February 27, 2010

Market Insights - 27 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Long Period Of Low Interest Rates
• Inflation vs. Deflation - The Ongoing Debate
• FDIC List 702 Problem Banks
• Some Notes on Diversification
• Email From A Colleague
• Week-end Reading 

Weekly Snapshot
• Real GDP in the US rose at an annual rate of 5.9% in the fourth quarter of 2009 (ESA)
• US existing home sales fell 7.2% to a seasonally adjusted annual rate of 5.05 million (AP)
• SEC voted 3-2 to curb short selling for securities that drop 10% in a single day (NY Times)
• A report on pay at Wall Street firms found that bonuses rose by 17% last year, to $20.3 billion (Economist)
• US Initial unemployment claims jumped to 496,000, the highest level since November (Bloomberg)
• US durable goods increased 3.0% from December '09 but excl. transportation they decreased 0.6% (ESA)
• Industrial new orders up by 0.8% in euro area (Eurostat)
• US new home sales in January-10 fell 11.2% from December-09 and were 6.1% below January-09 (ESA)
• Fed Chairman Bernanke told Congress that low interest rates are still needed to support the economy (AP)
• German GDP remained unchanged Q4 of '09 from previous when it expanded by 0.7% (Economy.com)
• 702 banks are on the FDIC list of  “Problem Banks”, an increase of 450 since 2008 (FDIC)
• US consumer confidence declined sharply from 56.5 in January to 46.0 in February (Conference Board)

Chart Of The Week
You may have heard that Wall Street bonuses paid to New York City securities industry employees rose by 17 percent to $20.3 billion in 2009.  In light of these numbers, public anger is understandable. 


At the same time, I have just read Warren Buffet’s Annual Letter to Shareholders which is full of insightful information and highly recommended!  With his usual sobering clarity, Mr. Buffett has these things to say about Wall Street’s CEOs and the largest financial institutions:

In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the  financial consequences for him and his board should be severe.

It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.

The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.

Weekly Barometers  (click on chart for larger image)

Stock2010-0226   FX2010-0226

Long Period Of Low Interest Rates  
In his opening statement of the Semiannual Monetary Policy Report to the Congress, Fed Chairman Ben Bernanke emphasized that he did not plan to begin raising interest rates anytime soon given that the economic recovery would likely slow down later this year when government stimulus is withdrawn as expected in the coming months. 

Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1-3/4 and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment.

The possibility of a deflationary threat has increased as indicated by the core inflation rate which fell by 0.1% in January, dropping for the first time in 28 years.  Assuming that economic growth remains subdued in the face of a challenging labor market and considering the possibility of further deleveraging in private and commercial real estate,  deflation could be a serious threat. 

Using an analogy by Paddy Hirsch, senior editor of Marketplace, the Fed stimulus in terms of interest rates looks like someone driving a car with the accelerator pedal almost pushed to the floor.  It does not appear that the Fed's ultra-low rate policy had much of an effect on the real economy so far and there is not much more the Fed can do to accelerate.  Is this Japan all over again?  Is this country prepared for a possibility that the S&P500 might be at or below 1,000 in 2010?


Click on image to view Mr. Bernanke’s opening statement.

Inflation vs. Deflation, The Ongoing Debate 
The heated debate over inflation/deflation continues. Depending on time frame and data points, the pendulum appears to be swinging back and forth between the two opposing camps which stand firm and passionately support their views.

The supporters of inflation point to the massive stimulus efforts by the Fed and other central banks which lowered interest rates to historically unseen levels and they used an array of easy money measures including quantitative easing to spur economic activity and growth. Such easy money policies should, in theory, lead to inflation somewhere down the road, so their argument.

The deflationist camp however argues that further deleveraging is necessary. Stubbornly high unemployment would lead to a demand crunch and a longer than expected housing slump would make any return to higher price levels unlikely. Some evidence of that was presented in the recent core CPI data showing the first, albeit miniscule, -0.1% drop since 1982. Mr. Bernanke, in his recent remarks before Congress, re-emphasized that extremely low interest rates would remain for an extended period of time given a potential slow-down of economic recovery later this year.

Let me try to put both camps in some disarray...

In terms of the inflationist view, one has to concede that ultra-low interest rates and easy money are typical text-book moves in spurring economic activity and the typically unavoidable inflation that comes with it. This time might be different however. Money and credit given to the banks has not found its way into the economy because it made more sense (and still does) for banks to park that cash taking advantage of the instant money making give-away i.e. borrowing at near 0% and buying Treasuries – easy returns for the banks at no risk. Given these hand-outs, why bother with much riskier consumer or commercial loans, particularly given the chance of further declines in asset prices. Looking at it from the supply side, so what if interest rates are at historic lows? On paper, one might get a 30 year fixed mortgage for 5% but banks aren’t lending, so strike that argument.  From the demand perspective, businesses and consumers are scared and they would much rather reduce their leverage and save in view of a difficult economic recovery or worse, a possible a double-dip recession.

Best evidence in terms of credit (=money) finding its way into the economy is seen in what economists call the (Money) Multiplier Effect.  The chart below indicates that despite the well publicized efforts by the Fed, the monetary base has fallen below 1.0 which means it has a negative multiplier effect i.e. it is contracting, quite the opposite of the results central bankers were hoping to achieve.


To the deflationists, I would point towards the increasing cost of healthcare, education and other necessities that put the prospects of lower prices into question. For instance, California health insurance giant Anthem Blue Cross scheduled rate hikes of up to 39% as reported by the LA Times. If you have children in schools or college, you know for a fact that there is no deflation whatsoever to be found in the cost of education. For many other countries unthinkable, US students can easily pay $40,000-$50,000 per year for the cost of a college education. In terms of deflationary trends in financing, have you read the fine print on your credit card agreements recently? Financing rates of 20% or higher are not exactly indicative of deflationary trends. Other price indicators like oil don’t appear to be heading back to below $40 a barrel prices anytime soon either.

The true inflation is probably best examined in terms of the “felt-inflation” which is of course a lot harder to measure because it’s different for everyone. One has to look at various scenarios and a possible scenario for a US person might look like this:

You have a secure (government) job, full benefits (i.e. benign healthcare costs), recently bought a house taking advantage of the low interest rates and the depressed housing prices, and you live in a nice neighborhood with a public school district still intact, then yes; recent and possibly near-to-medium-term outlook would indeed be deflationary.

However, if your income has been stagnant for the past 5 years (that is if you are lucky to still have a job), you bought your house 5 years ago with an adjustable rate mortgage, you do not have an employer sponsored healthcare plan and you send your children to a private school while paying for some essentials with credit cards, then deflation must feel as an unreachable as Nirvana.

Defining and measuring inflation is one thing. One could argue whether the baskets of goods measuring consumer and producer prices are adequate and whether one can trust the data and metrics. However, a more realistic measure, albeit more difficult to implement, would be a scenario based personal inflation barometer similar to the Cost of Living Index and using that as a determining factor for policy and investment decisions.

FDIC List 702 Problem Banks
Along the lines of why banks aren’t lending, the FDIC released the Quarterly Banking Profile for the 4th quarter of 2009 today. 702 banks are on the list of  “Problem Banks”, an increase of 450 since 2008.  Equally disturbing is the increase of failed institutions.  140 institutions failed in 2009 up from only 25 in 2008.
Should we be worried?  Elizabeth Warren, Chair of the Congressional Oversight Panel, believes so as she introduces the COP's February Report "Commercial Real Estate Losses and the Risk to Financial Stability."  She addresses a larger problem that may not be apparent from the FDIC report.  The risk to financial stability from the exposure of some 2900 banks with a “high concentration of commercial real estate loans”.  All banks on that list are smaller community banks which is a rather worrying development. If a large number of community banks were to fail, the impact on the small business community, the real back-bone of our economy, could be devastating.

The full report is available online at: http://cop.senate.gov/documents/cop-021110-report.pdf

Please consider this excellent video.

Some Notes on Diversification
In prior commentaries, we have discussed the concept of Correlation as an important element of the asset allocation process.  In simple terms, one should try to invest in asset classes which are showing a lesser degree of correlation in order to balance risk.  That said, correlation of assets changes over time and, as we saw during the financial crisis, different asset classes can achieve a high degree of correlation resulting in extreme difficulties to balance risk (see chart below as a reminder).


Since we discussed inflation earlier, reviewing the correlation of asset classes can help to determine if an inflation hedge is actually working.  For instance, when the US Dollar came under pressure in 2009, a good way to hedge against the possible dilution in value of the Dollar (i.e. an implied inflation) was to buy Stocks.  The US Dollar and the S&P500 moved almost as mirror images.


From a US perspective, other possible inflation hedges included Gold and so-called commodity currencies such as Australian or New Zealand Dollars.  To understand why the Australian Dollar is called a commodity currency, please review the chart below.  For a large part of 2009, Aussie Dollar and Gold moved in the same direction and charts is showing near parallel movements upward.


It is therefore important to assess current and future correlation of two asset classes so as to make sure one doesn’t necessarily “load up” too heavy on one side.  For instance, buying Gold and Australian Dollar at the same time might give an added return during times of high correlation.  But it also increases the risk by the same amount.  One needs to carefully balance these factors when establishing a portfolio and assess whether one is comfortable with the potential risk.  If you have a specific question about the correlation of two or more asset classes, please send us an email.

Email From A Colleague  
While discussing economic trends, a colleague sent me this neat check list in terms of assessing the prospects for a balanced budget. Referring to the ballooning US deficit, Eric Van Wetering noted:

From a strategic point of view the deficit is even more worrying because of the fact that it weakens the strength of the US position in the world. In the past the US has 'veered back' again (if that is correct English) but now there is more doubt about that ability (certainly long term).

• Obama has to help to reverse the economic trend in the US (need money).
• Has to bring people back to work (need money).
• Still has, apart from terrorism, 1 1/2 war on his mind (need money).
• Must make an effort to improve the health care system in the US (need money).
• Must make an effort to improve education in the US (need money).
• And has to bend back the strong deficit trend (will have much less money available).

Reminds me of FDR and the New Deal. The Great Depression ended for the US in real terms in about 1941-1942 when they were already boosted by massive European defense orders and started the massive ramp-up after Pearl Harbor. I sincerely hope we don 't 'need' a major war to get out of this one.

Week-end Reading
A bit lengthy but invigoratingly cynical, please consider this nice round-up of this seemingly never-ending story:  Wall Street's Bailout Hustle by MATT TAIBBI.

Have a wonderful week-end!

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