After careful research and examination, I am excited to announce that as of Monday April 8th, I have joined Covenant Asset Management as a Senior Portfolio Manager and Principal.  I will be bringing the same commitment, dedication and discipline that I showed for the past thirteen years at AEPG Wealth Strategies to my new position at Covenant.

 

I will be working closely with President John Guarino and his exceptionally talented team to further develop their already extensive client base and investment capabilities.  Covenant is an excellent company with exceptional asset management capabilities and a long history of delivering superior wealth management services to affluent individuals, businesses, and non-profit organizations.  More information is available on the company website LINK

I welcome any questions you may have about this unique company. 

 

As I settle in, I will be working out the possibilities of continuing this blog and/or expanding Covenant's social media presence.  Until then posts will be infrequent.  Thank you all for reading. 

It Finally Happenned

It took until the final day of the quarter, but the S&P 500 put in a new all time high closing at 1,569 on March 28th. 



Source: StockCharts



It has taken a while for the S&P 500 to reach these levels again.  This chart from JPMorgan should help put things in perspective.

When the S&P 500 first reached these levels thirteen years ago, it was trading at a forward P/E of 25.6 and competing with a ten year Treasury yield of 6.2%.  Now, the forward P/E is 13.8 and the ten year yield is 1.9%.  So as we have worked through the excesses of the tech, real estate and finance bubbles, overall corporate earnings have continued to grow.  This has made valuations more reasonable and therefore stocks relatively less risky.  At the same time, yields have come down lessening their attractiveness.  With the Fed committed to its current low interest rate policies (think liquidity wave) until unemployment reaches 6.5%, there is no reason to think this relative attractiveness should change any time soon (baring some geopolitical black swan). 

Since making new highs, the S&P500 has since pulled back a little.   While a weaker than expected gain in jobs from the ADP report today was the reason cited for the pullback, a consolidation after reaching new highs is not too surprising.  In addition, investors are anticipating announcements from the Bank of Japan and the European Central Bank Thursday and US employment data on Friday morning.   All potentially market moving events. 

While forecasts of EPS growth have been shrinking, the forward P/E of under 14 does not scream overvalued.  On a positive note, Markit and JPMorgan announced that the JP Morgan Global PMI increased to 51.2 for March from 50.9.

Source Markit JPMorgan

 

Given its large international exposure, the S&P 500 is highly correlated to global growth.  The increase in global PMI is a good sign for better earnings in the future.  While Europe remained a drag, the US continued its growth, the rate of expansion accelerated in China and Japan saw the first growth in ten months. 

Source: StockCharts

While Japanese manufacturing might have seen growth in March, the Nikkei has been consolidating after a large run up since mid November.  Some of this is a function of a short term strengthening of the yen due to increased tensions with North Korea.  In any case, a weaker yen is critical for an export led economy such as Japan's.

New Central Bank Governor Haruhiko Kuroda will lead his first meeting on Thursday.  With the Nikkei approaching its 50 Day moving average the markets will be watching closely for signs of continued commitment from the BOJ to bringing the yen down and bringing inflation up.  A perceived lack of commitment would probably be seen as a time to take profits in the Japanese markets.

Meanwhile in Europe, the resolution of the Cyprus banking crisis, has led to continued talk of contagion by pundits.  So far calm seems to be prevailing as both Italian (4.62%) and Spanish (4.94%) ten year yields closed below five percent.  The pressure seems to be releasing through the decline in the Euro (and drops in the Italian and Spanish stock markets). 

The ECB meeting tomorrow may help shed some light on the situation.

CFAI Investment Research Challenge New York Regional Winners

Outside of writing this blog one of my activities is volunteering at the New York Society of Security Analysts (NYSSA) currently as the Vice Chairman.  NYSSA is one of the founding societies of what later became the CFA Institute and has approximately 9,000 members.  It is committed to the promotion of best practices and the highest professional and ethical standards in the investment industry.

 

Eleven years ago NYSSA introduced the Investment Research Challenge as a way to promote best practices among the next generation of analysts.  Since then it has grown into a global competition organized by the CFA Institute.  The CFAI Research Challenge is an annual educational program where leading investment professionals teach business and finance students how to research and report on a publicly traded company. 

 

Today I have the honor of being with the team from Fordham University, the winners of the New York Regional Final at the Nasdaq market site for the closing bell.  Ken Boswell, Paul Kearney, Jonathan LaSala and Elaine Lou did an exceptional job researching, reporting and presenting on Microsoft with the guidance of their faculty advisor Roberst Fuest and mentor Michael Kiernan.  All of their hard work, effort and sacrifice these past few months is extremely impressive.  Congratulations and good luck to them at the Global Finals in London in April!

Cyprus??

So a crisis in another small country threatens to take down Europe.  This time auditioning for the role of Serbia,  host country for the assassination of Archduke Ferdinand in 1914, will be Cyprus.  That's Cyprus in the highlighted box in the lower right below Turkey.   Cyprus has a bit over 1 million people and a GDP of $23.5 billion making it a bit smaller than Mozambique, but bigger than Burkina Faso and less than one tenth that of Greece.  However, by dint of being a part of the Eurozone it is certainly punching above its weight in the global economy.

 

Source: CIA World Factbook

News broke over the weekend that for the first time as part of a Eurozone bailout, depositor funds would take a hit through a so called 'bail in' (George Orwell would be proud).  Deposits under the €100,000 guarantee amount would pay a 6.75% tax and those over a 9.99% tax.  Although depositors would get equity in the bank as compensation.  (Links to several posts on the topic are at the bottom)

 

You may ask why would those in charge call all of the deposit insurance programs in the Eurozone into question by having those covered pay?  Well, Cyprus is known as an offshore banking sector with a reputation for laundering money, particularly for the Russian mafia.  As of January 2013, €20 billion of Cyprus' €68 billion in deposits were from the rest of the world, believed to be primarily from Russia. You would think those offshore accounts would be the ones to take the hit.  A German politician's remarks about burning "Russian black money" point in that direction.  So then why hit the locals and little guys?  The financial sector is huge in Cyprus and by not having outside depositors take the full brunt of the pain it appears someone would like to keep the possibility of this business alive at some point in the future.  However, even if that is the case, I am not sure how losing €2 billion will go over in Mother Russia, especially if it is money being laundered.  The Russian mafia does not have a gentle forgiving reputation. 

 

In any case, putting aside the obvious pain being suffered by smaller depositors, the big risk, as it was with Greece, is contagion.  That this idea of covered depositors paying part of the price in a bank bailout, sorry bail in, spreads to other peripheral countries.  Will depositors in Spain or Italy decide they better get their euros out while they still get them at full value?  Or will they be assuaged by the Eurocrats, that Cyprus is a one off case.  We will need to keep track.

 

 

Don't Get Too Excited About Cyprus - Humble Student of the Markets

Report From Paris - David Kotok on The Big Picture

The Cyprus File - Why it Matters Even to Americans - The Big Picture

The War on Common Sense Continues - Tim Duy's Fed Watch

Still Risk On

Risky assets have been on the move lately.  This can be seen in multiple asset classes.  The first sign that we are in a Risk On environment is the widening of spreads on US Treasury Debt versus other governments' debt.  US Treasuries are considered by many the ultimate safe haven and so tend to enjoy a premium when investors are worried.  The premium shrinks or disappears when the worries go away.  

Source: Wall Street Journal

The second sign is the S&P 500 Index's relentless move towards new highs.  The last high was 1,565 in 2007.  We are less than one percent away.



Source: StockCharts.com

With earning's growth expected to be minimal, this has brought up Price Earnings ratio, but not to exorbitant levels. 

Source: Dr. Ed's Blog

On the economic front, while the 'fiscal cliff' and 'sequester' would appear to have taken away much of our margin for error on the growth front, there are positive signs coming from the private sector.  Construction employment, which tends to pay well, is coming back, along with the housing market.  And both would appear to be still early in the game.

On a more global and esoteric note, South Korean exports, which tend to be a leading indicator of global exports, are growing.  This is despite the increased geopolitical tensions on the Korean Peninsula.  North Korea recently cancelled the Korean War ceasefire and cut off the hotline to South Korea.

Source: Humble Student of the Markets

Other signs of healing include Ireland's first successful ten year debt auction since 2010, Spanish and Italian ten year yields both nicely under 5%, and yields on 'junk' bonds hitting a record low of 5.56%.  Overall, investors seem to be taking a positive view of things.  With things relatively calm on the investment front, I would urge you to make sure you know what your goals are for your investments, what the time frames for those goals are and have a plan in place and know what you will do given different scenarios.  It is much easier and better to do this without the influence of sharp emotions and media hype.

In Japan meanwhile, the Nikkei continues to move up.

Source:StockCharts.com

With the Yen moving down at the same time, the currency affect needs to be hedged out.  While it does not track the Nikkei, the Wisdom Tree Japan Hedged Equity Fund (DXJ)* does hedge out the currency risk and has been a good way to play this rise. 

 

Source: StockCharts.com

While DXJ has moved up significantly since the middle of November, the valuations are just reaching the average for the last five years:

Source:ETF Research Center

Source:ETF Research Center

 

While the speed and size of the move would indicate caution, the valuations would indicate, that there is still more room to go before we get into overvalued territory.  That DXJ has increased  almost 40% in approximately 4 months and has only now reached its average valuations for the last five years, gives an indication of how far sold it was.  Currently, allof this has been based on the election results, statements, intentions and the nominee for Bank of Japan Governor.  We have not seen much hard action.  The situation needs to be watched carefully for continued follow through and success on the part of the Japanese authorities and economy.

*Disclosure: I own DXJ and some vertical call spreads on DXJ in my accounts.

What's Your Investment Time Frame?

Two good posts on investment time frames in the last two days.  Barry Ritholtz of The Big Picture started it off with "Why Time Frames Matter to You" and Roger Nusbaum of Random Roger expanded on it with "Time (Frame) Management".  In my opinion, the key points to take away are:  decide what the right time frame is for you, concentrate on what affects your investments over that time frame and pay attention to them. 

 

It is very easy in today's age of instant messaging, 24/7 media and twitter to get caught up in the idea that every little piece of information matters.  Not necessarily.  If you are a short term trader it may matter, while if you are a long term investor it probably doesn't, unless it is a big change or is the confirmation of a change to your underlying reason to buy.  What this constant barrage of data does do is give an advantage to the long term investor that can sift through the noise and take what opportunities the market gives them.  Individual stocks, sectors, or asset classes knocked down based on a single unconfirmed data point, can give you a nice entry point, provided you have done your homework and are paying attention.  Or if you don't have time to pay that close attention, then it can provide a nice entry point for your advisor. 

Some Thoughts on Picking an Advisor

Now that even  Jack Brennan, chairman emeritus of low cost do it yourself king Vanguard Funds, has come out saying most people need an advisor, you know something has changed.  When picking an advisor, there are many good sources for the standard questions to ask, including the SEC website.  But after spending almost twenty years as an advisor and learning alot about the industry, I thought I would mention some of the things I think you should look for when picking an advisor. 

The first item I would review is whether the advisor is a broker or a Registered Investment Advisor (RIA). There used to be two main distinctions between them, but some of that is blurring.  The first big difference is in the level of responsibility.  Traditionally, a broker only needed to determine that an investment was suitable for the client before recommending it.  An RIA however, is held to a higher fiduciary standard to act in the client’s best interest.  So while a large cap mutual fund may be suitable for a client, if it is the fifteenth one they would own, it would not be in their best interest.  The second big difference was in how they were paid.  Brokers would be paid for completing a transaction, while RIA’s would be paid a percentage of the assets they managed for you.  Therefore, brokers worked in a system where they were paid for selling to clients and had a lower level of responsibility.   RIA’s, meanwhile, were paid on how big the pile of assets was.  They were, therefore, incentivised to grow that pile.  Now large brokers can offer a full spectrum of services ranging from suitability to fiduciary responsibility.  They can also charge in different ways, from straight commissions to a percent of the assets they manage.  The lines have blurred alot and further rulings on fiduciary standards may further muddy the waters.  If you decide to go with a broker, I would just make sure you know which hat (broker or fiduciary) they are wearing.

If you plan to choose the investments and only want someone to bounce ideas off and execute transactions, then a broker may be a better fit.  If you are looking for someone to take control and manage your portfolio for you based on agreed upon goals, then an RIA may be better.

Once you have that straightened out, then I would put a list together of potential advisors to consider.  Depending upon what you are looking for, you can search on the Internet.  It can get overwhelming.  Therefore, I would also ask friends for recommendations.  Once you have a list put together, go to the Securities and Exchange website for some basic information and questions to ask.  It is a good source of information.   To get a copy of an RIA’s Form ADV (their ‘official’ brochure) go here.  To check on brokers go here.

Once you have this information and ruled out the obvious bad matches, consider these points:

·         Philosophical fit – Do they look at investing the same way you do?  Are you comfortable with how they say they manage money?  If you are looking for high returns and the advisor is talking about conservative asset allocation and wealth preservation, then you are probably not a good match.  No matter how good the advisor, not being on the same page will just lead to frustration, bad decisions and losses.  Just because they are a good fit for your friend or brother-in-law, does not mean they are a good fit for you.  In addition, do not count on most advisors turning you away if you are not a good fit.  Many will take you on no matter the fit.  Some in the hopes of changing you to be the client they want.   Like a romantic involvement where one partner wants to change the other, this does not end well either. 

·         Do they know what they are talking about?  Like most professions, investing has its own set of acronyms and jargon.  This makes it easier for sales-types to impress the uninitiated by spouting the latest jargon and buzzwords without really understanding them.  Ask them what the terms mean in plain English.  Then ask how that applies to your portfolio.  Then check out the answer when you get home.  If they cannot explain it in plain English, that is a potential warning sign that they do not really understand it.  If it does not match what you research later, you can ask for clarification, but be ready to move on.  After you have met with a few advisors, you can compare the answers to get an even deeper understanding and weed them out faster.

·         Another thing to do is to check their credentials.  Many are easy to get and not that helpful.  Go for quality, not quantity.  The ones that stand out are:

o   CFA – The Chartered Financial Analyst designation is the global old standard for investing.  You want to see that the person with final decision-making authority over your investments has this.  From the CFA Institute website:

“Earning the charter requires demonstrating four years of professional investment experience, committing to uphold a comprehensive code of ethics, and passing three levels of rigorous exams that test an advanced curriculum of investment management and analysis skills. This achievement takes multiple years of persistent effort and hundreds of hours of study per exam level.” 

*Full disclosure, I am a CFA holder since 1998 and on the Board of one of the founding societies of what later became the CFA Institute. 

o   CFP – Many consider the Certified Financial Planner designation the standard for financial planning in the United States.  There are significant requirements to earn the designation, including a BS degree, three years experience, demonstrated theoretical and practical knowledge of planning and passing a comprehensive examination. 

 

·         For further peace of mind, make sure that the advisor has no more than a limited power of attorney over your funds (so they can buy and sell investments and pull their fee, but not transfer out funds) and you get independent statements from the custodian (or can check on custodian’s website).

·         Also, once you have decided on an advisor, make sure they will create an Investment Policy Statement for your portfolio.  This should lay out what the objectives are and how the advisor plans to go about achieving them.

So to sum it up, you should determine what you want from an advisor, get recommendations, interview a bunch of them to find out if they are a good match and know what they are talking about, and get a written plan of how the money is going to be managed and to what goal.  Simple.

That was quick!

Well that was certainly a quick correction!  Score one for the Fed and its liquidity wave.  Less than a 3% drop in the S&P 500 was all it took and the buyers came in and have taken us to within 2.5% of the all time highs. 

Source: StockCharts.com

Meanwhile, the narrower, but better known Dow Jones Industrial Average has broken out to new highs this morning.  The media is all over it.  Even the relatively staid Wall Street Journal is in on the act with this little feature in the middle of its online page:

Source: Wall Street Journal 3/5/13

The Dow's breakout to new highs will undoubtedly attract a lot of attention from both the financial and mainstream media.  Given the relentless drumbeat of negative economic news in the media, this may come as quite the shock to many people.  It becomes clearer, when you remember that the main driver of media is to sell either ads or subscriptions.  Hype, outrageousness and promotion are all part of the playbook to get your attention and sell ads.  A good summary is posted on the site Abnormal Returns.  Keep this in mind as the media hypes the new highs theme. 

 

In the meantime, as has been noted here and elsewhere, the negative factors affecting the global economy keep piling up (fiscal cliff deal, sequester, gas prices, Italian elections, etc.).  Adding to that list, the Shanghai Composite broke through its 50 day moving average.  This is important for two reasons.  First is that over the last few years, the Shanghai Composite has been somewhat of a leading indicator.  Second, it comes in response to China's renewed attempts at cooling its property market.  Anything slowing down one of the few engines of world growth is not a positive.

Source: Bespoke Investment Group

Keep all of this in mind as the you watch the market the next few days.  It will be extremely tempting to change your plan or add more risk to your portfolio than intended.  In many ways it is natural to get caught up in all of the excitement.  The key however, is to stick to whatever long term plan you made in more peaceful times.  Remember, purely emotional decision making is the enemy of good investing.  In the meantime, stick to the plan, hang ten and enjoy the ride!

Garrett McNamara riding an approximate 100 foot wave.

Source: Guardian

 

A Different Debt Bomb?

In its Quarterly Report on Household Debt and Credit, the New York Federal Reserve noted that outstanding consumer debt increased slightly, breaking the downtrend in place from the peak in 2008. 

Understandably so, most focused on the mortgage market. The foreclosure pipeline, so crucial to a revitalized housing market, although still large and far above 2006 levels has continued to shrink.  While there is still a long way to go, this measure continues to head in the right direction.

Away from mortgage debt however, there is one portion of debt that never saw a decline and continues to grow:  Student Loans.

While still dwarfed by the over $8 trillion of mortgage debt, student loans, at nearly $1 trillion, now constitute the second largest balance of household debt.  Given the historical value assigned to a college education, and higher compensation associated with it, this would not be quite so worrisome were it not for the change in the delinquency rate over the same time frame.

Approximately 35% of those borrowers under the age of 30 and in the process of repayment are over 90 days delinquent.  This is up significantly from the low 20% range just 8 years ago.  With the large increase in the unemployment rate among 20 - 24 year olds from 7.2% to a peak of 17.2%  during the Great Recession and currently at 14.2%, the delinquency rate may not be improving anytime soon.

Source: Bureau of Labor Statistics

Also, keep in mind that unlike most other debt, student loans are generally not disposable in bankruptcy court. That debt will therefore be a drag on the household formation and spending patterns of this generation for a long time.  Something to keep in mind when looking at stocks that would normally benefit from those trends.

Destiny is Fickle

Destiny is a fickle mistress, making the S&P 500 Index wait for it's date with new all time highs.  It appears we will be getting that correction everyone was talking about first.  Since closing at 1,530 on February 19th, the S&P 500 has shed 42 points, almost 3%, to close yesterday at 1,487.85. 



Source: StockCharts.com

Last week worries that the Fed might tighten sooner than expected started the pullback.  The European Commission's change in its 2013 economic forecast from a little growth to a slight contraction added to it.  Monday's deadlocked election results in Italy put the hammer down.  The Italian election results were exceptionally jarring as initial reports indicated Bersani's Democratic Party would have a majority in both houses of parliament enabling it to continue the prior government's austerity and reform efforts.   After it became clear that was not the case, the S&P 500 sold off strongly. 

The protest vote against austerity, brought eurozone breakup worries back to the forefront.  The effect was clearly seen in the Italian bond market.  Bonds were hit hard with ten year yields rising over 30 basis points to 4.85%.  Given the deadlocked results, pundits are predicting new elections in the next couple of months.

Source: Bloomberg.com

In the US, the sequester is due to start on Friday, forcing approximately $85 billion in cuts to discretionary spending.  We also have the potential for a US government shutdown on March 27, when funding for this fiscal year expires.  With GDP growth trending a bit under 2% a year lately, the combination of  the revised fiscal cliff tax hikes and spending cuts, the sequester cuts and rising gasoline prices have whittled away at our margin of safety regarding growth.  It would take less and less of an exogenous shock to tip the economy over into recession.  With these storm clouds on the horizon, review your investment plan and expect more volatility ahead. 

Gasoline Prices WTF?

Previously, I have mentioned rising gasoline prices both here and on LinkedIn.  It is now a story on the major news outlets and you are probably painfully aware of it.  The chart below shows this year's price increase compared to the last two years.  You can see we are already fast approaching the peak prices of the prior two years.

Source: AAA.com

Since we are still below the prior peaks, if you were wondering why it feels so bad, the chart below may help put things in perspective:

Source: Global Macro Monitor

Except for 2008 (which was no picnic with over $4 a gallon gasoline), this is the highest estimated percentage of mean household income we have spent on gasoline since the early 1980's.  If you are wondering why this is happening, it is a combination of things.  Below is a chart of what makes up the price at the pump:



Source: US Energy Information Administration

As you can see, two thirds of the price is based on crude oil.  Both global benchmark crude oil prices (North Sea Brent and West Texas Intermediate) have moved up since December, explaining much, but not all of the increase in gasoline prices.

Some of it is because inventories have been constrained due to lingering effects from Superstorm Sandy.  The rest comes from the smallest percentage piece, the refining part.  Over the last few years, approximately 1 million barrels of refining capacity on the East Coast and St. Croix has been shut down.  In addition, this January Hess announced plans to close its Port Reading NJ refinery.  (More pieces on this are here and here.)  This is on top of seasonal refinery shutdowns to switch over to summer blend gasoline, which is happening earlier than usual.  This has combined to start off the usual increase into the summer driving season in February instead of March.  If the experts are right, the price should top off around the same level as the last two years, just a lot sooner.

 

 

 

President's Day Update

I hope everyone had a good weekend and is enjoying the added day of market respite this President's Day.  Last week was mixed on the economic front.  On the plus side, housing inventory and unemployment claims both dropped in the US.  On the negative side, so did industrial production.  The big news was the return of M&A on a big scale, with Warren Buffett's Berkshire Hathaway taking Heinz private and American and US Airways coming together to form the world's largest airline.  For all of that, the S&P 500 Index was roughly flat for the week.

Looking ahead, this holiday shortened week has some interesting data points.

Tuesday:      German ZEW Survey         
Wednesday: US Housing Starts, PPI and Fed minutes, German and French CPI, Chinese Flash PMI
Thursday:    US Jobless Claims and CPI
Friday:         German GDP and IFO Survey
Sunday:       Italian elections

The two German surveys should give us insights into the state of that economy, as should the Chinese Flash PMI.  Here in the US, housing starts, Fed minutes and jobless claims will draw alot of attention.  With the Italian 10 year yield down 12 basis points (bps) YTD and spreads 45 bps tighter versus German bunds through Friday, the markets seem to anticipate at worst a neutral result to Sunday's Italian election, but we will need to see.  On Monday, the European markets did appear to get uneasy about the probable election results.  As they say, that is why they play the game.  

While the G-20 declared that they will refrain from competitive devaluation, there does seem to be a distinct benefit to a lower currency for ones stock market.



Both the UK and Japanese markets with their falling currencies are doing about ten percentage points better than Brazil with its strengthening currency, the real.  On Monday, with a seeming all clear from the G-20, the trend continued.  In Asia, the Nikkei was up over 2% as the yen fell to almost 94 to 1$US.  In South America, the Brazilian stock market (the Bovespa) fell another 50bps as the real rose against the dollar. 


On another front, correlations between various risk based asset classes have been coming down indicating some differentiation between them, as opposed to a blind risk on/risk off trading environment.  The chart below shows the trailing 24 month correlations between various asset classes as of 2/17/13 as represented by ETF's.  The red cells show high positive correlation.

Source: AssetCorrelation.com

The chart below shows the one month trailing asset correlations:



Source: AssetCorrelations.com

You can see how the dark red area has shrunk significantly, with even Emerging Market (EEM) correlations falling under 0.7 to the Real Estate indexes and the US stock market indexes.  While we are still subject to headline risk (Sequester, Italian elections, etc.) this is a healthy development as it indicates investors are differentiating more on the basis of each asset class' underlying fundamentals, rather than on the latest headlines.

Mid Week topic update

US and the Liquidity Wave

Despite all of the concerns, the S&P 500 Index (1,519 close 2/12/13) continues on its seeming date with destiny at its all time high of 1,576. 

Source: StockCharts.com



The liquidity wave continues to push the market higher.  In addition, there are some signals that there may be a structural shift in risk taking going on.  This would support the wave further than many expect.  On the negative side we have the usual cast of suspects, including slowing earnings growth, higher taxes, higher gasoline prices etc.  To these we should add the austerity risk; that the federal budget deficit has never fallen as fast as it is now without a coincident recession.  We never said riding this big wave would be easy. 

Japan

About a month ago, I mentioned that the Japanese stock market was up about 22% from November 14th.  After a short consolidation period, it has continued its upward trend and is now up about 31% from November 14th.

Source:StockCharts.com

A good part of this gain has been based on the drop in the yen. 

Source: Yahoo Finance

With the yen dropping against the dollar, it is important to hedge this out.  The Wisdom Tree Japan Hedged Equity Fund (DXJ) is one way to do this.  Comparing the returns for the DXJ and the iShares MSCI Japan Index Fund (EWJ) which is unhedged can illustrate how important this is.

Source: StockCharts.com

While the two track different indexes, DXJ was able to approximately double EWJ's return because it hedged out the currency depreciation.  For another way to see the effects of the yen on click here. 

On top of this, the Japanese government is now taking a page out of the Fed's playbook and specifically targeting asset prices.  This past weekend, Japan's Economic Minister Akira Amari said:

“It will be important to show our mettle and see the Nikkei reach the 13,000 mark by the end of the fiscal year (March 31),”
 

This is about another 15% from current levels and a full 50% from it November 14th close.  That would be quite the move in four and a half months.  Yet another fun wave to ride.

Pre Mardi Gras Weekend Update

Pitchers and catchers were officially supposed to report today for the Cubs, Indians, Rockies and Red Sox.  For many it is the start of a new season.  The Super Bowl is over and now on to baseball (with a little thing called March Madness in there too).  In the Chinese calendar, it is the start of the new year (Snake).  The markets seem to be turning towards a new season also.  Year to date, stock markets are generally up and Treasury bond prices are down.  The Fed seems to be succeeding in pushing investors out on the risk curve as funds are flowing into equities and out of money markets for the first time in years. 

 

While the S&P500 Index managed to eek out a small gain on the back of some positive economic news, most major international markets were down for the week.  European stock markets, and the euro, dropped after ECB President Mario Draghi said the exchange rate was important for growth.  Corruption allegations against Spain's Prime Minister Rajoy and the possibility of a hung parliament in Italy also fueled the downdraft. 

 

This coming week is a slow one:

 

• Tuesday - State of the Union address, UK PPI, CPI
• Wednesday - US retail sales and EMU industrial production
• Thursday - French, German and Italian GDP
• Friday - US industrial production

With earnings growth minimal, the recent rise in the market has been accomplished through increasing valuations.  The S&P 500 Index is approaching the upper end of its recent valuation range on a P/E basis, while the Price to Sales ratio is approaching pre crash 2008 levels.  Market confidence remains high even as the US average gasoline price has reached $3.54 a gallon and is over $4.00 a gallon in parts of Southern California.  While the fiscal cliff was avoided, most consumers are facing a decrease in take home pay as the temporary 2% reduction in Social Security taxes of the last two years expired.  In addition, many expect that the mandatory sequester cuts will now take place on March first, further slowing the economy.  While these factors should not push the economy into recession, they should also not be a valuation expanding event.  At the very least, they're definitely not helping the situation.

 

So why is the US market rising?  That would be the wave of liquidity we mentioned in Anecdotes vs the Fed.  This is an exhilarating and dangerous ride that can last longer than you think.  It can also crash down very hard on the unskilled and unwary.  So know what your plan is and in the meantime, don't fight the Fed and as they say in New Orleans:

Laissez Les Bons Temps Rouler*

 

*Let the good times roll



Note: The original post had the wrong week's international data announcements.  This is now corrected.  I apologize for the mistake.

Bond Prices: What Has Gone Up Must Come Down

Yesterday, the Congressional Budget Office came out with its budget and economic forecast through 2023.  In it, they project that the ten year US Treasury Bond will average a 5% yield in 2017, compared to 2% today.  This is only four years away.  With many investors holding bonds for their safety, I wanted to illustrate what would happen to bonds if that projection was accurate.  I looked at both a current ten year Treasury bond and a fourteen year bond that would be a ten year bond in 2017.  According to the Wall Street Journal, as of the close of business on 2/15/13, these were priced as follows:

Maturity	Price	Coupon	YTM
8/15/2023	140.08459	6.250%	2.007%
2/15/2027	149.14204	6.625%	2.461%

In early 2017, the 6.625% bond maturing on 2/15/2027 will be a ten year bond.  If it were to yield 5% at that point, it would be worth 112 for over a 24% drop in principal value.  Fortunately, some of that loss would be offset by interest income, so the total return would be roughly -6.7% over the next four years, or -1.7% a year.   In four years, the 2023 bond will be roughly a six year bond. If the yield curve stays approximately the same shape, we could assume it would yield around 4.12% and trade at 112. This would be a 20% drop in value in the principal. 

 

 

The other thing to keep in mind, is that the premium price on these bonds will naturally diminish (or amortize) as it approaches maturity, when it will be redeemed at par (100). If the ten year rate were to stay at 2%, the value of the 2027 bond would still decrease, but to only 141, or a 5% loss.  Similarly if yields on a six year bond were to stay at 1.12%, the 2023 bond would still drop around 6% in value as the premium amortizes. 

Investment grade corporate bonds with their higher yields offer a bit more protection in this regard.  However, the spreads over US Treasuries are between one and two percent depending upon maturity.  The cushion is not that large, given the current low rate environment.    If spreads stay stable, they will suffer losses as well. 

 

Alot of money has flowed into bond funds over the last few years. It will be interesting to see how those investors react if under either scenario.   




Note: This post was updated 2/13/13 with revised data.  The original prices under both scenarios were incorrect due to a data entry error.  The revised data shows a slightly smaller principal loss (24% vs 27% and >20% vs 20%) under the baseline scenario and a small principal loss under the unchanged rate scenario (5% vs 16% and 6% vs 8%).  The main implications are unchanged. 

Quick Pre Super Bowl Weekend Update

It was generally a good week in terms of economic reports.  While fourth quarter GDP came in slightly negative, much of it was due to inventory destocking probably associated with fiscal cliff uncertainty.  In contrast, the Case Shiller Home Price Index, ISM Manufacturing Index and Construction Spending all rose.  And while fewer jobs than expected were created in January, this was cancelled out by strong upward revisions to prior months data.  All this positive information helped power the S&P 500 further upward to close at 1,513 and the Dow Jones Industrial Average at 14,009. 

 

Source:Yahoo Finance

This stock market strength has not been confined to the US as can be seen in the chart below.  Both the London  and Tokyo markets are doing even better than either the S&P 500 or the Dow Jones Industrials.  

 

 

 

The flip side of all this good economic news was the rising yield on the ten year US Treasury Bond.  It closed over 2% for the first time in almost a year, which was 25 basis points higher than the start of the year.  This rise in yields was equal to over a 3% point loss in value. 



Source: Yahoo Finance

This week in the US, we get factory orders on Monday and chain store sales on Thursday.  Thursday is also a big day internationally, with German Retail Sales, Unemployment and CPI, Japanese Household Spending and Unemployment and Chinese PMI. 

With all of this data coming out, combined with the tremendous wave of liquidity continuing to spew from central banks around the world and the US indexes approaching their highs, it should be an interesting week.  Time to brush up on your surfing skills.

Source: BBC.com

 

Anecdotes vs. the Fed

As the S&P 500 Index nears its all time high of 1,565, anecdotal evidence of an imminent top keeps piling up.   This past weekend, the front page of the New York Times had an article on small investors getting back into the market.  CNBC has their little bugs in the bottom right of the screen with how many points to go to the all time high.  It is hard to find a bear on the major financial news outlets.  Bill Gross, Dan Fuss and Jeffrey Gundlach are moving into equity management.  (Okay maybe not this last one, since they are all smart guys and after all how much more can you squeeze out of bonds with the ten year Treasury around 2%?  But the others definitely qualify.)

Against this stands the Fed and many of the other central banks of the world.  By nailing short term rates to zero and doing their best to keep the rest of the yield curve as close as possible, they have been trying to force investors out on the risk curve.  As the Ned Davis chart below shows, it appears that they are finally succeeding.  After years of outflows, equity funds have experienced large inflows so far this year.

 

Source: Ned Davis Research

While there are many reasons that the market should not go up, it continues to defy the skeptics.  The main reason appears to be the unrelenting liquidity supplied by the Fed and now supplemented by individual investors.  It is apt that this week surfer Garrett McNamara possibly broke his own record by riding a an approximate 100 foot (30 meter) wave.

Source: Guardian



In many ways, staying invested in this market is similar.  Both are powered by huge amounts of liquidity, can take you a lot further than you think, it is an exhilarating ride, and can end either in glory or disaster. 

"You can't stop the waves, but you can learn to surf"
John Kabat-Zinn

 Learn to surf (investments).