The Reformed Broker
Ben Bernanke's speech yesterday was very well-received by the Blognoscenti and the Twitterati who cover economics and finance; they found it to be his most forthright and unapologetic in terms of laying out the body's shorter-term objectives to lower unemployment.
The format of for the Fed Chairman's remarks was a rhetorical Q&A, these are the five questions he asked and answered:
- What are the Fed's objectives, and how is it trying to meet them?
- What's the relationship between the Fed's monetary policy and the fiscal decisions of the Administration and the Congress?
- What is the risk that the Fed's accommodative monetary policy will lead to inflation?
- How does the Fed's monetary policy affect savers and investors?
- How is the Federal Reserve held accountable in our democratic society?
My friend Joe Weisenthal called this a dazzling speech in that it was heavy on myth-busting and took some of the more popular conspiratorial delusions about the Fed's activities and aims head on...
...what we liked about the speech was the sheer volume of myths and misconceptions that he debunked or clarified in a short period of time.
Myths about the Fed are legion (repeated ad nauseam by pundits and politicians) and it seems that Bernanke realizes that the more exotic Fed policy becomes, the more he must inevitably debunk memes in order to justify his actions. Lowering rates during normal times is fairly uncontroversial and easy to understand. Buying bonds on an unlimited basis while indicating that rates will be kept low for years requires some 'splaining. Today's mythbusting is an extension of something he did at his September 14 press conference...
I highly recommend that everyone reads the whole speech at some point this week, no matter how sophisticated (or unsophisticated) so as to truly understand the mind and workings of the FOMC right now.
Full text here: Federal Reserve Board
Syntagma Square in Athens is once again filled with the sound of beating drums and the flames of firebombs as the entire nation walks off the job for the first general strike since the coalition government was formed this past June. In Spain, the situation is rapidly deteriorating; protestors beat up a policeman in the middle of the street last night in full view of the news cameras - we're talking about a heretofore unseen level of rage as PM Rajoy readies his official bailout request to the Northern purse string-holders.
Which brings me to the US equity markets, which are coming off of a virtually uninterrupted melt-up since the end of June, with virtually every sector and stock participating regardless of economic sensitivity. This in the face of eroding fundamentals for many bellwether stocks and industry groups, Fedex and Caterpillar being just the latest examples to tell us how lousy things are.
But we ignored the fundamentals and rampaged higher on sentiment. This is how you explain a stock market that runs up 15% with no change in earnings estimates for the forward two quarters. The improvement in sentiment - driven by the assumption and then confirmation of permanent Fed support - is responsible for virtually all of your portfolio's gains since the Summer Solstice, no offense to the regard with which you hold your stock-picking abilities. Even the most bullish strategists with the highest year-end S&P targets acknowledged that multiple expansion was the key ingredient for their forecasts, none of them were looking for an acceleration in fundamentals by year-end.
In short, we built a Castle on a Cloud, the accumulated moisture of performance-chasing and confidence were its only foundation. And now, with European markets back in turmoil - with all of the volatility and drama that brings - the only question is whether or not our Castle on a Cloud can remain aloft, above the disturbances at ground level.
That's the thing about Castles on Clouds - a surrounding siege army is not required for them to fall, only a change in air current that dissipates the molecules.
Ray Dalio, with the winship of his hedge fund Bridgewater, has acquired a mystique of mythic proportions over the last year or two. And with this success, the assets under management have followed.
And that unfortunate thing that happens with all managers who get really big, really quickly, has started to happen to him.
Here's a quick idea from a piece in Forbes about the wealthiest hedge fund managers in America:
The current king of the hedge fund industry, Ray Dalio, can be found in Westport Ct., where he lords over the world’s biggest hedge fund firm, Bridgewater Associates, with about $130 billion in assets. He scored spectacular returns in the 20% range last year at a time when most other hedge funds struggled. Dalio’s net worth is $10 billion. He has not been able to keep his winning streak going so far in 2012, with one of his most prominent funds down by nearly 3% through the first half of the year. Now at age 63, Dalio is ceding more responsibility and selling ownership stakes in his firm to his employees and clients. Also on the drawing board: A new $750 million headquarters that if it gets regulatory approval will be built by 2017 in Stamford, Ct., to accommodate more than 2,000 employees, nearly double the number of people currently working at the firm.
This is not to say that it's time to write Dalio off as an investment manager, but make no mistake - he is now more than just a manager. He is now a hedge fund mogul, with all the trappings and pitfalls that come along with it. It is interesting to note how this sort of thing becomes unavoidable, no matter who it happens to. The payrolls get bigger, there are more families depending on him to keep succeeding and obviously more investors. Life gets harder, not easier, should he continue on in his current role.
Don't get me wrong, I'd trade places with him in a moment
Berkshire's got a brand new bag. You've almost never seen Warren's company buy a stock and then blow it out a year later. Berkshire's corporate culture is and has always been buy and hold; Buffett tries to own things he would never want to sell.
But there's some new blood at the company. Todd Combs was brought in followed by Ted Weschler to take the reins on the investment portfolio, and I highly doubt Buffett and Munger hired them with an expectation that they'd do things a different way.
New blood is good sometimes.
As a shareholder myself and an adviser with virtually all of my clients in the stock, it's really interesting to watch this whole thing evolve...
Berkshire Hathaway Inc. (BRK/A) locked in a gain on its Intel Corp. (INTC) bet by selling its stake less than a year after making the investment, shunning the buy-and-hold strategy favored by Chairman Warren Buffett.
Berkshire’s Geico unit accumulated 11.5 million shares of Santa Clara, California-based Intel in the second half of 2011 for an average price of about $22 each, according to National Association of Insurance Commissioners data compiled by Bloomberg. Buffett’s firm sold the stake in the world’s largest semiconductor maker for an average price of $27.25 this year through May 8, netting about $60 million in profit.
Now everything is different. At first blush, QE3 does indeed look like a game changer.
This is business is not about making calls and sticking with them for the sake of being able to say you were right all along, it is about processing new information that will make a difference and dropping the opinions that have been invalidated. I come to work every day hoping I'll be able to do that. It's easier to write about than to actually do. Is your decision making process flexible? Are you hung up on what "should happen" rather than what is likely to happen?
I think the open-ended nature of this new bond buying program ($40 billion a month, unencumbered and without limit) demands that we acknowledge the new rules of the game:
Q3 earnings will still matter for individual stocks, as they always have, and misses will be punished.
And there will be plenty of misses and negative warnings, just like Q2.
But this will not affect the major averages, paradoxically. They should be be able to weather this as they are driven by large companies with incoming dollar flows into their shares as a result of Bernanke flooding the market with dollars.
Worry less about the "E" for now and more about the "P" - QE3 does wonders for multiple expansion, especially as it makes bond holdings even more unpalatable than they already are - the money has to go somewhere.
The new question is not "bonds or stocks?" It is "which kind of stocks?" We prefer the bigger stocks with bond-like characteristics (lower vol, high rate of returning cash to shareholders). Others will reach for garbage and buy cyclicals hoping for improvement from China. Maybe they will get it, the pain will be severe on an individual stock basis if they do not.
When in doubt, do something other than cash.
Dips can be bought. They will be gifts, specifically headline-driven stuff. Because the Europeans are following the Fed now. So long as China doesn't blow up between now and Christmas, we should have a lot less volatility than previously expected into year-end.
These are the new rules in my way of thinking, unless something changes - in which case my job is to reassess. Again, much easier to write about than to actually be about.
Josh here - Nick Colas, Chief Market Strategist at ConvergEx, calculates that investors have left roughly $65 billion in gains on the table by walking away from their equity mutual funds over the last several years. This is offset by the fact that they may have simply switched some of the money into bond funds, of course. Even still, pulling $347 billion from stock funds over three years seems like a lot until you consider that they are still holding $5.6 trillion worth.
Some interesting stats from the ConvergEx team below...
- Since August 2009, the S&P 500 is up 39.6%. It has had some pullbacks, to be sure, such as the drops in mid-2010, late 2011, and mid-2012. But if you had entered the market on August 28th, 2009 you would not have experienced a loss on your initial investment except for one week in July 2010.
- Over the same period, investors in U.S. stock mutual funds have withdrawn $347.2 billion. The outflows have been persistent to the point of monotonous. Only six of the last 36 months have seen net inflows, the last one in April 2011. The average net monthly outflow has been $9.6 billion.
- The period from January 2007 to July 2009 was almost as bad, with $204.3 billion leaving U.S. stock funds. Yet the flows were not as persistent negative during this period, the worst for domestic stock volatility. Of the 31 months in this period, 10 of them actually saw inflows.
- There are several reasons, in my opinion, for the move out of U.S. stocks funds. Investors have clearly shifted to less-risky investments, a in a moment. There is also likely a demographic aspect to these flows, as recent retirees juggle their portfolios for incremental income rather than outright growth. An estimated half of U.S. stock fund assets sit inside defined-contribution plans such as 401(k)s, after all. And lastly, I am sympathetic to the notion that structure still dealing with some very visible teething pains.
- Exchange Traded Funds now offer investors a competing product to mutual funds, and flows into U.S equity ETFs over the last 3 years amounts to some $93.9 billion according to our friends at www.xtf.com. The fact that ETFs are not widely used in defined contribution plans means that these flows may not be the destination of the money that has left mutual funds, however. In fact, we've spoken to ETF sponsors who posit that ETF investors represent a younger demographic than mutual fund holders and therefore the two pools of money have origins in different rivers of capital.
I'm reading more and more about the Fed's liquidity trap these days, which is interesting considering the timing - on the probable eve of yet another guns-blazing Fed bond-buying program.
The trouble with zero-bound interest rates is that they wreck business models, specifically in the financial industry (insurance companies, lending, investment management, etc). Which would only be a temporary problem if they could actually spur lending and borrowing. But in the context of a decade's long deleveraging process, the simple fact is that they can't spur these things, not in any meaningful way.
And so they end up acting as a damper of financial activity in a bizarre way.
Bill Gross's latest missive at PIMCO explains this phenomenon beautifully this morning:
When yields are too low, and acceptable risk spreads so narrow that top line interest revenue is increasingly marginalized, then lending is at risk. Excessive historical overhead represented by rents, salaries, pension and health benefits, to name just a few, force financial and lending institutions to do one of two things: They lever up to cover those costs or they slow or shut lending down to preserve equity and the ultimate franchise. The levering up is indeed difficult given the 2008 financial crisis and the ensuing follow-through of intensified regulatory oversight. And so, what we are witnessing instead is the beginning of a waltz, a dance where financial institutions such as banks, insurance companies and investment management firms fail to reap the economies of scale so reminiscent of the prior era of fat as opposed to the present one of lean. In the process, they lay off, instead of hire new workers; close branch offices or even ATM machines by the thousands as did Bank of America recently; and yes, ultimately reduce the rate of lending or credit growth which propelled the global economy so effortlessly over the past century.
Talk about the Law of Unintended Consequences...
The Blogfather Howard Lindzon put this post up recently where he laid out a handful of really simple rules to learn how to invest while enjoying oneself. The thing about investing rules is that we all know what they are, after a while at least. The trouble we have is sticking to them and reminding ourselves of them.
So it's helpful to see them in print here and there. Howard's version is great:
1. Do not let trades become investments, but it is ok to let investments become trades.
2. Personality first. Know yourself! (The markets will exploit your weaknesses)
3. Develop your own approach.
4. Be flexible because you will be very wrong.
5. Find mentors. Today! Don’t expect anything from them.
6. START today. While learning how to invest, decide on an amount that you can invest in the markets and dollar cost average. Invest an equal amount of money once a month or quarter for a long period of time.
7. Keep your costs down.
8. Focus on your strengths, invest some profits in your weaknesses.
9. Do not ‘practice’ investing and do not call your investing money ‘Vegas’ money. Develop a routine.
10. Write it down! Start a journal.
11. Immerse yourself in the language of the markets and investing. It has never been easier.
12. Knowing when and how to sell remains the most mystical of processes. I just say do it consistently. There is no shame in leaving money on the table.
Good stuff and simple.
On The Street, we call junk bonds "chicken equity" in the context of portfolio construction.
Many allocators are buying junk bonds not as part of their fixed income allocation but really in search of an almost-equity return with slightly less risk and volatility. So, for example, you'll see a financial advisor carve out a 5 or 10% spot for junk bond index ETfs (HYG, JNK etc) but that allocation won't be coming from the bond side of his clients' portfolios, it'll be coming from the stock side.
He's re-risking a bit to get slightly more aggressive - without quite going so far as to buy stocks and throw off his precious 60-40 mix
But now what happens when you get a lot of people doing this all once - interest rates and fears about stocks being what they? You get a deluge of cash into the asset class.
Check this out from Brendan Conway at Barron's Focus on Funds:
Investors have fed the SPDR Barclays Capital High Yield Bond ETF (JNK) and the iShares iBoxx High Yield Corporate Bond ETF (HYG) a combined $7.3 billion this year, driving those two funds’ assets up 35% in less than eight months. They seemingly cannot get enough of these passive, index-tracking high-yield funds, whose annual yields are north of 6%.
First, you know what the next step is should the chicken equity trade treat these allocators well, right? It's more actual stock exposure most likely.
Second, Brendan makes the point that ETFs now account for 10% of all high yield bonds. In other words, should the going get rough, not everyone who's put this trade on is going to be able to get liquid at once. Especially during a panic.
We've got a smidge of junk exposure via ETFs in one of our income models, but we're certainly not using it as a "chicken equity" play. We prefer stocks as opposed to stock-like bonds right now.
Say this for the GOP: by resurrecting the very bad, no good, truly awful idea of a gold standard, they’ve given us something to talk about.
Matthew O’Brien makes one obvious point: anyone who believes that the gold standard era was marked by price stability, or for that matter any kind of stability, just hasn’t looked at the evidence. The fact is that prices have been far more stable under that dangerous inflationist Ben Bernanke than they ever were when gold ruled.
I’d like to offer a different take. There is a remarkably widespread view that at least gold has had stable purchasing power. But nothing could be further from the truth.