Posts filed under ‘International’
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (February 3, 2014). Subscribe on the right side of the page for the complete text.
The porridge for stock market investors was hot in 2013, with the S&P 500 index skyrocketing +30%, while the porridge for bond investors was too cold, losing -4% last year (AGG). Like Goldilocks, investors are waiting to get more aggressive with their investment portfolios once everything feels “just right.” Dragging one’s feet too long is not the right strategy. Counterintuitively, and as I pointed out in “Here Comes the Dumb Money,” the investing masses have been very bashful in committing large sums of money out of cash/bonds into stocks, despite the Herculean returns experienced in the stock market over the last five years.
Once the party begins to get crowded is the period you should plan your exit. As experienced investors know, when the porridge, chair, and bed feel just right, is usually around the time the unhappy bears arrive. The same principle applies to the investing. In the late 1990s (i.e., technology bubble) and in the mid-2000s (i.e., housing bubble) everyone binged on tech stocks and McMansions with the help of loose credit. Well, we all know how those stories ended…the bears eventually arrived and left a bunch of carnage after tearing apart investors.
Fragile 5 Bed Too Hard
After enjoying some nice porridge at a perfect temperature in 2013, Goldilocks and investors are now searching for a comfortable bed. The recent volatility in the emerging markets has caused some lost sleep for investors. At the center of this sleeplessness are the financially stressed countries of Argentina and the so-called “Fragile Five” (Brazil, India, Indonesia, Turkey and South Africa) – still not sure why they don’t combine to call the “Sick Six” (see chart below).
|Source: Financial Times|
Why are these countries faced with the dilemma of watching their currencies plummet in value? One cannot overly generalize for each country, but these dysfunctional countries share a combination of factors, including excessive external debt (loans denominated in U.S. dollars), large current account deficits (trade deficits), and small or shrinking foreign currency reserves. This explanation may sound like a bunch of economic mumbo-jumbo, but at a basic level, all this means is these deadbeat countries are having difficulty paying their lenders and trading partners back with weaker currencies and depleted foreign currency reserves.
Many pundits, TV commentators, and bloggers like to paint a simplistic picture of the current situation by solely blaming the Federal Reserve’s tapering (reduction) of monetary stimulus as the main reason for the recent emerging markets sell-off. It’s true that yield chasing investors hunted for higher returns in in emerging market bonds, since U.S. interest rates have bounced around near record lows. But the fact of the matter is that many of these debt-laden countries were already financially irresponsible basket cases. What’s more, these emerging market currencies were dropping in value even before the Federal Reserve implemented their stimulative zero interest rate and quantitative easing policies. Slowing growth in China and other developed countries has made the situation more abysmal because weaker commodity prices negatively impact the core economic engines of these countries.
In reviewing the struggles of some emerging markets, let’s take a closer look at Argentina, which has seen its currency (peso) decline for years due to imprudent and inflationary actions taken by their government and central bank. More specifically, Argentina tried to maintain a synchronized peg of their peso with the U.S. dollar by manipulating its foreign currency rate (i.e., Argentina propped up their currency by selling U.S. dollars and buying Argentinean pesos). That worked for a little while, but now that their foreign currency reserves are down -45% from their 2011 peak (Source: Scott Grannis), Argentina can no longer realistically and sustainably purchase pesos. Investors and hedge funds have figured this out and as a result put a bulls-eye on the South American country’s currency by selling aggressively.
Furthermore, Argentina’s central bank has made a bad situation worse by launching the money printing presses. Artificially printing additional money may help in paying off excessive debts, but the consequence of this policy is a rampant case of inflation, which now appears to be running at a crippling 25-30% annual pace. Since the beginning of last year, pesos in the black market are worth about -50% less relative to the U.S. dollar. This is a scary developing trend, but Argentina is no stranger to currency problems. In fact, during 2002 the value of the Argentina peso declined by -75% almost overnight compared to the dollar.
Each country has unique nuances regarding their specific financial currency pickles, but at the core, each of these countries share a mixture of these debt, deficit, and currency reserve problems. As I have stated numerous times in the past, money ultimately moves to the place(s) it is treated best, and right now that includes the United States. In the short-run, this state of affairs has strengthened the value of the U.S. dollar and increased the appetite for U.S. Treasury bonds, thereby pushing up our bond prices and lowering our longer-term interest rates.
Their Cold is Our Warm
Overall, besides the benefits of lower U.S. interest rates, weaker foreign currencies lead to a stronger dollar, and a stronger U.S. currency means greater purchasing power for Americans. A stronger dollar may not support our exports of goods and services (i.e., exports become more expensive) to our trading partners, however a healthy dollar also means individuals can buy imported goods at cheaper prices. In other words, a strong dollar should help control inflation on imported goods like oil, gasoline, food, cars, technology, etc.
While emerging markets have cooled off fairly quickly, the temperature of our economic porridge in the U.S. has been quite nice. Most recently, the broadest barometer of economic growth (Real GDP) showed a healthy +3.2% acceleration in the 4th quarter to a record of approximately $16 trillion (see chart below).
|Source: Crossing Wall Street|
Moreover, corporate profits continue to come in at decent, record-setting levels and employment trends remain healthy as well. Although job numbers have been volatile in recent weeks and discouraged workers have shrunk the overall labor pool, nevertheless the unemployment rate hit a respectable 6.7% level last month and the positive initial jobless claims trend remains at a healthy level (see chart below).
Skeptics of the economy and stock market assert the Fed’s continued retrenchment from quantitative easing will only exacerbate the recent volatility experienced in emerging market currencies and ultimately lead to a crash. If history is any guide, the growl from this emerging market bear may be worse than the bite. The last broad-based, major currency crisis occurred in Asia during 1997-1998, yet the S&P 500 was up +31% in 1997 and +27% in 1998. If history serves as a guide, the past may prove to be a profitable prologue. So rather than running and screaming in panic from the three bears, investors still have some time to enjoy the nice warm porridge and take a nap. The Goldilocks economy and stock market won’t last forever though, so once the masses are dying to jump in the comfy investment bed, then that will be the time to run for the hills and leave the latecomers to deal with the bears.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in AGG, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
I wouldn’t say the nail is in the emerging market coffin quite yet. During the financial crisis, the EMSCI Emerging Market Index (EEM) was left for dead (down -50% in 2008) before resurrection in 2009 and 2010 (up +74% and +16%, respectively). For the last two years however, the EMSCI index has underperformed the S&P 500 Index massively by more than -30%. Included in this international index are holdings from China, Russia, India, Brazil, South Korea, and South Africa, among others.
The question now becomes, can the emerging markets resurrect themselves from the dead again? Recent signs are flashing “yes”. Over the last three months, the emerging markets have outperformed the S&P 500 by more than +8%, but these stocks still have a lot of ground to make up before reaching the peak levels of 2007. Last year’s slowing growth in China and a European recession, coupled with talks of the Federal Reserve’s “tapering” of monetary stimulus, didn’t provide the EMSCI index any help over the last few years.
With all the distracting drama currently taking place in Washington D.C., it’s a relief to see some other indications of improvement. For starters, China’s most recent PMI manufacturing index results showed continued improvement, reaching a level of 51.1 – up from August and signaling a reversal from contraction earlier this year (levels above 50 point to expansion). Chinese government leaders are continuing their migration from an externally export-driven economy to an internally consumer-driven economy. Despite the shift, China is still targeting a respectable +7.5% GDP economic growth target, albeit a slower level than achieved in the past.
Adding to emerging market optimism is Europe’s apparent economic turnaround (or stabilization). As you can see from the chart below, the European Institute for Supply Management (ISM) service sector index has lately shown marked improvement. If the European and Chinese markets can sustain these recovering trends, these factors bode well for emerging market financial returns.
While it is clear these developments are helping the rebound in emerging market indices, it is also clear the supply-demand relationship in commodities will coincide with the next big up or down move in developing markets. Ed Yardeni, strategist and editor of Dr. Ed’s Blog, recently wrote a piece showing the tight correlation between emerging market stock prices and commodity prices (CRB Index). His conclusions come as no surprise to me given these resource-rich markets and their dependence on Chinese demand along with commodity needs from other developed countries. Expanding populations and rising standards of living in emerging market countries have and will likely continue to position these countries well for long-term commodity price appreciation. The development of new, higher-value service and manufacturing sectors should also lead to sustainably improved growth in these emerging markets relative to developed economies.
Adding fuel to the improving emerging market case is the advancement in the Baltic Dry Index (see chart below). The recent upward trajectory of the index is an indication that the price for moving major raw materials like coal, iron ore, and grains by sea is rising. This statistical movement is encouraging, but as you can see it is also very volatile.
While the emerging markets are quite unpredictable and have been out-of-favor over the last few years, a truly diversified portfolio needs a healthy dosage of this international exposure. You better check a pulse before you put a nail in the coffin – the emerging markets are not dead yet.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including emerging market ETFs, but at the time of publishing, SCM had no direct position in EEM, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
With the emerging market currencies and financial markets under attack; Japan’s Nikkei index collapsing in the last three weeks; and the Federal Reserve hinting about its disciplinarian tapering of $85 billion in monthly QE3 bond purchases, one would expect higher beta small cap stocks to get hammered in this type of environment.
Before benchmarking results in the U.S., let’s take a closer look at some of the international carnage occurring from this year’s index value highs:
- Japan: -19% (Nikkei 225 index)
- Brazil: -22% (IBOVESPA index)
- Hong Kong: -12% (Hang Seng index)
- Russia: -19% (MICEX/RTS indexes)
Not a pretty picture. Given this international turmoil and the approximately -60% disintegration in U.S. small-cap stock prices during the 2007-2009 financial crisis, surely these economically sensitive stocks must be getting pummeled in this environment? Well…not necessarily.
Putting the previously mentioned scary aspects aside, let’s not forget the higher taxes, Sequestration, and ObamaCare, which some are screaming will push us off a ledge into recession. Despite these headwinds, U.S. small-caps have become the top dog in global equity markets. Since the March 2009 lows, the S&P 600 SmallCap index has more than tripled in value ( about +204%, excluding dividends), handily beating the S&P 500 index, which has advanced a respectable +144% over a similar timeframe. Even during the recent micro three-week pullback/digestion phase, small cap stocks have retreated -2.8% from all-time record highs (S&P 600 index). Presumably higher dividend, stable, globally-diversified, large-cap stocks would hold up better than their miniature small-cap brethren, but that simply has not been the case. The S&P 500 index has underperformed the S&P 600 by about -80 basis points during this limited period.
How can this be the case when currencies and markets around the world are under assault? Attempting to explain short-term moves in any market environment is a hazardous endeavor, but that has never slowed me down in trying. I believe these are some of the contributing factors:
1) No Recession. There is no imminent recession coming to the U.S. As the saying goes, we hear about 10 separate recessions before actually experiencing an actual recession. The employment picture continues to slowly improve, and the housing market is providing a slight tailwind to offset some the previously mentioned negatives. If you want to fill that half-full glass higher, you could even read the small-cap price action as a leading indicator for a pending acceleration in a U.S. cyclical recovery.
2) Less International. The United States is a better house in a shaky global neighborhood (see previous Investing Caffeine article), and although small cap companies are expanding abroad, their exposure to international markets is less than their large-cap relatives. Global investors are looking for a haven, and U.S. small cap companies are providing that service now.
3) Inflation Fears. Anxiety over inflation never seems to die, and with the recent +60 basis point rise in 10-year Treasury yields, these fears appear to have only intensified. Small-cap stocks cycle in and out of favor just like any other investment category, so if you dig into your memory banks, or pull out a history book, you will realize that small-cap stocks significantly outperformed large-caps during the inflationary period of the 1970s – while the major indexes effectively went nowhere over that decade. Small-cap outperformance may simply be a function of investors getting in front of this potential inflationary trend.
Following the major indexes like the Dow Jones Industrials index and reading the lead news headlines are entertaining activities. However, if you want to become a big dog in the investing world and not get dog-piled upon, then digging into the underlying trends and market leadership dynamics of the market indexes is an important exercise.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including emerging market ETFs, IJR, and EWZ, but at the time of publishing, SCM had no direct position in Hong Kong ETFs, Japanese ETFs, Russian ETFs, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Everybody loves a free lunch, myself included, and many in Japan would like free sushi too. Despite the short term boost in Japanese exports and Nikkei stock prices, there are no long-term free lunches (or free sushi) when it comes to global financial markets. Following in the footsteps of the U.S. Federal Reserve, the Bank of Japan (BOJ) has embarked on an ambitious plan of doubling its monetary base in two years and increasing inflation to a 2% annual rate – a feat that has not been achieved in more than two decades. By the BOJ’s estimate, it will take a $1.4 trillion injection into economy to achieve this goal by the end of 2014.
Lunch is tasty right now, as evidenced by a tasty appetizer of +3.5 % Japanese first quarter GDP and this year’s +46% spike in the value of the Nikkei. Japan is hopeful that its mix of monetary, fiscal, and structural policies will spur demand and increase the appetite for Japanese exports, however, we know fresh sushi can turn stale quickly.
Quantitative easing (QE) and monetary stimulus from central banks around the globe have been hailed as a panacea for sluggish global growth – most recently in Japan. Commentators often oversimplify the benefits of money printing without acknowledging the pitfalls. Basic economics and the laws of supply & demand eventually prevail no matter the fiscal or monetary policy implemented. Nonetheless, there can be temporary disconnects between current equity prices and exchange rates, before underlying fundamentals ultimately drive true intrinsic values.
Impassioned critics of the Federal Reserve and its Chairman Ben Bernanke would have you believe the money supply is exploding, and hyperinflation is just around the corner. It’s difficult to quarrel with the trillions of dollars created by the Fed’s printing presses via QE1/QE2/QE3, but the fact remains that money supply growth has continued at a steady growth rate – not exploding (see Calafia Beach Pundit chart below).
Why no explosion in the money supply? Simply, the trillions of dollars printed by the Fed have sat idly in bank vaults as reserves. Once nervous consumers stop hoarding trillions in cash held in savings deposit accounts (see chart below) and banks begin lending at a healthier clip, then money supply growth will accelerate. By definition, money supply growth in excess of demand for goods and services (i.e., GDP) is the main cause of inflation.
Although inflationary pressure has not reared its ugly head yet, there are plenty of precursors indicating inflation may be on its way. The unemployment rate continues to tick downwards (7.5% in Aril) and the much anticipating housing recovery is gaining steam. Inflationary fear has manifested itself in part through the heightened number of conversations surrounding the Fed “tapering” its $85 billion per month bond purchasing program.
We’ve enjoyed a sustained period of low price level growth, however the Goldilocks period of little-to-no inflation cannot last forever. The differences between current prices and true value can exist for years, and as a result there are many different strategies attempted to capture profits. Like the gambling masses frequenting casinos, speculators can beat the odds in the short-run, but the house always wins in the long-run – hence the ever-increasing size and number of casinos. While a small number of professionals understand how to shift the unbalanced odds into their favor, most lose their shirt. On Wall Street, that is certainly the case. Studies show speculating day traders persistently lose about 80% of the time. Long-term investors are uniquely positioned to exploit these value disparities, if they have a disciplined process with the ability to patiently value assets.
Even though the Japanese economy and stock market have rebounded handsomely in the short-run, there is never a free lunch over the long-term. Unchecked policies of money printing, deficits, and debt expansion won’t lead to boundless prosperity. Eventually a spate of irresponsible actions will result in inflation, defaults, recessions, and/or higher unemployment rates. Unsustainable monetary and fiscal stimulus may lead to a tasty free lunch now, but if investors overstay their welcome, the sushi may turn bad and the speculators will be left paying the hefty tab.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Article is an excerpt from previously released Sidoxia Capital Management’s complementary February 1, 2013 newsletter. Subscribe on right side of page.
The red carpet was rolled out for the stock market in January with the Dow Jones Industrial Average rising +5.8% and the S&P 500 index up an equally impressive +5.0% (a little higher rate than the 0.0001% being earned in bank accounts). Movie stars are also strutting their stuff down the red carpet this time of the year as they collect shiny statues at ritzy award shows like the Golden Globes and Oscars. Given the vast volumes of honors bestowed, we thought what better time to put on our tuxes and create our own 2013 nominations for the economy and financial markets. If you are unhappy with our selections, you are welcome to cast your own votes in the comments section below.
By award category, here are Sidoxia’s 2013 selections:
Best Drama (Government Shutdown & Debt Ceiling): Washington D.C. has provided no shortage of drama, and the upcoming blockbusters of Shutdown & Debt Ceiling are worthy of its Best Drama nomination. If Congressional Democrats and Republicans don’t vote in favor of a new “Continuing Resolution” by March 27th, then our United States government will come to a grinding halt. At issue is Republican’s desire for additional government spending cuts to lower our deficit, which is likely to exceed $1 trillion for the fifth consecutive year. If you like more heart pumping drama, the Senate has just passed a Debt Ceiling extension through May 18th…mark those calendars!
Best Horror Film (Sequestration): Most people have already seen the scary prequel, The Fiscal Cliff, but the sequel Sequestration deserves the horror film honors of 2013. This upcoming blood-filled movie about broad, automatic, across-the-board government cost cuts will make any casual movie-watcher scream in terror. The $1.2 trillion in spending cuts (over 10 years) are so gory, many viewers may voluntarily leave the theater early. If you are waiting for the release, Sequestration is coming to a theater near you on March 1st, unless Congress, in an unlikely scenario, cancels the launch.
Best Director (Ben Bernanke): Federal Reserve Chairman Ben Bernanke’s film, entitled, The U.S. Economy, had a massive budget of about $16 trillion dollars, based on estimates of last year’s GDP (Gross Domestic Product). Nevertheless, Bernanke managed to do whatever it took (including trillions of dollars in bond buying) to prevent the economic movie studio from collapsing into bankruptcy. While many movie-goers were critical of his directorial debut, inflation has remained subdued thus far, and he has promised to continue his stimulative monetary policies (i.e., keep interest rates low) until the national unemployment rate falls below 6.5% or inflation rises above 2.5%.
Best Foreign Film (China): Americans are not the only people who produce movies globally. A certain country with a population of nearly 1.4 billion people also makes movies too…China. In the most recently completed 4th quarter, China’s economy experienced blockbuster growth in the form of +7.9% GDP expansion. This was the fastest pace achieved by China in two whole years. To put this metric into perspective, compare China’s heroic growth to the bomb created by the U.S. economy, which registered a disappointing -0.1% contraction at the economic box office. China’s popularity should bring in business all around the globe.
Best Special Effects (Japan): After coming out with a series of continuous flops, Japan recently launched some fresh new special effects in the form of a $116 billion emergency stimulus package. The country also has plans to superficially enhance the visual portrayal of its economy by implementing its own faux money-printing program modeled after our country’s quantitative easing actions (i.e., the Federal Reserve stimulus). As a result of these initiatives, the Japanese Nikkei index – their equivalent of our Dow Jones Industrial index – has risen by +29% in less than 3 months to a level of 11,138.66 (click here for chart). But don’t get too excited. This same Nikkei index peaked at 38,957 in 1989, a far cry from its current level.
Best Action Film (Icahn vs. Ackman): This surprisingly entertaining action film features a senile 76-year-old corporate raider and a white-haired, 46-year-old Harvard grad. The investment foes I am referring to are the elder Carl Icahn, Chairman of Icahn Enterprises, and junior Bill Ackman, CEO of Pershing Square Capital Management. In addition to terms such as crybaby, loser, and liar, the 27-minute verbal spat (view more here) between Icahn (his net worth equal to about $15 billion) and Ackman (net worth approaching $1 billion) includes some NC-17 profanity. The clash of these investment titans stems from a decade-old lawsuit, in addition to a recent disagreement over a controversial short position in Herbalife Ltd. (HLF), a nutritional multi-level marketing firm.
Best Documentary (Europe): As with a lot of reality-based films, many don’t receive a lot of attention. So too has been the commentary regarding the eurozone, which has been relatively peaceful compared to last spring. Despite the comparative media silence, European unemployment reached a new high of 11.8% late last year. This European documentary is not one you should ignore. European Central Bank (ECB) President Mario Draghi just stated, “The risks surrounding the outlook for the euro area remain on the downside.”
Best Original Song (National Anthem): We won’t read anything politically into Beyonce’s lip-synced rendition of The Star-Spangled Banner at the presidential inauguration, but she is still worthy of the Sidoxia nomination because music we hear in the movies is also recorded. I’m certain her rapping husband Jay-Z agrees whole-heartedly with this viewpoint.
Best Motion Picture (Sidoxia Video): It may only be three minutes long, but as my grandmother told me, “Great things come in small packages.” I may be a little biased, but judge for yourself by watching Sidoxia’s Oscar-worthy motion picture debut:
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in HLF, Japanese ETFs, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Article is an excerpt from previously released Sidoxia Capital Management’s complementary July 2012 newsletter. Subscribe on right side of page.
I love pizza, and most fellow connoisseurs have difficulty refusing a hot, fresh slice of heaven too. Pizza is so universally appreciated that people consider pizza like ice cream – it’s good even when it’s bad (I agree). However, even the biggest, diehard pizza-lover will sheepishly admit their fondness for the flat and circular cheesy delight changes when you integrate anchovies into the mix. Not many people enjoy salty, slimy, marine creatures layered onto their doughy mozzarella and marinara pizza paradise.
With all the turmoil and uncertainty going on in the global financial markets, prudently investing in a widely diversified portfolio, including a broad range of equity securities, is viewed as palatable as participating in an all-you-can-eat anchovy pizza contest. Why are investors’ appetites so salty now? Hmmm, let me think. Oh yes, here are a few things that come to mind:
- Presidential Election Uncertainty
- European Financial Crisis
- Impending Fiscal Cliff (tax cut expirations, automatic spending cuts, termination of stimulus, etc.)
- Unsustainable Fiscal Debt & Deficits
- Slowing Subpar Domestic Economic Growth
- Partisan Politics and Gridlock in Washington
- High Unemployment
- Fears of a Hard Economic Landing in China
Doesn’t sound too appealing, does it? So, what are most investors doing in this unclear market? Rather than feasting on a pungent pie of anchovies, investors are flocking to the perceived safety of low yielding asset classes, no matter the price. In other words, the short-term warmth and comfort of CDs, money market, checking, and fixed income assets are being gobbled up like nicotine-laced pepperoni pizzas selling for $29.95/each + tax. The anchovy alternative, like stocks, is much more attractively priced now. After accounting for dividends, earnings, and cash flows, the anchovy/stock option is currently offering a 2-for-1 special with breadsticks and a salad…quite the bargain!
Nonetheless, the plain and expensive pepperoni/bond option remains the choice du jour and there are no immediate signs of a pepperoni hangover just quite yet. However, this risk aversion addiction cannot last forever. The bond gorging buffet has gone on relatively unabated for the last three decades, as you can see from the chart below. In spite of this, the bond binging game is quickly approaching a mathematical terminal end-game, as interest rates cannot logically go below zero.
Since my firm (Sidoxia Capital Management) is based in Newport Beach, next to PIMCO’s global headquarters, we get to follow the progression of the bond binging game firsthand. I’ve personally learned that if I manage close to $2 trillion in assets under management, I too can construct a 23-story Taj Mahal-esque headquarters that overlooks the Pacific Ocean from a stones-throw away.
Beyond glorified headquarters, there is evidence of other low-risk appetite examples. Here are some reinforcing pictures:
The Bond Binge
The Anchovy Special
Even though anchovy pizza, or a broadly diversified portfolio across asset class, size, geography, and style may not sound appealing, there are plenty of reasons to fight the urges of caving to fear and skepticism. Here are a few:
1) Growth Rolls On: Despite the aforementioned challenges occurring domestically and abroad, growth has continued unabated for 11 consecutive quarters, albeit at a rate less than desired. We are not immune to global recessionary forces, but regardless of European forces, the U.S. has been resilient in its expansion.
2) Jobs and Housing on the Upswing: Unemployment remains high, but our country has experienced 27 consecutive months of private creation, leading to more than 4 million new jobs being added to our workforce. As you can see from the clear longer-term downward trend in unemployment claims, we are moving in the right direction.
3) Eurozone Slowly Healing its Wounds: The Greek political and fiscal soap opera is grabbing all the headlines, but quietly in the background there are signs that the eurozone is slowly healing the wounds of the financial crisis. If you look at the 2-year borrowing costs of Europe’s troubled countries (ex-Greece), there is an unambiguous and beneficial decline. There is no doubt that Spain and Italy play a larger role than Portugal and Ireland, but at least some seeds of change have been planted for optimism.
4) Record Corporate Profits: Investors are not the only people reading uncertain newspaper headlines and watching CNBC business television. CEOs are reading the same gloomy sensationalistic stories, and as a result, corporations have been cautious about dipping their short arms into their deep pockets. Significant expense reductions and a reluctance to hire have led to record profits and cash hoards. As evidenced by the chart below, profits continue to rise, and these earnings are being applied to shareholder friendly uses like dividends, share buybacks, and accretive acquisitions.
5) Attractive Valuations (Pricing): We have already explored the lofty prices surrounding bonds and $30 pepperoni pizzas, but counter-intuitively, stock prices are trading at a discount to historical norms, despite record low interest rates. All else equal, an investor should pay higher prices for stocks when interest rates are at a record low (and vice versa), but currently we are seeing the opposite dynamic occur.
Even though the financial markets may look, smell, and taste like an anchovy pizza, the price, value, and return benefits may outweigh the fishy odor. And guess what…anchovies are versatile. If you don’t like them on your pizza, you can always take them off and put them on your Caesar salad or use them for bait the next time you go fishing. The gloom-filled headlines haven’t been spectacular, but if they were, the return opportunities would be drastically reduced. Therefore you are much better off by following investor legend Warren Buffett’s advice, which is to “buy fear and sell greed.”
Investing has never been more difficult with record low interest rates, and it has also never been more important. Excluding a small minority of late retirees and wealthy individuals, efficiently investing your retirement dollars has become even more critical. The safety nets of Social Security and Medicare are likely to be crippled, which will require better and more prudent investing by individuals. Inflation relating to food, energy, healthcare, gasoline, and entertainment is dramatically eroding peoples’ nest eggs.
Digesting a pepperoni pizza may sound like the most popular and best option given the gloomy headlines and uncertain outlook, but if you do not want financial heartburn you may consider alternative choices. Like the healthier and less loved anchovy pizza, a more attractively valued strategy based on a broadly diversified portfolio across asset class, size, geography, and style may be the best financial choice to satiate your long-term financial goals.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
These days, pundits continue to talk about how the same financial crisis plaguing Greece and its fellow PIIGS partners (Portugal, Ireland, Italy & Spain) is about to plow through the eurozone and then ultimately the remaining global economy with no mercy. If all the focus is being placed on a diminutive, calamari-eating, Ouzo-drinking society like Greece, whose economy matches the size of Maryland, then why not evaluate an even more miniscule, PIIGS prequel country…Iceland.
That’s right, the same Iceland that just four years ago people were calling a “hedge fund on ice.” You know, that frozen island that had more foreign depositors investing in their banks than people living in the country. Before Icelandic banks became more than 75% of the overall stock market, and Gordon Gekko became the country’s patron saint, Iceland was more known for fishing. The fishing industry accounted for about half of Iceland’s exports, and the next largest money maker may have been Bjork, the country’s famed and quirky female singer.
In looking back at the financial crisis of 2008-2009, as it turned out, Iceland served as a canary in the global debt binging coal mine. In order to attract the masses of depositors to Icelandic banks, these financial institutions offered outrageous, unsustainable interest rates to yield-starved customers. How did the Icelandic bankers offer such high rates? Well of course, it was those can’t-lose American subprime mortgages that were offering what seemed like irresistibly high yields. Of course, what seemed like a dream at the time, eventually turned into a nightmare once the scheme unraveled. Ultimately, it became crystal clear that the subprime borrowers could not pay the outrageous rates, especially after rates unknowingly reset to untenable levels for many borrowers.
At the peak of the crisis, the Icelandic banks were holding amounts of debt exceeding six times the Icelandic GDP (Gross Domestic Product) and these lenders suffered more than $100 billion in losses. One of the Icelandic banks was even funding a large condominium project in my neighboring Southern California city of Beverly Hills. When the excrement hit the fan after Lehman Brothers went bankrupt, it didn’t take long for Iceland’s stock market to collapse by more than -95%; Iceland’s Krona to crumple; and eventually the trigger of Iceland’s multi-billion bailout by numerous constituents, including the IMF (International Monetary Fund).
Bitter Medicine First, Improvement Next
Today, four years after the subprime implosion and Lehman debacle, the hedge fund on ice known as Iceland is beginning to thaw, and their economic picture is looking much brighter (see charts below). GDP growth is the highest it has been in four years (4.5% recently); the stock market has catapulted upwards (almost doubling from the lows); and the Iceland unemployment rate has declined from over 9% a few years ago to about 7% today.
Re-jiggering a phony economy with a faulty facade cannot be repaired overnight. However, now that the banking system has been allowed to clear out its excesses, Iceland can move forward. One tailwind behind the economy has been Iceland’s weaker currency, which has led to a +17% increase in foreign tourist nights at Icelandic hotels through April this year. What’s more, tourist traffic at Iceland’s airport hit a record in May. Iceland has taken its bitter medicine, adjusted, and is currently reaping some of the rewards.
Although the detrimental effects of austerity experienced by the economies and banks of Greece, Spain, and Italy crowd out most of today’s headlines, Iceland is not the only country to make painful changes to its fiscal ways and then taste the sweetness of progress. Let’s not forget the Guinness drinking Irish. Ireland, like Greece, Portugal, and Spain received a bailout, but Ireland’s banking system was arguably worse off than Spain’s, yet Ireland has seen its borrowing costs on its 10-year bond decrease dramatically from 9.2% at the beginning of 2011 to about 7.4% this month (still high, but moving in the right direction). The same can be said for the United States. Our banks were up against the ropes, but after some recapitalization, tighter oversight, and stricter lending standards, our banks have gotten back on track and have helped assist our economy grow for 11 consecutive quarters (albeit at uninspiring growth rates).
The austerity versus growth debate will no doubt continue to circulate through media circles. In my view, these arguments are too simplistic and one dimensional. Every country has its unique culture and distinct challenges, but even countries with massive financial excesses can steer themselves back to a path of growth. A floating hedge fund on ice to the north of us has proven that fact to us, as we witness brighter days beginning to thaw Iceland’s chilly economy to expansion again.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in Lehman Brothers, Guinness, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Article is an excerpt from previously released Sidoxia Capital Management’s complementary June 2012 newsletter. Subscribe on right side of page.
Traditional music records have been replaced with CDs (compact discs) and digital downloads. Although the problem of a broken record repeating itself is no longer an issue, our financial markets have not conquered the problem of repetition. More specifically, the timing of the -6.3% stock market decline during May (as measured by the S&P 500 index), coincides with the same broken sell-offs we have temporarily experienced over the last two summers. First, we had the “Flash Crash” in the summer of 2010, and then the debt ceiling debate and credit downgrade of 2011.
So far, the “Sell in May and go away” mantra has followed the textbook lessons over the last few years, but as you can see from the chart below, the short-lived seasonal sell-offs have been followed by significant advances (up +33% from 2010 lows and up +29% from the 2011 lows). Given the global challenges, a two-steps forward, one-step back pattern in equity markets should not be seen as overly surprising by investors.
Although the late-spring and summer doldrums have not been a joy-ride in recent years, these overly simplistic seasonal trading rules of thumb have not been exceedingly reliable either. For example, even though the months of May in 2010-2012 produced negative returns, the previous 25 Mays going back to 1985 produced positive returns more than 2/3 of the time. Rather than fiddle with these unreliable, unscientific trading rules, individuals would be better served by listening to famous Jedi Master Yoda from Star Wars, who so astutely noted, “Uncertain, the future is.”
Voting Machines and Scales
Given the spread of globalization and technology, the speed of news dissemination has never been faster. With the 2008-2009 financial crisis still burned into investors’ minds, the default response to any scary news item is to shoot first and ask questions later. Renowned long-term investing legend Ben Graham famously highlighted, “In the short run the market is a voting machine. In the long run it’s a weighing machine.”
As it relates to short-run current events, here are some of the items that investors were voting on (no pun intended) this month:
Europe, Europe, Europe: This problem has been with us for some time now, and there are no signs it will disappear anytime soon. In a game of chicken between the EU (European Union) and Greek legislators, fresh elections are taking place on June 17th, which will ultimately determine if Greece will exit the Euro monetary union or stick to the bitter medicine of austerity prescribed by the key European decision-makers in Germany. As Greece attempts to clean up its own mess, European politicians and G-20 leaders around the globe are scrambling to create plans that ring-fence countries like Spain and Italy from succumbing to a Greek-born contagion.
Presidential Politics: If you haven’t been living in a cave for the last six months, you probably know that 2012 is a presidential election year. Regardless of your politics, there are big questions surrounding the economy, jobs, deficits, debt, taxes, entitlements, defense, gay marriage, and other important issues. Answers to many of these questions will remain unclear until we get closer to the elections. The financial markets do not like uncertainty, so probabilities would indicate volatility will remain par for the course for the foreseeable future.
Facebook Folly: Despite my warnings, Facebook’s initial public offering (IPO) failed to live up to the social media giant’s hype – the share price has fallen -22% since the shares originally priced. Great companies do not always make great stocks, especially when a relatively new kid on the block has his company’s stock initially valued at a hefty price-tag of more than a $100 billion. Finger pointing is being spread liberally on the botched Facebook deal (e.g., Morgan Stanley, NASDAQ, Facebook), but no need to shed a tear for 28-year-old founder Mark Zuckerberg since his ownership stake in the company is still valued at around $15 billion – enough to cover a European trip to McDonald’s with his newlywed wife.
Dimon in a Rough Spot: Jamie Dimon, the poster child of the banking industry (and CEO of JP Morgan Chase – JPM), dropped a bomb on the investment community earlier in the month by explaining how a rogue “whale” trader racked up $2 billion in initial losses (and growing) by taking excessive risk and throwing controls into the wind.
Chinese Dragon Losing Steam: The #2 global economy has been losing some steam as witnessed by slowing industrial production and GDP growth (Gross Domestic Product). In turn, the self correcting economic forces of supply and demand have provided relief to consumers and corporations in the form of lower fuel, energy, and commodity prices. Chinese leaders are not sitting still – there are plans of accelerating infrastructure spending and assisting banks in the form of capital injections and lower reserve requirements.
As I discussed in a previous Investing Caffeine article (see The European Dog Ate My Homework), although the current headlines remain gloomy, that will always be the case. Just a few years ago, Bear Stearns, Lehman Brothers, AIG, CDS (credit default swaps), and subprime mortgages were the boogeymen. In the 1980s, we had the Savings & Loan financial crisis and the infamous 1987 Crash. During the 1970s, the Vietnam War, Nixon’s impeachment proceedings, and rising inflation were the dominating issues. Since then, the equity markets are up over 20x-fold – time will always reward those patient long-term investors. Despite all the doom and gloom, stock markets have roughly doubled over the last three years and all the major indexes remain solidly in the black for the year. Choppy waters are likely to remain as we approach this year’s elections, but for those who understand broken records often repeat themselves, there’s a good chance the music will eventually sound much better.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including commodities, inflation protection, floating rate bonds, real estate, dividend, and alternative investment ETFs), but at the time of publishing SCM had no direct position in FB, MCD, JPM, MS, NDAQ, AIG, Lehman Brothers, Bear Stearns, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
I never thought my daily routine would be dominated by checking European markets before our domestic open, but these days it is appearing like the European tail is wagging the global dog. Tracking Spanish bond yields from the Tesoro Publico and the Italia Borsa index is currently having a larger bearing on my portfolio than U.S. fundamentals. When explaining short term performance to others, I feel a little like an elementary school student making an excuse that my dog ate my homework.
Although the multi-year European saga has gone on for years, this too shall pass. What’s more, despite the bailouts of Portugal, Ireland, and Greece in recent years, the resilient U.S. economy has recorded 11 consecutive quarters of GDP (Gross Domestic Product) growth and added more than 4 million jobs, albeit at a less than desirable pace.
Could it get worse? Certainly. Will it get worse before it gets better? Probably. Is worsening European fundamentals and a potential Greek eurozone exit already factored into current stock prices? Possibly. The truth of the matter is that nobody knows the answers to these questions with certainty. At this point, the probability of an unknown or unexpected event in a different geography is more likely to be the cause of our economic downfall than a worsening European crisis. As sage investor and strategist Don Hays aptly points out, “When everyone is concerned about a problem, that problem is solved.” That may be overstating the truth a bit, but I do believe the issues absent from current headlines are the matters we should be most concerned about.
The European financial crisis may drag on for a while longer, but nothing lasts forever. Years from now, worries about the PIIGS countries (Portugal, Ireland, Italy, Greece, Spain) will switch to others, like the BRICs (Brazil, Russia, India, China) or other worry geography du jour. The issues of greatest damage in 2008-2009, like Bear Stearns, Lehman Brothers, AIG, CDS (credit default swaps), and subprime mortgages, didn’t dominate the headlines for years like the European crisis stories of today. As compared to Europe’s problems, these prior pains felt like Band Aids being quickly ripped off.
Eventually European worries will be put on the backburner, but until some other boogeyman dominates the daily headlines, our financial markets will continue to correlate tightly with European security prices. How does one fight these tight correlations? For starters, the correlations will not stay tight forever. If an investor can survive through the valley of strong security association, then the benefits will eventually accrue.
Although the benefits from diversification may disappear in the short-run, they should not be fully forgotten. Bonds, cash, and precious metals (i.e., gold) proved to be great portfolio diversifiers in 2008 and early 2009. Commodities, inflation protection, floating rate bonds, real estate, and alternative investments, are a few asset classes that will help diversify portfolios. Risk is defined in many circles as volatility (i.e., standard deviation) and combining disparate asset classes can lower volatility. But risk, defined as the potential of experiencing permanent losses, can also be controlled by focusing on valuation. By in large, large cap dividend paying stocks have struggled for more than a decade, despite equity dividend yields for the S&P 500 exceeding 10-year Treasury yields (the first time in more than 50 years). Investing in large companies with strong balance sheets and attractive growth prospects is another strategy of lowering portfolio risk.
Politics & Winston Churchill
Some factors however are out of shareholders hands, such as politics. As we know from last year’s debt ceiling melee and credit downgrade debacle, getting things done in Washington is very challenging. If you think achieving consensus in one country is difficult, imagine what it’s like in herding 17 countries? That’s the facts of life we are dealing with in the eurozone right now.
Although I am optimistic something will eventually get done, I consider myself a frustrated optimist. I am frustrated because of the gridlock, but optimistic because these problems are not rocket science. Rather these challenges are concepts my first grade child could understand:
• Expenses are running higher than revenues. You must cut expenses, increase revenues, or a combination thereof.
• Adding debt can support growth, but can lead to inflation. Cutting debt can hinder growth, but leads to a more sustainable fiscal state of wellbeing.
Relieving all the excess global leverage is a long, tortuous process. We saw firsthand here in the U.S. what happened to the U.S. real estate market and associated financial institutions when irresponsible debt consumption took place. Fortunately, corporations and consumers adjusted their all-you-can-eat debt buffet habits by going on a diet. As a matter of fact, corporations today are holding records amounts of cash and debt service loads for consumers has been reduced to levels not seen in decades (see chart below). Unlike governments, luckily CEOs and individuals do not need Congressional approval to adapt to a world of reality – they can simply adjust spending habits.
Governments, on the other hand, generally do need legislative approval to adjust spending habits. Regrettably, cutting the benefits of your constituents is not a real popular political strategy for accumulating votes or brownie points. If you don’t believe me, see what voters are doing to their leaders in Europe. Nicolas Sarkozy is the latest European leader to be booted from office due to austerity backlash and economic frustration. No less than nine European leaders have been cast aside since the financial crisis began.
The fate for U.S. politicians is less clear as we enter into a heated presidential election over the next six months. We do however know how the mid-term Congressional elections fared for the incumbents…not all sunshine and roses. Until elections are completed, we are resigned to the continued mind-numbing political gridlock, with no tangible resolutions to the trillion dollar deficits and gargantuan debt load. Obviously, most citizens would prefer a forward looking strategic plan from politicians (rather than a reactive one), but there are no signs that this will happen anytime soon…in either party.
Realistically though, tough decisions made by politicians only occur during crises, and if this slow-motion train wreck continues along this same path, then at least we have something to look forward to – forced resolution. We are seeing this firsthand in Greece. The “bond vigilantes” (see Plumbers & Cops) and responsible parents (i.e., Germany) have given Greece two options:
1.) Fix your financial problems and receive assistance; or
2.) Leave the EU (return to the Drachma currency) and figure your problems out yourself.
Panic has a way of forcing action, and we are approaching that “when push comes to shove” moment very quickly. I believe the Europeans are currently taking a note from our strategic playbook, which basically is the spaghetti approach – throw lots of things up on the wall and see what sticks. Or as Winston Churchill stated, “You can always count on Americans to do the right thing – after they’ve tried everything else.”
There is no question, the European sovereign debt issue is a complete mess, and there are no clear paths to a quick solution. Until voters force politicians into making tough unpopular decisions, or leaders come together with forward looking answers, the default position will be to keep kicking the fiscal can issues down the road. In the absence of political leadership, eventually the crisis will naturally force tough decisions to be made. Until then, I will go on explaining to others how the European dog ate my homework.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including commodities, inflation protection, floating rate bonds, real estate, dividend, and alternative investment ETFs), but at the time of publishing SCM had no direct position in AIG, JNJ, Bear Stearns, Lehman Brothers, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.