Posted by Don Martin on Tue, Jun 18, 2013 @ 03:41 PM
What are the implications of the Fed getting a new Chairman?
|
Obama may not renew Bernanke’s term when it expires January 31, 2014 according to today’s Wall Street Journal article. Bernanke is Federal Reserve Chairman who has been instrumental in the risky, experimental unprecedented Quantitative Easing program. If he is replaced it may be by a more aggressive Chairman who would try to increase QE.
Investors should look at what happened in Japan where the new Prime Minister aggressively increased QE six months ago and it hasn’t solved problems. The risk of getting a new, more aggressive Fed chairman is that the new leader might antagonize and energize the hawkish members of the Federal Reserve into trying to stop QE. At first the stock market bulls would be happy that a more aggressive new Chairman had stimulated the economy only to find that it didn’t work and that the Federal Reserve Board decided to trim back or end QE. The resulting shock from the news of the ending of QE will hurt the stock market, along with bonds, real estate, and commodities.
There are many anomalies occurring because of artificially low rates. Many tax shelters are facilitated by the use of artificially low interest rates. Things like a tax deductible contribution to a Defined Benefits Pension, a family loan using the Applicable Federal Rate to reduce Estate tax, or qualifying for Medi-cal to pay for nursing home expenses all benefit from using absurdly low rates to meet some type of test.
Insurance companies make less money and have to impose an inflationary fee hike because the yield on their bond portfolios has dropped. The lower yields that banks and insurance companies experience has hurt profitability and thus endangered the solvency of these institutions which may contribute to future problems where the government may have to bail them out.
I have written an article “Get ready for higher rates”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Jun 17, 2013 @ 06:56 PM
What does currency devaluation have in common with the end of Quantitative Easing?
|
When a nation’s government secretly plans to devalue its currency word leaks out and the government then needs to step up denials. As the market increasingly anticipates a devaluation the currency goes down and the government is forced to increase denials of the rumored devaluation.
Would this behavior be similar to the Federal Reserve’s planned exit from Quantitative Easing? Someday, somehow the Fed needs to end the Quantitative Easing (QE) program. When it does the absence of QE will drastically increase interest rates damaging the prices of bonds, stocks and real estate. The way for the Fed to handle this would be to deny it, because lack of Fed denials in the face of rumors would result in the “Invisible Hand” of the market doing the tightening (raising interest rates) on its own. Since Bernanke’s damaging Congressional testimony of May 22 which sent interest rates up, the Fed has realized it needs to make the market believe that somehow magically that “tapering” (reducing Quantitative Easing) will never happen. For Quantitative Easing to work the Fed must fool businesses into thinking that low interest rates will always be low so that businesses will think they should engage in reckless expansion of their businesses. Of course no one (except Flash Crash causing over-leveraged speculators) is dumb enough to believe rates will always be low and stable.
For Quantitative Easing to work its end must be done very carefully. Thus tapering (ending QE) is analogous to a government denying obviously true rumors of an impending devaluation. However, unlike a devaluation of currency, the end of QE will make the dollar go up as foreigners will seek higher interest rates here when rates are normalized, so they will buy dollars. Thus the currencies that will be devalued when QE ends are the currencies of other nations, while the dollar goes up. In this case it is the value of bond prices that will be “devalued” (as a metaphor) when the Fed raises rates. The “devaluation” will also impose its downward gravitational tug on all conventional types of assets such as stocks, real estate, and commodities.
Investors should reduce risk, reduce bond duration, reduce allocation to “BIG” (Below investment grade) credit quality and increase allocation to investment grade quality bonds. Junk bonds will be less attractive and thus go down when investors can get a decent yield from investment grade bonds.
I have written an article “Which is riskier for bonds duration or credit quality risk?”
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Jun 14, 2013 @ 04:33 PM
A counter-intuitive observation about bond market risk
|
The bond crash that started with Bernanke’s testimony May 22 really affected junk credit quality more than duration risk. (Duration risk refers the fact that long term bond prices go down more than short term bonds when rates rise). The reason is that even though junk has a reasonable chance of not defaulting investors have overpaid for it on a relative value sense so it needs to go down even if there is no recession threat that would increase default rates. For example a bond issued by Bolivia six months ago was issued at 104, a four point premium over par and is now at 94, 10% drop in six months (20% annualized). Investors were so eager to earn a high rate of interest from junk bonds that they threw caution to the wind.
The risk of junk bonds is that during good times they only experience a 3 to 5% default rate, but during bad times the default rate could be 13 to 17% with substantial loss of principal. The economy is improving and thus the risk of default is receding, however, if a good investment is purchased at too high of price then the price will come down even if nothing is wrong with the investment. Any investment can be a bad investment if the buyer paid too much for it.
The “fixed income” asset class that is the least discovered and thus best priced are bank loan participation funds. These have duration of 0.5, which is almost nothing, since their rates adjust quarterly. Of course the phrase fixed income is meaningless since the rate varies according to index changes.
The recent bond market crash that started May 22 with Bernanke’s testimony to Congress showed that poor credit quality is perceived by the market as a higher risk than duration risk. Based on logic, it should be the other way around because as the economy improves rates will go up, hurting long term bonds (which ahs big duration) and a rising economy will improve the credit quality of junk bonds. The problem is that investors have overpaid for junk in hopes of getting a high yield but have been more careful about overpaying for investment grade bonds with high duration risk. So even though duration risk is more threatening, because of the micro-bubble in junk bonds it is junk credit quality that is riskier than high duration.
The current investment climate with ultra-low carry trade funding rates means that greedy investors may be tempted to buy high yielding assets using margin loans and then protect themselves with tight, closely placed stop loss orders. Then the slightest downward price movement will trigger a wave of aggressive selling leading to a mini Flash Crash, like the one that happened this week in EM bonds. This is why investors need to avoid high risk assets that are “rented” instead of owned (meaning they want to own the asset for a very brief time) by short term speculators because these speculators will bolt and run at the drop of a hat causing big losses for more stable investors.
I have written an article “How much will bond market investors lose in the next crash?”
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 13, 2013 @ 04:43 PM
Fed to pushback against tapering rumors – don’t be fooled
|
The Federal Reserve may seek to push back against market opinions that rates will increase according to the Wall Street Journal. However in my opinion the bond market vigilantes are stirring from a 32 year long slumber and are waking up to the risk of long duration and the risk that the Fed will suddenly raise interest rates. I remember the rate increases in 1994 and 2003 when people thought the economy would never get better and rates seemed that they would be stuck at low levels forever.
The Fed doesn’t want to shock the economy by raising rates but the markets are anticipating that it will occur. When a country wants to devalue the currency the government always denies the leaks and rumors until it actually happens; by analogy when the Fed wants to end an era of Easy Money stimulus they need to fool investors into thinking nothing dramatic will happen and then they suddenly announce a surprise tightening. Ultimately the Fed can’t do any more dramatic “shock and awe” to impress the bond market with more bond buying. Each day that passes bond investors will get more nervous about duration risk (where long term bonds are hurt by rising rates) so the risk premium for these bonds will keep increasing to the point where Fed will have lost control of rates.
I don’t expect much inflation risk, especially since much of the Developed world, except the U.S., has a lot of recession risk, especially Southern Europe and Japan. However the market needs to discount the possibility that in a few years things will be back to normal so that means bonds with a duration over five years need to be discounted for a higher future interest rate. This interest rate increasing “discount” process is stronger than the Fed (since no one wants to get hurt by duration risk) and the more the Fed tries to fight it the worse things will get for the Fed.
For the Fed to induce investors into foolishly buying long term debt at low rates there needs to be a reward to offset the fear of risk. But there is no way for the Fed to create an imaginary reward so soon no one will be buying long term bonds at current prices. In the stock market an investor can fantasize that a stock is going to infinity and his greed will make him overlook risk and overpay for stocks, but no such mechanism exists in today’s bond market.
The 32 year era of the bond bull market is over, however, there will still be some minor interest rate dips when bad news for stocks are published.
Investors should reduce duration risk and avoid excessive credit quality risk. Probably all that will happen is that 10 year Treasury rate will go to 3.2% (per Dan Fuss) or 4.0% (per Jim O’Neill) in 2014, which is not the end of the world, as long as one keeps duration low. Non-financial corporations often have issued long term fixed rate bonds and have lots of cash in offshore subsidiaries so I don’t expect the P&L of non-financial corporations to be hurt by rising rates, except for homebuilders. However, this is mainly correct only for the healthiest large cap companies. The smaller, less healthy companies depend on bank loans for financing. These are indexed monthly so small companies will be hurt by rising rates.
I have written an article “Fed’s QE end in sight”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Jun 12, 2013 @ 09:54 PM
What are the implications of Japan’s Nikkei stock market crash? It crashed Thursday, June 13th (it is still Wednesday in the U.S.) by 6% and has gone down 20% in the past 21 days. Imagine how U.S. investors would feel if the SP index had dropped by 20% in the past three weeks. Japan has spent the last six months trying to stimulate the economy with a new, more aggressive use of Quantitative Easing by the Central Bank including an attempt to devalue the Yen. However the Yen recently went up against the dollar from about 103 to 94 in the past 21 days, which is a substantial move for a major nation’s currency.
What this means to investors is that bigger doses of Quantitative Easing carry increasingly greater amounts risk of failure and economic volatility. Thus in the U.S. the Federal Reserve may decide to end QE sooner rather than later. Since QE has greatly helped to inflate the U.S. stock market then the end of QE would be bearish for stocks and bonds and real estate.
The other lesson from Japan is that investors shouldn’t simply buy into a stock market with a low PE ratio. In addition to seeking low PE ratio prices an investor must also seek to buy quality investments, which means seek to buy well run businesses. Despite the high quality of Japanese goods unfortunately their corporate governance, accounting records, transparency and profitability ratios have all been poor compared to U.S. markets. So there is a reason why Japanese stocks are cheap and will stay cheap, so one should avoid buying them. Japanese companies, like companies in the Eurozone and in China are often run for the purpose of creating jobs and expanding GNP instead of for profits. Thus these nation’s companies are not stockholder friendly and are not reliable places to invest.
As the world’s investors tire of the pitfalls of investing in foreign companies that are not designed to make profits then more capital will flee to the U.S., making the dollar go up.
I wrote an article “Are Japanese stocks the best investment?”
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Jun 11, 2013 @ 03:34 PM
Are corporate profit margins going to stay permanently high?
|
An excellent article in FT.com today by Gavyn Davies discussed why corporate profit margins have risen for legitimate and sustainable reasons. Bearish analysts have claimed that profit margins are mean reverting and will go down so that means stocks need to go down. However Mr. Davis glossed over a very important fact when he said that the equity risk premium will shrink as interest rates rise so that the coming era of higher interest rates won’t hurt stock prices. I think this is wrong. Stock values are based on using a blend of the risk free Treasury interest rate and the equity risk premium to discount future earnings streams. Unfortunately the equity risk premium (ERP) is very erratic and unpredictable. At times it has even been negative! There is no guarantee that as the economy improves and interest rates rise that the ERP will magically go down just enough to offset the rise in interest rates.
Mr. Davis says that labor’s share of a corporation’s expenses has declined over 30 years leading to larger, sustainable profit margins. But this is because of jobs that moved to China. Now Chinese wages are going up very fast and there is no alternative to accepting those cost increases. So the Chinese induced deflation or disinflation (in terms of goods imported into the West) of the past 20 years is now a bygone era and from now on rising Chinese wages will eat into Western corporate profits. When I was in China last month I was stunned by the high cost of goods. I paid $11 for a thimble sized cup of coffee in Guangdong – surely that “sale” is unsustainable as I have no intention of repeating that.
Corporations hate to lose sales and thus may be willing to avoid passing on wage increases to consumers, so I expect a mean reversion of corporate profits to finally occur. There was a 30 year period of de-unionizing in the West and use of cheap Chinese labor that reduced labor’s share of the pie. However, all the ore has been mined out of that low cost mine, so it is time for profit margins to mean revert. There are no workers remaining in the U.S. private sector to de-unionize or Walmartize into low wage jobs. Large companies’ profits are usually 6% of sales but in recent years went to 9% and even to 11%.
The best guess about stocks is to use the ten year inflation adjusted Price-Earnings ratio (PE10), which is now at 24. A normal level is 16, which implies the market price of the SP needs to drop from 1600 to roughly 1000 to reach equilibrium. Even if today’s higher profit margins are logical and unimpeachable as per Mr. Davies the problem in my opinion is that the PE ratio is too high.
The investors’ best defense against being fooled is to use a long term average of income rather than use contemporaneous data such as current earnings which could have been warped by a temporary unsustainable trend. The SP500 companies are so big they rarely can grow much faster than the economy, so using the ten year income average for them is an excellent way to use lots of data so as to avoid the error of using only a small amount of data.
The Fed’s Quantitative Easing program has made stocks too high as part of a deliberate effort by the Fed to induce a “Wealth Effect” to induce more consumption of goods. No amount of assurances by an economist that corporate profits are stable and legitimate can override the dominant fact that the PE ratio is simply too high.
I have written an article “Equity risk premium’s role in stock selection”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Jun 10, 2013 @ 05:41 PM
Improving Labor Market May Fool Investors
|
The labor market is improving which may provoke naïve investors into thinking that the prospects for stocks will get better, but this is incorrect. Labor usually improves late in the economic cycle. Stocks often anticipate an improving economy and go up before the economy improves. So the benefits from a rising labor market have already been reflected in stocks increase in the past. Instead what will happen is that a rising labor market will reduce corporate profitability, putting downward pressure on stocks. A rising labor market may contribute to inflation, thus provoking the Federal Reserve to shut off the Quantitative Easing Easy Money spigot which was responsible for much of stocks increase in recent years. This would increase interest rates, hurting long term bonds. Ironically an improving labor market would be bearish for stocks.
If the inflationary era of the 1970’s somehow repeats then labor will get stronger, profits will be a smaller percentage of sales, and interest rates will rise. During the 1970’s stocks didn’t keep up with inflation, despite the stereotype that they can simply act as a “pass through” entity that passes inflation through to the consumer. During the 1970’s cash and short term bonds were the best performing assets, even though it was an inflationary era.
There are huge fundamental differences between the 1970’s and today. In the 1970’s the Keynesian inflation creation mechanisms established in the 1930’s had never been turned off. Today these don’t exist and there are well established globalization tools that business use to evade the power of unions and workers. Much of the world is run by countries that have covered up their problems with false stimulus and these countries could easily revert back to near-deflationary scares. Examples are the Eurozone, Japan, possibly China. Practically the only solid, honest growth story in a major region or country is the U.S. So if much of the rest of the rest of the world experiences surprise moderate economic shocks this will help to offset the risk of U.S. based inflation.
Ultimately inflation is caused by someone getting a bank loan and spending the proceeds, (presumably on non-productive consumption), provided the loan funds came from an increase in the money supply and not simply a saver handing over his savings to a spender in return for a promissory note. The job growth I expect at McDonald’s, etc. will not pay enough for new workers do much inflationary damage since one has to have sufficient income to qualify for a loan to get a loan. The highly paid skilled workers are already at full employment and they have not created inflation. Future job growth will be that which serves low paid entry level applicants, and these people can’t contribute much towards creating inflation, especially if many are already consuming goods paid for with a welfare check.
The pattern I see is for stocks to go up but in an increasingly blatantly dishonest bubble-like way. This makes it very important not to be brainwashed by the public’s incorrect admiration of stocks. When a “blowoff” phase occurs that is when naïve investors buy stocks at bubble top prices. Long term bonds are not the refuge that they used to be, so one needs to consider alternative strategies.
I have written an article “Improving employment rate to hurt investments.”
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Jun 07, 2013 @ 07:33 PM
Today’s unemployment data released by the BLS (the monthly employment report) showed that jobs increased by 175,000 which is consistent with the average monthly gain in the past three years.
The 10 year Treasury market yields rose to 2.16% to match the previous two year high that occurred a week ago. Yields closed near the high of the day. Often when the monthly employment report shows lots of new jobs the yield goes up significantly in the start of the trading day and then declines to the middle of the day’s trading range. So this rate increase looks more threatening than the typical increase that occurs during the monthly release of BLS employment data.
The bond market is gradually moving from a bull market to one where interest rates are gradually forming a bottom through fits and starts after a 32 year downtrend. Investing in long term bonds is becoming increasing more the domain of short term traders making a temporary trade rather than long term investors making a long term investment.
As long as the Federal Reserve is determined to keep rates low to create more jobs then Treasuries will be stuck in their current trading range. Eventually the members of the Fed will suddenly wake up and realize that QE is dangerous, ineffective and can’t help the hard core unemployed as much as fiscal policy can.
Many of the hard core unemployed want to stay that way so they can enjoy either being on the welfare dole or living with their parents. They want to avoid getting hired since they would only be able to find unappealing jobs. Thus no amount of Easy Money from the Fed will get these people a job.
The best way to help hard core unemployed is to channel all of their government benefits into a “paycheck” that is delivered to them upon performance of some type of worth ethic building make-work duties. When confronted with the requirement to pay taxes on benefits and to work to get benefits they may decide to go out and look for job instead.
News stories that the Fed will begin to reduce the rate at which it purchases bonds (so called tapering) say that it could happen in June. Well now it is June and it will soon be time a Fed meeting. The cliché “Sell in May and go away” is based on traditional June declines in stock prices. If the Fed stops buying bonds rates will rise, thus hurting stocks.
The Fed is afraid to raise rates but one day they will feel the cold hand of fear tap ping them gently on the shoulder in terms of becoming afraid of all the risks of problems with QE such as making insurance companies raise prices because their bond yields are too low, encouraging investors to take on risky speculation in mortgage REIT’s and oil MLP’s, etc., and making pensioners go back to work.
I have written an article “Fed’s QEi is a once in forty years event”. This makes it very hard for economists to predict what the Fed will do next.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Jun 06, 2013 @ 11:08 AM
Tomorrow’s unemployment data may not contain big surprises for Treasuries
|
Tomorrow the monthly employment report will be released by the BLS. The consensus estimate is 167,000 new jobs. After adjusting for a population increase of 125,000 that is a net increase in real terms of 42,000 in a labor force of 130million. This is an annualized rate of improvement of 0.4%. If these estimates are correct then the Treasury bond prices will not change much tomorrow.
Eventually over the next half year or so the unemployment rate will come down from the current 7.5% to the Fed’s target of 6.5% which would then trigger a Fed “tapering” of bond purchases and an end to the QE program.
Employment is a lagging indicator. Often workers are the last to recover from a recession, so reaching a full employment target doesn’t mean that corporate profits would continue to increase. Stock prices are influenced by corporate profits and interest rates. When the Fed shifts policy to raising rates that will hurt stocks because artificially low interest rates have acted as a lever to lift stock and real prices. Also the massive liquidity supplied by the Fed to stimulate the economy has contributed to rising stocks prices over the past 20 years. Once the Fed reduces this liquidity then stocks will lose an important support, thus leading to downward pressure on stocks.
Stocks are already too high and will come down even if the Fed doesn’t raise rates. There is nothing for the world to get bullish about and there are plenty of bubbles ready to burst which would create downward pressure on stock prices. China and other EM countries, commodity exporting countries and the commodity boom they created and benefited from are in need of a cooling off period and restructuring to a consumer based economy instead of a capital intensive economy. U.S. mortgage REIT’s, energy MLP’s, etc. also need to cool down from excessive levels of artificially high distributions and profits. When stocks, REIT’s, and MLP share prices come down then people will flee into bonds and bond rates will go back down to the 1.7% area for the ten year Treasury. The ten year Treasury now yields 2.08%.
People worry that an improving economy with more jobs will lead to inflation, which would damage bonds. I have written an article “Lower unemployment to result in inflation?”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Jun 05, 2013 @ 01:18 PM
QE risks of a fatal error could affect stocks
|
The risks of unlimited, unending Quantitative Easing are greater than assumed. The Federal Reserve may be tempted to think that all that matters in risk mitigation is to be able to stop inflation caused by QE by simply raising interest rates high enough to shut down the economy. So the Fed assumes it has future QE risks under control. The problem is not simply the risk of inflation, rather the real problem with QE is that it creates market distortions which will result in “innocent”, naïve investors getting hurt as they try to play the carry trade in an attempt to earn a reasonable yield. Remember when Orange County experienced losses during the 1994 bond market rout?
The fundamental problem with QE is that it is a radical, untested, and therefore unknown and potentially unmanageably technique. It is like a mountain climber going up very high where no one has ever gone before. The risk is great that the climber who ascends by facing into the wall (to avoid looking down) may eventually look down and get scarred of just how high he is and how risky his situation is. Then he may panic and come down suddenly, possibly making a fatal mistake.
When interest rates return to normal then lots of carry trade programs will be shut down causing losses for some investors. Some of these programs could be embedded inside of major corporations and government agencies looking to earn extra money by playing interest arbitrage. They borrow at rates of less than 1% and lend at 3% and lever it up several times during the current market. However, when rates return to normal these arbitrageurs may find their assets default or go down in value and their carrying costs exceed the portfolio’s yield. If they are leveraged five times then a 10 to 20% portfolio asset loss could result in a 50 to 100% loss of equity. Lehman was leveraged 30 times.
The expectation of QE is that the “wealth affect” will make consumers buy more things. But for every affluent consumer who made some money in stocks there may be another consumer who suffered a severe drop in interest income. Thus the wealth affect is minimal. QE incurs the hidden risk of a future economic blowup which will do worse damage than the alleged benefits of the wealth affect. The recent bond market rate increase in the week of May 28-30 was the worst in two years. It hurt the high yield alternatives to bonds more than it hurt bonds. My concern is that naïve retail investors may seek yield by buying high risk junk bonds, oil MLP’s, mortgage REIT’s and when the truth comes out these assets will have only panicked sellers and no buyers leading to “Flash Crash” price drops. But unlike a Flash Crash, when these drop in price and cut their dividends after QE ends they won’t recover.
Another problem with QE is that it is supposed to motive allegedly wimpy overcautious savers (who are actually brave enough to withstand Wall Street bubble propaganda and instead keep their funds in bonds and CD’s) to switch to investing in equities. An analogy would be if the government closed down Social Security for a few years and told the beneficiaries to earn money by starting a small business. The problem is that if everyone starts a small business at the same time there won’t be enough demand for the goods and services produced and the business may lose money. So an attempt to nudge savers into equity ownership won’t create sustainable jobs because there has to be demand for the services of the corporations. If I buy a share of stock in GM that doesn’t mean a car buyer will decide to buy a car and that the company will then hire a worker. All QE does is encourage more aggressive, overleveraged forms of speculation in non-productive things like mortgage REIT’s rather than encourage funds to be put into new businesses that may create jobs. Today the Barclays Aggregate bond index yields 1.75% if bought in the form of an ETF. Several years ago the yield was around 6%, which is a decline of 71%. The opportunity loss incurred by savers has resulted in some people over age 55 returning to the work force thus making it harder for young workers to find a job, thus defeating the forecasted benefits of QE to reduce unemployment.
When there is a Flash Crash caused by QE’s end that will hurt traditional high quality non-speculative stocks, as they are moderately overpriced and should only be bought at good, low prices.
I have written an article “Fed’s QE end in sight”.
Investors should seek independent financial advice.