Big Brains Don’t Outsmart Markets

By Rick Ferri

No amount of brain mass can outsmart the markets. A new study shows that all expert market predictions − from academics to Wall Street professionals − do not beat a simple buy-and-hold strategy, nor do they beat strategies that utilize simple economic timing models. Significant return differences do exist among these experts, but none are able to beat the market or a naïve forecasting method.

On the Forecasting Quality of Professionals, by Aron Veress, University of Liechtenstein, exams the stock market forecasting record of academics and professionals as published by the Federal Reserve Bank of Philadelphia’s Livingston Survey. The economic survey is conducted twice a year across a spectrum of academics and professional investors. As part of the survey, participants forecast S&P 500 values over the next 6- and 12-month periods.

The study focuses on the forecasts of five different participating groups: academic institutions, commercial banking, governmental agencies, investment banking and non-financial business. The forecast results were then compared to a buy-and-hold portfolio of the S&P 500 index or seven naïve forecasts created using simple econometric models. The results were compared over time and during business cycles, as reported by the National Bureau of Economic Research (NBER).

Veress also found that the experts’ forecasts were not nearly as volatile as the market itself. A low deviation of prediction is reflected in all groups whereas the market itself exhibited far more extreme values. He also determined that investment bankers tended to be the most optimistic in their forecasting, government agencies the most pessimistic, academicians the most consistent, and non-financial businesses the lowest quality.

Each group’s forecasting ability was compared to a simple buy-and-hold forecast and seven naïve forecasts based on economic models. The buy-and-hold method produced the highest returns. The naïve forecasts also outperformed the experts. Those forecasts used dividend yield, earnings-price ratio, gross discrete change in consumer price index, continuous change of 3-month secondary market T-bill rate, long-run historical mean, recessions as reported by NBER, and a “kitchen sink” model incorporating all predictors simultaneously.

Overall, all groups underperformed; any investor using the simple buy-and-hold forecast as well as the seven naïve forecasts based on economic models would have outperformed the academics and professionals. These findings are largely in line with other findings, highlighting the low predictive power of experts in stock market forecasting.


The Fed’s New Tax on Retirees

by Rick Ferri

Jan. 30 2012 — 5:27 pm |

Last week, the Federal Reserve rolled out their inflation forecast and interest rate intentions through 2014, and it’s not good news for retirees or anyone else who relies on interest income.  The yield on money market funds, CDs, and other fixed income investments will likely remain well below the inflation rate for the foreseeable future. This financial repression will result in a trillion dollar transfer of real wealth from fixed income investors to the persons, businesses and governments borrowing at below free-market rates.

Inflation is a tax, even if the inflation rate is low. The Federal Reserve Board Members and Federal Reserve Bank Presidents are projecting long run inflation to be 2.0 percent, although this year the rise is expected to be slightly lower. Combine the Fed’s inflation target with their intention to leave short-term interest rates at rock-bottom levels through late 2014, and the result is an onerous phantom tax on the owners of CDs, money market funds, bonds, and bond funds.

People who own fixed income investments in the U.S. are disproportionally retirees and persons nearing retirement. Thus, the Fed has created a “retiree tax.”

Why the Fed wants low rates

I understand why the Fed has slapped this repressive tax on savers. They had no choice. The economy is in the early stages of recovery, and the Fed wants to give businesses, consumers, and local governments more time to borrow money cheaply and bolster recovery. The fragile housing market and the European sovereign debt crisis also played a large role in this policy decision.

I’m particularly interested in the housing aspect of the Fed maneuvering. Banks already own 440,000 homes and another 1.9 million homes are in some form of foreclosure. Low mortgage rates help strengthen the housing market by making homes more affordable and put hundreds of thousands of people back to work building homes. This is all very good for the economy.

It also gives existing homeowners the option to refinance at lower interest rates, thereby reducing their monthly interest payments and increasing the amount of money available for other purchases. Recall that a large number of loans issued in the housing bubble years were adjustable-rate mortgages (ARMs). The initial rate on an ARM is set low to qualify a buyer for a home, and then in the years ahead based on the prevailing rate at that time. There are $450 billion in ARMs remaining to be reset in 2012 and 2013 (see Figure 1). The Fed’s intent is to keep mortgage rates low through 2013, thereby ensuring these ARMs reset low enough to prevent widespread default and a million or so new foreclosures.

Figure 1: Value of Mortgage Resets by Year

Another issue near and dear to the heart of the Fed is the European debt crisis and the looming recession it has created in that part of the world. European banks are in much worse shape than the U.S. banks. They were heavy buyers of U.S. subprime loans from 2004 through 2007, and consequently, their balance sheets were crippled prior to the more recent sovereign debt crisis.

The U.S. Fed doesn’t have many options with Europe. It must accommodate the European banks in an effort to stop them from dumping their U.S. mortgage portfolios, and thereby killing the fledging housing market in this country. They are also concerned with a European recession spreading through contagion and hitting the U.S. shores before long.

Who the Lenders are

Interest rates are at record lows in this country, which means someone is buying a lot of U.S. debt. We know the Federal Reserve Bank is the largest holder, but who else holds it?

According to data from the Federal Reserve, about half of the U.S. debt is held by foreigners and the other half is held by investors in this country. The foreigners hold U.S. debt because they do business in the U.S. and because the U.S. dollar is still considered the world’s safest currency. U.S. investors hold U.S. debt for the interest income and because it’s generally more secure than owning equity or other investment assets.

The mix of investments that individuals own at different stages in life is of no surprise. IRA owners under age 45 were less likely to be invested in investments tied to interest rates while those over age 45 were more likely to be invested in interest rate sensitive investments, according to a 2011 Employee Research Benefit Institute (EBRI) report on IRA asset allocation.

Older investors are the primary direct holders of U.S. debt. According to the US Government Accountability Office (GOA), bank account balances, stocks, bonds, and mutual funds held outside of retirement plans—are important sources of income for retirees.

Social Security is the largest source of retirement income for households with someone aged 55 or older, earned income is next, and pension income is third. Income from investments accounts for 13 percent, with annuity payments and pensions making up most of the remaining income (see Figure 2).

Figure 2: Income of the Population 55 or Older, 2008

Source: U.S. Social Security Administration, Office of Retirement and Disability Policy

The findings from the EBRI database show the most detailed average asset allocation of IRAs currently available, by providing more asset types from various IRA administrators/recordkeepers. The asset allocation found in IRAs is very similar to that in 401(k) plans.

The asset allocation of an IRA investment portfolio for all investors showed 38.5 percent in equities, 22.3 percent in cash investments (market market funds, savings accounts and CDs), 13.6 percent in bonds, 12.1 percent in balanced funds, and 13.6 percent in other assets (stable value funds, annuities). When combining the allocation of balanced funds attributable to assets that are interest rate sensitive (bonds, cash investments, stable value and some annuities), the average allocation to interest rate sensitive investments is about 50 percent.

The allocation to interest rate sensitive investments increases to about 60 percent in the 60 year and older age categories. This shift in risk preference is consistent with the idea that as people prepare to enter retirement they become more conservative. There are some extremes in the data. About 40 percent of people over the age of 60 have less than 10 percent of their assets in equity and about 30 percent held no equity. These extremes tended to be investors with lesser amounts in their retirement portfolios.

Retirees who are spending the interest they are earning in money market funds, CDs, bonds and other fixed income investments are earning less than they would be if the Fed were not keeping interest rates artificially low. On average, this amount is about 2.0 percent less based on calculations I made in an earlier two-part article titled The Fear of Soaring Rates are Overblown.

What investors can do about low rates

What options do those over the age of 55 have to stem the transfer of wealth from lenders to borrowers?

Unconventional times require unconventional ideas. Too often we fall into traps created by a rule-of-thumb that hurt our chances for investment survival. This is a time to step back and question those rules-of-thumb.

For example, the rule-of-thumb in the 1990s was to follow the Fed Model for stock valuation. According to the model, the right price-to-earnings ratio (PE) for the market, simply divide 100 by the 10-year Treasury bond yield. That may work fine when rates are at 6.0 percent, but now that rates are 2.0 percent, the Fed Model says that the stock market is about 200 percent undervalued. Maybe stocks are 200 percent undervalued, but I doubt you’ll find many people using this model today.

Another rule-of-thumb says to find an appropriate asset allocation for your age, invest your age in bonds (or CDs, fixed annuities, money funds, etc). According to the model, a 40-year old should have 40 percent in fixed income investments and a 70-year old should have 70 percent. In my opinion, this rule-of-thumb needs to be put on ice for a while because it isn’t the right model for today.

Burton Malkiel recently wrote an opinion article for the Wall Street Journal titled The Bond Buyers Dilemma where he offered some alternatives. Dr. Malkiel is Chemical Bank Chairman’s professor of economics at Princeton University and a former member of the Council of Economic Advisers.  At the end of the article, he made a general comment that I do believe sums up the situation, “The traditional diversification advice of a simple stock-bond mix needs to be fine-tuned.”

I’ll borrow Dr. Malkiel’s line by saying that the rule-of-thumb for a simple stock-bond mix needs to be fine-tuned. Your age-in-bonds may work OK in free-market interest rate environment; but it doesn’t fit well into a period of artificially low interest rates created by unusually accommodative Fed policy.

I’m not a big fan of Dr. Malkiel’s investment solutions for the bond buyer’s dilemma because they infuse too much specific risk into a portfolio. One rule-of-thumb that does seem appropriate for today is “Don’t fight the Fed.” The Federal Reserve is pumping money into the economy by every means possible. There is no other period in history to which you can compare their actions. It is an unprecedented period. The aim is to reward risk takers on the backs of bond holders.

Accordingly, I advocate being a risk taker to the extent you’ve already been a risk taker.

Investors flee the market, miss big gains

By Larry Swedroe, Nov. 14, 2011

We’ve already seen investors miss the greatest bull market of the past 70 yearsdue to panic selling from the 2008 bear market. Now, it looks like the same panicked selling caused investors to miss out on big gains once again.

Investors withdrew almost $18 billion from the market in October, marking the sixth straight month of withdrawals seemingly in response to the market dip we experienced from May through September. It was bad timing, as the S&P 500 Index returned almost 11 percent in October, more than the annualized return the market has provided over the long term.

Study after study shows that the returns investors earn are well below the return of the very funds in which they invest. Advisor, columnist and author Carl Richards coined the phrase the “behavioral gap” to label the difference between investor returns and investment returns.

The gap is created because investors persistently follow a pattern of buying high after a period of strong performance (as greed and envy take over) and selling low after a period of poor performance (as fear and panic take over). They sell when things go bad, when valuations are low and expected returns are high. Then they buy when the coast appears to be clear, when valuations are high and expected returns are low.

Surely investors can’t believe that buying when expected returns are low and selling when they’re high is a good strategy. Yet, they persistently repeat this behavior.

If you find yourself reacting to the noise of the markets, allowing your emotions to take over and following this cycle, it’s time to break the pattern of destructive behavior. Admitting you have a problem of addictive behavior is the first and necessary step on the road to recovery. However, it’s not a sufficient one.

The second step is to write and sign and investment policy statement, one that defines your goals and makes sure your asset allocation doesn’t cause you to take more risk than you have the ability, willingness or need to take. My book,The Only Guide You’ll Ever Need for the Right Financial Plan, provides you with the knowledge you need to build that plan.

The third step is actually the hardest, having the discipline to adhere to the plan. Helping investors do that is perhaps the most important role a financial advisor plays.

How to View the Current Economic Situation

By | Oct 11, 2011

As advisors and students of financial history, we know that investors hate uncertainty. While most of us understand that only legends in their own mind have perfect clarity as to the future, when presented with conditions that create a heightened sense of uncertainty, even investors with well-designed plans react, letting their emotions and stomachs take over. And stomachs don’t make good decisions. Fear, and eventually panic, tends to set in.

Unfortunately, we can’t remove the uncertainty that may have your stomach rumbling. While it seems to be an all-too-human need to believe that there’s someone who can protect us from bear markets, the evidence from academic research demonstrates that no such person exists. All crystal balls are cloudy, including mine.

Instead, I’d like to provide some perspective on what has been happening and to prevent you from committing costly errors — failing to differentiate information from insights you can use to outperform the market and engaging in what I call “stage one-thinking.”

Information or Actual Insight

Let’s start with confusing information with insights that can be used to outperform the market. The wrong way to think about all the bad news is to believe that prices must go lower. The right way to think about all the bad news is to understand that prices are where they are because of the bad news. In other words, if the news was bad, but not quite so bad, prices would actually be higher. In addition, low current valuations mean that future expected (though not guaranteed) returns are high. So before you sell, you should ask yourself: “Does it make sense to buy when valuations are high because things look safe, and expected returns are low? And does it make sense to sell when things look dark and valuations are low and expected returns are high?” That doesn’t seem very rational. Yet, that’s exactly the behavior of most investors. Consider the following.

On March 9, 2009 the S&P 500 closed at 676. By the close of May 2, 2011, it had more than doubled to 1,361, and that doesn’t count the return from dividends. How were investors reacting during the greatest bull market since the 1930s? They were withdrawing hundreds of billions of dollars from equity mutual funds. That’s why it has been said that bear markets are the mechanism by which wealth is transferred from those without plans, or the discipline to stick to plans if they exist, to those with plans and the discipline to adhere to them. Those who stuck to their plans in 2008-2010, simply rebalancing, were able to buy at low prices, when expected returns were high, and then sell (at much higher prices) when markets had recovered, taking precious chips off the table. In addition, the gains for some were so great that they were able to lower their equity allocation and still be likely to achieve their life and financial goals.

As was noted earlier, we don’t have a clear crystal ball as to the outcome of this or any other crisis. It’s certainly possible that the uncertainty in Greece and other countries could drag on for months without a solution, in which case risk premiums would likely expand, creating the potential for a repeat of 2008 in terms of the depths of a bear market. It’s also possible that we could quickly get agreement on a broad solution, including recapitalizing the banks. That would restore confidence, risk premiums would likely contract sharply, and all the losses could be quickly erased. There’s simply no way to know what scenario will play out.

Stage One Thinking

I would now like you to consider the following situation: You have back pain. You visit two doctors. Each reviews the MRI. The first states that she’s seen many similar cases and that it’s hard to say exactly what is wrong, as it’s hard to predict what will work for any one person. She suggests you try Treatment A first, and then go on from there. The second doctor states that he knows exactly what is wrong and what to do. Which doctor do you choose? Almost always people will choose the latter. Yet, that might very well be the wrong choice. While we want certainty, it rarely exists. And it certainly doesn’t exist in the investment world where so much of returns are explained by unforecastable events such as Mideast revolutions, Japanese earthquakes and tsunamis and the attack on the World Trade Center buildings. Remember this example the next time someone tells you they know what is going to happen to the market. Also remember that the academic research on forecasting clearly demonstrates that as much as we would like to believe there are those who can predict the future, prognosticating is the occupation of charlatans.

I’d now like to turn back to the second of the two costly mistakes I mentioned at the beginning that far too many investors make — they limit their thinking to “stage one.” Let me explain. When there are crises, investors focus on the negative news and fail to consider the likelihood, if not certainty, that governments and central banks will act to try to resolve the crises and restore their economies to a healthy state. Those who engage in “stage two” thinking understand that crises lead to actions to counter the problem. (In fact, it often takes crises like our budget crisis to get governments to act.) Faced with crises, governments typically enact stimulative fiscal policies, and central banks implement stimulative monetary policies. Those policies often take time to produce results, but markets are forward looking. That means that well-designed policies will typically lead to the financial markets recovering well before the economies recover.

This is why the stock market is one of the government’s nine components of the index of leading economic indicators. The failure to think beyond stage one and look to stage two causes panicked selling and the resulting sell-low/buy-high outcomes most investors experience. And because it often takes a crisis to get the action, and the more severe the crisis the more likely you will get action and the stronger the measures are likely to be, the more likely it is that if investors limit themselves to stage one thinking, the more likely it is they will sell just before the markets begin to recover.

There’s one other critical point we need to cover regarding stage-one thinking. Those who decide to sell until the “green light” comes back on, indicating that it’s once again safe to invest in stocks, don’t understand that there’s never a green light when it comes to equity investing. It’s never safe to invest. There’s always a high degree of risk. For example, if you had sold in March of 2009, when would have it been safe to again invest in stocks?

  • The unemployment rate continued to rise and stay at very high levels.
  • We had a series of mid-East revolutions.
  • North Korea launched an attack on South Korea.
  • Our budget deficit problems have not been solved in any way.
  • The U.S’s credit rating was downgraded.
  • Oil soared from below 50 to well over 100.
  • We had the PIGS crisis.
  • We had a flash crash.
  • Housing prices continued to fall.
  • Hundreds of banks failed.
  • Let’s not forget Meredith Whitney’s dire forecast for municipal bonds.

There never was a green light, which was why most investors missed the rally. And there never is a green light. So if you decide to sell, you must have a plan to get back in. But there’s really no effective way to design such a plan, because history is likely to repeat itself, and you’ll be trapped in a vicious circle of buying high and selling low.

There are very few investors who can avoid all risks and still achieve their life and financial goals. And the evidence against trying to time the market is that efforts are highly unlikely to prove successful. That means that the strategy most likely to allow you to achieve your goals is to abandon hope of trying to time the market, and instead focus on the things you can control:

  • The amount of risk you take
  • Diversifying the risks you take as much as possible
  • Keeping costs low and tax efficiency high

In other words, while the advice to stay the course may not seem to be the most satisfying of answers, we believe the evidence demonstrates that it’s the right one. The last thing investors should do in response to a crisis, or any period of volatility and uncertainty is to let their stomachs take over.

Before closing I would like to discuss one other issue, diversification. Today, I hear many people saying the U.S. is the safest place to invest. That is probably a result of the S&P 500 Index outperforming the MSCI EAFE and MSCI Emerging Markets Indexes. However, the proper perspective is that this crisis demonstrates that international diversification is important. All one has to do is to think about the issue from the perspective of a European. If one of them had chosen to limit investments to the countries of the European Monetary Union, they would certainly be regretting it today.

In conclusion, the key to successful investing is to understand what Napoleon knew — most battles are won in the preparatory stage. For investors that means having a plan that incorporates the certainty that they’ll have to face many crises over their investment careers. Therefore, it’s critical to not take more risk than you have the ability, willingness or need to take. A Monte Carlo simulation can help you determine the right asset allocation for you. If your stomach is roiling now, check to see if you are able to lower your equity allocation and still be able to achieve your goals. And if you find that is not the case, then you should at least consider lowering your goals, spending less now (saving more so don’t have to take as much risk), or planning on working longer.

Before closing, I offer these words of wisdom. It’s critical to remember that once something bad has happened, and we know the outcome, it’s too late to act because markets have already done so. You have already taken the risks and incurred the loss. Any reaction at this point is likely to be an overreaction, caused by panicked selling.

And finally, I would like to note what I consider to be an amusing irony. While most investors revere Warren Buffett, they ignore virtually all of his advice, including his advice to ignore all market forecasts and his advice to not try and time the market, but if you do you should buy when others are panicking and sell when others are getting greedy.

The End of the Line: Eurozone Crisis Hits Tipping Point

The End of the Line: Eurozone Crisis Hits Tipping Point

Charles Schwab
By Liz Ann Sonders & Michelle Gibley
September 12, 2011

The inevitability of the eurozone crisis was foreshadowed by the late, great economist Milton Friedman. At the time of the euro’s debut in early 1999, Friedman expressed concern that it would not survive the first major European economic recession or crisis. Prescient thinking. 

Euro 101 
The primary motivation for the creation of the euro was less economic than political. The goal was an integrated Europe that could more effectively compete with (and/or rival) the United States. The hope was that a single currency would also force economic restructuring in the more-wayward peripheral countries, requiring them to abide by the Maastricht Treaty rules that govern member countries’ budget policies. 

Things didn’t work out as planned. Blatant disregard for budget policies among the “PIIGS” nations (Portugal, Ireland, Italy, Greece and Spain) brought on wage and price inflation greatly exceeding the eurozone average. In addition to the resultant diminished competitiveness of these peripheral members was the effect of burgeoning budget deficits as a percentage of their gross domestic products (GDP). 

Fast-forward to today, and there’s legitimate risk that these countries don’t have the wherewithal to honor their debt obligations. The major problem is that European leaders don’t appear (at least publicly) to understand either the gravity of the crisis or the impact that confidence has on the financial system. The very recent decision by Germany to begin contingency planning and shore up its banking system suggests perhaps they are just getting to this point of awareness. 

Not contained to Europe … 
The pressures emanating from the overhang of government debt in the eurozone continue to negatively impact trading in Europe, but why have US stocks also been taking their cues from the eurozone? Why does Greece matter so much? 

Because the crisis is about more than just Greece. The problems in the eurozone are more about the health of the banking system in Europe, the long-term viability of the euro, Europe’s contribution to global growth and the indirect impact on the US dollar.
… but Greece is unique in severity 

Greece’s deficit and debt levels (15% and 140% of GDP, respectively), lack of economic growth and commitment to austerity put it in a class of its own, and Greece is the most likely member to default on its debt. Greece’s quarterly review for funding conducted by the troika of the International Monetary Fund, European Commission and the European Central Bank (ECB) broke down in early September. The breakdown was due to lack of progress on achieving fiscal targets, implementing structural reforms, selling off public assets (privatization) and a public debt-swap plan rumored to be short of the 90% participation goal. 

In an illustration of Greece’s struggle, the ability for Greece to generate the revenues targeted under the bailout is severely hampered: the economy contracted 7.3% in the second quarter and Greek officials have confirmed that they have cash for only a few more weeks. If this sounds familiar, it is: Greece was in the same position in mid-July of this year when cash was running low because the deficit was higher than expected. 

This was partly due to lack of progress on austerity and reforms, leading to the second Greek bailout to cover higher-than-expected cash needs. Since then, yields on Greek two-year debt have skyrocketed relative to the other peripheral nations.

Greek Two-Year Bond Yields Go Parabolic 

Chart: Greek Two-Year Bond Yields Go Parabolic
Source: FactSet, as of September 9, 2011.

So is forcing more austerity on a country already suffering from a lack of economic growth the solution, or will this just exacerbate the problem? It’s clear to most observers that this is an unsustainable situation, with a restructuring of debt obligations ultimately needed. 

Contagion from Greece is infecting the European banking system 

Policymakers have been hoping to postpone a Greek debt restructuring until growth recovers, reforms have been put in place and banks have had a chance to better capitalize to cover potential losses. However, the lack of agreement and ability to act in a coordinated way by eurozone policymakers has allowed a crisis of confidence to develop, resulting in contagion to other countries and a banking-system infection. As a result, banks are less willing to lend to each other, as highlighted in the chart below by the widening in the three-month Euribor/EONIA spread, indicating a growing credit crunch.

European Bank Stress Up, But Below 2008

Chart: European Bank Stress Up, But Below 2008
Source: FactSet, as of September 9, 2011. Europe Bank Stress=three-month EURIBOR (Euro Interbank Offered Rate) minus three-month EONIA (Euro Overnight Index Average) swap rate.

There’s a question of which came first, the chicken or the egg here, but the interaction between banks and governments appears to be reinforcing this negative feedback loop. Reasons include:

  • Banks have large holdings of sovereign debt which they may need to write down.
  • Governments tend to be the backstop for banks.
  • Yields on government debt are often the basis for loan rates.
  • Banks themselves can have funding issues if they’re using government debt as collateral for loans.

As a result, we believe European banks need more capital. Reasons include: 

  • Eurozone banks have low levels of capital. European banks remain highly leveraged, not having recapitalized or deleveraged to the same degree as those in the United States. According to Michael Cembalest, head of JP Morgan’s private bank, European banking-sector liabilities are three-to-four times the size of European GDP, versus the one-to-one ratio in the United States.
  • It’s likely that sovereign debt (Greek in particular) will have to be written down further at many banks. While the proposed second bailout for Greece forced a 21% write-down of some Greek debt, markets are pricing in more than a 50% discount, in line with the haircut many believe is sustainable for Greece to support.
  • There’s a need to bolster confidence that banks can absorb losses. Banks’ overreliance on short-term funding has exacerbated uncertainty and volatility, and investors need comfort before providing capital.
  • Banks must have the strength to lend—the lifeblood of economic growth.

Why not let Greece default and stop the contagion? 
Some believe that separating Greece’s solvency issues from liquidity issues elsewhere by drawing a line in the sand and recognizing that Greece needs restructuring may ultimately be a positive action. While this could be destabilizing in the near term, it’s possible that by sizing asset values and removing uncertainty, markets could form a base from which to build. 

The problem for markets is that we just don’t know the broader implications of a Greek default on European banks or contagion to the other PIIGS. Banks across the eurozone own Greek debt, and Greece is only one of the three countries currently under bailout (Portugal and Ireland being the others), while the debt of the other two PIIGS (Spain and Italy) is currently being propped up by ECB purchases. An immediate default without a longer-term plan to “ringfence” banks and other sovereigns (like Italy) would be quite risky. 

The question is whether the value of the debt of these other countries will also be marked down and whether Portugal and Ireland will decide to either default or ask for new conditions. Lastly, the lack of transparency in the credit default swaps (CDS) market means we don’t know where all the liabilities exist. 

Ultimately, it’s unknown how much additional capital eurozone banks would require if contagion spreads, but it’s believed that even including CDS exposures, US banks would feel little impact. The chart below shows the direct exposure of US banks to PIIGS’ sovereign debt, relative to the European banks.

US Exposure to PIIGS Limited

Chart: US Exposure to PIIGS Limited
Source: BCA Research and Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.). Debt as of December 31, 2010, and includes public and private. GDP as of June 30, 2011, and expressed in nominal terms.

US banks’ capital ratios are about double those of the average European bank. In addition, many banks claim that their “net” (including CDS) exposure is limited. But as we learned through the Lehman Brothers debacle in 2008, if you have “insurance” via CDS, but the party on the other side (AIG at the time of the Lehman failure) can’t pay the claim, a can of worms is opened. (You can see a chart of Greece’s CDS further below.) 

Meanwhile, the ECB’s ability to purchase debt, which has helped ease pressure in Spain and Italy, is limited by its need to sterilize (offset) injections of money into the financial system with withdrawals of liquidity elsewhere. Discouragingly, even the ability of the ECB to stabilize the situation has been hampered. 

Greek default may force decision between euro breakup or fiscal union 
A potentially bigger-picture implication of a Greek default is whether it would come in conjunction with a decision to leave the euro, either voluntarily or involuntary. In the near term, Greece leaving the euro and returning to the drachma could result in debt defaults for businesses and households, require banking system recapitalization and disrupt international trade. There would need to be strong coordinated action in the eurozone to stabilize the situation and keep things orderly—something that’s been lacking thus far in the crisis. This may ultimately require coordinated global central-bank intervention. 

Any country opting (or forced) to leave the euro would find the process a lengthy one. An exiting country would have to negotiate with the entire European Union (EU), not just the eurozone authorities. All treaties and legislation governing the euro are EU treaties. In fact, several of the 27 countries encompassing the EU require referenda to be held on changes to treaties. 

On the other side, a full eurozone fiscal union may be desired but politicians must convince their citizens of the advantages. Additionally, many new laws and treaties would be required—which would not be an easy or quick process. To date, more-austere nations have been unwilling to consider measures toward fiscal union (such as issuing common eurobond debt) until bailout nations make more progress on austerity and reform. 

One outcome of the German court decision this week (that ruled the European Financial Stability Facility constitutional) is that it rules out open-ended, longer-term fiscal responsibility for other nations, thwarting the possibility of eurobonds. The flaw exposed during this crisis is that a currency and monetary union without fiscal union may not be sustainable. 

Greek CDS surge 

The choice will be between kicking the can down the road again or removing the band-aids and taking the short-term pain. Over the weekend, Greek officials indicated further measures to close the deficit gap for this year and renewed their commitment to meeting obligations rather than default. Additionally, despite continued resistance to assist in bailouts and strong language that austerity and reforms agreed to must be adhered to, the German finance minster has rejected speculation of a Greek default. Markets remain unconvinced, as the CDS market is indicating a 92% probability of a Greek default.

Greek CDS Go Parabolic 

Chart: Greek CDS Go Parabolic
Source: Bloomberg and FactSet, as of September 9, 2011.

It’s also important to note that both Italy and France five-year CDS have increased sharply, indicating that contagion has begun. We don’t know when a Greek default will happen, and it is possible the can will be kicked down the road again before a restructuring ultimately occurs. Additionally, while the current negative sentiment may end up presenting the possibility of a short-term bounce for stocks, we await better visibility on a resolution to the eurozone crisis before changing our cautious outlook on the eurozone. 

2008 redux? 

Whether we’re heading on a path to repeating the 2008 crisis is a question we often receive. There are many indications that the global banking system is in far better shape today than it was back then and that the crisis is likely to be relatively contained to the eurozone. But we don’t take pictures like the one below lightly either.

Foreign Banks Shovel Money to Fed
Chart: Foreign Banks Shovel Money to Fed
Source: FactSet and Federal Reserve Bank of St. Louis, as of September 9, 2011.

Foreign official and international accounts have deposited nearly $103 billion at the US Federal Reserve, up from less than $58 billion at the beginning of 2011 and well above the prior crisis high of less than $89 billion in January 2009. This indicates a loss of trust in the European banking system. 

Lars Tranberg from Danske Bank said European banks have been reduced to borrowing dollar funds for “a week at a time,” as opposed to the typical six-to-12 months. “This closely resembles what happened in late 2008, though the difference this time is that the major central banks have dollar swap lines in place. If the dollar funding market completely freezes up, the ECB can act as a backstop.”

Growth under attack in the eurozone, pressuring the global economy 

The eurozone is an important part of the global economy, as it accounts for nearly 20% of global GDP. While the eurozone has not recently been a big driver of growth, a breakdown in economic growth or the banking system would be felt globally. With growth already slowing globally, a recession in Europe would hurt. While we think a recession in several European countries is very likely, we believe a broader global recession akin to that experienced in 2008 can be avoided. 

As a result of falling confidence in the longer-term viability of the euro and the potential that the ECB may need to pursue its version of quantitative easing by making unsterilized purchases of either sovereign or bank debt, the value of the euro has fallen. There’s also pressure (rightly so) on the ECB to lower short-term interest rates. 

This has resulted in a corresponding increase in the US dollar, as you can see in the chart below. History is mixed as to whether a stronger dollar (which we expect) would necessarily be negative for the stock market. Recently, the two have moved inversely, but over long-term history, a stronger dollar has more often been met with a stronger stock market. Regardless, a stronger dollar would mean weaker profits for multi-national companies, but less inflation. 

US Dollar Breaks Out on Upside

Chart: US Dollar Breaks Out on Upside
Source: FactSet, as of September 9, 2011.

What’s next? 

The situation in the eurozone remains fluid, with key events still ahead, including final approval of the new Italian austerity package, French banks bracing for a potential downgrade by Moody’s and the European Commission pushing for a global agreement on a potential financial transaction tax later this month. 

Importantly, the second Greek bailout and expanded European Financial Stability Facility has yet to be ratified by the parliaments of all 17 nations that comprise the euro, which is expected to occur in September and October. Additionally, Finland’s demand for a collateral guarantee in exchange for its bailout contribution is expected to be resolved in mid-September. 

What’s an investor to do? 

This all begs the question about how an investor should be thinking about portfolio positioning. From a stock perspective, we continue to think that the US market will remain a decent relative performer (though not necessarily a decent absolute performer). In fact, on a year-to-date basis, the US stock market is ranked seventh among the 33 largest stock markets globally. And we know readers will be shocked, just shocked, that Greece’s stock-market performance is dead last.

While we’ve been negative on Europe, we don’t believe in completely avoiding the continent, but instead supplementing diversified European exposure with an allocation to Switzerland’s defensive market. Elsewhere, we’re favorably disposed to Japan, where we believe there’s an improving environment in which companies can operate more competitively globally. In combination with low expectations and declines in valuations, it could bring about the long-awaited revival of Japanese stocks. 

Lastly, we believe the global economic slowdown and strength in the dollar may provide emerging markets with inflation relief. That would enable a pause in monetary tightening to the potential benefit of stock-market performance, once the uncertainty and high correlations (degree to which asset classes move in tandem) eases.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. 

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

  (c) Charles Schwab

Where From Here?

As you likely know, on Friday evening rating agency Standard and Poors lowered the credit quality rating on America’s government debt one notch from AAA to AA+.  The other two major ratings agencies have maintained their AAA ratings and have indicated that they will continue to do so.  In the odd way that markets work, the early observation is that S&P is coming away from this with a black eye, while the U.S. is receiving sympathy from the rest of the world, as if to say, “so what – U.S. Treasury bonds at AA+ are higher perceived quality than France’s AAA bonds.”  Still, the market reaction tomorrow will likely follow through on last week’s momentum based on this news, on top of the other issues it was already dealing with.  

Fundamentally, however, the downgrade doesn’t mean anything but a shameful PR black-eye for America.  The market had priced the news in, to a large degree, but Monday’s open will adjust it down further.  What this political theatre of the last 45 days has done, however, is taken a relatively healthy economy and scared it and its participants out of their minds – and not unjustifiably.  That fear and lack of confidence has trickled into the recent economic indicators, and this downgrade news won’t help.  One good piece of news from this mess?  The price of oil has fallen to $84 per barrel this weekend, making the pump a little less painful (it was at $115 just three months ago).

Without the downgrade news, I was anticipating a sharp move higher for stocks early this week.  Three indicators that only come around at rare inflection points are screaming “buy”.  These indicators have literally been correct 100% of the time.  Each signaled the end of corrections or bear markets in 1987, 1990, 2003, and 2009.  The other was last Friday.

The urge is strong to say “it’s different this time”.  But stocks never drop 12% in ten days for no reason, it’s always a crisis or shock that does the damage.  This mess is a serious shock, but simply another negative driver nonetheless, just like all the others in history.  My sense is that based on the global economic condition, we could be looking at putting some of our substantial cash reserves to work soon, once the dust settles.

An interesting piece of data from Bespoke Investment Group points out just how rare this August has been thus far, and what that could mean for the rest of the year:  The 7.19% decline the S&P 500 has seen over the first five trading days of August is the worst start to the month in the S&P 500’s history going back to 1928.  The next worst start to August came in 1990 when the S&P declined 5.99% over the first five trading days.  For what it’s worth, the index continued to decline for the remainder of August in 1990 by 3.66%.  It then rallied slightly from September through the end of the year.

There have been three other starts to August where the S&P declined more than 3% (1982, 2002, 2004), and in each of these instances, the index gained significantly for the remainder of August.  In 1982, the S&P then went on to gain 35.61% for the remainder of the year, and in 2004, the index gained 13.91% over the rest of the year.  In 2002, the index was essentially flat for the remainder of the year after dropping 3.82% in the first five days of August.

 “Buy and pray” won’t work anymore than jumping in and out of the market on gut or fear.  Staying diversified, unemotional, and rebalancing when opportunities arise will work in this environment, as it did in 1987, 1990, 2003, and 2009.  As will keeping your portfolio in line with the long-term goals we set in place at the outset.  I will be in touch this week with further updates.



So Tell Me the Good News…

Staring at the Ceiling
Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
July 18, 2011

Key points

  • Everyone’s focused on the debt-ceiling negotiations, impacting everything from market action to consumer confidence.
  • Default remains unlikely, but investors are wondering about portfolio positioning in the event the unthinkable occurs.
  • Behind the scenes, the news isn’t all bad, as some economic readings and most corporate earnings releases have been pleasant surprises.

The debt ceiling negotiations have taken center stage and it seems they’re all anyone cares about at the moment. Bank Credit Analyst (BCA) wrote in a recent report, “…it seems that short-term, vicious circles of debt crisis, policy paralysis and a sickening banking system are intertwining with the bleak, secular trend of debt, deficit and growth stagnation, to create a weird miasma of both complacency and despair.”

Interestingly, BCA was writing about the eurozone debt crisis (which has now troublingly spread to Italy), but it also characterizes our own problems here in the United States. Two major ratings agencies, Moody’s and Standard & Poor’s, are certainly weighing in with their consternation by threatening to lower the US Treasury’s AAA rating.

Having gotten the subprime crisis so very wrong, the agencies have stepped up to try and redeem themselves by getting ahead of the curve on US and other sovereign debt ratings via downgrade threats. S&P went as far as specifying that it’s looking for a very large deal of around $4 trillion over 10 years to accompany the raising of the ceiling.

Market reactions?
Today, I want to lay out in a little more detail possible market reactions as we head toward the deadline of August 2 (which in reality is July 22, since time is needed to pen a bill’s language).

Assuming the United States did indeed default on its debt (which we believe is still extremely unlikely), most investors and certainly the media believe it would be calamitous for both the stock and bond markets. A worst-case scenario would have Treasury yields rising significantly, bringing other yields up alongside, representing a material tightening of financial conditions in less-than-perfect economic times. The dollar would likely drop, as would stocks—perhaps meaningfully so.

I don’t disagree with that pessimistic assessment, but I still wouldn’t attempt to handicap or forecast moves by any asset class. There’s a more-benign, albeit non-consensus view that markets may not move as dramatically as many are assuming. In fact, it’s supported by the so-far benign moves by both stocks and Treasury bonds as we’ve approached the deadline.

Demand for Treasury securities has remained strong throughout the debt-ceiling debate and stocks have been volatile, but not starkly weak. This suggests investors don’t believe there will be a default and/or that Treasury prices are reflecting the global soft patch.

A default (particularly if it was short-lived) could cause the stock market to fall to the lower end of the trading range it’s been in for more than a year, but may also provide some support for stocks if it triggers more meaningful negotiations and ultimately a bigger deal on debt/deficit reduction. Bonds might also rally under a more-benign scenario due to the reduction in government spending, suggesting a lessened need for Treasury financing going forward. A smaller supply of Treasury notes and bonds via issuance could lead to higher prices. This is not my base case, but I think it’s always important to review every possible reaction by markets.

History as a guide?
We don’t really have much history to go on to gauge market reaction except for other countries that have lost AAA ratings. S&P downgraded several European countries (Belgium, Ireland, Italy, Portugal and Spain) from AAA in May 1998—a week later, 10-year bond yields for those countries were only slightly higher; a month later they were actually slightly lower; and a year later they were nearly 1% lower.

Japan lost its AAA rating in February 2001. A week later its 10-year bond yield was flat; more than 0.3% lower a month later and only slightly higher after a year. As noted by ISI, both the European and Japanese experiences suggest that other factors, such as the market’s own opinion of a country’s creditworthiness and broad macro and policy trends, may be more important than official credit ratings in determining a country’s borrowing costs.

We can look at past government shutdowns as a pseudo-proxy for what we might expect. The most recent US government shutdown was from December 13, 1995 to January 6, 1996. The Dow Jones Industrial Average actually rose about 2% during that period.

What to do?
We’ve heard a lot of questions about what investors should do in their portfolios to account for the risk of a default. We continue to preach the benefits of diversification among and within asset classes, both domestic and international.

There are indications that many investors have moved money into other currencies and gold, and are buying insurance against the possibility of a US default. Supporting those moves: the dollar has taken a fresh turn down, sharply relative to the Japanese yen; gold has hit record highs over the past two weeks; and the price of US Treasury credit-default swaps have risen by about 20% since early April.

Why not just recommend investors flee to cash? Even if you did put all your money under your mattress (if only figuratively), you’d have problems if inflation accelerated, not to mention the opportunity cost in the event of a substantial relief rally in stocks and/or bonds.

Any progress over the weekend?
There doesn’t appear to have been much forward movement over the weekend. This week Republicans will hold a House vote on a balanced-budget amendment that limits government spending and makes it difficult to increase taxes. Although success in the House is expected, passage in the Senate is unlikely.

As noted by ISI, unless a deal is reached between President Barack Obama and House Speaker John Boehner (R –Ohio), the Senate seems poised to vote on some version of the proposal from Sen. Mitch McConnell (R –Kentucky), which would raise the debt ceiling and cut $1.5 to $1.8 trillion in spending. It would create the possibility of another major round of deficit reduction for later this year or early next year. But the McConnell approach has not been well received by either political party in the House, so passage is far from certain.

In the meantime, a lot has happened over the past couple of weeks. The Federal Reserve’s second round of quantitative easing (QE2) came to an end and a rash of economic reports have been released, including the second consecutive weak jobs report.

Unemployment claims are just coming down from a troubling spike, but are not yet back into the sub-400,000 comfort zone. The Empire Index for July was weaker than expected and the University of Michigan consumer sentiment report was a real dud, although I think the debt ceiling debate was a major contributor to that weakness versus elevated concerns about the health of the economy. Home prices may be stabilizing, with the Case-Shiller index down only 0.1% in April.

As hard as it can be in a volatile period, I remain optimistic that we’ll see a deal struck before August 2 and that the second half of the year will see a pick-up in growth. I’m often asked about “favorite” indicators and I want to highlight one below. Thanks to the Fed keeping short rates on the floor and longer-term yields remaining near 3%, the spread between the 10-year Treasury yield and the fed funds rate is near an all-time high. For those fretting a double-dip recession, note in the chart below that spreads this steep in the past have occurred well before recessions have begun.

Yield Curve Says Recession is Far Off
Yield Curve Says Recession is Far Off
Source: FactSet, Federal Reserve, ISI Group, Ned Davis Research, Inc., as of July 15, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.) Dotted line represents most recent peak.

On top of that, the global central bank tightening phase may be over as China’s Premier Wen Jiabao has publicly said China’s inflation problems are waning. And even though the European Central Bank’s latest tightening was roundly criticized for its improper timing, the futures market is showing the next move by the ECB to be a rate cut.

Fed and QE3
Another reason for hope can be seen when looking at the lending environment, particularly post-QE2. Although Fed Chair Ben Bernanke troubled markets on Wednesday and Thursday last week when it was perceived he was hinting at QE3 during testimony before Congress on Wednesday before seeming to back-track the following day.

Bernanke is keen to avoid two major mistakes made by the United States and Japan in the past. In 1937, the Fed halted a recovery by tightening policy too soon. In the 1990s, Japan failed to convince markets that they could fight systemic deflation.

Regardless of the market misreads of Bernanke’s position, we believe his view is simply that all options remain on the table—that QE3 would only be announced if both of the Fed’s mandates, stable prices and maximum employment, are breached. In other words, the Fed would need to see a significant deflation risk emerge anew and significant further deterioration in employment.

After all, the United States is no longer facing a liquidity crisis, as it was back in 2008 and 2009. As you can see below, borrowing has picked up (albeit from a very depressed level).

Lending Picking Up
Lending Picking Up
Source: FactSet, Ned Davis Research, Inc., as of July 8, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.) Data prior to March 31, 2010, adjusted by Ned Davis Research, Inc. to reflect FAS166 and FAS167 changes.

Earnings looking good
Finally, another reason for hope beyond the debt-ceiling debate comes courtesy of corporate earnings. We’re still early in the reporting season for second-quarter earnings, but so far about 75% of companies have beaten expectations, which is historically high. Beats have been across a broad range of industries and sectors and earnings are on track to surpass their 2007 peak.

In sum, however, the debt ceiling is still a big cloud overhead. It has likely driven confidence way down, but other downside risks remain. Washington must act soon to restore confidence by getting a deal done.

Debt Ceiling: Why You Shouldn’t Rush to Change Your Portfolio

By | Jul 18, 2011

As you might expect, I’ve received lots of calls and e-mails asking what to do about the impending crisis surrounding the debt ceiling. So I thought I’d share my thoughts.

As I noted in my post on the Greek crisis, the first and most important point is that if you have a well-developed investment plan, it will have anticipated crises (which by definition aren’t predictable or we would avoid them) and incorporated the virtual certainty that they’ll occur.

In other words, we live in a world of uncertainty. As Napoleon Bonaparte stated, “Most battles are won or lost [in the preparation stage] long before the first shot is fired.” That means we shouldn’t take more risk than we have the ability, willingness or need to take. Having a plan that anticipates severe bear markets gives you the greatest chance of staying disciplined and avoiding panic selling. Without a plan, you’re much more likely to allow your stomach to make investment decisions, and stomachs don’t make for good advisors.

Returning to the debt limit problem, it certainly is true that this crisis creates the potential for another financial “meltdown,” especially when we consider that there’s a similar crisis on the other side of the Atlantic — a crisis in Greece that has the potential to rapidly spread to Ireland, Portugal, Spain and even Italy. These crises taken together — or even separately — contain the seeds for another “seizing up” of capital markets as occurred when Lehman failed.

Though my crystal ball is always cloudy, if that were to occur, it’s seems likely the valuations of all risky assets (stocks and bonds) would fall rapidly, and the more risky and less liquid the asset, the faster and steeper the fall. And since this time the crisis would encompass what U.S. investors consider the riskless asset (Treasury debt), it’s hard to even imagine what could happen. And investors hate uncertainty.

The risks are clearly great if we don’t get an agreement. The problem is that we don’t know what will happen. The crisis could be resolved, or we could see a default. We could also see defaults in Greece and other defaults might follow (or at least markets would likely worry about that happening), and we might also see the end of the Euro, and who knows what else.

I think it’s interesting to note that the stock market has risen in the past month despite these problems. On June 15, the S&P 500 Index closed at 1,265, despite:

  • The failure to resolve the US debt ceiling problem
  • No resolution on the Greek crisis
  • Weakening economic data
  • Rising unemployment
  • The end of QE2 (which some gurus were predicting would lead to major problems for the bond and stock market alike)

On July 14, the S&P 500 closed at 1,308, up more than 3 percent (note:  as of July 19, the S&P 500 stands at 1,329).  And despite Moody’s warning of a downgrade of Treasury debt, the 10-year Treasury rate was unchanged at 2.98 percent. I seriously doubt anyone would have predicted that outcome. Certainly bond guru Bill Gross didn’t forecast this. He sold Treasuries back in March, and did so with a lot of fanfare. Yet just recently he started buying back Treasuries, at much higher prices.

So that brings us to what should YOU do about the situation. I can tell you what we are doing as advisors. We aren’t making any adjustments to client portfolios in response to the debt ceiling debate. The market is well aware of the fact that the debt ceiling discussions are ongoing and U.S. Treasury rates are still very low, indicating the market believes the debt ceiling will be increased and that financial market disruptions are unlikely. We believe that efforts to try to move in or out of the stock or bond markets in anticipation of what will happen aren’t productive.

Even if the worst case scenario materialized and the U.S. debt ceiling isn’t raised, it’s seems likely that it would be raised quickly if there were any subsequent disruptions in the financial markets. Also keep in mind that this is a political technicality more than anything and not an issue with the capacity of the U.S. government to pay its debts.

If you won’t follow our advice, just ask yourself what Warren Buffett is doing these days. Is he selling?

With that said, we have minimized exposure to European banks and governments. We moved money out of money market funds that had significant exposures to these credits and into what we believe are safer assets. That is a move you should consider, as it’s a classic example of Pascal’s Wager (the consequences of being wrong are really bad compared to the benefits if you’re right and no losses occur).

The bottom line is this: If your stomach is growling and you’re losing sleep worrying about the outcome, you likely either don’t have a well-developed plan or you were overconfident about your ability to deal with bad economic times. If the former is the case, then you should immediately develop a plan. If it’s the latter, you should probably rewrite your plan and permanently lower you equity allocation, because this likely won’t be the last crisis you’ll have to deal with.

Photo courtesy of Public Notice Media on Flickr.

Market Perspective: Dealing with Debt

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research
July 1, 2011

Key points

  • Global governments are dealing with rolling debt crises, which are translating to shaky investor confidence. We are concerned that many of the solutions being proposed will weigh on growth prospects, but are hopeful about short-term resolutions that restore business confidence and lead to more investment and hiring.
  • The economic sluggishness globally continues, largely affected by short-term factors. We believe a rebound is likely in the second half of 2011, but are wary of policy mistakes and weak confidence. The Fed continues to hold steady, keeping short rates near zero and likely reinvesting maturing Treasury securities after QE2 ends.
  • Greece passed the austerity package required to get short-term funding but much more is needed. And while the focus has been on Europe, it may be time to start paying more attention to the Asian region.

Debt concerns have combined with soft economic data to weigh on markets and we’ve seen a bit of return to the “risk on, risk off” trade that dominated 2010. We believe this is a relative temporary phenomenon that should start to reverse toward the end of summer, but there are growing risks. Tenuous confidence among businesses and investors could again be shaken depending on how the debt crises are dealt with or if the economic soft patch lasts longer than we currently believe.

Small business confidence is tenuous
Chart: Small business confidence is tenuous
Source: FactSet, Natl. Federation of Independent Business. As of June 27, 2011.

For now, we continue to have a relatively optimistic view of the latter half of 2011, with stocks setting up for a potential rally. Corporate balance sheets remain flush with cash and earnings continue to hold up remarkably well, although we’ll get another update on that during the upcoming second quarter earnings season. Additionally, much of the bad news seems to be “known” and may already be reflected in stock prices, setting up the possibility for upside surprises as some of the temporary burdens begin to ease. Finally, investor optimism has taken a blow from the recent action, which is typically a contrary indicator—a potential good sign for the market in the coming months.

Debt decisions key
The focus has been largely on the European debt crisis, which is detailed below, but the US debt situation continues to add to uncertainty. We certainly don’t believe that there is any real risk of default by the United States due to not raising the debt ceiling, a view confirmed by the continued extremely low yields of Treasury securities; but we are concerned about the deal that may be made in Washington. It appears highly likely that the agreement will involve at least an agreement to cut spending by approximately the amount of the boost to the debt ceiling—likely somewhere around $2 trillion. Spending needs to be cut, but details are important including the timing of the cuts and whether there’s a bias toward budget gimmickry. If too much cutting is pushed out into future years, any short-term benefits to the recovery would be offset by longer-term continued uncertainty.

However, that risk can be softened by the US economy growing at a more rapid rate, much as we saw during the early 1980’s recovery. Government policies that add uncertainty into the market and stymie risk-taking and innovation only make the future bill more difficult to pay. At Schwab, we have long been advocates of free markets and capitalism as the solution to many of the perceived problems in the world. Increased regulation and government interference has already started to weigh on business and we believe is a large contributor to the reluctance of companies to put their massive cash balances to work. Uncertainty and concern over the health care bill and resultant costs, regulation on interchange fees in the financial sector, environmental decrees that raise the cost of doing business, and an uncertain tax policy as we continue to deal with our debt all contribute to business uncertainty. A more globally competitive tax policy, a rollback of some of the more egregious regulations instituted recently, more certainty with regard to the health care law and the new financial derivative regulations, and cuts to spending on entitlement programs would help. It’s important to convince businesses and ratings agencies that our country is on the right track in order to accelerate economic growth over the next several years and bring down the unemployment rate; while repairing housing, and increasing growth and tax receipts. This would result in a more tenable debt situation at both the Federal and state levels.

Soft data continues- transitory?
Uncertainty over the US government’s actions in advance of the August 2 debt ceiling expiration, combined with soft economic data contributed to the recent market correction. Regional manufacturing surveys have dipped into negative territory, jobless claims remain stubbornly above the key 400,000 level, and housing continues to scrape along the bottom. However, all has not been negative as the Index of Leading Economic Indicators rebounded strongly, gaining 0.8%, inflation remains relatively low, and the yield curve remains historically steep, which has typically been a good indicator of future economic growth.

We continue to believe much of the weakness can be explained by temporary factors, including the disaster in Japan, severe winter and early spring weather, and a spike in oil prices that has since reversed. It is the waning of these pressures that we believe will usher in a better second half of the year.

The Federal Reserve apparently agrees with this assessment as during their most recent meeting they came to the same conclusion and held steady on their policy. QE2 has now ended without much fanfare as Treasury yields remain historically low despite the lack of Fed support going forward. The asset purchases have not stopped, however, as the Fed will continue to reinvest money received from securities maturing in order to maintain the size of its balance sheet. Stopping this process would be a likely first step in the long road to a more normal policy. The Fed gave no indication of a fresh round of asset purchases, despite downgrading its economic assessment slightly, and signaled that the bar for such a move remains quite high.

We continue to believe the Fed should be considering moving toward more normal monetary policy. While the aforementioned factors are keeping money on the sidelines, the near-free ride banks are getting gives them little incentive to move out the risk spectrum on their loan portfolios. With the ability to borrow from the Fed at near-0%, and invest the proceeds in Treasuries, they earn a risk free 2.5-3.5%; and as seen below, that has enticed many banks to do just that.

Banks are holding Treasuries instead of making loans
Chart: Banks are holding Treasuries instead of making loans
Source: FactSet, Federal Reserve. As of June 27, 2011.

A rise in rates may provide the incentive needed to get money flowing through the economy, while also potentially strengthening the dollar, which could further pressure commodity prices down, helping US consumers while also attracting more foreign capital.

Greece: what still needs to happen
While near-term moves to avert a default in Greece have whipsawed global markets, we believe a default is not likely in the cards at this time. Meanwhile, exposure in the United States to a default of any one peripheral country is not definitively quantifiable but is likely small, reaffirmed by Fed Chair Bernanke in his press conference following the June Fed meeting.

The near-term liquidity strain, with Greece needing cash immediately to keep its government working and make interest and principal payments on its debt, was likely solved when Parliament passed the austerity package demanded by the ECB and IMF. However, longer term, there is a need for Greece to address its two main problems: too much debt (insolvency) and an inability to grow.

The current Greek “bailout” program is too reliant on austerity, which alone cannot work. As austerity increases in each successive change to bailout terms and funding, the recession deepens. The result can be a never-ending spiral of cutting spending and raising taxes because the pie never grows enough to support current spending policies, increasing the likelihood of default.

Even if Greece meets its austerity goals, grows inline with what are likely optimistic growth forecasts and privatizes government-owned companies and sells assets, debt as a percentage of GDP is forecasted to rise to 160%. This is unsustainable because the interest burden continues to rise and eats up an increasingly larger portion of the budget. This is no bailout. As such, Greece needs to restructure its debt, allowing it to wipe the slate clean and provide a strengthened position from which to grow.

Additionally, Greece needs to increase tax receipts by addressing growth and tax collection. Greece needs additional labor reforms to allow companies to more easily fire employees and adjust when times are tough. This would allow companies to be more efficient and productive, increasing profitability, and attract new businesses that are now starting in more business friendly eurozone countries. Greece’s economy remains largely in state-run hands; typically less efficient and less productive than privately operated companies. Additionally, measures should be put in to foster new industries.

Lastly, Greece needs to clamp down on tax evasion, improve tax collection and strengthen consequences for evasion, while simultaneously restructuring its tax code to make it simpler and more business friendly. It is estimated that somewhere between 30 – 40% of the activity in the Greek economy that might be subject to income taxes goes unrecorded. However, changes to address growth and tax collection will be slow, if they ever occur, and will take a long time before aiding Greece’s fiscal recovery.

Greece may need to exit the euro eventually, as it would allow the country to reduce the value of its currency, or devalue, in order to gain competitiveness through lower export prices, thus aiding economic growth. However, this is unlikely in the near-term and policymakers would need a policy to allow for exit. Additionally, closer European fiscal union could help keep deficits in line, but is unlikely due to political and cultural differences. Due to a true lack of union and disparate economies, the crisis has demonstrated politicians’ reluctance to achieve consensus, and a country leaving the euro is a possibility over the next five years.

While European stocks could rally after near-term Greek liquidity issues are addressed, we favor other regions longer-term, as we expect continued periodic scares about solvency in peripheral countries, which could create ongoing volatility and a cap on rallies.

Will synchronized slowdown result in synchronized upturn?
It is easy to find reasons to be negative when growth is slowing, but the economic slowdown and government debt risks are well-known at this point.

Meanwhile, some of the pressures on global growth are starting to ease. While there are near-term risks to Japanese earnings estimates and reliability of power supply, Japanese industrial production is bouncing back sharply. Reduced inventories in the supply chain for technology and automotive companies as a result of Japan disruptions are likely to be replenished over the summer, contributing to economic growth. Additionally, there have been some announcements from Japanese companies to undertake actions to increase their competitiveness and profitability, an optimistic development. Japanese stocks may have more upside than downside from here.

Japan production returning
Chart: Japan production returning
Source: FactSet, Bloomberg. As of June 28, 2011.

Elsewhere in Asia, there is potential for a change in direction in China. Recall that China has been tightening policies directed at property speculation and excessive lending since January 2010. Despite measures to slow the rate of money growth, inflation has picked up, providing adding pressure to pursue tight monetary policy.

Over the past month, we have come to believe the Chinese tightening cycle is in the late innings, as liquidity was tight, with both small businesses and property developers struggling to access capital. Despite the sharp clampdown on credit and economic slowing, growth remains healthy, at a 9.7% annual rate in the first quarter of 2011. The Chinese government sounds as though they are near completion of their task, with Premier Wen saying that measures targeting inflation “have worked.” Just as the slowdown was initiated by the Chinese government, who has many levers to slow inflation and excess growth, it can quickly reverse policy to reaccelerate growth. A soft landing in the Chinese economy is increasingly likely, with growth slowing and no crash. See more in Michelle’s article Bears and Bulls in the China Shop.

While inflation could still rise and additional tightening measures could still be implemented, the Chinese government has already begun to either implement or contemplate new stimulus measures, such as a new “cash for clunkers” program, policies to loosen credit for small businesses, provide relief on luxury goods import duties, and pilots to reform the pension system.

Positive reaction to possible end of Chinese tightening
Chart: Positive reaction to possible end of Chinese tightening
Source: FactSet, Shanghai Stock Exchange, Standard & Poor’s. As of June 28, 2011.
* * Indexed to 100 as of June 28, 2010. A larger/smaller number above 1 denotes greater outperformance/underperformance of the Shanghai Composite Index relative to S&P 500 Index.

Local investors in China have taken notice, prompting a rise in the Shanghai Composite. The Chinese market is often viewed as a leading indicator, due to China’s rapid growth and large size. Rising Chinese stocks may be a sign that global growth is on the mend. With Japanese production coming back online and the boost to consumers’ pocketbooks from declining gasoline prices, we could finally witness a virtuous cycle of self-sustaining growth.

Are Stocks Telling a Better Story For the Second Half?

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
July 5, 201

Key points
  • Investors continue to focus on the macro … but the micro is telling a much better story.
  • There was lots of good micro and macro news last week.
  • Is the market’s rally sending a signal that the second half of the year is looking up?

Lately, one of the most frequently asked questions I hear at client events is, “What keeps you up at night?” It reflects an at-times grave set of macro obstacles that the market has had to climb.

In fact, the vast majority of questions I’ve been getting at events are of the macro variety. Rarely am I asked about what companies are doing or saying, about corporate earnings, about the stock market’s short- or even longer-term fundamentals.

The macro remains top-of-mind, including:

  • US debt ceiling deadline.
  • Euro-zone debt crisis/Greek austerity.
  • Impact of Japan’s disasters on global growth.
  • Global soft patch/risk of a double-dip recession.
  • China’s potential hard economic landing.
  • Inflation risks.

One of the things I like to talk about at events is what could actually go right (and maybe already is). I am always most intrigued by the story no one is telling.

Today, that story would be a very positive one. I don’t write this with blinders on, but I want to lay out a realistic case for a better macro (and market) environment than many are expecting.

Déjà vu 
As you all know, much of what has been plaguing markets and confidence this spring/early summer is reminiscent of last summer’s economic soft patch. Other than the aftermath of Japan’s natural and nuclear disasters, the markets have faced similar pressures as last summer.

But at the same time, there has been meaningful improvement in most of the underlying fundamentals, as you can see in the table below.

Economic Fundamentals Last Year Current
Initial unemployment claims (4-week moving average) 468 427
Private employment (millions of persons) 107.2 108.9
Corporate profits ($, billions) $1,567 $1,727
Durable goods orders ($, billions) $2,153 $2,347
S& P 500® index 1027 1340
Vehicle sales (millions of units) 11.6 11.8
Manufacturing PMI 55.3% 55.3%
10-year Treasury yield 2.96% 3.22%

Source: FactSet and ISI Group, as of July 1, 2011.

Earnings surprise potential 
Let’s hone in on corporate profits, which are 10% higher than they were at this point last year (see table above).

We are just now heading into the reporting season for 2011’s second-quarter earnings. According to Bloomberg, the S&P 500 is expected to post 13.3% year-over-year earnings growth in the second quarter, which is down from over 14% less than a month ago.

And there’s a lot of chatter that estimates haven’t come down enough to reflect the aforementioned economic soft patch (and margin pressure from previously elevated commodity prices).

ISI Group recently looked at the history of quarterly earnings relative to expectations and found that in the past 12 nonrecessionary quarters, analysts’ earnings estimates were too low 75% of the time by an average of 10.8 percentage points (see table below). All other factors aside, it would suggest that second-quarter S&P 500 earnings growth could actually be above 20%.

S& P 500 Operating Earnings Per Share Growth
EPS Year-Over-Year % Change Earnings
Expected Actual
2Q2011 13.3% ? ?
1Q2011 11.4% 16.6% 5.3%
4Q2010 30.3% 27.8% -2.5%
3Q2010 21.4% 38.6% 17.1%
2Q2010 23.9% 51.3% 27.4%
1Q2010 37.0% 91.6% 54.6%
4Q2009 185.2% NA NA
3Q2009 -16.6% -2.5% 14.1%
2Q2009 -25.4% -18.9% 6.6%
1Q2009 -36.2% -39.2% -3.0%
4Q2008 -9.6% -100.6% -91.0%
3Q2008 -6.7% -23.5% -16.8%
2Q2008 -13.0% -29.3% -16.3%
1Q2008 -12.1% -25.8% -13.7%
4Q2007 -14.0% -30.8% -16.8%
3Q2007 -0.7% -9.4% -8.7%
2Q2007 4.8% 9.6% 4.8%
1Q2007 3.2% 7.9% 4.7%
4Q2006 9.7% 8.9% -0.7%
3Q2006 15.6% 22.2% 6.6%

Source: Bloomberg and ISI Group, as of July 1, 2011. Expected EPS based on Bloomberg tally for the week prior to the start of earnings season. Red text indicates recessions.

During the past seven quarters, the stock prices of companies that beat earnings estimates outperformed the overall market by about 275 basis points over the ensuing six weeks. On the other hand, the stock prices of companies with earnings disappointments underperformed the overall market by about 400 basis points during the same period.

As for this year’s fourth quarter, Thomson Reuters First Call estimates that S&P 500 earnings will be up 17.7%, which would put earnings at $103 per share for the full year. That puts the price/earnings (P/E) ratio at only 13 times, below the historical mean of 17.

Micro story better than macro story
Another positive sign for the stock market is corporate equity issuance (or lack thereof). US corporations have amassed a nearly $2 trillion cash war chest, allowing them to go from huge sellers of stock at the market’s weakest point in 2009, to buyers and acquirers of stock in four of the five quarters through 2011’s first quarter.

According to a study by Ned Davis Research, when there is excessive net retirement of corporate equities, it’s generally good for the stock market.

Retirement is Good
Retirement is Good
Source: Ned Davis Research, Inc., as of March 31, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.)

Unless we’re wrong and the economy doesn’t exit the soft patch soon, US corporations are likely to be a positive factor for the supply and demand for equities.

Survey data supports this measure of optimism by corporations. A recent Business Roundtable survey of generally large company CEOs shows that 87% of them are optimistic, as you can see in the table below.

Business Roundtable’s Second Quarter 2011 CEO Economic Outlook Survey
Increase No Change Decrease % Change
from 1Q11
How do you expect your company’s sales to change in the next six months? 87% 12% 2% -5%
How eo you expect your company’s US capital spending to change in the next six months? 61% 32% 7% -1%
How do you expect your company’s US employment to change in the next six months? 51% 38% 11% -1%

Source: Business Roundtable’s Second-Quarter 2011 CEO Economic Outlook Survey, as of June 14, 2011.

Indeed, that optimism weakened slightly versus the first quarter, but remains quite high in the face of so many macro obstacles. Again, it’s the positive micro story versus the negative macro story. One caveat, though: Smaller companies’ optimism, though improved, remains relatively weak.

Rally mode! 
The stock market may be onto something with its latest powerful rally. Some might suggest the market’s become overbought and, based on simple technical analysis, that’s true.

However, history shows that thrusts as positive as what we’ve seen recently tend to bode well for the market over the ensuing short-to-medium term.

During the rally, the 10-day advance/decline (A/D) line of the S&P 500 quickly moved from oversold in mid-June to extremely overbought as of last week’s close. As such, it’s one day away from making a new bull-market high.

According to Bespoke Investment Group (B.I.G.), since 1990, there have been 15 prior periods when the 10-day A/D had a similar positive reversal in the span of a month. Over the following month, the S&P 500 was up 80% of the time, with an average return of 2%.

In another sign of the strength of the rally, it was only the 10th time in the history of the S&P 500 that the index gained at least 0.75% for five straight days. According to SentimenTrader, after eight of the other nine times, buying the next day and holding for two weeks thereafter, resulted in gains.

That’s typical of extreme momentum moves: a short-term counter-reaction, then a longer-term move in the direction of the initial thrust.

It’s not just the US stock market that’s in rally mode. The majority of the key global markets have just moved back above their 50- and 200-day moving averages, suggesting that the global market trend is back in bullish territory.

July bucks “sell in May”
Finally, for what it’s worth, investors were reminded of the “sell in May and go away” phenomenon this year. For those not familiar with the adage, it reflects the typical weakness of the market in the half-year from May through October. However, one of the months that has historically bucked that trend is July—typically a strong month.

Weak consumer confidence good for stocks … huh? 
I want to transition back to the macro landscape now. Let’s take a look at what has been one of the stickiest of weak indicators—consumer confidence.

As you can see in the chart below, the Conference Board’s measure of Consumer Confidence hit an all-time low in March of 2009. It has since risen, but the latest dip puts it back in extreme pessimism territory—a territory in which it’s resided less than 15% of the time.

Weak Consumer Confidence Good for Stocks
Weak Consumer Confidence Good for Stocks
Source: FactSet and The Conference Board, as of June 30, 2011.

Dow Jones Industrial Gain/Annum When …
Consumer Confidence is: Gain/Annum % of Time
Above 110 -0.2 20.8
Between 66 and 110 6.4 61.7
66 and below* 14.9 17.5

Source: Ned Davis Research, Inc., as of February 28, 1969-June 30, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.) *Indicates current reading.

One might believe this would be by extension negative for the stock market. But much like investor sentiment, which works its contrarian magic on stocks, the same can be said for weak consumer confidence.

As you can see in the table above, the best performance for the stock market has historically come when consumer confidence was its weakest. Remember, consumers are generally reactive, while the stock market looks ahead.

Back to macro
Even some of the beleaguered macro story is getting sunnier.

Last week brought some much-needed good news:

  • The Greek government passed its austerity package as a condition for further International Monetary Fund assistance, pushing potential default down the road.
  • China’s Premier, Wen Jiabao, was quoted in the Financial Times as saying the tightening phase was coming to an end after a dozen hikes to its required reserve ratio, noting “growth in money and credit supply has returned to normal.” (China’s input prices in June were at the lowest level in 11 months.)
  • Japan’s industrial production growth hit a 50-year high as production is coming back online more quickly than many expected after its disasters. (US auto production schedules are confirming strong growth for the third quarter.)
  • The Chicago Purchasing Managers’ Index (PMI) and Institute for Supply Management Manufacturing Survey were both better than expected and the latter actually saved the global PMI from plunging.
  • Core capital goods orders were strong again in May, highlighting the tax benefit of accelerated depreciation available until year end, when it’s set to expire.
  • Although questionable as to rationale, the International Energy Agency decided to release oil from the Strategic Petroleum Reserve in order to boost supply and depress prices. It is also having the side-effect of pushing speculators out of long oil futures positions, which has been a reason for recently high prices of both crude oil and gasoline.
  • Bank loans increased, bringing the positive trend to 13 weeks and counting.
  • House prices appear to be starting a bottoming pattern.
  • The Federal Reserve’s second round of quantitative easing (QE2), or buying back Treasuries, ended without the “bang” many had expected. And, although Treasury yields are up, stock prices and yields remain positively correlated.
  • The latest Fed forecast, citing the record wide-output gap (spread between actual and potential gross domestic product), suggests the fed funds rate will stay near zero through next year.
  • Cyclical stocks have been outperforming during the rally, signaling a better growth outlook.

Again, it’s intriguing to think about the story no one is telling. It might have a happy ending.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.