Archive for June, 2010

More Recessions?

You will not hear much about recessions from the usual sources.


The period from 1986 to 2007 has been called “The Great Moderation.” A whole generation of economists, market players and market commentators grew up and learned about the financial markets under these benign (and unusual) conditions. It is therefore not surprising that much of the longer range prognostications from financial firms, the media and even government agencies are premised on an eventual return to that era of steady trend growth with occasional shallow recessions. Simply stated, most market professionals and commentators are not prepared for the markets as they exist today and are likely to exist in the medium term future (next five years).

Why do we think the markets are different?

The first clue is to take a bird’s eye look at the S&P from the Internet bubble to today.
S&P 500 from 2000 to 2010
S&P 500 Price Source: Yahoo Finance

And compare it to two other recent periods: 1966-1982

S&P 500 from 1966 to 1982

…and 1982-2000

S&P 500 from 1982 to 2000

We have not proven anything yet, but we are certainly starting to get an idea that the current market looks a lot more like the period from 1966-1982 than the glory days of 1982-2000.

But what is causing this secular trend?

For that answer, we need to go to an organization which tends to look at the data from a longer view than most of the financial media and blogosphere.

The folks at ECRI have put out a very enlightening slideshow (click here for the version with notes) which explains in fairly clear language why we are likely to experience more recessions in the near future. To accept their thesis, one needs only a single leap of faith: that business cycles exist. This may not sound radical today but many observers thought the G7 countries had largely conquered the business cycle while Alan Greenspan was Chairman of the Federal Reserve and Europe had joined Central Banks to form the ECB and the Euro.

Theoretical Business Cycle

To summarize the argument, the ECRI slideshow argues that economies move in cycles and, on a fairly regular basis, the swing will take you into negative territory (or a recession). There are only two ways to escape. One is to raise the trend rate of growth (as China has experienced over the past 20 years) to the point where the bottom of the cycle doesn’t reach negative territory. The other (as the US has experienced in the last 20 odd years), is to lower the volatility of growth to the point that the bottom of the cycle only dips slightly into negative territory for a short amount of time.

Since the Developed Economies are unlikely to be able to lift their trend growth rates much above the 1%-3% found in Europe, the US and Japan, the ECRI argues that the only real alternative is to develop policies to achieve the second case of lower volatility around the trend line. Slide 6 of the presentation shows the trends of most of the key coincident indicators in the US and the trend is definitely not towards Chinese rates of growth.

The second case has been achieved from 1986 to 2007 in what has been dubbed “The Great Moderation” which you can see represented in slide 9 below.

Volatility in Growth Figures for the US

Why did we have the “Great Moderation”? And how can we get it back?

ECRI identifies three possible sources of the Great Moderation:

  1. Better Supply Chain Management
  2. Better Monetary Policy Management
  3. Luck

The first two sources are dismissed in fairly short order.

Supply Chain Management, which has indeed improved greatly with rising globalization, has raised incomes around the world. But, as demonstrated in the Great Recession, it has not insulated the global economy from volatility.

Monetary Policy is also shown to lack any discernible prescience without a healthy dollop of hindsight bias.

So that leaves luck or, if you do not like that term, a beneficial set of circumstances. Specifically, the end of the Cold War freed up resources and trade routes and non-synchronized recessions in the US, Europe and Japan ensured that inflationary pressures never got a chance to build. Betting on a repeat in the next few years is not a plausible investment strategy.

So what does that mean for investors?

If, as we believe, the ECRI has its arguments right, we should experience more volatility in growth rather than less in the coming five years and that will translate into more recessions. If that is the case, a traditional Buy and Hold strategy will likely return very flat results (note the S&P 500, 1966-1982 chart).

However, that doesn’t mean there is no money to be made in the financial markets in the coming five years. We feel that using a systematic approach that allows you to shift asset classes as they move in and out of favor will yield a much better result than a simple buy and hold strategy. The IPR system allows you to identify asset classes with good momentum and, on a regular basis, signals when it is time to switch to the new leaders. You can learn more about it at the website.

Checking your Frame of Reference

A fun piece came into my email box about analyst coverage of BP after the Deepwater Horizon. The article, by The Reformed Broker, is a rant about fundamental analysts. It is a good fun read for those who enjoy some schadenfreude (a guilty pleasure at viewing other’s misfortune). Yes, the analysts did spend too much time with their DCF (Discounted Cash Flow) models and not enough time studying up on how Exxon became part of Exxon Mobile (XOM). If you listened to the analysts, you might have lost close to 50% of your investment in very short order. Let’s try to learn something by looking at this strange disconnect between the analysts and the events playing out in the Gulf of Mexico, Washington DC and London.

First, Ask What Went Wrong?

Start with the obvious: How could almost all the key institutional analysts have gotten the call on BP so wrong?

There are two reasons:

  1. Analyzing what is visible; overlooking what is invisible
    Each call was based on extrapolations of existing accounting information and models of potential liabilities based on the Exxon Valdez oil spill in 1989. The analysts were focusing on the visible data: historic financial data and an accident that happened on the surface of the water near the coast of Alaska. All good and well but the market decided to focus on two problems that are invisible (or at least very opaque).
    First, the blowout is located 5,000 feet below the surface of the Gulf of Mexico. It is literally invisible. The most modern US nuclear submarine would not be able to get to half of that depth before being crushed by the pressure and almost all light cuts out below 650ft. In the case of the Exxon Valdez, both the US Government and the management of Exxon were clear about how much oil was being carried on the ship. This time, no one has a clue about how much oil will eventually spill into the water.
    Second, no one can say for sure how much new regulation will be imposed on the offshore drilling industry as a result of this disaster. These two invisibles have been driving the stock price, not DCF values.
  2. If you liked it at that price, you are gonna love it now!
    OK, that may be a bit of exaggeration. We are not talking about kitchen appliances (or gold coins) on late night TV. But the hyperbole highlights the frame of reference problem. The analysts who liked BP at $60 were in the wrong frame of mind when it was marked down to $50 then $45, $40 and so on. If they thought fair value was north of $60 before, how could they not get excited about a clearance sale? But it wasn’t a sale. The frame of reference changed because the market was in the process of digesting the steadily worsening picture in the Gulf. Sometimes, the market is trying to tell you something. It might be a 20% off sale but at the very least, you should be willing to challenge your assumptions.

Next, ask if you should even be here?

For this frame of reference, we should question where the energy sector belongs in the greater scheme. It is fascinating to follow the reports and learn about how oil companies drill for oil a mile under water. But what does that have to do with your investment portfolio today? How much should one be investing in energy companies today with the global economy just barely out of the Great Recession? The answer is not difficult or complex. Taking IXC as a proxy (IYE if you would like to limit yourself to US only), you have not missed much by ignoring the sector over the last 6 months (both before and after the blowout). If you look at the medium term prospects of IXC (click here), the System is telling you that your money is better off elsewhere. Does that make sense? Before the blowout, low industrial capacity utilization and the prospect of a cooling Europe and possibly China signaled caution. After the blowout, the case for underweighting energy is even stronger when you think about how much more it will cost to drill for oil once the US Congress finishes passing new laws and President Obama finishes issuing executive orders. The time to look at this sector is when all the bad news is public and the economy looks ready to demand fresh sources of oil. We have reached neither of those conditions at present.

What can we conclude?

Bottom up research can be risky business. The conclusions can be undone by factors that are hard to fathom (or in this case, are invisible) and the analysts themselves are often too close to their subjects to offer good perspective. The next time you see a hot tip like BP at $48 on your favorite blog, ask yourself if all the bad news is really in the market and what would happen if another shoe were to drop. BP’s management may have been able to deal with a blowout leaking 1,000 barrels of oil a day but at 60k a day, the company’s prospects look very different.

By having a top down framework, which has been telling you that energy is at best a lagging sector right now, you can avoid investing in these “hot opportunities”. Picking a good sector in a broader index or a solid stock in a promising sector is a far easier way to make money in the long term.

Where are we this week?

The System shows us in much the same place as last week. Although the markets did perk up a little, most risk assets are still sporting low or negative scores. One issue looming over the equity markets is the huge number of large equity issues crowding the gates in Hong Kong and Shanghai as Chinese corporates clamor over one another to issue new shares. The expected valuations look rich compared to what investors seem willing to pay, the potential cash call is significant and any hiccups might generate bad news that could reverberate around the world. Perhaps the G-20 meeting isn’t the only reason China has announced a further revaluation of the RMB.

Try our new tool

Check out your favorite stock, ETF, index or Mutual Fund on our “Steam Gauge“. If you click this link or the picture below, it will take you to a page with the S&P500 ETF loaded into the ticker window. You can hit the “Try Me” button or enter your own ticker. After you get the result, the reset button will give you a blank window to try other tickers. We will be rolling out a more advanced tool for our Gold Members that will allow you to put in multiple tickers and see how they compare to each other.

IRP Steam Gauge

Correction or Bear?

Riskier assets have taken a pounding in the last month or so as investors calibrate the extent of the damage in Europe. Whether a Greek default will happen is almost irrelevant at this point because almost three quarters of investors think that a Greek default is highly likely. That is why Developed Europe is at or near the bottom of all the representative portfolios that we monitor. In the ETF Long/Short Portfolio, the Short EAFE ETF (Europe, Australasia, Far East or EFZ) is now joined by the Short Commodity ETF (DDP) at the top of the list. Please note that the readings for short products can change quickly so unless you are willing to follow those trades closely, the Long/Short Portfolio may not be for you.

However, the implications are important for all investors. As we have mentioned in the past few newsletters, the global “liquidity bathtub” has been tilted towards the US dollar. Most of the new money flooding into the US dollar is going into short term US Treasuries rather than equity, property or other assets, so it is short term in nature. On the equity side, money is flowing from the Big Caps to Small Caps. The reason for the small caps preference can be traced to the relatively large proportion of earnings that come from overseas in indices like the S&P500.

A strong US dollar does not bode well for export-led recoveries in the US or in most of Asia (where currencies show a “high correlation” to the US dollar). Copper prices had a bit of a bounce (an important leading indicator for construction and manufacturing in China), but commodities are generally still soft across the board. The only exception is Natural Gas (UNG) which is probably due to the continuing disaster in the Gulf of Mexico.

All of these developments send us scrambling to our favorite economic indicator, the ECRI Weekly Leading Index. A critical question in investors’ minds is the likelihood of a second dip into recession. Although the WLI has not signaled an upcoming recession yet, the trend is definitely not comforting. Like any leading indicator, major equity indices are going to have a weighting and certainly much of the drop from 12% in May to -3.5% in June is due to the sharp correction in major market indices. We will have to wait a few weeks to see how much a market bottoming will impact upon the numbers.
ECRI Weekly Leading Indicator
Source : ECRI

Will we go into a double dip recession? There is no doubt that GDP growth rates and corporate profits will slow for the rest of the year. Looking at a new set of indicators developed by Richard Davies at Consumer Metrics Institute, which uses a modern, updated approach to gathering sales data from the US economy, consumer demand is turning negative. Although these data series have not been around as long as ECRI, the approach is very interesting, the series leads GDP figures and the conclusions are also not positive.
Consumer Index Chart

So, what is the answer? Bear or just a correction?

Unfortunately, the jury is still deliberating. The System is designed to favor cash and cash equivalent asset classes when everything else is falling. We are not there yet and the risk of getting out of the market at a short term bottom is high when sentiment is as negative as it is now. Overall, our system is still showing a preference for some classes of equity over money market related investments although the readings are approaching a turning point. One sector which has fallen out of favor is the Biotechnology both in our mutual fund and ETF portfolios. But US stocks remain at the top of the portfolios with a skew towards small caps.

New research tool

For intrepid readers who are interested in seeing how some of our numbers are put together, we have developed an application which is still in the testing stage. Try it out here. For now, it only works with US equities, ETFs and Mutual Funds and you need to know the ticker (which can be found on Yahoo Finance). We would appreciate any feedback might have; please that you send it here.

The Rising Dollar

As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).
US dollar index and UUP ETF
Source: Bloomberg

Why is the yield curve so steep?

Relative Yield CurvesThe short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.


On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.


Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.

Can Extraneous Information Impact Your Decisions?

Check out this New York Times article, The Impact of the Irrelevant on Decision-Making, by Robert Frank.

Make sure that the “madding crowds” don’t convince you to make a trade you might regret later.

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