Tag Archives: Portfolio management

thinking about 2013

May 31, 2012 By in Strategy, Current Market Thoughts, Constructing a Portfolio, Portfolio management, securities markets, stock market Tags: , , , , , , , , , Leave a comment

looking ahead

Today is the last day of May.  In a normal stock market year (let’s define “normal” as a time when investors are neither euphoric nor ready to jump out windows on high floors in tall buildings), this is the time when equity investors begin to ponder what the following calendar year will bring.

Why so early?  No extremely compelling reason.  It’s just the way it typically works.  Equity markets are futures markets, after all.  And by this time participants will have already discounted much of what the current year is likely to bring and are asking “What’s next?”.

not normal everywhere, but definitely normal in the US

Conditions are by no means normal all around the world.  Europeans are scared out of their wits by the politics/economics of the EU.  Pacific Basin markets are keeping a close eye on China, while hoping the battering they’re taking from European selling will soon end.  In the US, in contrast, the economy is entering its fourth year of recovery.  Employment is stable-plus, compensation for regular employees (as opposed to CEOs, who always pay themselves well) is beginning to rise, and the housing market–a key source of wealth–is showing its first signs of life since 2007.  While daily price volatility may be high and the shrill noises from talking heads may be particularly bearish, I think 2012 is a normal year.

therefore, time for pondering 2013 to begin

(You may argue that pondering season has already started, and point to the 8% decline in the S&P since its intraday high on April 2nd as evidence.  I don’t interpret the data that way, but you may be right.  If so, you should be more bullish than I am, since you think Wall Street has been factoring bad news into prices for longer than I do.)

a few numbers

Let’s begin with a back-of-the-envelope (which is the best you’ll get from me) calculation.  According to Factset, Wall Street is estimating earnings of around $105 for 2012, up from $97 in 2011.

Let’s say S&P 500 eps will reach $110-$115 in 2013, which is roughly the consensus.

based on 2012 eps

If the market could trade at 14x earnings, a target for the S&P based on estimated earnings would be 1470.

The 1422 high of two months ago was about 3% below that, giving new money absolutely no motivation to buy stocks.  That also meant short-term traders had a reason to bet against a further rise.

Yesterday’s close was about 12% below 1470, suggesting the US stock market may be on more stable ground.

…and based on 2013 eps

The same calculation gives a target range of 1540-1610 for the S&P based on my guess about next year’s eps.  Potential appreciation from yesterday’s close would be +17% to +23%.

If you want to say that the US stock market continues to trade at the current multiple of 13x eps instead of 14x, then potential appreciation would be +9% to +14%.

In a world of 1.6%-yielding ten-year Treasuries, and 2.7% thirty-years, either case looks pretty good.

clouds on the horizon

I can see three, all of them the obvious ones:

1.  slowdown in China   For what it’s worth, as macroeconomics I think this is old news.  Policy is already beginning to move in a stimulative direction.  However, it will take some time for the new policy direction to take effect.  This probably means weaker prices for industrial commodities–and for commodity-dependent stocks–as well as for negative earnings surprises for firms whose profits are strongly linked to Chinese customers.  So China does have stock market implications.  But they’re stock selection ones rather than market-moving ones.

2.  ”fiscal cliff” in the US    On January 1, 2013, the temporary federal payroll tax cut is set to expire.  So, too, is the extension of Bush-era income tax reductions.  Large mandatory cuts in federal government spending, triggered by Washington’s failure to come up with an overall plan for deficit reduction, are supposed to happen as well.

This combination is enough to send the domestic economy beck into recession.

The consensus view is that after the election, the lame-duck Congress will do something to soften the blow.  My guess is the consensus will prove correct, although an accident is always possible.

3.  implosion in the EU    This is the main concern of global stock markets.

To recap:

–The crisis has been going on for almost three years.

–Worries have been discounted in waves of selling over that time, the worst of which (I think) have been the one currently in progress and the previous one last summer.

–The general parameters of a solution have been well-understood for a long time.

–I think Greece being in the EU or out is a big deal for that country but for no one else.

–The end game is unlikely to be a Japan-like fading of the EU into irrelevance, which would be bad for Europeans but ok for world equity markets.  Unaddressed, an outcome more like the 1996-98 crisis in smaller Asian markets is more probable.

timing?

Evidence to date to the contrary, I tend to think that the worst won’t happen.  I’d feel better about markets if I thought I were in the minority.  But if I were, I think global equity prices would easily be 10% lower than they are now.

If I’m correct, the main imponderable is the timing of a solution.  What little I know (or think I know) about politics says that when resolving a difficult issue involves sacrifice, the problem must be seen as so bad that solving it–no matter what the cost–can be presented to voters as a victory.

Are we at that point yet with the EU?  I don’t know.  Martin Wolf, chief economist with the Financial Times, has a good summary of the state of play.

Were the EU to show it finally has the resolve needed to adequately address its financial woes, however, I’m confident that the higher S&P targets for 2013 mentioned above would quickly become Wall Street’s game plan.  And a mini-version of last year’s autumn rally would likely occur.

In the meantime, markets will likely drift.

care for a Beveridge? … a curve, that is.

May 4, 2012 By in Beveridge curve, employment Tags: , , , , , , , , , Leave a comment

the Beveridge curve

This is a new one for me.  …and I thought I had seen most basic macroeconomic relationships.

The Beveridge curve is named in honor of a British economist, William Beveridge–although he didn’t develop it himself.  It maps the relationship between the unemployment rate and the job vacancy rate (number of unfilled jobs as a percentage of the labor force).

The relationship is inverse:  the higher the unemployment rate, the lower the percentage of vacant jobs should be; the lower the unemployment rate, the more likely it is that jobs will go at least temporarily unfilled–therefore raising the vacancy rate.

why is the curve important?

I found out about the Beveridge curve from a post written by Gavyn Davies, former head of the global economics department for Goldman, on the blog he writes for the Financial Times.  The post is titled “Why the Fed has taken QE3 off the agenda.”

It gives two important reasons for thinking that further quantitative easing is unlikely in the US.  One of these is the current behavior of the Beveridge curve.

In illustration, Mr. Davies prints a pair of charts which he’s borrowed from an economist from Barclays Capital, Peter Newland.  They depict the job vacancy rate on the vertical axis and the unemployment rate on the horizontal.

The first chart demonstrates that the current Beveridge curve is different from the pre-recession one.  The curve has shifted substantially to the right since 2008.  The present job vacancy rate would have been associated with a 5.5% unemployment rate less than a decade ago.   It’s now associated with an 8%+ unemployment rate.

Both Mssrs. Davies and Newland appear to believe that this shift is a permanent change.  In support of this idea, Mr. Newland’s second chart shows that a similar phenomenon occurred after the first oil shock in 1973-74, which triggered the worst post-WWII recession the world had seen until the recent Great Recession commenced.  So an outward shift of the Beveridge curve during a time of great economic change has already occurred before.

The conclusion they draw is that the current 8% unemployment rate is the functional equivalent of the pre-recession 5.5%.  If they are correct, and I think they are, today’s shifted Beveridge curve signals that we’re much closer to full employment in the US than the raw unemployment data would suggest.

This is important.

At full employment, monetary easing doesn’t create new jobs–there’s no one with the skills needed to fill them.  Instead, all loose money does is create a potentially damaging inflationary wage spiral as bidding wars break out to lure already employed workers from one firm to another.  Therefore, QE3 won’t happen.

another reason QE3 is off the agenda:  labor force participation rate

The labor force participation rate is the percentage of people of working age who are actually in the labor force–that is, either employed or willing to/looking for work.  What’s left over includes homemakers and students, among other groups.

One other group of non-participating persons of particular economic concern are so-called “discouraged workers.” These are people who have lost heart because they can’t seem to find a job and have ceased to look.  Although without jobs, they disappear from the unemployment statistics.  But they still lurk in the shadows, as it were, waiting to reenter the workforce when they conclude their chances they’ll find a job are more favorable and start looking again.

A quick look at the labor force participation rate suggests there might be a lot of discouraged workers.  The rate during 1998-2001 was 67.3%.  Now it’s at 64%.  Where did all those other 3.3% go?  Are they discouraged workers?

The short answer is “no.”

Mr. Davies cites a recent study by the Chicago Fed which concludes that the largest force behind this decline isn’t workers being discouraged by recession.  Rather, it’s a natural falloff in participation owing to the aging (and retirement) of the Baby Boom.  The Chicago Fed predicts that by 2020 the labor force participation rate will be lower than it is today, for the same age-related reasons.

Why is this important?  It, too, suggests that, with no gigantic pool of discouraged workers to fall back on, we’re much closer to full employment than the raw data would lead one to believe.

my thoughts

I’m solidly in the structural unemployment camp.  The wage increases for workers that we’re just beginning to see are further evidence that the US is running out of suitable candidates for jobs available.

Chronic unemployment is a terrible social problem.  But it can only be fixed through retraining and through continuing unemployment benefits.  Accommodative money policy won’t help.  Make-work infrastructure spending programs won’t do anything, either.   Facing a similar situation in 1990, Japan launched a series of massive public works construction projects, whose sole impact has been to mire that country more deeply in debt.

The bottom line is that the present loose money stance isn’t likely to last until late 2014, in my opinion.

Bond Environment, 2Q12 (ii)

April 27, 2012 By in Bond Environment, currency effects, Current Market Thoughts, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , , Leave a comment
This is the second installment of the current bond market outlook of Denis Jamison of Strategy Managers, LLC.  The first installment appeared yesterday.
Free money…
…at least until 2014 according to the Federal Reserve. They just about guaranteed they will maintain the current zero to 0.25% Federal Funds rate until early 2014.
When the financial crisis began to unfold in 2008, the Federal Reserve responded by flooding the monetary system with credit. Now, they have a new gambit in their efforts to push consumers and businesses toward more spending – a low interest rate guarantee. The Fed seems to be taking the role of the real estate salesperson getting you to buy a house you can’t afford by offering a temporarily low mortgage rate or the car dealer looking to reduce inventories by providing zero percent financing. As Yogi Berra said after seeing back-to-back homers by Maris and Mantle, “it’s déjà vu, all over again.” Wasn’t it the mispricing and misallocation of capital that got us here in the first place?
Excess liquidity creates bubbles either in the real economy or the financial markets. Right now, the benefits of low interest rates and surplus central bank credit have flowed to the financial markets and the big commercial banks. Market participants know the Fed is behind the curve on its interest rate policy. Based on a formula derived by Stanford University economist John Taylor, the current short-term interest rate should be 0.65%. That, however, is based on trailing core CPI of just 1.9% and the current unemployment level of 8.2%. It’s reasonable to assume that core CPI will trend higher -CPI including food and energy prices is already 2.7% – and the unemployment rate will gradually respond to 2%-plus GDP growth. If you plug 2.25% inflation and 7.5% unemployment into the professor’s formula, you come up with a Federal Funds target of 1.8%. How we get there from here is anyone’s guess. But it’s very hard to get the air out of bubbles – financial or otherwise – without a pop.
Go Straight Ahead
When you reach $5 trillion, make a sharp left. That appears to have been the roadmap for the federal government’s debt expansion. From 1970 until 2008, the outstanding debt grew about 3.5% yearly and reached about $5 trillion. (In the Fifties and early Sixties, the annual increase was less than 1 %.) Direct federal government debt is now $10.4 trillion or about 68% of nominal GDP. (This only includes public debt outstanding. It doesn’t include the $4.7 trillion of inter-government holdings – otherwise known as the Social Security Trust Fund – theoretically owed by the federal government .) With the government’s debt burden growing at 11% a year and nominal GDP expanding 4% to 5%, debt could top GDP within six years.
That’s the point of no return – the debt trap. From that point forward, the cost of funding the national debt will grow faster than the economy.
There are only two ways to escape the debt trap: budget austerity or currency devaluation. So far, our elected officials appear to be unwilling to address the first alternative – and for good reason. Most of the money is spent on folks who vote. Social Security, Medicare and Medicaid account for 44% of total outlays. The defense budget grabs another 24% and social welfare spending – mostly going to state and local governments – claims another 12%. That’s 80% of the total. (Meanwhile, the small 6% slice going to pay the interest on the national debt will likely balloon over the next few years.) Devaluation is tricky – but much more doable. If inflation can be pushed higher, the nominal value of everything real goes up and the actual value of debt goes down. It’s worth remembering from 1974 through 1981, nominal GDP grew at a 10% annual rate despite two recessions. Little of this growth was real – inflation adjusted GDP averaged just above 2% a year –but it sure lowered everyone’s debt burden.  In that regard, it’s worth citing a quote from Adam Smith, “All money is a matter of belief.”
Keeping a Low Profile
We continue to keep the effective maturity of our clients portfolio’s below that of their benchmarks. This served us well during the March quarter and the accounts tended to outperform their benchmarks. It is worth noting, however, that a bearish stance in a bear market does not necessarily mean you make money. Good relative performance does not mean good absolute performance. During 2011, long-term U.S. Treasury bonds returned nearly 30% and the mortgage market recorded an 8% gain. We expect most of those outsized increases to be reversed this year. Given the low absolute level of coupon income for most bonds, even a small increase in interest rates will translate into a negative total return. The current year promises to be quite difficult for most bond investors.

Bond Environment, 2Q12 (i)

April 26, 2012 By in Bond Environment, Current Market Thoughts, economics, employment, Portfolio management, Strategy Tags: , , , , , , , , , , Leave a comment
Here’s the first part (of two) of the April bond market analysis prepared for clients by the firm of my friend and mentor, Denis Jamison.  The second will appear tomorrow.
The alarm clock sounded for bond investors in the March quarter.
On the strength of some positive readings on the economy, markets discounted the possibility of additional Federal Reserve easing.  More accommodative policies by the European central bank reduced the risk of a credit crisis in Spain and Italy. Accordingly, doomsday speculators pulled money from the U.S. government bond market. The result was a dip in bond prices. With little coupon income to cushion the fall, investors suffered big losses.
Long term U.S. Treasury bonds recorded a negative 6% total return. Other sectors fared better; mortgages returned about 0.6% for the quarter while corporate bonds gained about 2.5%. The investment dynamics of these sectors differ somewhat from those of the government bond market. Mortgages are big beneficiaries of the Fed’s zero short-term interest rate policy while corporate securities are helped by the improving financial strength of U.S. business, especially the banks. Yield spreads between corporate bonds and U.S. Treasuries narrowed sharply during the quarter. Whether this can continue, remains to be seen.
Bond prices snapped back sharply after a ho-hum employment reading for March (reported on April 6th)
…and on renewed concerns about Spain’s fiscal position. However, investor focus on these transient economic and credit risk factors obscures the underlying reality of the government bond market. The current low yield level has made these securities more risky. Their price sensitivity to any given change in interest rates has increased. For example, a full coupon thirty year bond priced to yield 3% is about 10% more volatile than a similar full coupon security priced to yield 4%. In addition, there is significantly less coupon income now than in prior periods.
The fixed income markets are anesthetized by a cocktail of promised zero short-term interest rates, a flood of liquidity being provided by central banks around the world and quiescent inflation.  So, it is likely we will continue along the bottom of this interest rate trough for some time.  That doesn’t mean, however, that the bumps and dips won’t provide large swings in total returns for bond holders.
Back on track?
For the U.S. economy, that’s probably true. Despite disappointment regarding the March employment numbers, by any reasonable measure, the U.S. economic expansion is where it should be. Based on the March workplace survey by the U.S. Labor Department, about 132.8 million folks are employed versus 130 million a year ago. That’s a 2.1% year on year gain. A respectable increase considering that the public sector – particularly state and local governments – reduced payrolls. Only 22 million people worked in the public sector in March – 600,000 less than a year ago. In addition to the increase in total workforce, those employed are taking home more money. Average weekly earnings are up about 2.6% over the last twelve months.
Thanks to the employment gains and higher earnings,
retail sales have fully recovered from the recession lows.  They are running ahead 6.5% on a year over year basis. Auto sales are now averaging between 14 and 15 million units on an annualized basis compared with less than 10 million units during much of 2009.  GDP – the broad measure of total goods and services being produced in the U.S. economy – grew at a 3% rate during the final quarter of 2011. While that pace of expansion is unlikely to be sustained, it is reasonable to expect growth will exceed the 1.6% pace set during the full year of 2011. Most economists predict something between 2% and 2.5% growth this year.
Most of the risks to this moderate expansion scenario don’t hold up well under close examination.
Some argue that the recent growth spurt is being fueled by the large increase in reported consumer debt – consumer credit expanded 6.9% in the final months of 2011. However, most of that increase reflected an expansion of government education loan programs which replaced private sector programs that were not included in the consumer credit totals. Basically, the consumer is not overextended. Gasoline prices are also a concern to many. However, auto fuel efficiency has increased and gasoline usage is down. Price changes at the pump will have a much more muted impact on consumer spending. Given this backdrop, it isn’t surprising that many Fed governors are beginning to question the need for a continuation of the current monetary stimuli being provided by the central bank. However, financial markets now appear to be addicted to these opiates. This may be the real risk facing both investors and the working public.
Stay tuned for the concluding section of the Jamison report tomorrow.
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