Elephant In America's Living Room

In the second half of 2009, we witnessed a dramatic increase in investor risk appetites and the reduction in risk premiums relative to US treasuries. Speculative interest in riskier assets rose further over the balance of December.  Yields on 5 and 10 year treasuries increased about 9% and gold prices decreased 6% while the VIX rose 2% due to a sharp 8% advance on the last trading day. The VIX is often referred to as the "fear index" and represents the market's expectations of volatility over the next 30 day period. Since 1990, the VIX has typically traded at 20 or above, except during the periods of highly stable economic activity from 1992 to 1997 and 2004 to mid-2007.  The decline of the VIX below 20 is highly unusual given the consensus view of the Federal Open Market Committee that higher than normal economic uncertainty lies ahead.  In this context, portfolio insurance is now very cheap from a historical perspective.

 

This rise in investor complacency appears to reflect wide market acceptance that the U.S. economy and financial system has returned to "normal" based in part on recent self-congratulatory commentary by Fed and treasury policymakers.  Hazy suggestions have been made that the recent financial crisis has been resolved "profitably" simply because most of the TARP money has been repaid by too-big-to-fail financial institutions.  The government's mission accomplished banner is once again prematurely on display.    But the "open secret" is that things are far from "normal."  How can they be with an elephant in America's living room?

 

 

 

The expression "elephant in the room" refers to a situation where something hugely dysfunctional is going on.  It's on everyone's mind and impossible to ignore -- like an elephant in the room.  Yet nobody talks about the "elephant" because nobody knows what to do about it. For example, Uncle Barleycorn is busily getting intoxicated at the family Thanksgiving dinner. There's ultimately going to be a drunken scene with pink elephants on parade. But everyone feels powerless and chooses to ignore his behavior and pretend everything is normal.

 

The elephant in America's living room is the Federal Reserve and U.S. government's pervasive support of the housing and mortgage market.  Fed holdings of mortgage securities is substantial and growing as the following chart depicts.   In the chart, MBS is mortgage backed securities.  Agencies represent holdings of Fannie Mae and Freddie Mac paper.  Maiden Lane and other assets represent the bailouts of Bear Stearns and American International Group (AIG)). 

 

 

 

Lest someone think the ubiquitous government's role supporting the economy and financial system is diminishing please note that late last year GMAC Financial Services received a third round of TARP bailout funds from the U.S. Treasury Department, and the government took a controlling stake in the company.  The troubled auto and mortgage lender received $3.8 billion of additional aid on top of the nearly $13.5 billion already received since December 2008.  The fresh lifeline is intended to avoid placing its home lending unit, Residential Capital (ResCap), into bankruptcy. ResCap was one of the largest subprime mortgage underwriters.  With this capital infusion, our government retains yet another prop for the mortgage and financial systems to go along with its fiscal backing of money losing Fannie Mae and Freddie Mac and the Federal Reserve's massive mortgage securities purchases.  The NY Fed has estimated that its purchases lowered mortgage interest rates by 1.5%.  In other words, free market mortgage rates would be substantially higher absent Fed intervention.  Last but not least while we were busy with family gatherings, the U.S. Treasury made a Christmas eve announcement that it would be providing Fannie Mae and Freddie Mac with unlimited financial support for the next three years. Release available at http://treasury.gov/press/releases/2009122415345924543.htm

 

Like an elephant in your living room, these government actions do not reflect normalcy and order, but rather dysfunction and chaos.   Much like Uncle Barleycorn's holiday folly, the government and Fed's behavior will likely have costly, unintended consequences. But there will also be opportunities in the aftermath.

 

During my transition period from public company CFO in 2003-2004, I recall telling my pre-teens while at the Ringling Brothers & Barnum and Bailey's Greatest Show On Earth that if I couldn't find employment in finance, I was certain there was a job for me in the circus (or government).

 

 

The Art of Indexing Conference

The Art of Indexing Conference was held in New York on October 28, 2009.  It is one of a number of conferences that allow investment advisors to maintain relevance on industry developments in indexing and exchange traded funds (ETFs). A number of ETF sponsors and research and investment advisory experts were in attendance.  The following summarizes the conference's most engaging presentations on the evolution of index investing, currencies as an asset class, and volatility and risk management.

 

Active vs. Passive Investment Strategies

 

A panel of experts reviewed the age old debate over whether or not active investment management provides value or if passive indexing is the best investment strategy for most individual investors.   Numerous investment studies have shown that active managers underperform passive index benchmarks primarily due to higher management fees charged for active management.  The following are the highlights from the "Standard & Poor's Indices Versus Active Funds Scorecard" for the year ended 2008.

 

·     Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P MidCap 400 outperformed 79.1% of mid cap funds and S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.

·     The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.

·     Benchmark indices outperformed a majority of actively managed fixed income funds in all categories over a five-year horizon. Five year benchmark shortfall ranges from 2-3% per annum for municipal bond funds to 1-5% per annum for investment grade bond funds.

·     The script was similar for non-U.S. equity funds, with indices outperforming a majority of actively managed non-U.S. equity funds over the past five years.

 

The dynamic growth of the ETF industry demonstrates that increasing numbers of investors appreciate the performance advantages of indexing. Individual investors recognize indexing is an above average approach because it avoids the costs of active management.  ETF assets under management have increased 1.9 times since the end of 2004 to $664 billion as of August 31, 2009. Meanwhile, the number of ETFs has exploded to 770 as increasingly innovative products have been introduced that allow individual investors to capture asset class and return profiles previously available only to large institutions.  Today, ETFs represent only about 5% to 6% of fund assets under management domestically and roughly 2% to 3% internationally.

 

The panel debate also reinforced the conclusions of the 1986 Brinson, Hood and Beerbower study that found that 90% of the variability of investment returns comes from asset allocation.  Security selection and timing accounted for 10% of the variability of returns.  At this point, one of the speakers also referenced a recent study by Dalbar, a Boston research firm, conducted a few years ago on the performance of individual investors. The study quantified the behavioral costs associated with the average investor's tendency to chase performance and follow the crowd.  According to Dalbar, from 1984 to 2000, when the S&P 500 was compounding at 16.3% per annum, the average US equity mutual fund investor achieved a return of only 5.23% per annum. The average fixed income investor did not do much better, with an annualized return of 6%, compared with 11.83% for the long term government bond index.  Dalbar calculated that $100,000 invested in the S&P 500 in 1984 would have been worth $1,301,000 at the end of 2000, whereas the average stock investor’s $100,000 was actually worth only $241,000.

 

In their closing remarks one panel member stated "It's an index picker's market", a play on the old Wall Street adage "It's a stock picker's market."  Investors are increasingly viewing indices as investment vehicles that capture various asset class and return parameters.  Investors are placing greater reliance on their investment advisors for a holistic approach to asset management and the responsibilities and skills required by advisors must evolve accordingly.  Investors expect advisors to quarterback the investment process through 1) index/asset class selection, 2) portfolio construction and risk management and 3) active management of asset allocation as the expected return-to-risk profile of markets change.  To do this well, investment advisors must be knowledgeable about indices and ETF construction and fundamentals.   Since it pays to be contrary to crowd behavior, successful advisors will need to employ macro-statistical approaches and form global views of world markets to identify relative value opportunities and risk factors. Sophisticated quantitative and qualitative approaches to asset allocation and portfolio risk management will become the capstone of successful investment advisory programs.  More rigorous statistical approaches to investment management will mitigate structural weaknesses introduced from behavioral influences on the portfolio construction process.

 

International Currencies

 

This presentation was made by a Florida-based investment advisory firm that was able to produce positive returns in the tumultuous fourth quarter of 2008 when, by all appearances, the investment world as we knew it was coming to an end.  The primary instrument used by these advisors to generate the positive returns for the period was currency ETFs.  There are currently two ETF providers in this niche.   These funds buy forward contracts on currencies that provide an implied interest rate or earnings on the cash the ETF invests in the applicable currency. These funds essentially replicate a savings account in a foreign bank.  The advisory firm stated the following advantages of investing in foreign currencies:

·    world's largest and most liquid asset class

·    no credit risk (governments can always print more money to avoid default so credit risk is limited but there is the risk of devaluation)

·    currencies trade 24 hours a day

·    low correlation with other asset classes

·    exposure to devaluation of local currency is diversified

 

Investing in foreign currencies is equivalent to making a deposit in a foreign bank account.  Given that the Fed is committed to maintaining the Federal Funds rate near zero "for an extended period," savers and investors are being penalized by maintaining deposit and savings accounts in US financial institutions.  Along these lines, a subsequent speaker challenged the audience to stop thinking of treasuries as having a risk free return in this low interest rate environment but rather contemplate this period as providing for the "return of free risk." 

 

This last speaker's statement appeared to be an amusing hyperbole until the subsequent review of an investment report from Sprott Asset Management entitled "Surreality Check Part Two - Dead Government Walking" that reported the following.

 

The Q2 Flow of Funds Report published by the Federal Reserve revealed that the Federal Reserve purchased as much as half of the newly issued treasuries in the second quarter.  This means that the Federal Reserve isn't merely supporting the market for US Treasuries…it is the market for US Treasuries.  Printing new dollars to support an almost $9 trillion dollar budget deficit that stretches out over the next ten years puts the US on the road to ruin, and the major governments of the world have noticed and are taking action…Most of these countries have historically supported their own currencies by stockpiling an average of 63% of their foreign currency holdings in US dollars.  Recently, however, it was revealed that the US dollar now makes up only 37% of new foreign reserve holdings (emphasis added).

 

Foreign governments are diversifying their reserve holdings through the purchase of gold and other real assets, particularly India and China.  The Reserve Bank of India recently purchased a massive 200 metric tons of gold from the International Monetary Fund (IMF). This is the largest gold purchase in at least 30 years and took up half of what the IMF intends to sell. David Rosenberg provided the following commentary to put this purchase into a monetary context.

 

All India did was bring gold to a 6% share of its total FX reserves from 4%. Fifteen years ago, that representation was closer to 20%. China has increased its gold holdings by 76% over the past six years but they are a mere 1.9% of the aggregate 2.2 trillion of reserves and Russia’s gold holdings is just under 5%...It is very clear that central banks are behaving in a way that would suggest that gold is now again being considered a currency within the global monetary system. As we said before, it is all about relative scarcity and a well-defined supply curve — fiat currency at this juncture does not share that quality. As a good friend reminded me yesterday, when the Fed was created nearly a century ago, it was acceptable to have at least 40% of the money supply backed by gold reserves. The U.S. now has 8,133 tons of gold in reserve, which equates to $285 billion at this year’s pricing. Meanwhile, the Fed has spiked the punchbowl to such an extent that the monetary base now stands at $1.7 trillion. Do the math — under the old regime (which indeed hamstrung the Fed), the U.S. alone would need to buy an incremental $400 billion of bullion or the equivalent of what would be nearly four times the typical level of annual demand.

 

The speakers closed their currency session with recommendations on various research papers on currency investing.  Additional research on these currency ETFs will be undertaken to understand their risk-reward profile relative to investing in short term treasuries and corporate bonds.

 

Volatility And Risk Management

 

This interesting presentation was given by David Blitzer, Managing Director and Chairman at Standard and Poor's.  He indicated that S&P has been recently focused on risk management tools.  S&P has established a number of new risk control indices that use various weightings of the S&P 500 and money market funds to achieve targeted volatility levels (standard deviation of a statistical population).  Mr. Blitzer mentioned that managing volatility within an investment portfolio is an increasingly important risk tool for investors.  He mentioned two iPath Exchange Traded Notes (ETN) that allow investors to go long volatility as measured by the Chicago Board Options Exchange Volatility Futures or VIX Index.  By investing in these ETNs (going long volatility), an investor can reduce the implied volatility of a broadly diversified portfolio in a manner similar to S&P risk control indices without going directly into low yielding cash. 

 

Although the stock market has rallied almost 60% from its March lows and investor sentiment is turning more bullish (and complacent), a number of measures of market risk are giving warning signals.  This past week's Barron's had an article which discussed the UBS Global Strategy Risk Indicator.  This UBS risk gauge combines equity- and currency-volatility measures, credit spreads, and investor preferences for higher-risk geographic regions, like emerging markets, and stock sectors, like cyclicals.  A reading higher than 1.3 points above the mean suggests high risk appetite and provides a reliable sell signal.  This risk measure hit 1.56 on October 23, 2009, the highest point since March 2000. Likewise, the VIX index surged 48% from October 22 to October 30, 2009.

 

Interestingly, a subsequent article in Barron's corroborated the increase in animal spirits and investor risk appetites.  The "Barron's Fall 2009 Big Money Poll Results" included the following data on bullish and bearish sentiment for various asset classes.  The most bullish asset classes (greater than 30% of respondents indicated a bullish view) were as follows:

·     Asian Stocks - 59% (up from 23% in 2008)

·     Latin American Stocks - 54% (up from 22% in 2008)

·     Oil - 48% (up from 22% in 2008)

·     Gold - 36% (up from 25% in 2008)

 

The high bearish asset classes (greater than 30% of respondents indicated a bearish view) were as follows:

·     US Treasuries - 65% (up from 52% in 2008)

·     US Dollar - 57% (up from 19% in 2008; 47% bullish in 2008)

·     Real Estate - 37% (down from 60% in 2008)

·     Corporate Bonds - 36% (up from 19% in 2008)

·     Cash - 34% (up from 15% in 2008)

 

What a difference a year and an unprecedented amount of global government stimulus makes! We can see from the above table that animal spirits have indeed been released from their brief hibernation as fear now takes a nap.   Investor bullishness generally lies in the historically riskiest and most volatile asset classes - emerging market equities and oil - while bearish sentiment resides in the historically safest and least volatile asset classes - US Treasuries, US Dollar, corporate bonds and cash.  This data alone suggests that risk is very high.  The presently hidden danger of volatility will likely return with a vengeance once economic reality collides with investor perceptions. At that time, many of the highflying, risky asset classes will be revealed as wolves in sheep's clothing.

Beware of False Prophets

Despite stretched market fundamentals and less than robust economic readings, the S&P 500 on a total return basis advanced 3.7% for the month of September.  As of the close on October 20, 2009, the S&P 500 stood at 1,092 down (43%) from its October, 2007 peak and ALL-TIME closing high of 1,562.  In this bear market rally, the S&P 500 has now advanced a remarkable 61% from the bear market cycle closing low of 677 on March 9, 2009.  At this level the S&P 500 is trading at 20 times 2009 estimated operating earnings (PE ratio) of $55 and 22 times 2008 actual operating earnings of $50.  The 2009 PE ratio of 20 times is above the historical average multiple of 15 -16 times operating earnings and suggests the S&P 500 is trading significantly above fair value, particularly if one considers the awful employment picture. With 70% of U.S. GDP derived from consumer expenditures, it is quite amazing that the S&P 500 can rally more than 60% while employment continues to roll over and delinquencies and defaults on mortgage and consumer debt accelerate.

While the stock market has headed further northward in September and October the employment picture headed further south.  In fact, the Bureau of Labor Statistics (BLS) recently released employment statistics for September which were far worse than expected. Nonfarm payroll jobs declined 263,000 in September compared to an expected decline of 175,000.  Economists and Wall Street strategists had been taking comfort because job declines had been improving sequentially (i.e., still negative but less so) over the summer months, but September showed sequential deterioration for the first time since May. The unemployment rate grew to 9.8% in September, the highest level since December 1982 when the rate was 10.8%.  Although initial jobless claims have peaked, the real issue has been that there is no visible pickup in hiring. For every company in the BLS survey adding to staff, there were more than two firms cutting back. The average duration of unemployment rose to 26.2 months in September, a full half year!  The more inclusive U-6 measure of employment (which includes part-time workers looking for full time jobs and those discouraged individuals who have stopped seeking employment) also reached a new high of 17% in September.  Worse yet, 7.2 million Americans have lost their jobs since the business cycle peak in December 2007. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) has designated December 2007 as the most recent cycle peak.  NBER has not yet determined an endpoint for the recession that began in December 2007.

Despite Federal Reserve Chairman Ben Bernanke missing the call on the front end of this recession (he was denying a recession was underway well into 2008), it appears that there has been a lot of faith placed in his mid-September call that the recession had come to an end consistent with his "green shoots" prophecy of mid-March 2009.   The gullible U.S. media produced easily, consumable headlines for the masses like "Bernanke: Recession Likely Over." To be fair, Mr. Bernanke's full statement which included some cautionary statements follows:

"Even though, from a technical perspective, the recession is very likely over at this point.  It's still going to feel like a very weak economy for some time, as many people still find their job security and their employment status is not what they wish it was.  So that is a challenge for us and all policymakers going forward."

My tongue in cheek translation of Bernanke's speech is as follows:

"As Fed Chairman, I can assure you that the highly managed government GDP statistics for the third quarter of 2009 will definitely be positive. This will signal to the masses that the recession is "technically" over and take some pressure off of me. The economy will remain very weak for some time however.  It will not seem like a recovery to the millions of unemployed and underemployed Americans "wishing" for full time employment.  It is on behalf of these American dreamers that we must continue to promote my "green shoots" prophecy if we are to have any hope for a true recovery. So that is a challenge for us and all policymakers going forward."

Beware of false prophets as well as false profit projections. Be vigilant. Analyze the potential outcomes.  If these prophecies prove true, you may miss an opportunity.  If false, you could lose precious investment capital ahead of more tumultuous economic conditions.   Risk remains very high.

Economic Alchemy As Good As Gold

The month of June 2009 was marked by the ongoing struggle between the optimists who believe that the worst of the economic downturn is behind us and the pessimists who believe that the global economy has not yet reached its nadir.  In the first half of June, the optimists were winning out, as there was a feeling in the market that economic recovery was right around the corner and that the U.S. Federal Reserve would be forced to raise interest rates soon to combat the threat of higher inflation.  The second half of the month witnessed a sharp reversal, where economic data pointed to a bleaker picture and the ongoing absence of the ever popular "green shoots."  In short, stocks had priced in a meaningful economic turnaround in early June and as the month progressed investors became increasingly impatient when substantive proof of economic recovery had failed to appear. 

 

This investor impatience may lead to an error of pessimism and the mistaken belief that the end of the recession is dead on arrival when recovery is just around the corner.  Although we are skeptical of the sustainability of government induced economic "green shoots", we do believe that the massive government stimulus will eventually have a very favorable, but transitory impact on the economy.   Paul Kasriel, Chief Economist at Northern Trust and an early forecaster of recessionary conditions, recently analyzed economic activity during the Great Depression.  He found that federal government spending and Fed money printing in the 1930s promoted economic recovery in the middle of the Great Depression.  Paul further cautioned with respect to the current economic crisis "…never underestimate the initial positive impact on aggregate demand of that powerful combination of increased federal spending/tax cuts and a central bank running the monetary printing press at a high speed (emphasis added)." 

 

In closing his article, Paul encouraged investors to monitor the leading economic indicators to discern whether or not an economic recovery is at hand.  To this end, we have been on the lookout for actionable information on leading economic indicators.   A recent issue of Grant's Interest Rate Observer noted that "there is good reason to believe that the U. S. economy is mending, not relapsing" based upon the work of Economic Cycle Research Institute (ECRI).  ECRI is an independent institute dedicated to economic cycle research in the tradition established by its founder, Geoffrey H. Moore, whom The Wall Street Journal called "the father of leading indicators." 

 

Like an alchemist searching for the elixir of life, ECRI has been studying and transforming economic data series into economic crystal balls since the 1950s.  The June edition of ECRI's "U.S. Cyclical Outlook" indicated that their leading economic indicators are on a tear to the upside.  ECRI stated that "What we have are pronounced, pervasive and persistent upswings in a succession of leading indexes of economic revival  -  the most powerful possible predictor of a business-cycle recovery (emphasis added)." Although ECRI's impressive use of alliteration in their economic forecast is a close runner-up to Mother Goose's classic tongue-twister, "Peter Piper picked a peck of pickled peppers …", the real question is whether this harmony of economic alchemy and alliteration makes their forecast "good as gold."

Green Shoots and the Sower

There appears to be growing conviction that what we've been witnessing the past eight weeks in the stock market is something more than a bear-market rally. Unfortunately, this is not the beginning of a secular bull market.  Bear market conditions will likely resume.  Buying the S&P 500 at these valuations is very risky given the awful economic fundamentals and considerable work required to repair the damage to the financial and economic system caused by the excesses of the past two decades. The massive monetary and fiscal policy responses to this crisis alone would suggest that this will not be a typical recession and recovery in severity or duration. 

 

Grant's Interest Rate Observer estimates that the government has currently provided combined monetary and fiscal stimulus of approximately 30% of U. S. gross domestic product (GDP) of $14.2 trillion.  This level of stimulus is unprecedented.  For example, monetary and fiscal stimulus applied in The Great Depression period of August 1929 to March 1933 totalled 8% of GDP.  The combined stimulus in the 2001 recession totalled 7% of GDP.  The central issue for the U.S. economic system is that we have too much debt - personal, corporate and governmental.  Total debt to GDP approximates 360%, up dramatically from 230% in the early 1990s.  This debt needs to be paid off through savings, restructured (debt for equity exchanges), destroyed through defaults or otherwise inflated away. This is likely the beginning of a major generational economic adjustment with prudent savings for retirement replacing profligate spending of the massive baby boomer generation.  Consumer spending represents approximately 70% of U.S. GDP and will be adjusting downward toward 63% level as the consumer savings rate rises to 5% to 10%.

 

U.S. economic issues of this size and scope will not be resolved quickly.  Ever since Ben Bernanke, chairman of the Federal Reserve Board, told 60 Minutes in mid-March that he detected "green shoots" of economic recovery, the phrase "green shoots" has become an often used propaganda message.  Desperate for any sign of hope, the political establishment, Wall Street strategists, and media experts have taken to repeating the phrase "green shoots" as a soothing mantra.  The Administration, Congress and the Fed continue to throw manure on these economic "green shoots."  Please do not let this beautiful farming imagery mask the truth. In reality, the U.S. economy has only shown signs that it was deteriorating more slowly.  This passes for improvement and economic "green shoots."  Like life, there are no shortcuts to economic nirvana. There is a lot of hoeing still required to get our economy back on a sustainable growth path.  As Dwight Eisenhower once said  "Farming looks mighty easy when your plow is a pencil and you're a thousand miles from the corn field."  In short, Ben Bernanke is an academic, pencil pushing bureaucrat, not a green thumbed farmer.  Some of Ben's monetary actions and related Federal policy responses will undoubtedly fail to produce the intended results and may also have major unintended consequences.

 

This is reminiscent of the parable of the sower. The parable tells of seeds that were erratically scattered by a sower, some falling on the road and consequently eaten by birds, some falling on rock and consequently unable to take root, and some falling on thorns which choked the seed. According to the parable, it was only the seeds that fell on good soil and were able to germinate, producing a crop thirty, sixty, or even a hundredfold.  Like the sower in the parable, the U. S. government has crudely distributed massive amounts of monetary and fiscal stimulus (seeds). Unfortunately, many financial experts believe that only a limited number of these economic seeds have been targeted to the "good soil" of infrastructure projects or other fertile commercial areas that will ultimately enhance the long term productive capacity of our nation.  The rest of the seed has fallen on road, rock or near thorns.