for half of its time as a Sovereign entity (200 years) Greece has been in default on its debt. So what we are witnessing here has been seen before. Ultimately, we believe that this will present an excellent opportunity to get back into the equity markets and look for the resolution as the catalyst.
Monday, February 1, 2010
Ramblings of a Portfolio Manager
Stock Ideas from Punxsutawney Phil
Well, so far it seems we got it half right. Earlier this year we posited that good economic data would be taken by the market as negative and that bad news would be taken as good--as this information would signal the timing of the Fed’s pending rate hike--but that individual stocks would trade based on earnings surprises and guidance. Everything is just going down on good news now. There hasn’t been a great deal of bad news in either earnings or economic data but (and this may all be due to timing) for stocks and the market as a whole, bad news seems to be greeted with better price action than good news. Like the Groundhog, investors are running from their own shadows and using positive data as the opportunity to sell.
Is this the long-awaited correction and if so how long and deep will it be? The Dow and S&P are now off more than 6% from their January 19th highs while the NASDAQ and Russell 2000 are down over 7% from their peaks of the same day. That’s a lot of carnage for 8 trading days. According to S&P data the average post-war correction is about 8.5% and lasts 45 days so in magnitude, but not duration, we’re getting close to the long term average pullback. A couple of more days like last week’s and we’ll be there. However, to answer the question on everyone’s lips—if and when to buy or sell--we need to ascertain why stocks are selling off. Certainly some of the price action in individual stocks is “sell on the news” reaction, particularly in technology, which had a great run last year and is thus already discounting a fair amount of good results. And then there is the “noise factor,” which we discussed last week. Some of that noise, such as Bernanke’s renomination and the President’s State of the Union message, is already out of the way and probably discounted. Others, like China’s fate and populist attacks on financial institutions, are still being debated and digested. Noise that we neglected to mention is now coming from technicians who have all sorts of pins in their voodoo dolls in the form of points on the charts at which things are going to either bottom, rebound or fall further. Finally, there is the ever-present fear of a double-dip recession, something the President’s level of noise only serves to amplify. Taking all of the above together, investors would rather just take their dice and go play elsewhere.
Assuming we’re right on the above and that it captures the bulk of the motivation behind the recent sell-off, then we see nothing in it that is based on earnings fundamentals, which, over the long run, are what drives stock prices. The wild card is the last point on the rhetoric coming out of Capitol Hill. Will the anti-business populist sentiment be enough to jawbone us back into recession? On this point we think not for the simple reason than nothing coming out of Washington has changed in tone since the new administration moved in. Was it really a surprise to anyone that Obama would propose anti-Wall Street initiatives? If anything, what is surprising is the level to which even his own confidants disagree with him on that point. So we think businesses are already expecting the worst from DC and at some point will most likely just discount the new pap and move ahead. That being the case, at some point one should one buy, but when? The answer to this is why the technicians are now getting some attention.
When markets are moving on noise and sentiment rather than fundamentals it’s very difficult to pick buy and sell points, which is why investors often turn to charts. Retail brokers often use the acronym DEAD, or Don’t Ever Average Down a strategy with which we don’t always agree. Given the rapidity of the sell-off and the spike in the VIX we have just seen, there is still a good deal of fear in the market so plunging in headfirst probably isn’t the best strategy. We would suggest focusing on companies with good near to intermediate-term fundamentals and slowly accumulating positions over the next month as things sort themselves out. Technology is probably a good place to start after the drubbing it has received in the face of positive information. Non-bank financials are also a good place to look. We don’t agree with the run-up in regional banks on the woes of the multinationals as we expect the yield curve to flatten this year in a rising rate environment. Energy stocks also look interesting to us since they did not keep pace with the prices of the underlying commodities last year yet have sold off along with energy prices this year. In our opinion the groundhog approach taken by institutions over the last two weeks has presented investors who have avoided chasing the market over the last 8 months a good chance to get invested at better prices. Happy Groundhog Day!
Well, so far it seems we got it half right. Earlier this year we posited that good economic data would be taken by the market as negative and that bad news would be taken as good--as this information would signal the timing of the Fed’s pending rate hike--but that individual stocks would trade based on earnings surprises and guidance. Everything is just going down on good news now. There hasn’t been a great deal of bad news in either earnings or economic data but (and this may all be due to timing) for stocks and the market as a whole, bad news seems to be greeted with better price action than good news. Like the Groundhog, investors are running from their own shadows and using positive data as the opportunity to sell.
Is this the long-awaited correction and if so how long and deep will it be? The Dow and S&P are now off more than 6% from their January 19th highs while the NASDAQ and Russell 2000 are down over 7% from their peaks of the same day. That’s a lot of carnage for 8 trading days. According to S&P data the average post-war correction is about 8.5% and lasts 45 days so in magnitude, but not duration, we’re getting close to the long term average pullback. A couple of more days like last week’s and we’ll be there. However, to answer the question on everyone’s lips—if and when to buy or sell--we need to ascertain why stocks are selling off. Certainly some of the price action in individual stocks is “sell on the news” reaction, particularly in technology, which had a great run last year and is thus already discounting a fair amount of good results. And then there is the “noise factor,” which we discussed last week. Some of that noise, such as Bernanke’s renomination and the President’s State of the Union message, is already out of the way and probably discounted. Others, like China’s fate and populist attacks on financial institutions, are still being debated and digested. Noise that we neglected to mention is now coming from technicians who have all sorts of pins in their voodoo dolls in the form of points on the charts at which things are going to either bottom, rebound or fall further. Finally, there is the ever-present fear of a double-dip recession, something the President’s level of noise only serves to amplify. Taking all of the above together, investors would rather just take their dice and go play elsewhere.
Assuming we’re right on the above and that it captures the bulk of the motivation behind the recent sell-off, then we see nothing in it that is based on earnings fundamentals, which, over the long run, are what drives stock prices. The wild card is the last point on the rhetoric coming out of Capitol Hill. Will the anti-business populist sentiment be enough to jawbone us back into recession? On this point we think not for the simple reason than nothing coming out of Washington has changed in tone since the new administration moved in. Was it really a surprise to anyone that Obama would propose anti-Wall Street initiatives? If anything, what is surprising is the level to which even his own confidants disagree with him on that point. So we think businesses are already expecting the worst from DC and at some point will most likely just discount the new pap and move ahead. That being the case, at some point one should one buy, but when? The answer to this is why the technicians are now getting some attention.
When markets are moving on noise and sentiment rather than fundamentals it’s very difficult to pick buy and sell points, which is why investors often turn to charts. Retail brokers often use the acronym DEAD, or Don’t Ever Average Down a strategy with which we don’t always agree. Given the rapidity of the sell-off and the spike in the VIX we have just seen, there is still a good deal of fear in the market so plunging in headfirst probably isn’t the best strategy. We would suggest focusing on companies with good near to intermediate-term fundamentals and slowly accumulating positions over the next month as things sort themselves out. Technology is probably a good place to start after the drubbing it has received in the face of positive information. Non-bank financials are also a good place to look. We don’t agree with the run-up in regional banks on the woes of the multinationals as we expect the yield curve to flatten this year in a rising rate environment. Energy stocks also look interesting to us since they did not keep pace with the prices of the underlying commodities last year yet have sold off along with energy prices this year. In our opinion the groundhog approach taken by institutions over the last two weeks has presented investors who have avoided chasing the market over the last 8 months a good chance to get invested at better prices. Happy Groundhog Day!
Monday, January 25, 2010
Even the Grinch Got Used to Pantookas and Wuzzles
Ramblings of a Portfolio Manager or Even the Grinch Got Used to Pantookas and Wuzzles
What a week in the equity markets. The market took the triple onslaughts of Chinese monetary policy tightening, Scott Brown’s upsetting (to Democrats) victory, which produced the opposite of the expected effect by spurring Obama’s attempted face-saving attack in the form of plans to dismantle our world-leading financial system and a slew of rats, er Congressmen fleeing the sinking ship of State by backing away from the President by rejecting his preference for the reappointment of Federal Reserve Chairman, Ben Bernanke. As for the later case, when rats flee a sinking ship it is to save their own skins and they typically jump overboard rather than chewing a hole in the hull, hastening the demise of the doomed vessel. But Congressman, like rats it seems, cant read or understand spoken English and our boys on the hill are chewing big holes by ignoring the effect their defection from support of Bernanke would have on our already weakened economy and financial system and, by derivative, the equity markets. But at least they can comfort constituents on Main Street with “I didn’t support that guy who single-handedly brought down our financial system…Oh, so sorry your 401(k) is down 20% as a result.” At least our rats have their own safety net for the capsizing they will cause. Too bad for their constituents. Anyhow, the result of the Trifecta of bad news was the worst three day period in the markets since last February, a time when it wasn’t clear whether or not the Country was going into another great depression. The S&P 500 ended down 3.9% on the week and is now down 2.02% for the month while the Dow dropped 5.2% (552 points), ending down 2.45% for the year, and the Russell 2000 lost 4.53% ending down 1.29% for the year. Thanks, fellas, for working hard for the unemployed and looking out for the savings of the still employed.
Reality check. Is there reason to be concerned over the news and results last week? Is this the long-expected market correction? Our answer is no and no. First of all, everything that happened last week was the result of ever lurking but always surprising headline risk. Occasionally, politicians will say or do something dumb (maybe more than occasionally lately) and the markets extrapolate that information into a virtually certainty and immediately discount the expected results. That’s what markets do, but it doesn’t mean they are always accurate in their predictive power. In any market there is what is called “noise,” which is information that is market moving but non-impactful to underlying long-term fundamentals, and there are long-term policy or structural economic shifts, which are. We put last week solidly into the noise category.
Noise #1, China: funny how all the cynics who claim China is falsely inflating their economic numbers jumped on board with “told you so” when the Central Government tapped on the economic brakes last week. Let’s get this straight—the Chinese are purposely faking monetary contraction to lend credence to their faked economic expansion? Uh huh. Believe it or not, many of the Chinese Central Bankers were educated in Western Capitalist running dog business schools, studying past Fed actions, and understand the value of signaling. That is, it’s not so important what the “Fed” does as what it says in accomplishing its goals. We believe last week’s news release that the Chinese told banks to stop lending for the rest of month was more signaling than fact but, in any case, let’s put it in perspective—will two weeks (that’s all it is—not a permanent change) of reduced credit really derail the expansion of the worlds’ largest population? We don’t think so. Remember, our thesis is that the Central Government has 1.3 billion angry peasants to please. Putting the economy into decline is not going to cause them to put down their pitch forks and torches.
Noise #2, Banking reform: Even Geithner and Frank were surprised by the President’s announcement and subsequently tried to tone it down. In the former case, Turbo Tax Tim may be shown the door but Barney Frank is notoriously difficult to remove. Even that radical Congressman publicly declared the proposal too drastic and sought for a 3-5 year transition period, if the bill ever passes. We think the whole proposal dies an ignominious death either when we get a goodly portion of the democrats out of our Congress in November.or even earlier, when the incumbents get smart enough to realize that a consistent message of scapegoating does nothing for getting their constituents jobs and them votes.
Noise #3, Bernanke. This is a little more disturbing than the previous two as it is based on the unpredicability of panicky politicians. As Warren Buffet said, “let me know if Bernanke isn’t going to get reappointed so I can sell stocks.” We agree with him wholeheartedly. Blaming the prior administration for the current ills is a favorite tactic on Capital Hill and Bernanke is the scapegoat du jour, especially among Senators wishing to distance themselves from the flailing President. In point of fact, even if he is not reconfirmed, Bernanke will still sit on and control the FOMC, which sets rate policy decisions, so we will still have his wisdom and education to guide rate policy, but a weakened Fed is one without great credibility on Wall Street, which is not good. We believe that, ultimately, sanity will prevail and Bernanke will be reappointed (or for no other reason than they don’t have a viable alternative), but it will prove to be a volatile week ahead as rumors, sound bites and polls pollute the airways.
Bottom line: We think the 5% correction we just had is healthy and about as much to expect from the latest round of headlines. Volatility may remain elevated for a time but, ultimately, the markets will continue to grind higher as pending Congressional gridlock draws nearer and companies continue to report stronger than expected earnings.
What a week in the equity markets. The market took the triple onslaughts of Chinese monetary policy tightening, Scott Brown’s upsetting (to Democrats) victory, which produced the opposite of the expected effect by spurring Obama’s attempted face-saving attack in the form of plans to dismantle our world-leading financial system and a slew of rats, er Congressmen fleeing the sinking ship of State by backing away from the President by rejecting his preference for the reappointment of Federal Reserve Chairman, Ben Bernanke. As for the later case, when rats flee a sinking ship it is to save their own skins and they typically jump overboard rather than chewing a hole in the hull, hastening the demise of the doomed vessel. But Congressman, like rats it seems, cant read or understand spoken English and our boys on the hill are chewing big holes by ignoring the effect their defection from support of Bernanke would have on our already weakened economy and financial system and, by derivative, the equity markets. But at least they can comfort constituents on Main Street with “I didn’t support that guy who single-handedly brought down our financial system…Oh, so sorry your 401(k) is down 20% as a result.” At least our rats have their own safety net for the capsizing they will cause. Too bad for their constituents. Anyhow, the result of the Trifecta of bad news was the worst three day period in the markets since last February, a time when it wasn’t clear whether or not the Country was going into another great depression. The S&P 500 ended down 3.9% on the week and is now down 2.02% for the month while the Dow dropped 5.2% (552 points), ending down 2.45% for the year, and the Russell 2000 lost 4.53% ending down 1.29% for the year. Thanks, fellas, for working hard for the unemployed and looking out for the savings of the still employed.
Reality check. Is there reason to be concerned over the news and results last week? Is this the long-expected market correction? Our answer is no and no. First of all, everything that happened last week was the result of ever lurking but always surprising headline risk. Occasionally, politicians will say or do something dumb (maybe more than occasionally lately) and the markets extrapolate that information into a virtually certainty and immediately discount the expected results. That’s what markets do, but it doesn’t mean they are always accurate in their predictive power. In any market there is what is called “noise,” which is information that is market moving but non-impactful to underlying long-term fundamentals, and there are long-term policy or structural economic shifts, which are. We put last week solidly into the noise category.
Noise #1, China: funny how all the cynics who claim China is falsely inflating their economic numbers jumped on board with “told you so” when the Central Government tapped on the economic brakes last week. Let’s get this straight—the Chinese are purposely faking monetary contraction to lend credence to their faked economic expansion? Uh huh. Believe it or not, many of the Chinese Central Bankers were educated in Western Capitalist running dog business schools, studying past Fed actions, and understand the value of signaling. That is, it’s not so important what the “Fed” does as what it says in accomplishing its goals. We believe last week’s news release that the Chinese told banks to stop lending for the rest of month was more signaling than fact but, in any case, let’s put it in perspective—will two weeks (that’s all it is—not a permanent change) of reduced credit really derail the expansion of the worlds’ largest population? We don’t think so. Remember, our thesis is that the Central Government has 1.3 billion angry peasants to please. Putting the economy into decline is not going to cause them to put down their pitch forks and torches.
Noise #2, Banking reform: Even Geithner and Frank were surprised by the President’s announcement and subsequently tried to tone it down. In the former case, Turbo Tax Tim may be shown the door but Barney Frank is notoriously difficult to remove. Even that radical Congressman publicly declared the proposal too drastic and sought for a 3-5 year transition period, if the bill ever passes. We think the whole proposal dies an ignominious death either when we get a goodly portion of the democrats out of our Congress in November.or even earlier, when the incumbents get smart enough to realize that a consistent message of scapegoating does nothing for getting their constituents jobs and them votes.
Noise #3, Bernanke. This is a little more disturbing than the previous two as it is based on the unpredicability of panicky politicians. As Warren Buffet said, “let me know if Bernanke isn’t going to get reappointed so I can sell stocks.” We agree with him wholeheartedly. Blaming the prior administration for the current ills is a favorite tactic on Capital Hill and Bernanke is the scapegoat du jour, especially among Senators wishing to distance themselves from the flailing President. In point of fact, even if he is not reconfirmed, Bernanke will still sit on and control the FOMC, which sets rate policy decisions, so we will still have his wisdom and education to guide rate policy, but a weakened Fed is one without great credibility on Wall Street, which is not good. We believe that, ultimately, sanity will prevail and Bernanke will be reappointed (or for no other reason than they don’t have a viable alternative), but it will prove to be a volatile week ahead as rumors, sound bites and polls pollute the airways.
Bottom line: We think the 5% correction we just had is healthy and about as much to expect from the latest round of headlines. Volatility may remain elevated for a time but, ultimately, the markets will continue to grind higher as pending Congressional gridlock draws nearer and companies continue to report stronger than expected earnings.
Tuesday, January 19, 2010
Ramblings of a Portfolio Manager 1-19-2010
Hey Lloyd, will you autograph the dashboard of my Chrysler Sebring?
Einstein defined insanity as doing the same thing over and over expecting different results. If that former Nobel Laureate is correct, then a certain recent prize recipient may be overdue for a Rorschach and rubber room. One would think that, having witnessed the greatest slide in fist year/first-term popularity in history, our President might logically conclude that the public was tiring of punish the rich populist rhetoric, craving instead real solutions for the Nation’s stubbornly high unemployment rate, and modify his message. But dot connecting is a skill absent in Washington, DC these days and the White House response to news of an additional 85,000 jobs lost and a stated unemployment rate hovering around 10% (the true rate, which includes workers who have given up looking for a job, is estimated to be 17%) was the same old anger and outrage aimed at those fat cat bankers who, we are told, caused it all.
Last week’s anti-Wall Street message came in the form of a tax, er “Financial Crisis Responsibility Fee,” on large banks with more than $50 billion in assets (10 banks will bear 60% of the burden). The 10-year, $90 billion program is purported to pay back losses incurred under the TARP but it was introduced with the usual anti-wealth creation rhetoric, making its true intent suspect. Nothing about how this “fee” is going to spur loan growth or job creation. Also ignored was the fact that the big banks have all paid back all their TARP loans with interest (Accounting 101 tells us that means they incurred no losses), something the Union-controlled General Motors and Government –controlled Fannie Mae and Freddie Mac—all exempt from the fee--haven’t done. And no word on the vig Barney Frank and Chris Dodd will be assessed for their responsibility in the financial crisis. By week-end the populist harangue hit its latest zenith with Obama’s deal to exempt only union members from the “Cadillac Health Plan Tax” and a Democratic Michigan Representative’s pledge of support for the new bank fees because “Wall Street is solely responsible for all of Detroit’s woes.” Dang, we had forgotten that Goldman Sachs and Lehman Brothers were the saboteurs of the Pacer, Gremlin, Pinto and the remaining long list of Motown masterpieces. Anyhow, amidst all this political noise, its small wonder that the markets ended the week on a sour note.
That’s the “rambling” part. The real subject this week is interest rates. Since at least September the markets have been obsessed with the timing and magnitude of the Federal Reserve’s expected withdrawal of liquidity from the financial system. A key feature of the tapping on the brakes process will be a hike in short term rates—either the fed funds rate, the discount rate or both. The conventional wisdom is that higher rates are bad for the economy as they increase the cost of borrowing, reducing demand for loans while increasing the cost of doing business for virtually all companies, and they typically strengthen the dollar, slowing exports. We can’t argue with this economic theory and, of course, the whole point of a rate hike is indeed to slow down the economy. However, because we are in a political as well as economic Bizzaro Land these days, things don’t always follow the old playbooks. In fact, we posit that a hike in rates, at least in the initial phases, would be good for both the economy and equity markets. How so? To begin with, banks are currently dis-incentivized to lend. The ability to borrow at the Fed’s Discount Window at an effective rate of zero combined with the Government mandates to improve credit quality has motivated bankers to simply play the yield curve for profits. With long-term Treasuries yielding nearly 4% banks can earn a net interest spread comparable to the good old days with no default risk--so why make loans? A small hike in short-term borrowing costs to the banks, if it flattens the yield curve as it generally does, would give them more incentive to take risks in search of returns—i.e. make loans. Since the real problem now is the supply of lending, rather than demand, easier credit at this stage in the economic cycle would likely more than offset the braking effects of a small rise in short term rates.
What about the equity markets? It’s doubtful that the potential benefits to lending of higher rates would be immediately obvious to equity investors, however, since the markets are already discounting a long series of rate increases by the Fed beginning sometime this year (although that date is getting pushed out) the first rate hike, if it is small as expected (say 25bps) and accompanied by the proper “signaling” by the Fed would most likely spark a relief rally. After that, further fuel could come from the fact that retail investor money has been flowing out of equities and into fixed income investments for the last 16 months. A bump up in short term rates will knock down the value of short-term debt instruments, which might just be sufficient to scare that money out of the “safety” of T-bills and Treasuries and back into the equity markets. That’s a move, by the way, that could cause a virtuous cycle for some time as fixed income redemptions further depress the price of those securities while the flow into equities drives up stock prices, attracting more investment.
Of course, for the above scenarios to materialize, the Fed must properly signal its intent—e.g. “3 and done.” An open-ended series of rate hikes will eventually scare investors out of both asset classes (as well as real estate) and overshoot in their braking intent. As a student of the Great Depression, Bernanke is well aware of this. We just hope that the bout of insanity on Capitol Hill is temporary and that Congress will reappoint the Fed Chairman and start making noise about jobs rather than social engineering.
Einstein defined insanity as doing the same thing over and over expecting different results. If that former Nobel Laureate is correct, then a certain recent prize recipient may be overdue for a Rorschach and rubber room. One would think that, having witnessed the greatest slide in fist year/first-term popularity in history, our President might logically conclude that the public was tiring of punish the rich populist rhetoric, craving instead real solutions for the Nation’s stubbornly high unemployment rate, and modify his message. But dot connecting is a skill absent in Washington, DC these days and the White House response to news of an additional 85,000 jobs lost and a stated unemployment rate hovering around 10% (the true rate, which includes workers who have given up looking for a job, is estimated to be 17%) was the same old anger and outrage aimed at those fat cat bankers who, we are told, caused it all.
Last week’s anti-Wall Street message came in the form of a tax, er “Financial Crisis Responsibility Fee,” on large banks with more than $50 billion in assets (10 banks will bear 60% of the burden). The 10-year, $90 billion program is purported to pay back losses incurred under the TARP but it was introduced with the usual anti-wealth creation rhetoric, making its true intent suspect. Nothing about how this “fee” is going to spur loan growth or job creation. Also ignored was the fact that the big banks have all paid back all their TARP loans with interest (Accounting 101 tells us that means they incurred no losses), something the Union-controlled General Motors and Government –controlled Fannie Mae and Freddie Mac—all exempt from the fee--haven’t done. And no word on the vig Barney Frank and Chris Dodd will be assessed for their responsibility in the financial crisis. By week-end the populist harangue hit its latest zenith with Obama’s deal to exempt only union members from the “Cadillac Health Plan Tax” and a Democratic Michigan Representative’s pledge of support for the new bank fees because “Wall Street is solely responsible for all of Detroit’s woes.” Dang, we had forgotten that Goldman Sachs and Lehman Brothers were the saboteurs of the Pacer, Gremlin, Pinto and the remaining long list of Motown masterpieces. Anyhow, amidst all this political noise, its small wonder that the markets ended the week on a sour note.
That’s the “rambling” part. The real subject this week is interest rates. Since at least September the markets have been obsessed with the timing and magnitude of the Federal Reserve’s expected withdrawal of liquidity from the financial system. A key feature of the tapping on the brakes process will be a hike in short term rates—either the fed funds rate, the discount rate or both. The conventional wisdom is that higher rates are bad for the economy as they increase the cost of borrowing, reducing demand for loans while increasing the cost of doing business for virtually all companies, and they typically strengthen the dollar, slowing exports. We can’t argue with this economic theory and, of course, the whole point of a rate hike is indeed to slow down the economy. However, because we are in a political as well as economic Bizzaro Land these days, things don’t always follow the old playbooks. In fact, we posit that a hike in rates, at least in the initial phases, would be good for both the economy and equity markets. How so? To begin with, banks are currently dis-incentivized to lend. The ability to borrow at the Fed’s Discount Window at an effective rate of zero combined with the Government mandates to improve credit quality has motivated bankers to simply play the yield curve for profits. With long-term Treasuries yielding nearly 4% banks can earn a net interest spread comparable to the good old days with no default risk--so why make loans? A small hike in short-term borrowing costs to the banks, if it flattens the yield curve as it generally does, would give them more incentive to take risks in search of returns—i.e. make loans. Since the real problem now is the supply of lending, rather than demand, easier credit at this stage in the economic cycle would likely more than offset the braking effects of a small rise in short term rates.
What about the equity markets? It’s doubtful that the potential benefits to lending of higher rates would be immediately obvious to equity investors, however, since the markets are already discounting a long series of rate increases by the Fed beginning sometime this year (although that date is getting pushed out) the first rate hike, if it is small as expected (say 25bps) and accompanied by the proper “signaling” by the Fed would most likely spark a relief rally. After that, further fuel could come from the fact that retail investor money has been flowing out of equities and into fixed income investments for the last 16 months. A bump up in short term rates will knock down the value of short-term debt instruments, which might just be sufficient to scare that money out of the “safety” of T-bills and Treasuries and back into the equity markets. That’s a move, by the way, that could cause a virtuous cycle for some time as fixed income redemptions further depress the price of those securities while the flow into equities drives up stock prices, attracting more investment.
Of course, for the above scenarios to materialize, the Fed must properly signal its intent—e.g. “3 and done.” An open-ended series of rate hikes will eventually scare investors out of both asset classes (as well as real estate) and overshoot in their braking intent. As a student of the Great Depression, Bernanke is well aware of this. We just hope that the bout of insanity on Capitol Hill is temporary and that Congress will reappoint the Fed Chairman and start making noise about jobs rather than social engineering.
Subscribe to:
Posts (Atom)
