September 20, 2009

Market Insights - 20 September 2009

Dear Friends & Fellow Investors
Here is a new issue of market insights.
In case of questions, please email: .  Enjoy reading!
In This Week's Issue
▪   Weekly Snapshot
▪   Chart of the Week
   The Good Stuff
▪   Interesting Read
▪   Speaking of which...
▪   More on ETFs
   Currency Markets
▪   All that glitters is Gold
Weekly Snapshot
• Fed considers sweeping rules to regulate pay at banks (NY Times)
• Gold hit a new yearly high at $1,024 on Thursday, only $8 shy of all-time high (eSignal)
• The Federal Reserve reported that American households were $2 trillion in Q2 (Martketwatch)
• US Judge rejects $33 million deal settlement over Merrill Lynch Bonuses (NY Times)
• Euro area external trade surplus reaches 12.6 bn euro (Eurostat)
• US housing construction up 1.5%; surge in apartment building offset a decline in single-family activity (AP)
• US industrial production rose 0.8% in August, more than expected (Marketwatch)
• Bernanke said that the worst U.S. recession since the Great Depression was probably over (Reuters)
• US producer price inflation in August spiked 1.7% after dropping 0.9% in July (Bloomberg)
• US retail sales increased 2.7% in August. Consensus only expected an increase of 1.9% (
• European Commission: deficit-to-GDP ratio could be higher than the previous 6% estimate (Eurointelligence)
• Germany issued a $4bn bond denominated in US Dollars, only the second time in history (FT)
• European Central Bank nets €900m from crisis lending (FT)
Chart of the Week
Gold reached a new high for the year on Thursday, just shy of the all-time high of $1,032 from last year.  To get a sense of what $1,000 an ounce means, take a look at this historic chart going back to 1972.


The Good Stuff
We have been crying foul over the failings of CEOs, bankers, regulators and politicians for some time now.  But every now and then, someone in a position of power gets it right and shows that one can make a difference. Please consider: Judge Rejects Settlement Over Merrill Bonuses.
Not only did "Judge Rakoff refuse to approve a $33 million deal that would have settled a lawsuit filed by the Securities and Exchange Commission against the Bank of America".  He went one step further and "accused the S.E.C. of failing in its role as Wall Street’s top cop by going too easy on one of the biggest banks it regulates. And he accused executives of the Bank of America of failing to take responsibility for actions that blindsided its shareholders and the taxpayers who bailed out the bank at the height of the crisis."
Much applause to a man of courage who looked at this $33 million deal with a sense of realism in the context of the hundreds of billions of dollars that have been pumped into financial giants as part of the TARP program.  $33 million is a lot of money but it's really just small pocket change, the equivalent of a parking ticket, annoying but nothing more than a small inconvenience for one of these financial giants.  To put this amount into perspective, consider that John Thain, former CEO of Merrill Lynch, spent $1.2 million in corporate funds to renovate two conference rooms, and his office (for disclosure, he later on apologized and repaid the company). 
Throwing some more numbers around, John Thain also approved $5bn in accelerated bonus payments just days prior to closing the deal with Bank of America.   With all the trillions and billions that are floating around these days, we sometimes forget the significance of big numbers.  It helps to remember that $1 billion is 1,000 x $1 million  and  $33 million is only 0.66% of $5 billion...
By contrast, make a mistake on your tax return and you could easily see a penalty of 10% or more.  What if the SEC had asked for something in the order of 10% of $5 billion i.e. $500 million? That would have also been equivalent to more than half of the entire SEC budget for 2009 (see Market Insights 15 August 2009). One has to wonder whether regulators and officials really understand the significance of large numbers.  Judge Rakoff certainly did and once again, Kudos to someone who did the right thing.

Interesting Read
Please consider: Lawmakers' inside advantage to trading  (also available in Audio Format).
After last year's financial crisis, the question as to whether capitalism and free markets are still desirable or whether they are actually viable, continues. A growing number of Americans today feel that free market capitalism is dead, others fear that they are on an unstoppable path towards socialism.  Personally, I would argue that truly free markets never existed in the first place, at least not in recent history.  Free markets should be free, as the name suggests, but were they ever?  There may have been extended periods of time when markets were relatively untamed and a twisted form of capitalism reigned, most recently the years leading up the burst of the housing market. 
Although the proponents and critics of "free capitalism" couldn't be further apart these days, one major common ground should be a desire to have a "level playing field for everyone".  And one should think that insider trading would not be tolerated under any form of government or political regime but as the Marketplace article above uncovers...
"Insider trading is among the biggest of big-time no-no's. If you know something not everybody else does, you just aren't allowed to act on it. Corporate executives know there are laws against it. But there's nothing that says that lawmakers can't act on inside information they get just by doing their jobs."
Whether Americans will go down the path of socialism, revert to a pure capitalist society or whether the US will remain in its current hybrid form, we should heed the famous phrase from George Orwell's Animal Farm: "All animals are equal, but some are more equal than others".
Speaking of which...
The website devotes an entire section to the question of whether insider trading by congressional members should be allowed.  As their research suggests, political insight puts senators at an unfair advantage and they document their findings as follows:
US Senators' average annual stock performance beat the market average by approximately 12.3%, while stock purchases made by corporate insiders on average outperform the market by 7.4% and stock portfolios of the average US household underperform the market by 1.5%.
Assuming we can rely on this data, the returns of US senators puts them way ahead of some of the best fund managers.  On average, more than 70% of fund managers DO NOT outperform the market.   So how did they do it?  Pure genius or did they have some help along the way? 
Between 1993 and 1998, the S&P500 went from 435 to 1,229, an average annual return of about 30% which means US Senators returned over 42% on average.  Why can't the government hire these geniuses to run the Fed and the Treasury; the financial crisis may have been averted...

More on ETFs
Please consider: Complex ETFs hold up despite concerns
This recent article in the Financial Times highlights the same concerns we expressed for quite some time now: Certain ETFs, particularly the more complex ones, are confusing and may need additional disclosures. Better yet, they should not be offered to inexperienced retail investors. As we repeatedly pointed out, these ETFs only match the “daily returns”.  Although mathematically correct, this means the complex ones are not meant to be held long-term.
“The important thing for investors to understand is that leveraged and inverse ETFs reset on a daily basis,” says John Gannon, Finra senior vice-president for investor education. “If they hold them for longer than a day, they are unlikely to see the return they expected.”  He gave an example of a leveraged ETF that tracks the S&P 500. Some investors believe that if the S&P 500 is up 10 per cent for the year, the leveraged ETF will return 20 per cent. “That is not the case,” says Mr Gannon. “These funds only double the daily return.”
The article also highlights another significant issue.  Despite the fact that there is growing concern and a seemingly wider public awareness of the pitfalls of some ETFs, investor demand remains strong.
Of the 767 ETFs trading in the US, 127 are leveraged and/or inverse, according to Morningstar. The funds have seen nearly $9bn in flows this year on a net basis while daily trading volumes average “hundreds of millions of shares each day”, Mr Sapir says. “This tells us that the funds are viewed by many as a useful part of portfolios for certain investment strategies.”
Equally concerning is another aspect in the way these financial instruments are offered.  Dan O’Neill, Direxion Funds’ president and chief investment officer declared that  “the funds are sold properly as short-term, tactical products. We do all we can to convey that message.”
I thought, let’s put that to a test to see if we can find that "message".
Using an online trading account, I did two trades.  First, I placed an order to buy 100 shares of SPY, the ETF tracking the S&P500, which also happens to be the first ever ETF and still one of the least expensive ones in terms of its expense ratio.  This ETF is not leveraged and trades just like an ordinary share.

SPY Order
Next, I placed an order to buy 100 shares in DOG, the inverse ETF of the Dow Jones Industrial Index.  This ETF is tracking the inverse of the Dow and the fund is using futures and other derivatives to achieve the opposite of the returns of the Dow.

DOG Order

There is no difference in the way these orders were placed even though "SPY" is a traditional ETF that can be held long-term while "DOG" falls into the category of complex ETFs.  There are no other warnings or hints that would suggest this ETF would behave any different from a traditional ETF.  Declaring that investors should read the prospectus before investing is not enough in my opinion - financial institutions should be able to convey a simple message that "certain ETFs are short-term tactical products and that they may not be suitable for all investors".
How difficult can it be to put up additional warnings or better yet to prequalify investors the same way, one has to pre-qualify to trade stock options.  Financial institutions obviously want a piece of the pie in the huge revenue streams from any popular financial product.  It would only be natural for them to try everything they can do to sell these ETFs, the more the better. 
However, this highlights yet another regulatory failure.  Before setting up an ETF and selling it to the public, the funds have to go through a rigorous regulatory approval process, at least so it would seem.  Have the regulators not figured out that inverse and leveraged ETFs are inherently more risky and should therefore have additional disclaimers and higher hurdles in place? 
In the meantime however, buying shares as well as buying any kind of ETF is as easy as 123.  As the popular E*trade commercial suggests, a baby can do it…

Currency Markets

The US Dollar drifted lower during the week and touched 76.01 on Thursday, a new low for the year and just a hair above the technical support level of 75.89.  As the US Dollar showed continued weakness, several other major currencies approached new highs for the year.  Euro (1.4767), Swiss Franc (1.0276), Australian $ (0.8775),  New Zealand $ (0.7159), Singapore $ (1.4094) all reached their highest level against the US$ for 2009.


The US$ is currently approaching an important technical level where some profit taking could cause temporary retracements. Fundamentally however, there are several reasons why the US$ may come under continued pressure.   As I mentioned last week, the significant interest rate differential of some currencies (Aussie and New Zealand $) over the US$, is enticing investors to do carry trades.  Further, the fact that the US government continues to print money is making some investors and holders of US Debt increasingly nervous.  But the inquiring mind also considers another factor, a sort of eerie silence of Central Banks.  As FT correspondent Jennifer Hughes points out in her recent Short View, the silence of the Central Banks who are traditionally very outspoken when their own currencies appreciate above certain target rates, suggests that these Central Banks seem to be comfortable with the current US Dollar weakness.  Since neither the US nor other Central Banks have declared any target rates or plans for intervention in the currency markets recently, one has to wonder how far these Central Banks are willing to let US Dollar fall.  The famous line:  "The Dollar might be our currency but it is your problem" speaks volumes.
All that glitters...
Gold reached another yearly high at $1,024 on Thursday and is now dangerously close to the all-time high of $1,032 in March 2008.  Looking at the historic long-term "chart of the week" above we get a sense of the current price level in historic terms.  Outside of a brief episode in the late 70's and early 80's, Gold really did not move.  It drifted sideways for two decades.  Starting in 2002 it embarked on an unprecedented bull run topping $1,000 by now for the third time.  We looked at several pros and cons of further gold price increases last week, all of which are still valid today.  I would like to give some additional food for thought.

The chart above depicts the movement of Gold in relation to the US$ Index, as you can see it has been essentially a mirror image for the past 5 months.  Since Gold is priced in US Dollars, any decrease in the value of the US$ would make Gold less valuable in other currencies.  Hence to keep Gold at the same price level in other currency terms, Gold has to rise. 
On the other hand, Gold is now at a level that increasingly tempting to take some profits.  A recent Bloomberg article explained that the IMF Board approved the sale of 403.3 Metric Tons of Gold.  At current price levels, that sale would yield about $13 billion. It will be interesting to see how these sales affect the markets.
Good luck & good trading!


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