Market Temperature and Spain’s Pain

March 31, 2012

The S&P500 inched up 0.8% on light volume. For the second week in a row, the 30 day VIX rose slightly, suggesting that more professionals are starting to buy insurance against a general market sell-off over the next month or so.

Other technicals are also hinting at caution. The percent of investors who are bullish has reached heights associated with former short-term tops. The same applies to the percent of firms in the S&P that are above their 150 day moving average; while very high, this indicator is turning down. Insider selling is soaring. The NYSE summation index has been falling for several weeks now. And Treasury prices jumped back up (yields fell). Ironically, many of the same warning signs appeared in the spring of 2010 and 2011. Both times the stock markets sold of about 20%.

In macro news, the string of misses continued to grow. Pending home sales, the Chicago Fed survey, the Dallas Fed survey, consumer confidence, the Richmond Fed manufacturing index, durable goods orders, initial jobless claims, Chicago PMI, and personal income ALL missed expectations. Only consumer sentiment and consumer spending beat estimates. As described last week, the US economy appears to be slowing down.

Spain is back in the news. Last week, its government bond yields soared back up to higher and more troubling levels. The economy is sinking back into recession, and at the end of the week, the new government announced a massive $36 billion deficit reduction plan. Coming a day after almost a million workers held a general strike (shutting down most of the nation’s economy), this plan will shove the economy even further into recession. Meanwhile, Spain’s unemployment rate is pushing 24%, public debt (national and regional) is soaring, and real estate values are plunging. And the Spanish banks that have loaded up on public bonds are staring at implosions not only from collapsing real estate collateral values, but also the possible collapse of their public bond holdings.

Spain is very quickly moving toward disaster.

Meanwhile in the US, markets are positively exuberant. Despite weakening economic indicators, and despite the slowdown of corporate profits from record high levels (relative to sales and GDP), and despite the outflow of Main Street retail investors, the stock markets have continued to rally.

Almost every measure of equity market sentiment, bond market spreads, and overall market psychology are implying that, today, the stock markets are over-bought and over-valued. This means that the risk to being fully invested is excessively high and that the prospective returns are correspondingly low.

Better to wait for lower overall prices before meaningfully increasing equity exposure.

That said, there are individual equities and high yield bonds that have been oversold and could offer the lower risk entry prices and higher prospective returns.

In equities, HP is amazingly oversold and cheap by any common measure of value. In high yield, the coal sector has been thrown out. While many of the leading players are hitting new lows in stock prices, their bonds have also sold off and are now offering huge spreads even for medium term notes. Nibbling on these notes (especially those of the strongest of the coal miners) can provide a relatively safe, and potentially highly rewarding opportunity to capitalize on the sell-off.

At a time when almost everything in US capital markets is highly priced, there are still some securities and sub-sectors that are on sale…..and offering good value.


Economic Indicators are Rolling Over

March 24, 2012

The S&P 500 dipped a piddling 0.5% last week on the usual light volume. On the other hand, thirty day volatility, as measured by the VIX, crept higher, after reaching multi-year lows the week before. More and more data are suggesting that typical many investors have fled the stock market and have instead shifted a greater percentage of their funds into bonds and other fixed income assets. This has left professional traders and other sources of fast money to drive stock prices higher. After two 50+% market plunges over the last 10 years and essentially zero total returns, it seems as though Main Street is refusing to take the risk of incurring more losses.

On the macro front, the news was light. Housing was the biggest story and the results were disappointing. The Housing Market Index came in at 29, not the 30 that was predicted. Housing starts (especially single family home starts) dropped, instead of rising slightly as expected. Existing home sales fell; they were supposed to rise. The Mortgage Bankers’ association index of mortgage applications plunged, as interest rates began to tick up. New home sales fell, badly missing what was supposed to be an increase. Finally, in housing, the FHFA housing price index did not show any signs of rising, as expected. All in all, the experts who have been predicting a “recovery” in housing EVERY year starting in 2009, seem to have blown it again. Not only is the US housing market not recovering; it’s still falling.

At the end of the week, economist David Rosenberg of Gluskin Sheff came out with an interesting observation about the US economy. Over the last few months, the consensus in the media has been that the US has somehow successfully decoupled from the rest of the world, most of which is slowing down or in recession already (most of Europe is in recession again, China is either suffering from a soft or hard landing, Japan is stumbling as usual, Australia is slowing because of the Chinese slowdown, and Brazil and India are also slowing and introducing policy responses to fight their respective slowdowns). So amazingly, the world—its economy and its risk markets—has been depending on America to save the day.

So David Rosenberg’s simple observation was quite disturbing because he noted that 11 of the 13 most recent economic indicators in the US have indisputably missed consensus expectations. And the only two that supposedly “beat” (car sales were spiked by channel stuffing and jobs grew courtesy of seasonal adjustments) were arguably massaged by the government to produce better results.

And Rosenberg reminds everyone that the stock market is not always a leading indicator of the economy. He notes that it’s “amazing how many people out there believe that the economy is improving just because the S&P 500 managed to get to 1,400 this past week. The market doesn’t always get it right.”

Well, not immediately.

Also of note is that most of the 11 indicators that “missed” are true leading indicators of where the economy is headed. Remember, GDP results announced every quarter are historical results—relying on these results to forecast is akin to driving a car using a rear view mirror.

And finally, these misses are just that actual misses. Rosenberg isn’t projecting misses. He’s simply observing that they’ve already occurred.

There’s little to argue about here. The US economy is slowing down. The question is simply how soon and how hard.

The next question is:  how will the markets react? Especially since they’re priced on the exact opposite–no slowdown in US economic growth, no slowdown in corporate sales growth, no slowdown in corporate profit growth and no meaningful impact from near record high oil and gas prices.

Over the next few weeks, not months, we’ll know the answers.


Walter Schloss

March 18, 2012

The S&P500 pushed higher 2.4% last week on light volume and ever growing complacency–the volatility index has dropped to multi-year lows. While economic numbers actually deteriorated last week, and while retail money flows showed that the average investor pulled money OUT of the stock market last week, prices continued grinding higher on hopes for continued central bank money printing and simple momentum: to many professional investors, the logic is “prices are grinding higher, so why not stay with it”.

Beneath the surface, things aren’t so rosy. The breadth of the rise is narrowing, meaning that fewer and fewer “hot stocks” (think Apple) are leading the indices higher, while many less known stocks are lagging. If indices were already overbought, and overly bullish before last week, they have now become even more so.

The disappointing macro data came in several forms. Retail sales rose slightly less than predicted. Import prices were higher than expected; export prices were lower. Both will squeeze corporate profit margins. While inflation, as measured by the government’s PPI and the CPI was tame, inflation as measured by the credit markets (the 10 year breakeven rate) rose to a one year high: 2.41%. The big surprise disappointments of the week came on Friday. Industrial production growth collapsed; instead of rising 0.5%, it was flat. And finally, consumer sentiment was expected to rise to 76.0; instead, it fell to 74.3. And both industrial production and consumer sentiment are leading indicators.

Last month, an investment manager named Walter Schloss passed away at the age of 95. The Economist magazine paid a tribute to a man who had a remarkable investment career.

Most folks, even professional money managers, had never heard of Mr. Schloss. He never appeared on CNBC or Bloomberg to tout his “stock picks” or to peddle his services to prospective clients and other sources of asset management fees. As The Economist notes, Mr. Schloss never had more than 100 clients.

But Mr. Schloss was a disciple of Ben Graham, who also happened to be the mentor of Warren Buffett.

So why was Walter Schloss remarkable? Because over a 40+ year span of managing money, he beat the market by 60% on average, annually.

How did he do it? By doing the exact same thing that Howard Marks (profiled here a few months ago) espoused–by finding and buying stocks that were worth far more than the prices markets temporarily priced them at. These stocks were out of favor “cigar butt” stocks that “weren’t worth much, but sold for far less.”

So in time, as the markets recognized the price vs. value discrepancy, prices rose to meet the higher values. And that is a recipe for beating the market.

But there’s another set of key lessons here. First, a recipe for success can only be declared as such—as success—only when it’s assessed over a very long time period. And 40+ years qualifies as a very long time period. Why is this important? Because statistically, it’s very possible that any particular manager could have a lucky streak that lasts 2, 5, and sometimes 10 years. While the news media and the investing public falls in love with such a manager, the absence of a truly successful formula will ultimately lead to disaster. Bill Miller of Legg Mason, one such example, was a “rock star” manager for over a decade; he was fired last year after incurring several years of massive losses.

Second, how could Mr. Schloss do something so simple—and something so easily capable of being copied—while almost no other investors or investment firms did too? Because he did not manage for the short-term and he did not work with investors who expected short-term out-performance; both would work AGAINST his successful long-term strategy.

What does the rest of the investment world do? Most retail investors and even most professional and institutional investors cannot or will not manage for the long-term. Either they haven’t done the analysis to convince themselves that their bargain purchases will work in the long-term, OR they don’t have the emotional patience to wait until the prices of their investments rise to meet the higher intrinsic values. And professional managers who may even understand this process, may have no choice but to abandon good investments because their investor clients lose patience and choose instead to chase short-term performance goals instead (again, think Apple).

What’s an example (and only an example, NOT an investment recommendation) of an out of favor stock that’s very likely priced today for less than it’s actually worth? Hewlett-Packard.  Sexy? In favor? Sure to go up from here? No. No, and no.

But unlike Apple, essentially a two product company, that’s dominating the headlines today, Hewlett-Packard is under-priced, un-loved and under-owned. And by owning a portfolio of such firms and by holding on to them for many years, as Walter Schloss has proven, one can earn a healthy rate of return, a return that utterly blows away the market.


“Greece Will Default” (from May 1, 2010)

March 10, 2012

Another week has gone by, and the S&P500 has closed virtually unchanged again. Volume was light, and volatility was stuck near historically low levels. Beneath the surface, the breadth of the stock market was not strong—the summation index fell, and the percent of stocks above the 150 day moving average was unchanged. After a big sell-off early in the week, a mere rumor of a “sterilized” QE program from the Fed was enough to reverse the losses and end the week unchanged.

In macro news, factory orders fell month-on-month. The ISM services index rose slightly (after the ISM manufacturing index fell crashed last week). Productivity gains were 0.9%, as expected, but unit labor costs soared 2.8% (quarter over quarter), more than twice as much as expected. Initial jobless claims rose more than expected to 362,000. The US trade deficit last month was far worse than hoped for, causing most economists to lower estimates of first quarter GDP growth. Non-farm payrolls came in slightly better than expected, but almost half the jobs were created by the Birth/Death model from the BLS, and the jobs added tended to be far lower paying jobs than the ones lost in 2007-2009. The unemployment rate did not drop from a still terrifyingly high figure of 8.3%. And average hourly earnings disappointed.

In May 2010, our weekly entry was titled: Greece Will Default. Here’s what we wrote:

To be polite, politicians may not call it a default; a restructuring would be a less distasteful term.  And Greece may not default next week or even next month; still, at some point in the future, it will.

Last week, the inevitability of a Greek default started–and only started–to sink in.  Harvard economist and Ronald Reagan’s Council of Economic Advisors Chairman Martin Feldstein stated the obvious:  “there simply is no way around the arithmetic implied by the scale of deficit reduction and the accompanying economic decline; Greece’s default on its debt is inevitable.  In the end, Greece, the eurozone’s other members, and Greece’s creditors will have to accept that the country is insolvent and cannot service its existing debt.  At that point, Greece will default.”

But the real source of concern isn’t merely the issue of Greece’s credit risk; Greece, after all, makes up only about 2% of the Eurozone’s total GDP.

The real source of concern–and eventual source of panic–is the threat of contagion.  Even before Greece actually defaults, the risk that other PIIGS (and their banks) could also default will grow.  In fact, judging by their surging interest rates, the risk of contagion is already growing.

This means that as Greece topples, Portugal, Spain, Italy, Ireland, and then eventually the UK will also face the strong possibility of “restructuring” their debts.

Sure enough, on Friday March 9, 2012, almost two years after making this prediction, Greece officially defaulted, but wiping out over $100 billion in sovereign debt.

Yes, it was called a “restructuring”. And yes, it took a long time to come to fruition—despite the fact that almost every member of Europe’s elite ruling class insisted, two years ago, that a restructuring would never happen in Greece.

And yes, the worry now is that Portugal and Ireland are very likely next in line to default. What’s worse is that Greece’s debt load—after the default—is now actually greater than it was before the default. Why? Because the post-default bailout funds that will be loaned to Greece are GREATER than the amount of loans that were written down by the default. The result? Greece’s new post-default debt is already trading at yields far above the next most risky PIIGS state, Portugal. In fact, the high yields at which the new Greek government debt is trading imply that the probability of ANOTHER Greek default is already over 90%!

So not only is the threat of contagion now going to grow, as predicted here almost two years ago, but the Greek debt problem itself has not been solved.

What kind of solution is that?


Gold Continues to Deliver

March 3, 2012

The S&P500 finished the week virtually unchanged. Volume was still light, but somewhat higher only because volume jumped on two days when the S&P sold off. Volatility, while also unchanged, remains near multi-year lows. In the past, when volatility jumped higher, it was usually from low levels similar to the ones we see today.

In macro news, US economic data started to soften. Durable goods orders plunged, instead of dipping slightly, as expected. The Case-Shiller home price index came in below expectations—not only are home prices falling, but they’re falling at an accelerating rate. Chicago PMI was better than expected. Personal spending and personal income both came in well below expectations. And core PCE (the Fed’s favored measure of inflation) came in at virtually 2.0% on an annual basis. Why does that matter? Because the Fed has recently announced that it would justify more QE if core PCE was below 2%. This means that—per the Fed’s own rules—it’s going to be more difficult to announce QE3 anytime soon. Finally, the big surprise of the week was a very disappointing ISM manufacturing index. Not only did it miss badly, but this is a very critical leading indicator in the US economy, and it’s headed down.

Overseas, in Euroland, the most recent numbers were disastrous. EZ unemployment rose to 10.7%, the highest since 1999, and manufacturing PMI’s contracted for the seventh consecutive month. In short, Euroland is in a recession, and the recession is deepening. The repercussions to the rest of the world are strongly negative. China, the US, and other regions of the world depend on Europe as a huge market into which they sell their products and services. With a deepening European recession, these regions will suffer from diminished exports, which will in turn, diminish their economic growth.

Over two years ago, we made a case to go long gold. After making this recommendation—to buy on a pullback—gold did fall back down slightly to $1,050.

Sure enough, one year later, in January 2011, we followed up with a recommendation to continue to hold gold, and to buy more. At that time, it was trading around $1,350. This represented a 28.6% jump from the prior year’s buy signal.

A few weeks ago, almost exactly one year after the January 2011 recommendation, gold closed near $1,750. This represented a 29.6% jump from the 2011 buy and hold recommendation.

So now two years and 67% after first recommending gold, what are prospects for even further appreciation?

The answer is fairly simple, and can be measured by assessing real interest rates, and more precisely prospective real interest rates, or the nominal (or headline) interest rates on Treasuries less the inflation rate.

Very few factors track the price of gold (in dollars) better than real interest rates. And the relationship is inverse—when real rates fall, the price of gold rises.

Where are real rates today? They’re negative! When using the 5 year or the 10 year Treasury rates, and subtracting the appropriate inflation rates, the yields are less than zero.

So if investors lose value by buying “risk free” 5 and 10 year Treasuries, they figure—correctly—that gold offers a better store of value.

And since the most important point about real rates is what investors expect them to be going forward, well the Federal Reserve has already hammered home the message—ad nauseum—that not only will the Fed Funds rate be zero for several more years, but that if economic conditions deteriorate, then the Fed will very likely print more money (create more reserves via Quantitative Easing).

So unless there’s a reason to think the Fed is lying, that it will not do exactly what it has already done over the last several years, or that the US economy will somehow spring back to life without curing the underlying cancer that afflicts it, then investors can rest assured that real rates will be negative for several more years.

As a result, gold should continue to rise for several more years.

Could the price of gold dip during this period? Of course. It “dipped” over 20% last fall, only to bounce back and recover most of the drop in only two months. And if there’s a big risk-off phase later this year, gold (and silver) will almost certainly get sold off too.

But instead of panicking, consider any pullback as a surprise “clearance sale” offered by the markets for a “limited time only”….and buy, buy, buy all the gold you can comfortably afford. Chances are, you will not be disappointed.