Posts tagged ‘fiscal cliff’
USA Inc.: Buy, Hold or Sell?
If the U.S. was a company, would you buy, hold, or sell the stock? A voluminous report put out last year by Mary Meeker sought to answer that very question. Since we’re in the thick of the presidential elections, why not review the important financial state of our great nation.
For those of you who may not know who she is, Mary Meeker is the well-known partner at Kleiner Perkins Caufield & Byers, who is also affectionately known as the “Queen of Internet.” Apparently, beyond her renowned expertise in analyzing and valuing tech companies and start-ups, she also has the knack of dissecting government statistics and distilling wonky numbers down to understandable terms for the masses. “Distilling” may be a generous term, given the massive size of her 460-page report, USA Inc., but nevertheless, I am going to attempt to synthesize this gargantuan report even further.
As a visual learner, I think some key cherry-picked slides from her report will help put our multi-trillion debts and deficits in context, so here goes…
The Scope of the Problem
If one spends a few hundred billion dollars here, and a few hundred billion dollars there, before you know it, a trillion dollars will have piled up. Currently our government has run $1 trillion+ budget deficits for three years, and the estimated deficit is for another trillion dollar deficit this fiscal year. If you have ever wondered how many football fields it takes to fill with a trillion dollars of cash, then today is your lucky day. The answer: 217 football fields.
Financial Statements: The Health Thermometer
In order to determine the relative health of USA Inc., Meeker created financial statements for our country, starting with the income statement. As you can see from the chart below, unfortunately USA Inc.’s expenses have been significantly larger than its revenues, creating a “discouraging” trend of negative cash flows (deficits). An entity that takes in $2.2 trillion in revenue and spends $3.5 trillion, cannot sustainably continue this trend for long, before significant financial problems arise. The largest contributing factor to our country’s losses (deficits) has been the exploding costs of entitlements, including Medicare, Medicaid, and Social Security.
As the pie chart shows, the major categories of entitlements comprise a whopping 58% of USA Inc.’s 2010 total expenditures.
Trillion dollar deficits have been the norm over the last three years.
Why Entitlement Spending is a Problem
Why are entitlements such a massive problem? The plain and simple answer to why entitlements are a major issue is that government expenditures are growing too fast. You can’t have expenses growing significantly faster than revenues for 45 years and expect to be in happy financial place.
Another reason for the abysmal spending record is due to politicians horrendous forecasting abilities. Future promises are made by politicians to garner votes today, and when they make overly rosy estimates about the costs of those promises, future generations are left holding the underfunded bag. Meeker points out that when Medicare was instituted in 1966, total future spending of $110 billion turned out to be about 10x more expensive (see chart below) than originally planned…ouch!
No Defense for Defense
Trillion dollar deficits and debts can’t be solely blamed on entitlements, but $700 billion in annual defense expenditures is not exactly chump change. The inopportune timing of the financial crisis in 2008-2009 didn’t help either, while two unfunded wars were being fought. Even if you strip out the wars, defense spending is still obscenely high. Given our poor state of financial affairs, we cannot afford to be the globe’s babysitter (see Impoverished Global Babysitter). Legacy Cold War spending on obsolete ground warfare needs to be reprioritized to 21st Century threats (i.e. focus on unmanned drones and coordinated intelligence). When a government spends more than the top 25 countries combined (see chart below), that country can certainly find some defense fat to trim.
Demographic Headwinds
The out-of-control gluttonous government spending is a threat to our national security, and although I wish I could say time alone will heal our fiscal wounds, unfortunately the opposite is true. Time is our enemy because the ticking demographic time bomb is about to explode, unless government acts to solve our spending problems. For starters, Americans are living longer, which means entitlement spending has accelerated faster than revenues collected, and life expectancy consistently continues to rise. As you can see below, life expectancy has outpaced Social Security age adjustments by +23% over a 74 year period.
Another self inflicted problem contributing to our colossal health care costs is the obesity epidemic. Over an 18 year period, the rate of obesity more than doubled to 32%. Individuals can and should shoulder more of the burden for these belt-busting costs, and government should spend more on prevention and education in this area. Bad drivers pay higher premiums for their auto insurance, so why not have bad eaters pay higher premiums? Genetics certainly can play a role in obesity, but so to do eating habits. The same accountability principle should be applied to smokers who overly burden our healthcare system too.
The USA spends more on healthcare than all OECD countries combined and 3x the OECD per capita average, yet as you can see from the chart below, the USA is not getting a life expectancy bang for its buck. The argument that the U.S. has the best healthcare in the world may be true in some instances, but the overall data doesn’t support that assertion.
The Rubber Hits the Road
The problem is easy to identify: Government spending going out the door is running faster than the revenues coming in via taxes. The solution is easy to identify too: Politicians need to cut spending, increase taxes, and/or do a combination of the two options. Like dieting, the solutions are easy to identify but difficult to execute.
Source: Calafia Beach Pundit – Scott Grannis
Almost everyone wants the government to spend less, but at the same time nobody wants their benefits cut. You can’t have your cake and eat it too. Citing two different studies, Meeker shows how 80% of Americans want a balanced budget as a national priority, but only 12% are willing to cut spending on Medicare and Social Security.
The rubber will hit the road in the next few months when politicians in a post-presidential election period will be forced to face these difficult “Fiscal Cliff” choices – $700 billion+ in tax hikes and spending increases that jeopardize the current recovery and our fiscal future.
Source: PIMCO
As market maven Mary Meeker recognizes, our fiscal situation is quite “discouraging”. With that said, although USA Inc. may have earned a current “Sell” rating, Meeker acknowledges that our country can become a positive turnaround situation. If voters actively push politicians to making difficult but necessary financial decisions to lower deficits and debt, investors around the globe will be ready to “Buy” USA Inc.’s stock.
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 positions 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.
Autumn, Elections and Replacement Refs
Article is an excerpt from previously released Sidoxia Capital Management’s complementary October 1, 2012 newsletter. Subscribe on right side of page.
As September has come to a close, the grand finale of our annual seasons has commenced… autumn. How do we know autumn is here? Well, for starters, the leaves are changing colors; the weather is about to cool; and the NFL replacement referees are watching Sunday football games from their couches.
While 2012 is split into quarters, football games and investment seasons are also divided into four quarters. Right now, the economic fourth quarter has just started and the home team is winning. As we can see from the stock market scoreboard, the S&P 500 index is up +15% this year (+6% in Q3) and the NASDAQ index has catapulted +20% through September (+6% also in Q3). The U.S. home team is winning, but a fumble, blocked kick, or interception could mean the difference between an exciting win and a devastating loss.
Another game divided into four parts is the game of presidential politics. However, presidential elections are divided into four years – not four quarters. Five weeks from now, we’ll find out if our Commander in Chief Obama will get to lead our team for another game lasting four years, or whether backup quarterback Mit Romney will be called into the game. The fans are getting restless due to anemic growth and lingering joblessness, but for now, the coach is keeping the president in the starting lineup. Both President Obama and Governor Romney will take some head-to-head practice snaps against each other in the first of three scheduled presidential debates beginning this week.
Bernanke Changes Rules
The New York Jets have Tim Tebow for their secret weapon (1 for 1 yesterday!), and the United States economy has Ben Bernanke. Although our home team may be winning, it has required some monetary rule-changing policies to be instituted by Federal Reserve Chairman Ben Bernanke to keep our team in the lead. Just a few weeks ago, Mr. Bernake instituted QE3 (3rd round of quantitative easing), which is an open-ended mortgage buying program designed to lower home buying interest rates and stimulate the economy (see Helicopter Ben to QE3 Rescue). The short-term benefits of the $40 billion monthly bond buying binge are relatively clear (lower borrowing costs for homebuyers), but the longer-term costs of inflation are stewing patiently on the backburner.
Source: Calafia Beach Pundit (Scott Grannis)
As you can see from the chart above, August median home prices are up +10% for existing single-family homes over the last year. Housing affordability is at extremely attractive levels, and although the bank loan purse strings are tight, a modest loosening is beginning to unfold.
Economy Playing Injured
Our starters may still be playing, but many are injured, just like the jobless are limping through the employment market. Encouragingly, although unemployment remains stubbornly high, the number of people collecting unemployment checks is a lot lower (-1.25 million fewer than a year ago). Not great news, but at least we are hobbling in the right direction (see chart below).
Source: Calafia Beach Pundit (Scott Grannis)
Time for Fiscal Cliff Hail Mary?
If a team is losing at the end of a game, a “Hail Mary” pass might be necessary. We are quickly nearing this fiscal Armageddon situation as the approximately $700 billion “fiscal cliff” (a painful combo of spending cuts and tax hikes) kicks in at the end of the year (see PIMCO chart below via The Reformed Broker).
Running trillion dollar deficits in perpetuity is not a sustainable strategy, so for most people, a combination of spending cuts and/or tax hikes makes sense to narrow the gap (see chart below). Last year’s recommendations from the bipartisan Simpson-Bowles commission, which were ignored, are not a bad place to start. What happens in the lame-duck session of Congress (after the elections) will dramatically impact the score of the current economic game, and decide who wins and who loses.
Source: Calafia Beach Pundit (Scott Grannis)
Heated debates continue on how the gap between expenses and revenues will be narrowed, but regardless, Democrats will continue to push for capital gains tax hikes on the rich (see tax chart below); and the Republicans will push to cut spending on entitlements, including untenable programs like Medicare and Social Security.
Source: The Wall Street Journal
The game is not quite over, but the fourth quarter promises to be a bloody battle. So while the replacement refs may be back at home, the experienced returning refs have been known to blow calls too. Let’s just hope that autumn, the season of bounteous fecundity, ends up being a continued trend of sweet market success, rather than a political period of botched opportunities.
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 positions 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.
Fiscal Cliff: Will a 1937 Repeat = 2013 Dead Meat?
Source: StockCharts.com
The presidential election is upon us and markets around the globe are beginning to factor in the results. More importantly, in my view, will be the post-election results of the “fiscal cliff” discussions, which will determine whether $600 billion in automated spending cuts and tax increases will be triggered. Similar dynamics in 1937 existed when President FDR (Franklin Delano Roosevelt) felt pressure to balance the budget after his 1933 New Deal stimulus package began to rack up deficits and lose steam.
What’s Similar Today
Just as there is pressure to cut spending today by Republicans and “Tea-Party” Congressmen, so too there was pressure for FDR and the Federal Reserve in 1937 to unwind fiscal and monetary stimulus. At the time, FDR thought self-sustaining growth had been restored and there was a belief that the deficits would become a drag on expansion and a source of future inflation. What’s more, FDR’s Treasury Secretary, Henry Morgenthau, believed that continued economic growth was dependent on business confidence, which in turn was dependent on creating a balanced budget. History has a way of repeating itself, which explains why the issues faced in 1937 are eerily similar to today’s discussions.
The Results
FDR was successful in dramatically reducing spending and significantly increasing taxes. Specifically, federal spending was reduced by -17% over two years and FDR’s introduction of a Social Security payroll tax contributed to federal revenues increasing by a whopping +72% over a similar timeframe. The good news was the federal deficit fell from -5.5% of GDP to -0.5%. The bad news was the economy went into a tail-spinning recession; the Dow crashed approximately -50%; and the unemployment rate burst higher by about +3.3% to +12.5%.
Source: New York Times
Source: Blue Mass Group
What’s Different This Time?
For starters, one difference between 1937 and 2012 is the level of unemployment. In 1937, unemployment was +14.3%, and today it is +8.1%. Objectively, today there could be higher percentage of the population “under-employed,” but nonetheless the job market was in worse shape back then and labor unions had much more power.
Another major difference is the stance carried by the Fed. Today, Ben Bernanke and the Fed have made it crystal clear they are in no hurry to take away any of the monetary stimulus (see Hekicopter Ben QE3 article), until we have experienced a long-lasting, sustainable recovery. Back in early 1937, the Fed increased banks’ reserve requirements twice, doubling the requirement in less than a year, thereby contracting monetary supply drastically.
Furthermore, we live in a much more globalized world. Today, central banks and governments around the world are doing their part to keep growth alive. Emerging markets are large enough now to move the needle and impact the growth of developed markets. For example, China, the #2 global superpower, continues to cut interest rates and has recently implemented a $158 billion infrastructure spending program.
Net-Net
Whether you’re a Republican or Democrat, everyone generally agrees that job creation is an important common objective, which is consistent with growing our economy. The disagreement between parties stems from the differing opinions on what are the best ways of creating jobs. From my perch, the frame of the debate should be premised on what policies and incentives should be structured to increase competitiveness. Without competitiveness there are no jobs. At the end of the day, money and capital are agnostic. Cold hard cash migrates to the countries in which it is treated best. And where the money goes is where the jobs go.
There is no single silver bullet to solve the competiveness concerns of the United States. Like baseball (since playoffs are quickly approaching), winning is not based solely on hitting, pitching, defense, or base-running. All of these facets and others are required to win. The same principles apply to our country’s competitiveness.
In order to be a competitive leader in the 21st century, here are few necessary areas in which we must excel:
Education: Chicago school unions have been in the news, and I have no problems with unions, if accountability can be structured in. Unfortunately, however, it is clear to me that for now our system is broken (a must see: Waiting for Superman). We cannot compete in the 21st century with an illiterate, uneducated workforce. Our colleges and universities are still top-notch, but as Bill Gates has stated, our elementary schools and high schools are “obsolete”.
Entitlements: Social safety nets like Social Security and Medicare are critical, but unsustainable promises that explode our debt and deficits will not make us more competitive. Politicians may gain votes by making promises in the short-run, but when those promises can’t be delivered in the medium-run or long-run, then those votes will disappear quickly. The sworn guarantees made to the 76 million Baby Boomers now entering retirement are a disaster waiting to happen. Benefits need to be reduced and or criteria need to be adjusted (i.e., means-testing, increase age requirements). The problems are clear as day, so Americans cannot walk away from this sobering reality.
Strategic Government Investment: – Government played a role in building our country’s railways, highways, and our military – a few strategic areas of our economy that have made our nation great. Thoughtful investments into areas like energy infrastructure (e.g., smart grid), internet infrastructure (e.g., higher speed super highway), and healthcare (e.g., human genome research) are a few examples of how jobs can be created while simultaneously increasing our global competitiveness. The great thing about strategic government investments is that government does NOT have to do all the heavy lifting. Rather than write all the checks and do all the job creation from Washington, government can implement these investments and create these jobs by providing incentives for the private sector. Strategic public-private partnerships can generate win-win results for government, businesses, and job seekers. If, however, you’re convinced that our government is more efficient than the private sector, then I highly encourage you to go visit your local DMV, post office, or VA to better appreciate the growth-sucking bureaucracy and inefficiency.
Taxes / Regulations / Laws: Taxes come from profits, and businesses create profits. In order to have a strong and competitive government, we need strong and competitive businesses. Higher taxes, excessive regulations, and burdensome laws will not create stronger and more competitive businesses. I acknowledge that reckless neglect and consumer exploitation will not work either, but reasonable protections for consumers and businesses can be instituted without multi-thousand page regulations. Reducing ridiculous subsidies and loopholes, while tightening tax collection processes and punishing tax dodgers makes perfect sense…so why not do it?
Politics are sharply polarized at both ends of the spectrum, but no matter who wins, our problems are not going away. We may or may not have a new president of the United States this November, but perhaps more important than the elections themselves will be the outcome of the “fiscal cliff” legislation (or lack thereof). If we want to maintain our economic power as the strongest in the world, solving this “fiscal cliff” is the key to improving our competiveness. Avoiding a messy 1937 (and 2011) political repeat will prevent us from becoming dead meat.
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 positions 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.
Helicopter Ben to QE3 Rescue
Faster than a speedy credit default swap, more powerful than a federal funds interest rate cut, and able to leap a tall Mario Draghi in a single bound, look…it’s Helicopter Ben! How did Federal Reserve Chairman Ben Bernanke become a monetary superhero with such a cool nickname as Helicopter Ben (a.k.a. “HB”)? Bernanke, a former Princeton University professor, has widely been known to be a diligent student of the Great Depression, and his aviation nickname stems from a 2002 speech in which he referenced dropping money from a helicopter to combat deflation. While investors may worry about HB’s ability to fight the inflation thugs, there should be no questions about his willingness to implement accommodative, deflation-fighting monetary policies.
Chairman Bernanke may not epitomize your ideal superhero, however this slightly past middle-aged bearded and balding man has helped mastermind some of the most creative and aggressive monetary rescue efforts our country and globe has seen in the history of man (and woman). This week’s money-printing QE3 announcement solidified Bernanke’s historic capital saturating ranking.
Since Helicopter Ben’s heroic appointment as Federal Reserve Chairman in 2006 by George W. Bush, Bernanke has instituted numerous monetary gadgets in hopes of meeting the Federal Reserve’s dual mandate, which is i) to achieve low inflation and ii) to strive for maximum employment. Arguably, given the anemic growth here in the U.S.; the recession in Europe; and slowing growth in the emerging markets (i.e., China, Brazil, India, etc.), slack in the economy and static labor wages have largely kept inflation in check. With the first part of the dual mandate met, Bernanke has had no problem putting his monetary superpowers to work.
As referenced earlier, Bernanke’s bazooka launch of QE3, an open ended MBS (Mortgage Back Securities) bond binging program, will add $40 billion of newly purchased assets to the Fed’s balance sheet on a monthly basis until the labor market improves “substantially” (whatever that means). What’s more, in addition to the indefinite QE3, Bernanke has promised to keep the federal funds rate near zero “at least through mid-2015,” even for a “considerable time after the economic recovery strengthens.”
HB’s Track Record
Throughout superhero history, Superman, Spider-man, and Batman have used a wide-array of superhuman powers, extraordinary gadgets, and superior intellect to conquer evil-doers and injustices across the globe. Bernanke has also forcefully put his unrivaled money-printing talents to work in an attempt to cure the financial ills of the world. Here’s a quick multi-year overview of how Bernanke has put his unique talents to print trillions of dollars and keep interest rates suppressed:
Rate Cuts (September 2007 – December 2008): Before “quantitative easing” was a part of our common vernacular, the Fed relied on more traditional monetary policies, such as federal funds rate targeting, conducted through purchases and sales of open market securities. Few investors recall, but before HB’s fed funds rate cut rampage of 10 consecutive reductions in 2007 and 2008 (the fed funds rate went from 5.25% to effectively 0%), Bernanke actually increased rates three times in 2006.
Crisis Actions (2007 – 2009): Love him or hate him, Bernanke has been a brave and busy soul in dealing with the massive proportions of the global financial crisis. If you don’t believe me, just check out the Financial Crisis Timeline listed at the St. Louis Federal Reserve. Many investors don’t remember, but Bernanke helped orchestrate some of the largest and most unprecedented corporate actions in our history, including the $30 billion loan to JPMorgan Chase (JPM) in the Bear Stearns takeover; the $182 billion bailout of AIG; the conversion of Morgan Stanley (MS) and Goldman Sachs Group Inc. (GS) into bank holding companies; and the loan/asset-purchase support to Fannie Mae (FNMA) and Freddie Mac (FMCC). These actions represented just the tip of the iceberg, if you also consider the deluge of liquidity actions taken by the Fed Chairman.
HB Creates Acronym Soup
In order to provide a flavor of the vastness in emergency programs launched since the crisis, here is an alphabet soup of program acronyms into which the Fed poured hundreds of billions of dollars:
- Term Asset-Backed Securities Loan Facility (TALF)
- Term Auction Facility (TAF)
- Money Market Investor Funding Facility (MMIFF)
- Commercial Paper Funding Facility (CPFF)
- Primary Dealer Credit Facility (PDCF)
- Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF)
- Temporary Reciprocal Currency Arrangements (Swap lines)
- Term Securities Lending Facility (TSLF)
Plenty of acronyms to go around, but these juicy programs have garnered most of investors’ attention:
QE1 (November 2008 – March 2010): In hopes of lowering interest rates for borrowers and stimulating the economy, HB spearheaded the Fed’s multi-step, $1 trillion+ buying program of MBS (mortgage backed securities) and Treasuries.
QE2 (November 2010 – June 2011): Since the Fed felt QE1 didn’t pack enough monetary punch to keep the economy growing at a fast enough clip, the FOMC (Federal Open Market committee) announced its decision to expand its holdings of securities in November 2010. The Committee maintained its existing policy of reinvesting principal payments from its securities holdings and to also purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011 (an equivalent pace of about $75 billion per month).
Operation Twist (September 2011 – December 2012): What started out as a $400 billion short-term debt for longer-term debt swap program in September 2011, expanded to a $667 billion program in June 2012. With short-term rates excessively low, Bernanke came up with this Operation Twist scheme previously used in the early 1960s. Designed to flatten the yield curve (bring down long-term interest rates) to stimulate economic activity, Bernanke thought this program was worth another go-around. Unlike quantitative easing, Operation Twist does not expand the Fed’s balance sheet – the program merely swaps short-term securities for long-term securities. Currently, the program is forecasted to conclude at the end of this year.
The Verdict on HB
So what’s my verdict on the continuous number of unprecedented actions that Helicopter Ben and the Fed have taken? Well for starters, I have to give Mr. Bernanke an “A-” on his overall handling of the financial crisis. Had his extreme actions not been taken, the pain and agony experienced by all would likely be significantly worse, and the financial hole a lot deeper.
With that said, am I happy about the announcement of QE3 and the explosion in the Fed’s money printing activities? The short answer is “NO”. It’s difficult to support a program with questionable short-run interest rate benefits, when the menacing inflationary pressures are likely to outweigh the advantages. The larger problem in my mind is the massive fiscal problem we are experiencing (over $16 trillion in debt and endless trillion dollar deficits). More importantly, this bloated fiscal position is creating an overarching, nagging crisis of confidence. A resolution to the so-called “fiscal cliff,” or the automated $600 billion in tax increases and spending cuts, is likely to have a more positive impact on confidence than a 0.05% – 0.25% reduction in mortgage rates from QE3. Once adequate and sustained growth returns, and inflation rears its ugly head, how quickly Helicopter Ben tightens policy will be his key test.
Until then, Bernanke will probably continue flying around while gloating in his QE3 cape, hoping his quantitative easing program will raise general confidence. Unfortunately, his more recent monetary policies appear to be creating diminishing returns. Even before QE3’s implementation, Helicopter Ben has witnessed his policies expand the Fed’s balance sheet from less than $900 billion at the beginning of the recession to almost $3 trillion today. Despite these gargantuan efforts, growth and confidence have been crawling forward at only a modest pace.
No matter the outcome of QE3, as long as Ben Bernanke remains Federal Reserve Chairman, and growth remains sluggish, you can stay confident this financial man of steel will continue dumping money into the system from his helicopter. If Bernanke wants to create a true legendary superhero ending to this story, the kryptonite-like effects of inflation need to be avoided. This means, less money-printing and more convincing of Congress to take action on our out-of-control debt and deficits. Now, that’s a comic book I’d pay to read.
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 positions in JPM, AIG, MS, GS, FNMA, FMCC, 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.
Equity Quicksand or Bond Cliff?
The markets are rigged, the Knight Capital Group (KCG) robots are going wild, and the cheating bankers are manipulating Libor. I guess you might as well pack it in…right? Well, maybe not. While mayhem continues, equity markets stubbornly grind higher. As we stand here today, the S&P 500 is up approximately +12% in 2012 and the NASDAQ market index has gained about +16%? Not bad when you consider 15 countries are offering negative yields on their bonds…that’s right, investors are paying to lose money by holding pieces of paper until maturity. As crazy as buying technology companies in the late 1990s for 100x’s or 200x’s earnings sounds today, just think how absurd negative yields will sound a decade from now? For heaven’s sake, buying a gun and stuffing money under the mattress is a cheaper savings proposition.
Priced In, Or Not Priced In, That is the Question?
So how can stocks be up in double digit percentage terms when we face an uncertain U.S. presidential election, a fiscal cliff, unsustainable borrowing costs in Spain, and S&P 500 earnings forecasts that are sinking like a buried hiker in quicksand (see chart below)?
I guess the answer to this question really depends on whether you believe all the negative news announced thus far is already priced into the stock market’s below average price-earnings (P/E) ratio of about 12x’s 2013 earnings. Or as investor Bill Miller so aptly puts it, “The question is not whether there are problems. There are always problems. The question is whether those problems are already fully discounted or not.”
Source: Crossing Wall Street
While investors skeptically debate how much bad news is already priced into stock prices, as evidenced by Bill Gross’s provocative “The Cult of Equity is Dying” article, you hear a lot less about the nosebleed prices of bonds. It’s fairly evident, at least to me, that we are quickly approaching the bond cliff. Is it possible that we can be entering a multi-decade, near-zero, Japan-like scenario? Sure, it’s possible, and I can’t refute the possibility of this extreme bear argument. However with global printing presses and monetary stimulus programs moving full steam ahead, I find it hard to believe that inflation will not eventually rear its ugly head.
Again, if playing the odds is the name of the game, then I think equities will be a better inflation hedge than most bonds. Certainly, not all retirees and 1%-ers should go hog-wild on equities, but the bond binging over the last four years has been incredible (see bond fund flows).
While we may sink a little lower into the equity quicksand while the European financial saga continues, and trader sentiment gains complacency (Volatility Index around 15), I’ll choose this fate over the inevitable bond cliff.
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 KCG 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.
Financial Olympics: Chasing Gold, Siver & Bronze
Article is an excerpt from previously released Sidoxia Capital Management’s complementary August 1, 2012 newsletter. Subscribe on right side of page.
As a record number of 204 nations compete at the XXX Olympic Games in London, and millions of couch-watchers root on their favorite athletes, a different simultaneous competition is occurring…the 2012 Financial Olympics. So far, both Olympics have provided memorable moments for all. While the 2012 London Olympic viewers watched James Bond and Queen Elizabeth II parachute into a stadium filled with 80,000 cheering fans, investors cheered the Dow Jones Industrial Average above the 13,000 level on the same day of the opening ceremony. We have already witnessed a wide range of emotions displayed by thousands of athletes chasing gold, silver, and bronze, and the same array of sentiments associated with glory and defeat have been observed in the 2012 Financial Olympics. There is still a way to go, but despite all the volatility, the stock market is still up a surprising +10% in 2012.
Here were some of the key Financial Olympic events last month:
Draghi Promises Gold for Euro: Some confident people promise gold medals while others promise the preservation of a currency – European Central Bank President (ECB) Mario Draghi personifies the latter. Draghi triggered the controversy with comments he made at the recent Global Investment Conference in London. In the hopes of restoring investor confidence Draghi emphatically proclaimed, “The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” To view this excerpt, click video link here.
U.S. Economy Wins Bronze: Whereas Europe has been disqualified from the Financial Olympics due to recessionary economic conditions (Markit predicts a -0.6% contraction in Q3 eurozone GDP), the U.S. posted respectable Q2 GDP results of +1.5%. This surely is an effort worthy of a bronze medal given the overall sluggish, global demand. Fears over a European financial crisis contagion; undecided U.S. Presidential election; and uncertain “fiscal cliff” (automatic tax hikes and spending cuts) are factors contributing to the modest growth. Nevertheless, the US of A has posted 12 consecutive quarters of economic growth (see chart below) and if some clarity creeps back into the picture, growth could reaccelerate.
Source (Calafia Beach Pundit)
No Podium for Spain: Spain’s recent economic achievements closely mirror those of the athletic team, which thus far has failed to secure a sporting medal of any color. Why no Spanish glory? Recently, the Bank of Spain announced the country’s economy was declining at a -1.6% annual rate. Shortly thereafter, Spain estimated its economy would contract by -0.5% in 2013 instead of expanding +0.2%, as previously expected. Adding insult to injury, Valencia (Spain’s most indebted region) said central government support would be needed to repay its debts. These factors, and others, have forced the Spanish government to adopt severe austerity measures to cut its budget deficit by $80 billion through 2015. Spanish banks have negotiated a multi-billion-euro bailout, but they will have to hand control over to European institutions as a concession. Considering these facts, combined with an unemployment rate near 25%, one can appreciate the dominant and pervading losing spirit.
Global Central Banks Inject Financial Steroids: The challenging and competitive global growth environment is not new news to central bankers around the world. As a result, finance leaders around the world are injecting financial steroids into their countries via monetary stimulus (mostly rate cuts and bond buying). Like steroids, these actions may have short-term invigorating effects, but these measures can also have longer-term negative consequences (i.e., inflation). Here are some of the latest country-specific examples (also see chart below):
- U.S. Federal Reserve Chairman Ben Bernanke has already shot a couple “Operation Twist” and “QE” (Quantitative Easing) bullets, but as global growth continues to slow, he has openly acknowledged his willingness to dig into his toolbox for additional measures under the right circumstances, including QE3.
- The PBOC (People’s Bank of China) surprised many observers by employing its second rate cut in less than a month. The PBOC lowered its one-year lending rate by 0.31% to 6%.
- The ECB (European Central Bank) lowered its key lending rate by 0.25% to an all-time low of 0.75% and also cut its overnight deposit rate (the equivalent of our Federal Funds rate) by 0.25% to 0%.
- Brazil’s central bank recently cut its benchmark Selic rate for the 8th time in a year to an all-time low of 8% from 12.5%.
- South Korea’s central bank lowered its key interest rates by 0.25% to 3%, its first such action in three years.
- The BOE (Bank of England) raised its quantitative easing goal by 50 billion pounds (~$78 billion).
Source (Calafia Beach Pundit)
Banks Disqualified from Libor Games: As a result of the Libor (London Interbank Offered Rate) rigging scandal, Barclays CEO Robert Diamond resigned from the bank and agreed to forfeit $31 million in bonus money. Libor is a measure of what banks pay to borrow from each other and, perhaps more importantly, it acts as a measuring stick for determining rates on mortgages and other financial contracts. In an attempt to boost the perceived financial strength of their financial condition, multiple banks artificially manipulated the calculation of the Libor rate. Ironically, this scandal likely helped consumers with lower mortgage and credit card rates.
Rates Running Backwards: Sports betting on teams and events is measured by point spreads and numerical odds. In the global debt markets, betting is measured by interest rates. So while losing, debt-laden countries like Greece and Spain have seen their interest rates explode upwards, winning, fiscally responsible countries (including Switzerland, Austria, Denmark, Netherlands, Germany, and Finland) have seen their bond yields turn NEGATIVE. That’s right, investors are earning a negative return. Rather than making a bet on higher yielding bonds, many investors are flocking to the perceived safety of these interest-losing bonds (see chart below). This game cannot last forever, especially for individual and institutional investors who require income to meet liquidity and return requirements.
Source (The Financial Times)
China Wins GDP Gold Medal but No World Record: China currently leads in both the Olympic Games gold medal count (China 13 vs. U.S. 9 through July 31st) and GDP competition. Given the fiscal and monetary stimulus measures the government has implemented, it appears their economy is bottoming. Despite the tremendous anxiety over China’s growth, China’s National Bureau of Statistics just announced a +7.6% Q2 GDP growth rate (see chart below), down from +8.1% in Q1. Although this is the slowest growth since the global financial crisis, Even though this was the slowest GDP growth rate in over three years, most countries would die for this level of growth. Adding evidence to the bottoming storyline, HSBC recently reported the preliminary Chinese PMI manufacturing index rose to 49.5 in July, up from 48.2 in June – the highest reading since early this year (February).
Source (Calafia Beach Pundit)
Higgs Wins God Particle Gold: Michael Phelps and Missy Franklin are not the only people to win gold medals in their fields. Peter Higgs and fellow scientists had 50-years of their physics research validated when the Large Hadron Collider discovered the long-sought Higgs boson (a.k.a., the “god particle”). The collider, located on the Franco-Swiss border, measured approximately 17 miles in length, took years to build, and cost about $8 billion to finish. Pundits are declaring the unearthing of Higgs boson as the greatest scientific discovery since the sequencing of the human genome. Higgs’s gold medal may just come in the form of a Nobel Prize in Physics.
Source (The Financial Times)
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 Barclays 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.
Digesting the Anchovy Pizza Market
Source: Photobucket
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.
Source: Calafia Beach Pundit with Sidoxia comments
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
Source (The Financial Times): Bond purchases have exploded in the last three years.
Cash Hoarding
Source (Calafia Beach Pundit): Stuffing money under the mattress has accelerated in recent years as fear, uncertainty, and doubt have reigned supreme.
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.
Source: Calafia Beach Pundit
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.
Source: Calafia Beach Pundit
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.
Source: Calafia Beach Pundit
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.
Source: Yardeni.com
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.
Source: Calafia Beach Pundit
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.
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