More Stimulus Ahead?

Upon reviewing economic events for September, so far we have little indication of how some events may change the market. On Friday 7 September the August Non-Farm Payrolls (NFP) report came out. The expected number of 130k additional workers fell short at 96k, and the July figure of 163k was revised to just 141k workers. The number of Government workers declined 7000, while manufacturing employment declined 15k, and average earnings were flat, against expected gains. The unemployment rate fell to 8.1% largely on a decline in the participation rate. The Bureau of Labor Standards noted that employment increased in foodservices, professional and technical, and in health care workers. It was noted that the number of involuntary part-time workers remained steady at 8 million, with average worker hours at 33.7 hours. Average hourly earnings declined 1% to $23.52 per hour. Since June NFP were revised downwards from 64k to 45k workers, it appears that the level of unemployment is not improving at a fast enough pace. If we look at a longer trend since 2000, we can see that average hours worked in the United States has declined greatly, though this trend is similar across many developed nations. A continuation of this long trend may lead to deflation in the future.

Considering the poor NFP report, it may seem surprising that stock markets did not sell-off on that Friday data release. The reason is that the weaker than expected numbers have some analysts increasing their expectations for the Federal Reserve to take action. Many analysts now see the chance of QE3 stimulus at 60%, though few are stating we will definitely see that action. As Federal Reserve Chairman Ben Bernanke has pointed out several times, the Fed is concerned about creating “distortions” in markets. If we do not get QE3 or another form of stimulus soon, then we may see a substantial sell-off in equities markets. The Federal Open Markets Committee will meet on the week of 10 September to discuss the economy, though at the moment it is not expected that QE3 will be announced. The graph included here is from Bill McBride of Calculated Risk, and indicates the affects of hints and announcements of stimulus programs from the Federal Reserve. Clearly stock markets would advance on new stimulus, though it appears the markets are now addicted to stimulus. There is not yet any indication that equities markets can stand on their own without stimulus, which does not bode well for the future. At whatever point in the future the Federal Reserve begins another round of stimulus, we might expect similar market gains as in past stimulus measures. The only sector that did not gain on previous stimulus measures was industrial commodities.

As we have covered in past articles, there remains a lack of volume in equities markets, which suggests that the current gains on the S&P 500 may be unsustainable. Even USA Today, a newspaper not known for coverage of financial markets, ran an article about the lack of volume, and nearly $10 trillion of cash on the sidelines. Of course hoarding cash is not a good strategy to improve profits, even if that choice seems safe in the near term. Managing your level of risk is part of an effective investment strategy, though there are rarely times when 100% cash makes any sense. At this point in time, having 30% to 70% cash may not be a bad idea, in order to position your investments to take advantage of a decline. We may see acorrection without an announcement of QE3 soon, though we may avoid the lows of 2009. Some equities in Europe declined near 2009 lows in June, and we may see smaller companies decline to those 2009 lows again.

One place where government intervention did surprise markets slightly, was the report of additional stimulus measures from China. There was a recent approval of infrastructure projects totalling near$US160 billion, and a reduction in capital requirements at Chinese banks, estimated to place an additional $US190 billion into the Chinese economy. The Chinese government reported that future growth may fall under 7.2%, though some analysts think true growth is already far below the official reported figure. Also Spracht Analyst has some great research on the slowdown in Chinese railroad volume, as seen in the chart here. At the very least, China is still growing faster than developed economies, though the strong growth of the last few years appears to be slowing. The mention of new infrastructure investments by China lifted the iron ore market off recent lows, as expectations were high for an increase of iron ore exports to China.

As we head towards the end of 2012, there remain numerous headwinds, and potential events that may derail markets.Japan recently warned of similar problems, with the potential for the government to run out of funding as soon as this November. Fitch Ratings noted in a recent report that Money Market Funds increased their exposure to Japanese banks to 12.3% of holdings, though allocations to European banks only increased 9%. In Europe there is already German Bundesbank opposition to proposed fiscal measures put forward by Mario Draghi of the European Central Bank. Meanwhile, we are reminded of the ongoing problems in Greece, through a great article in The Economist about Tax Evasion in Greece. The interesting things pointed out about Greece, are that incomes are vastly under-reported, and it appears to be an accepted practice amongst self-employed individuals. Obviously solving monetary issues in Greece is a long term problem, though it appears that we may need to worry more about Japan than Greece at some point in the future. Of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) it appears that austerity measures in Portugal are improving the economy. Portugal may prove to be the model for further assistance elsewhere, and it is notable that the European Central Bank (ECB) and International Monetary Fund (IMF) did grant some concessions prior to providing assistance. Portugal proves that recovery with assistance is possible, though it is also slow and difficult.

The United States still faces a fiscal cliff and funding problems, though we may see temporary measures take us into early 2013. On Tuesday 11 September 2012, Moody’s Investors Service warned that a failure of the United States to produce a budget in 2013 that reduced debt levels, may cause the U.S. to lose it’s AAA rating. This would follow the downgrade by S&P ratings in mid 2011. I would expect Fitch Ratings to make some form of similar statement within the next month. Recent polls indicate a possible strengthening of Republican control of Congress, and President Obama returning to the White House, which might create even worse deadlock over the next few years. Obviously, much can change over the next few months, though the fiscal, budget, and deficit problems in the United States will still be there for whomever is sworn into office in early 2013. Despite the warning from Moody’s, the 3 year Treasury note auction on 11 September had far more bidders than offerings, indicating that investor demand for safe haven assets is still strong. In deference to government bonds, we see a great decline in corporate bond holdings, from $58.5 billion at the end of August, after hitting nearly $60 billion the week before. Historically the corporate bond holding low was $55.1 billion in March 2002. It’s another indication of how funding is disappearing, and why markets often move suddenly due to lack of liquidity. Many individual states still face funding issues and tax revenue shortfalls, though an ambitious carbon emissions trading market in California may point a way towards a new revenue source. Considering the issues in bond markets, and the lack of funds entering any markets, the plan for California to start carbon trading in the near future appears to face numerous challenges. Investors who may think we are headed towards much worse economic conditions, may want to watch this interview with Marc Faber, in which he notes that real estate and stock holdings might actually be good long term choices in the event of possible severe economic conditions.

The most anticipated event in September is the German Constitutional Court ruling on the European Stability Mechanism (ESM), and whether or not Germany can contribute funds to stabilize the bond markets and banks of other European countries. European stock markets rallied on statements by Mario Draghi of the European Central Bank (ECB). The promises made by the ECB have lifted markets, on the expectation that stated policy proposals will be enacted. Another issue beyond the German Constitutional Court ruling is that Spain and Italy will need to ask for additional funding. ECB Chairman Mario Draghi already clarified that funds would not be provided without conditions. One worry of many German politicians is that additional funding would delay much needed economic reforms in Spain and Italy, as politicians there with new bail-out funds could simply delay austerity or deleveraging actions. We may not see a decision on Greece until October, so it would not be surprising for Spain and Italy to delay funding requests until after that time. Spanish Prime Minister Mariano Rajoy has indicated he does not feel Spain should need to meet new austerity measures for additional funding, though he is fighting popular opinion in Spain against potential pension decreases, or further cuts in government workers. A softening of the requests made to Greece, might provide a greater bargaining position for Spain and Italy, though it would confirm German concerns that delays in cleaning up budget issues could hinder economic growth for many more years. The expectation of legal experts is that the German Constitutional Court will approve funding measures contained in ESM proposals, which is a result that might cause a rally in equities markets. Much of this action seems priced into current markets, so we may be seeing the highest point this year in equities. There was another motion filed challenging the ECB proposals, though at this time it appears that will not delay the main decision by the Court in Germany. Of course, not everyone is convinced the proposals by the ECB will actually work, as noted investor John C. Bogle, who founded Vanguard Funds, suggested to CNBC News that investors ignore comments from Mario Draghi. If he is correct in his assessment, then we may see markets decline soon, regardless of the German Constitutional Court decision.

Fitch Ratings latest report on Commercial Mortgage Backed Securities (CMBS) indicates losses on retail mall properties exceed the outstanding loan balances, though they rate the retail sector overall as Stable. The difficulty in rating these assets, or predicting future defaults, is that demographic studies do not reveal patterns that might determine future defaults; previously successful retail assets were found to be just as likely to become distressed as currently under-performing properties. Fitch noted that there is an increasing trend to modifying commercial property loans, and the time to workout was greatly reduced. Wells Fargo was reported to be closer to consolidating former Wachovia assets, notable in that both entities appear to hold a larger portion of distressed properties than other major lenders.

The latest Commodities Futures Trading Commission report on Commitments of Traders, indicates that short positions in EUR/USD (Euro to U.S. Dollar exchange) slightly increased. Some analysts are suggesting taking profits on the run-up of shares of major trading banks. Investors wondering where to place those profits, may want to look at housing or undeveloped land. The latest Freddie Mac Mortgage Rates Report indicates the 30 year is at 3.55%, and the 15 year is averaging 2.86%, rates substantially lower than in 2011. Noted investor Jim Rogers appears to agree with economist Marc Faber, that the earlier QE1 and QE2 programs opened the door for nearly endless money printing, which implies that at some point the markets will ignore stimulus programs. Holding longer term strong assets, like shares of large corportations, and real estate unencumbered by loans, may help weather a financial storm looming over the horizon. Individual investors are already moving to acquire more undeveloped land, much of it in previously distressed areas of the United States. This undeveloped land can sometimes be found at a discount, and is often easier to sell to future developers at a profit. As always, stay aware and informed, be cautious with your investment decisions, and don’t hesitate to take profits.

G. Moat

End of Summer Outlook

We ended a long, hot, and often slow August in financial markets on more of a whimper than a bang. The last week brought in various financial data for us to consider, and a meeting of the Federal Reserve in Jackson Hole, Wyoming. On the last Friday of August, Federal Reserve Chairman Ben Bernanke spoke about the outlook for the economy, and gave some thoughts on potential measures that the Fed may consider to stimulate the economy. To add a bit of turmoil, a mass shooting of protesting mine workers at a South African platinum mine, led to further mine worker strikes at other mines, including the fourth largest gold producer. This sent the futures of platinum and gold spiking higher. In an unrelated event, strategic maple syrup reserves in Canada were raided, though it appears Canada has the situation under control. Stock markets were closed in the U.S. for Labor Day, though most global markets were open.

On Tuesday 28 August 2012, the S&P Case-Shiller 20 city composite indicated a seasonally adjusted increase of 0.9% for the month of June. This increase in home prices was slightly higher than expected, though gains were not widespread across all 20 cities. In Atlanta home prices declined over 12%, while in Phoenix the decline was more than 14% lower than in 2011. This was some sign of improvement overall, though we will need to compare with the July Case-Shiller Index to see if increasing home prices are a sustainable trend. The Conference Board Index of consumer attitudes declined to 60.6 from 65.4 the previous month, making this the lowest survey level since November 2011. Even with a slight rise in home price levels, other consumer indicators are moving in a downward direction, somewhat due to rising gasoline prices, and continuing unemployment. Lastyear in August, the U.S. Congress and Senate flirted with the fiscal cliff, causing a huge sell-off, and prompting a ratings downgrade from S&P. This year in late July, Congress and Senate very quietly approved funding measures that will extend government spending through April 2013. This summer marks 15 years since the last budget was passed in the United States. I expect more attention on the fiscal cliff in the first quarter of 2013, though for now that is unlikely to affect markets through the end of 2012. Ratings agencies Moody’s and Fitch already stated that a failure to pass a budget in 2013 may result in a downgrade of U.S. credit worthiness. The danger there is that borrowing costs for servicing and rolling over existing previously issued debt, may quickly climb to much higher levels. This development could easily derail the economy, since a change in the U.S. credit rating would prompt a credit rating change for major corporations headquartered in the U.S. We saw an example of that in Spain, on the recent downgrade there, with only two major banks retaining a credit rating higher than the sovereign.

The Financial Times Alphaville uncovered some interesting comments from Goldman Sachs about Fannie Mae and Freddie Mac, the two Government Sponsored Enterprises (GSE) taken over by the U.S. Treasury after insolvency. Both agencies are still involved in mortgages, though both will eventually be wound down as the private sector takes over. One of the interesting recent funding proposals is a possible increase in guarantee fees on mortgages. Those are important fees for bundling and securitizing Mortgage Backed Securities (MBS). One of the reasons behind the potential increase, would be to offset the recent payroll tax cut extension. Goldman Sachs notes a concern that increasing those fees may make it more difficult for banks to issue new MBS, profitably enough, to offset losses on distressed MBS left over from the housing boom. A different proposal under consideration involves tightening of underwriting standards, though Goldman Sachs point out that politicians may move to avoid that, in the event such an action might slow down the housing market in an election year. Goldman Sachs point out that recent increases in housing prices may prompt the U.S. Treasury to try additional measures to reduce taxpayer burden for winding down Fannie and Freddie. Interestingly, Freddie Mac is reporting historically low mortgage rates for nearly all types of mortgages, for example the 30 year fixed rate averaging 3.59%. My feeling is that if we find the Case-Shiller Index declining over the next few months, and no action from the Treasury, then these changes may not be implemented. We will continue to watch this closely for changes, since there is some potential these may slow the housing market slightly.

We covered shadow banking and derivatives (CDS) in our last report. Given the persistent low volume in equities, commodities, and bonds, we uncovered another interesting report on FT Alphaville about CDS. One of the arguments often put forward in favor of CDS markets is that pension funds and insurance companies use these financial instruments for hedging. These players in the CDS market make up a very small portion of trades, so the argument for large financial companies being involved is to create liquidity. FT Alphaville managed to interview an investment manager at an insurance fund that uses CDS to “protect against tail risk”, and as an alternative to holding capital against existing investment positions. Definitely an interesting article for anyone more interested in shadow banking, since this points out a responsible use of CDS for hedging risk. It is tough to get market data on shadow banking, though at the moment it appears that the missing volume in equities is not flooding into shadow banking.

Marc Faber was on CNBC recently discussing an upcoming global recession. He is the editor and publisher of the Doom, Boom & Gloom report, known for being very bearish much of the time. However, it’s interesting the points he makes in this appearance. He does not feel markets will collapse, though he does not expect much of any gains. Part of what he mentions is the possibility of more stimulus from the Federal Reserve. Not long after Marc Faber appeared on CNBC, there was an article in the WallStreet Journal that covers his statement of real negative GDP growth. The primary way to look at this is that a low GDP growth per capita is unlikely to reduce unemployment. As Marc Faber points out in another report, free markets have not been allowed to function normally, and the Federal Reserve fails to mention that aspect of our current markets.At this point, the low volume in equities markets does not indicate that the current rally is sustainable. As we have seen in a look at other investment areas and indicators, there remains some money on the sidelines for various reasons. Eventually that money may provide a real sustainable rally, but given the current economic conditions world-wide, I don’t think that time is near. The current rally is not wide spread, in that only some companies are near 52 week highs. If you hold shares in those companies, you might consider taking profits, if you are at a good level of profit. If you hold shares in companies that have not taken part in this run-up, or are generating solid dividend payouts, then you may want to wait and simply watch where the market goes. I tend not to play markets on momentum, and I have been called a bear at times, though being cautious has still allowed me to generate good profits. We might see 1450 to 1500 on the S&P, but without some changes in other areas where we watch the market, those levels do not look sustainable. It would not surprise me at all to see a correction (drop) of 10% or more over the next several months. Good luck, be cautious, and stay flexible.

As part of new transparency policies at the Federal Reserve, there are releases of unaudited financial reports for operations. I took a glance through the recent Q2 2012 report, and the one item that stood out was $46.447B in interest payments to the U.S. Treasury, which refers to Operation Twist and the large accumulation of Treasury bonds now held at the Federal Reserve. The actual interest payment percentage is not given, but considering how little Treasuries now yield, this points to a massive amount of U.S. Treasuries held by the Federal Reserve. This is absolutely something of great concern, because at some point beyond the end of 2012, the Federal Reserve will need to re-sell these holdings on the open bond market. The other interesting part of the Q2 2012 Unaudited Financial deals with GSE sponsored MBS purchases. I noticed early in 2012 the Federal Reserve sold many of the older MBS holdings, and reduced their balance sheet. So it was a bit surprising to see an increase of MBS holdings over the last six months. This may go some way towards explaining the gains in the Case-Shiller Index, in that the Federal Reserve appears to be propping up demand for Mortgage Backed Securities. I’m not sure that is sustainable in the long term. At around 25 pages, these reports may be of interest to anyone who wonders how the Federal Reserve operates. On 29 August the Federal Reserve released the Beige Book report of current economic conditions. There was very little expansion of economic activity across all Federal Reserve districts. After the release, markets barely reacted to the latest Beige Book, which should not be too surprising with institutional investors still expecting some form of stimulus. At the end of the Federal Reserve meeting in Jackson Hole, Chairman Ben Bernanke gave a speech on the Fed’s outlook for the U.S. economy. Interestingly Bernanke did indicate that the Federal Reserve is open to more stimulus (QE3), but that economic conditions would need to be significantly depressed in order for the Fed to respond. He also indicated a concern that actions by the Federal Reserve could destabilize the normal functioning of markets. I mentioned this briefly in a previous report concerning Operation Twist and bond markets. Essentially, I see little chance of QE3 in the near future.

When we consider whether housing markets can continue to improve, we have many more factors to consider. Obviously with the Federal Reserve involved in MBS, we already see some stimulus supporting mortgage growth. Despite that involvement, nearly 3.8 million homeowners are set to lose their properties in the U.S. in the near future, which would place home ownership in the United States at a 50 year low point. Contrast U.S. housing with the United Kingdom, and we find that there is downward pressure on housing pricing in the U.K. Problems in other areas of Europe are ongoing, despite a push by German Chancellor Angela Merkel for a new Euro Treaty. The rally that began with European Central Bank Chairman Mario Draghi may quickly fade without some of the proposals being approved before a Euro wide treaty creates a longer term solution.

Part of the engine of growth for the last few years has been China. While it is still an emerging economy, growth has slowed greatly this year. A look at the Shanghai Composite Index should be a red flag that China is slowing. Industrial growth in China has driven the economy of Australia, mostly through the purchase of raw materials like iron ore and coal. A recent slowdown in iron ore usage has driven iron ore prices lower, which is now slowing the economy of Australia. You may recall from an earlier article that movement of the Australian Dollar (AUD) correlates well with movements of the S&P 500, and demand for raw materials in China is part of the reason that works. It helps that the banking system is very well managed in Australia, though the main driver of their economy has been raw materials. As China slows building of housing and infrastructure, we will see a decline in Australia. We can watch the AUD to U.S. Dollar (AUD/USD) as an early indicator of which direction the S&P 500 may turn. We may see AUD/USD fall back to parity over the next few months. UnfortunatelyChinese banks are unable to provide any additional growth, leaving the government as the main driver of the Chinese economy. Some Chinese banks played the iron ore markets and steel trade to profits, over the last few years, though it appears that direction can no longer be followed. I don’t think China is near an end to building and expanding, though at the moment it seems the demand for steel went a bit too far too fast. We may see some rebalancing of the Chinese economy in the near future. Compared to many industrialized developed economies, steel usage in China could easily have a decade or more to run before slowing in a significant manner. The economy of China is unlikely to experience a hard landing. Instead we should expect a near term gradual slowdown, followed by a resumption of building in mid to late 2013.

That leaves us with the more immediate concerns for September, nearly all of which are in Europe. FT Alphaville put together a great calendar of events happening in September. There is an article covering some of these events in a link in that image. Bernanke already spoke, and once again Greece has asked for more time. Probably the biggest event will be the German Constitutional Court ruling on the European Stability Mechanism (ESM). The Federal Reserve may announce additional stimulus measures the same day, though given recent economic reports it appears that is unlikely. The ESM is a proposal from Mario Draghi of the European Central Bank to purchase sovereign bonds of member states, in order to alleviate some borrowing pressure. This is not covered under current Euro area treaties, which prompted the German Constitutional Court to consider whether Germany can participate. Since Germany is still the strongest economy in Europe, if the Constitutional Court rules that ESM cannot be allowed, then there is not enough funding capacity in other countries for ESM to function. A failure of approval of the ESM would mean borrowing costs for Italy and Spain could climb higher. Stock markets would quickly begin to sell off over worries of solvency in Spain, which is one of the largest economies in Europe. There is some possibility of work-arounds from the meeting on the 20th of the European Central Bank (ECB), though with a failure of the ESM that may be the only hope for stimulus measures that would prop up markets longer. Stock markets have run upwards on comments from the ECB, and near term expectations are high. Disappointment could cause a run for the exits. Hopefully we will know more as we get deeper into September.

G. Moat

Time to Take Profits

The early August rally has gained some legs, though without any volume confirmation. As the old saying goes, markets can remain irrational far longer than investors can stay solvent. It is always difficult to find a top or bottom in any market, though we hope to buy near lows, and sell near highs. So the question we may be facing now is how much higher can markets rally. What is really interesting is that this rally is not widespread, with much of the volume going towards large caps very selectively.

Usually we can find some confirmation of a rally by looking at several other factors. Volume is only one issue, and by itself is not enough of a reliable indication that we should take notice, nor worry about a continued rally. We have been through a month with draught, heat waves, and the 2012 Olympics, and also a time of year when historically volumes are a bit low. However, to give this some perspective, average daily trading volume on the NYSE reached a multi-year low last seen in 2007. When we look at market conditions for 2007 at that low volume point, we find that stock markets were very close to a high point. The economic conditions were still favorable in 2007. Bear Stearnes had yet to show any signs of troubles in 2007, and Lehman Brother’s and AIG appeared to be financially healthy. Even the housing bubble was just beginning to show signs of trouble in 2007. So here we are five years later without much indication that the economy is better than in 2007, nor even that the economy near levels seen five years ago. The spark of the current rally appears to have been European Central Bank (ECB) chief Mario Draghi, though in essence all he stated was that the ECB was willing to do whatever is necessary to stabilize the Euro. Indeed, the debt levels of Spain and Italy are still high, and their respective bond yields have not changed much. Goldman Sachs Global Research recently noted that Mario Draghi’s speech did make a difference in lowering Spanish and Italian bond yields, yet those yields are still historically much higher than usual, measured against German bond yields. Nomura noticed a similar trend in bonds, yet point to a historical basis of convertability, based upon old currencies before the Euro. The implied suggestion is that bond purposes on secondary markets for Spanish and Italian debt are pointing towards a break-up of the Euro. I don’t personally think that will happen, and it should be noted that most of this secondary bond activity has been generated via hedge funds.

The next area we would look for confirmation of a rally would be in the market for U.S. Treasuries. A look at the 10 Year U.S. Treasury shows a bottom yield of 1.38% in late July, then a nearly straight climb up to 1.82% on 17 August 2012. On a six month basis, the yield is still low, though that may be more a factor of Operation Twist, as mentioned in previous articles. If we look at the 3 Year U.S. Treasury yield, we find a similar pattern, suggesting demand for safe haven investments has slowed slightly. A look at the 30 Year U.S. Treasury yield, which is not part of Operation Twist, confirms this trend. The new 10 Year note issuance on 8 August 2012 and weak action on new 30 Year notes issued 9 August 2012, suggest some movement out of safe haven assets. Usually we would see movements out of bonds, and into equities, in normal markets. So the weak bond auctions suggest that volume should have increased on stock markets, though it did not. That leads us to research why that did not happen as expected.

In mid July this year, The Financial Times noted an interesting comment from Federal Reserve Chairman Ben Bernanke, regarding the possibility of further “non-standard programs”. Economist Tim Dey noted that continuing Federal Reserve purchases of U.S. Treasuries, might eventually cause a deterioration of the functioning of bond markets. Since bond markets do seem to be hitting a lull in volume, this may be the early stages of problems. The trouble is that Operation Twist is slated to last through the end of 2012. The other interesting thing pointed out in the FT Alphaville article is how QE3 might be implemented, if the Federal Reserve makes such a move. One possibility is through purchases of Mortgage Backed Securities (MBS). This was part of QE1 and the Federal Reserve did manage to sell some MBS holdings purchased in 2010 at the beginning of this year. The implied impact on the housing market would be a further reduction in mortgage rates, or enabling an expansion of mortgage origination.

Keeping that in mind, the next thing we will look at is the current market inResidentialand Commercial Mortgage Backed Securities (RMBS and CMBS). Fitch Ratings has several reports and notes of interest that have been released recently. The first note of interest deals with Reverse Repo (or re-purchase) agreements, which are financial agreements that function like loans, though usually only used between banks. The greatest change noted by Fitch was the use of low quality sub-prime and Alt-A RMBS as collateral had greatly increased. The largest users of that collateral in these counter-party agreements has been large global banks who recently had purchased deeply discounted MBSs from the Federal Reserve, which had been part of QE1. The implication is that existing prior MBS were effectively removed from the market by use as collateral. This suggests that demand for MBS should increase, which would be expected to drive the market for mortgage origination and new MBS issuance. The other possibility is a shortage of collateral pushing large banks to use these lower quality MBS more often. The next Fitch Ratings report of note deals with default rates in CMBS, notable in that despite increased levels of real estate lending, loans continue to default at maturity. Fitch cover $24 Billion of the CMBS market, and expect around 41% of loans would become ineligible for refinancing. However, late payments declined in June on RMBS to around 8.48% overall, though the rate on multi-family property types only declined to 10.89%, while increasing to 11.46% in hotel properties. The Fitch delinquency index covers $33.2 Billion in existing loans. Fitch Ratings did not in a recent survey of investment managers that there was a greater expectation of homeprice increases over the next 18 months, which might provide some lift to the economy.

So far what we are finding in our research is that money is essentially tied up. That may go some ways to explaining the low volume on stock markets, but we need to look at other areas to get a better big picture view. Outside of bank counterparty agreements, we find that lending is still constrained, maybe not as badly as the start of the credit crunch, but there has been little improvement. Mario Draghi of the European Central Bank recently stated “… if we want to get out of this crisis, we have to repair this financial fragmentation.” European banks are in a tighter crunch than U.S. based banks, as their individual national level central banks have pushed them to constrain operations predominantly within their borders. Partially this is a sovereign debt issue, and a way to get certain banks to hold more sovereign debt, the idea being that easy to sell collateral provides “safer” asset holdings. When we look at the strong push to meet Basel III requirements, instead of a credit crunch we are now moving to a capital crunch (Basel III requirements included greater capital holdings). This would be less of an issue, if it was only central banks pushing on large financial institutions to operate more “safely” and minimize risk.

That led towards more research on the shadow banking sector, with a look at derivatives and other financial instruments. Under current accounting rules, certain financial instruments, like derivatives or CDS, can be used to hedge. This works somewhat like insurance, though over the last decade there has been a distortion of this market, and often CDS trade simply on supply and demand in an attempt to generate profit. The problem in accounting rule changes is that using CDS for hedging allows a bank to become more highly leveraged. Once this trend started over the last few years, despite some changes in regulations, the market for CDS and derivatives increased. Since it is often peer-to-peer trading and contracts, tracking activity becomes very difficult. There is little to no transparency in the shadow banking world, which is why it is called that. Shadow banking has nothing to do with conspiracy theories, it is quite simply banking activity with little to no reporting standards, so those outside the banking community are barely able to follow movements. When JPMorgan posted losses recently due to such activity, even financial markets traders had difficulty figuring out what positions JPMorgan actually held, and what positions might still be open. We might never know. The reason to point all this out is another great bit of research from FT Alphaville. As part of new proposed regulations on derivative trade in July, there is a move by regulatory authorities to increase the margin and collateral posting requirements on uncleared derivatives. Mostly this applies to systemically important financial institutions, otherwise called too-big-to-fail banks, and corporations that use derivatives for hedging are exempt. Since this started in the U.S. with a proposal from the Office of Comptroller of the Currency (OCC), it has now gone international. As FT Alphaville point out, the proposals are for uncleared swaps, which are less liquid, meaning less easy to sell. The interesting take-away from all this is that the OCC projects that about $2 Trillion in collateral would be needed, effectively removing that from other financial transactions. Usually large banks move ahead of regulations, so we may be seeing that necessary $2 Trillion being held on the side and not going to bonds nor stocks. That’s a huge amount of money to keep off bond and equities markets.

Another popular market metric is the Volatility Index (VIX), which is a measure of implied volatility on the S&P 500 Index. This looks at options and futures positions. A high VIX indicates a great deal of pessimism in the markets, while a low VIX signals complacency. Outside of a few companies with sustained high implied volatility, there has been a slight decline in options activity recently. Again, FT Alphaville tries to give an explanation for low VIX. The important thing pointed out is that VIX is a better near term indicator than a long term forecaster. The great explanation found was that the Chicago Board of Options Exchange (CBOE) altered the calculation for VIX recently. So what we see at the moment is not yet a good indicator of when stock markets will shift. In the past we may have worried about a low VIX, but until we get into September it may not be an accurate indicator. However, if we see the VIX go over 20 and the S&P 500 goes into a sharp decline, then we might be seeing the start of a correction.

At this point, the low volume in equities markets does not indicate that the current rally is sustainable. As we have seen in a look at other investment areas and indicators, there remains some money on the sidelines for various reasons. Eventually that money may provide a real sustainable rally, but given the current economic conditions world-wide, I don’t think that time is near. The current rally is not wide spread, in that only some companies are near 52 week highs. If you hold shares in those companies, you might consider taking profits, if you are at a good level of profit. If you hold shares in companies that have not taken part in this run-up, or are generating solid dividend payouts, then you may want to wait and simply watch where the market goes. I tend not to play markets on momentum, and I have been called a bear at times, though being cautious has still allowed me to generate good profits. We might see 1450 to 1500 on the S&P, but without some changes in other areas where we watch the market, those levels do not look sustainable. It would not surprise me at all to see a correction (drop) of 10% or more over the next several months. Good luck, be cautious, and stay flexible.

G. Moat

Housing Market Indicators

On the last day of July 2012, the most recent S&P / Case-Shiller Home Price Index data was released for May 2012. These Indices are calculated monthly using a three month moving average of data from 20 cities in the United States. There are further reports using 10 cities, and other reports for non-seasonal adjustments. Sometimes weather can be a factor in seasonal adjustments; as an example the recent mild winter across much of the U.S. likely contributed a disproportionate amount to increases. Though data recording for this began in the 1980s, based mostly upon repeated sales and behavioral finance, historical data was used to create an index as far back as the 1890s. In each sales transaction recorded, a search is conducted to find information on any previous sale. So this index does not look at new home sales data. San Diego is included in both the 10 city and 20 city index.

In this most recent report, we find that average home prices increased 2.2% from April 2012 to May 2012, for both the 10 and 20 city composites. Compared to May 2011, it was found that home prices declined 1.0% in the 10 city area, and 0.7% in the 20 city area. Spring and early Summer are historically stronger buying months, so keep that in mind with this two month improvement in data. The peak in all historical data was August 2006, and many of the cities in this index are still far below that level, with hard hit areas Phoenix over 50% below peak, and Las Vegas over 60% below peak. San Diego saw a 1.1% monthly improvement from April to May 2012, though average home selling prices are still 1.1% below the year ago period.

The housing market appears to be stabilizing, though we will need to see similar data over the next several months to confirm this possible trend. The third (Q3) and fourth (Q4) quarter of 2011 experienced a decline in average housing prices, while the early part of 2011 also indicated improvements similar to what we see in early 2012. While the hardest hit areas are showing improvement of supply and demand, the overall slowing economy could make continued improvement difficult to achieve. The number of underwater homes, representing negative equity or nearly that level, decreased to 28.5% of all residential loans in Q1 2012, compared to Q4 2011 levels of 30.1% underwater.

Since the Case-Shiller Home Price Index data is not released that often, investors may want to watch an interesting Electronically Traded Fund (ETF) offered through iShares, under the symbol IYR. This ETF attempts to replicate the performance of the Dow Jones U.S. Real Estate Index Fund, through holdings in companies involved in commercial and residential property. We can get an advance look into market trends by following this ETF, though the correlation of data to IYR is only near 65% accuracy over the last two years. Think of this more as a good short term trend indicator, rather than a longer term predictor. It’s important to follow developments in commercial real estate, since the amounts involved in most transactions are far greater than the residential housing market. While problems in the commercial real estate market are not necessarily a predictor of activity in the residential real estate market, a decline in that sector is likely to happen prior to a decline in residential markets. The main difference in the commercial market is that we are more likely to see work-outs of problem loans. Recently the Federal Housing Finance Agency rejected a request by the U.S. Treasury to write-down the principal of some underwater residential mortgages. The reason the FHFA stated for denying this move is they felt it would drive up the cost of a taxpayer bailout. Fannie Mae and Freddie Mac were seized by the U.S. Government after failing in 2008, mostly due to losses on sub-prime loans. Both Fannie and Freddie have received over $190 billion in funds to facilitate winding them down. The eventual hope is that the private sector will completely replace these government sponsored enterprises.

Housing was a much larger component of the overall economy prior to the recession. It is now less of an economic engine than in the past. In a way that may be better moving into the future, as the possibility of another housing bubble is far lower. That would mean more stable real estate markets without huge swings one way or the other. Consumer spending is responsible for about 70% of U.S. economic activity. Recently the savings rate increased to 4.4% even though household income increased 0.5% in June 2012, which suggests consumers are becoming more cautious and frugal. Without a significant improvement in the labor market, this trend may continue over the next several months. The increased savings is not a bad sign, though in a mostly credit driven economy, this activity is less likely to improve growth.

As mentioned in a previous article, the movement of money through banks, often in the form of the Carry Trade, can be a predictor of economic change, or even a predictor of loan availability. This relates directly to business loans, investment activity, commodity futures markets, commercial real estate, and housing. The Financial Times went through a great explanation of our current global banking environment recently (link to article in image). The main idea is that banks can predict the time value of money, in that loans are may to predict the need for funding of future goods and services. Under a conventional idea, as long as a population is growing, we can reasonably expect that demand for future goods show grow at least at the same pace. So inflation under this model would grow as population increases, under the assumption that money will become more available than goods and services. Banks have been able to lend based upon future scarcity of goods and services based upon their credit worthiness, mostly a reflection of their base capital holdings. Those who have read about upcoming Basel III rules and higher capital requirements for large banks may find more detail of interest, though for now I will save that for a future article. Until the establishment of Central Banks in many countries, banks operated under this model, and fared well unless they put forward too many bad loans, or in other words, over-predicted future economic activity. Heading into 2008 and the crash of housing markets and loan facilities, it appeared that banks had vastly over-estimated future economic growth. This left them far short of money, leaving many banks with too low of capital to initiate new lending activity. Asset write-downs and bankruptcies were inevitable, as we saw in late 2008 and early 2009. The Federal Reserve, as the Central Bank of the United States, saw this sudden change and initiated extremely low lending rates to large banks and financial companies. Partially this was in the hope of future banking activity improvement, because a central bank still functions much like the conventional banking model. If 2008 and 2009 had been a liquidity issue for banks, which caused the decline in lending, then we would have seen a faster recovery. While 2010 was a great improvement in the economy, it appears much of that was due to enhanced productivity, since lending activity remained constrained. When economic activity declined in 2008 and 2009, there were many inventory declines. Under the curtailed lending environment, corporations began to stock-pile money to use for future activity, mainly bypassing banks in the process. Corporations began to run more of their own lending and financial activity, often in the form of greater corporate bond issuance.

Fast forward to 1 August 2012, and Ben Bernanke of the Federal Reserve released newFederal Open Markets Committee meeting minutes. Lending rates to major banks and financial institutions are still held at 0.0% to 0.25% and expected to be this low through late 2014. The Fed notes that U.S. economic activity has somewhat slowed in the first half of 2012. Expectations are for moderate growth through the rest of this year. In the previous FOMC meeting, the Fed stated that they were prepared to “take further action”, while in this latest meeting, they stated: “The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” Since the stock market was expecting more stimulus in the form of another round of Quantitative Easing (QE), when more QE was not announced, stock markets quickly started to sell off, and the U.S. Dollar Index climbed. Those who have followed the Australian Dollar (AUD) movements against U.S. Dollar (USD) movements, as mentioned in the previous article, would have seen the drop happen first in AUD/USD. Just to add to the turmoil on the day, Knight Capital Group, one of numerous Market Makers for equities markets, experienced a computer algorithm malfunction that caused volumes to increase suddenly and excessively in shares of 148 different NYSE listed companies. While Knight Capital Group did quickly correct this action, and erroneous trades are likely to be unwound, this morning trading issue placed the market on edge for the afternoon FOMC announcement.

It appears at the moment that the equities markets were expecting more stimulus. The recent increase began just over a week ago when European Central Bank President Mario Draghi stated that the ECB would use any and all means to shore up the Euro, and assist troubled economies in Europe. It was a bold statement, and global markets rallied on the hope of future monetary expansion. My feeling is that we will see this unwind further as the ECB meets with various finance ministers in Europe, and policy change proposals quickly run into a wall of bureaucracy. On 2 August 2012 the ECB will meet to work out details of Draghi’s proposals. At the heart of this is the idea of the ECB buying bonds directly from troubled economies, like Spain and Italy. This is similar to the Federal Reserve’s Operation Twist, which I discussed in a previous article. This idea was attempted with Greece, though when Greece partially defaulted, the ECB was unwilling to write-down those bond purchases, and the action unwound in the markets as other financial institutions felt they were being treated unfairly. This further constrained lending and credit markets in Europe, though large global banks headquartered in Europe did not shift activity to lending in U.S. markets. Part of the reason again was the constrained capital levels, and requirements by governments to increase capital levels. The idea of increased capital is that banks and financial companies would better be able to handle economic shocks.

There have been some areas of improvement. New housing activity in the United States has risen slightly in the early part of 2012, though more recent activity is sharply lower. As mentioned above, favorable weather was one factor. Existing homes still account for nearly 90% of housing market activity, though new home sales accounts for building materials and construction worker activity. As we move towards a more favorable historical time for existing housing sales, the slowdown in new home sales indicates we might expectslower economic recovery heading towards the end of 2012. Housing research from RealtyTrac indicates that foreclosure activity increased in early 2012, compared to late 2011, in 125 U.S. metropolitan areas. Recently bankrupt Stockton, California posted the greatest foreclosure rate at 2.66% with 6218 units facing foreclosure. The greatest increase in foreclosure activity has been seen in Atlanta, with 46,267 units in foreclosure. Some areas did decrease foreclosure activity, with San Diego posting 11% fewer foreclosures than the year ago period. To add some context to this information, the 30 year mortgage rate reached a record low of 3.49% in late June 2012.

At the moment it appears that despite record low mortgage rates, traditional bank mortgage lending is still constrained due to macro-economic factors, deleveraging, and increased capital requirements. While equities markets expected more stimulus in the form of further Quantitative Easing, our take-away is that the perceived need for QE and other stimulative measures, is that the current economy is not quite strong enough to stand on it’s own. Real economic growth appears negative once we remove the influence of previous economic stimulus. Corporations have been using other forms of funding as banks constrain lending, and we may see similar moves amongst smaller companies, and perhaps even in the housing market. While all these factors may suggest we have hit a low in housing markets, caution is advised moving forwards. We will need to continue to watch economic activity indicators, labor markets, and potential action by Central Banks heading to the end of 2012.

G. Moat

Other Than Real Estate

Since early June the S&P 500 has rallied nearly 8% making it seem like stocks might have bottomed, and may now be headed towards new highs. If you only looked at the Dow Index, S&P 500, or NASDAQ, then you might be lulled into a false sense of confidence. With equities (stocks) going up globally lately, how can we tell if it is okay to dive back into the market, or if we should be more cautious? In this article we will explore a few helpful indicators, which will make your investment decisions more informed.

Financial Vizualizations is a great resource tool for a quick look at equities markets. Whether stocks moved up, indicated by green, or down, indicated by red, a glance at that website will give you the story of the day. The default is for a daily view, though if your investments tend more towards long term, then viewing the year-to-date or monthly Data may be a better choice. The World Market view only shows foreign companies shares listed on U.S. Stock Exchanges, usually called ADRs (American Depository Receipts), though sometimes called ADS (American Depository Shares). Over the last few years, global markets have often moved in step, with around a 90% correlation between major market moves. Each day markets open first in Japan, Australia, and parts of Asia, then later in the day in Europe. When the markets open in New York, most European markets are still active. There is also after hours trading in nearly all these markets, but the lower volumes mean that less change will be noticeable. Sometimes a down day in New York markets can lead to a down day in Asian markets a few hours later. Always check the longer term data, which can be more useful for trend spotting than the daily view data.

There is also an S&P 500 grid view, split up by sector, so you can see whether one sector drove the markets more than another. Once you are on FinViz.com, you can zoom in to individual areas to easily view specific companies share performance. Switching from day view, to month, year-to-date, or longer, can give you a better way to judge trends. When you notice one sector consistently moving more than another, then overall market moves tend to make more sense.

There are other reasons for the high correlation movements, though some of them are not really that intuitive. The largest institutional investors, comprised of sovereign wealth funds, large hedge funds, and global financial organizations, like the largest banks, comprise most of the daily trading volume in the major equities markets around the globe. The majority have trading desks that operate around the clock, sometimes only stopping from the Friday close of New York markets until the Monday morning opening of Asian markets. Besides movements of stocks, those large institutional investors are active in currency trading, known as Forex, and commodities trading.

Forex trading involves the buying and selling of currencies. It is essentially a range bound technical trading environment, often moving on news, though sometimes moved by large institutional investors. It is difficult to get accurate volume data without watching several dedicated trading platforms, though the platform I use gives an idea of major movement trends. Each day the largest movements are usually in the Euro (EUR) and U.S. Dollar pair, expressed as EUR/USD or more simply the exchange rate of those two currencies. This moves throughout the day, and is different than the rate a bank will give you when you walk in to exchange currency. The reason for the EUR/USD pair being the most heavily traded is that EUR are needed to buy European equities and European bonds, and USD are need to by U.S. listed equities, U.S. Treasuries, and to trade commodities futures, like crude oil. The U.S. is the largest issuer of debt, in the form of U.S. Treasuries, though closely followed by several European countries. In the United Kingdom, the Pound (GBP) is still in use, though oddly enough the GBP/USD is not the second most traded pair of currencies. That distinction goes to the Australian Dollar (AUD) on most days. The reason the AUD is so heavily traded is that it is a commodity play, due to the coal, iron ore, and natural gas export market there. An interesting more recent trend with the AUD/USD is that movement direction has a high correlation with the S&P 500. While the magnitude change can vary, the direction trend usually appears in the AUD/USD first. When you see the AUD/USD pair decline, you can usually expect the S&P 500 to decline, and the converse is also true for uptrends. Compare the 3 month AUD/USD with the S&P 500 to the 3 month EUR/USD with the S&P 500, then you can see how AUD/USD is a better leading indicator.

Some of the reason behind this correlation is due to what is known as the Carry Trade. There are several aspects to this, but the main idea is borrowing money in one country, then investing it in another. Sometimes the investment is through the bond markets, through the purchase of sovereign debt issued by a country. Among very large eligible institutional investors, the Discount Window is the mechanism of borrowing from the central bank of a country. You may see that referred to as the Prime Rate, or Primary Dealer Credit Facility in the United States. Obviously the average retail investor cannot make direct use of the Carry Trade, but it is responsible for much of the flow of funds around the globe. As retail investors, we are just along for the ride with the largest institutional investors, but through establishing an investment strategy, watching correlations, and sticking to our game plan, we can become more profitable in our investment decisions.

One of the more interesting indexes a self-driven investor can check at the end of each day, is the SPXA50R, or more simply the percentage of stocks listed on the S&P 500 that are above their 50 day moving average (50dma). There are also variations of this chart for the NYSE and NASDAQ, though with the S&P representing 500 companies, it is a better big picture viewpoint than other indexes. You can explore and compare those other similar indexes at StockCharts.com, including variations that use a 200 day moving average. The difference in using the 50dma over the 200dma is that the 200dma represents a longer trend, and it is easier to pick high and low points on the 50dma chart. While the market is moving down, it is tough to only use SPXA50R as a buying indicator, though usually if you are buying shares when this index is under 20, you are probably near a low point. Where this is more useful is knowing when to sell shares, and when to take profits. When you see SPXA50R go above 85, then you may want to check your investments, then decide if you want to take profits. Obviously individual company shares may not move exactly with this index, but it can provide a great market overview. The downside of this index is that you may find only once or twice a year when a market high or market low point is reached, and individual companies will not always match market moves. Use this in combination with your research, and company events, including earnings reports and major revenue change announcements.

10 Year Treasury Rate data by YCharts

As mentioned in the previous article, U.S. Treasuries are one of the most traded Safe Haveninvestments. This can also be one of our most useful indicators. While the Federal Reserve is still running Operation Twist, the yield has been pushed quite low on a historical basis. Despite that, the demand for Treasuries is still high. On 19 July 2012 the 10 year Treasury Inflation Protected Security, or TIPS, hit a record low yield of -0.627%. A simple idea behind TIPS is that there is a fixed payout rate, which is adjusted based upon the Consumer Price Index (CPI). So if the CPI indicates inflation, then the payout above the fixed rate increases. If the CPI indicates we are experiencing deflation, then the TIPS payment would decrease. When we see record low yields on any Treasuries, then we do not really have a sustainable market rally. Considering that TIPS are not part of the Fed’s Operation Twist, this is an indication that safe haven investment demand is still very strong. Checking the yield on the 10 year Treasury can be one of the quickest and easiest ways to see if markets really are turning around, or if a rally in stock markets might be a shorter term trend. Until safe haven demand declines, stock markets could quickly and easily turn around and decline.

In recent Argus Market Watch reports, other indications lead us to believe that current market sentiment is negative, despite the gains since early June. Vickers Stock Research noted corporate insiders selling their shares 3.3 times more than they were purchasing company shares. Insider buying can be a better individual company indicator than insider selling, but when sentiment is negative and growing, it can be tough for a rally to become sustainable. Argus Market Watch also note a recent widening of corporate bonds yields compared to Treasury yields, though they do not expect an increase in the corporate default rate. Fitch Ratings noticed a similar trend in Europe, as bond issuance outpaced loans for large corporations. Fitch reported that bonds comprised 52% of funding in the first six months of 2012, compared to 29% in 2011, while noting that this ratio of bonds to loans has increased every year since 2008. One reason for this is the relative safe haven status of highly rated corporate bonds, compared to sovereign bonds and bank bonds, though banks deleveraging are another reason behind the low loan issuance numbers. Fitch Ratings, in another report, places the U.S. corporate default rate at 2.2% for June 2012. This compares to an average corporate loan recovery rate of 72% over the last 12 years.

Commercial Mortgage Backed Securities, or CMBS, trade much like bonds, and are covered under a separate criteria of corporate ratings. Fitch Ratings currently maintains a stable outlook for 83% of issued CMBS, with 9% considered distressed, and a negate outlook for just 7% of CMBS. The latest default rates are Multifamily: 11.64% (from 11.35% in May), Hotel: 11.22% (from 11.15%), Industrial: 9.93% (from 10.00%), Office: 8.58% (from 8.64%), and Retail: 7.67% (from 7.45%). A recent news item puts this in perspective. The Blackstone Group, one of the largest private hedge funds in the world, spent $300 million to purchase over 2000 foreclosed homes to place onto the rental market. This is a huge bet on a recovery in the housing market. The Blackstone Group is not the only financial company making such a move, though so far this is the largest single move into the rental housing market. Since the Blackstone Group has many diversified investments in major companies, the futures markets, commodities, and Forex, this move shows that even some of the largest investors want some diversification.

At a minimum, like any investor, we want to get a return that is greater than the rate of inflation. Ideally we want to gain much more than that, increasing the value of our investments. There will always be times of uncertainty, and there is nothing wrong with sitting, watching, and waiting. As individual investors, we have no pressure to make moves every day. We can choose when we want to buy or sell, and in which directions we want to invest. It is always a good idea to be flexible in our choices, with some funds set aside in Money Market, bond fund, or just as cash, to take advantage of buying opportunities. Hopefully with some of the indicators I pointed out in this article, we can also make more informed decisions of when to move into investments, and when to take profits.

Investing is never without risk, so readers are encouraged to do their own research, check many sources of information, and determine the path of their investments. We hope the information we provide will be a launching point for that research, and point you towards the path of being an informed and successful investor.

G. Moat

Macro-economic Trends And Safe Haven Investments

After several years of market swings, at times it can seem that searching for a safe haven investment might be the best choice. Managed accounts, such as many mutual funds, often with highly regarded firms and prominent names, failed to move to avert or minimize losses during the market downturn of 2008, and the sell-off of 2009. Even Money Market funds were not immune from failure, as dramatically shown with the Reserve Primary Fund “Breaking the Buck”. Money market funds seek to return a minimum net asset value of $1 for every $1 invested. In the 37 year history of such funds, only three funds ever broke the buck. The Reserve Primary Fund invested in asset backed commercial paper and U.S. Treasuries, though some of that asset backed commercial paper was issued by Lehman Brothers. When Lehman Brothers filed for bankruptcy on 15 September 2008, the Reserve Primary Fund had to write-down the debt owed by Lehman Brothers. This caused the fund to drop to 0.97¢ breaking the buck, forcing the fund to close. To this day, despite the Securities and Exchange Commission filing charges against the managers of that fund, former investors in the Reserve Primary Fund are still awaiting some form of compensation payment.

Since that supposedly Safe Haven investment downfall, the U.S. Treasury created an Exchange Stabilization Fund (ESF) as a form of insurance for Money Market Funds. Investors who have funds in a Money Market account are encouraged to see whether or not their Money Market holdings fall under this protection. The events in late September 2008 and early 2009 led to a short run on some money market funds, as investors sought to withdraw their holdings. Most money market funds at the time liquidated their commercial paper holdings in order to pay redemptions. Commercial paper loans have been used by many businesses and corporations to finance short term activity, often with new commercial paper being issued to partially pay previously issued commercial paper, rolling over short term debt. Since money market funds were the largest investors in commercial paper loans, the sudden increase in redemption demands caused a lock-up of the commercial paper financial market. Companies unable to roll over debt, and short on cash to pay maturing debt, found themselves in a severe liquidity crunch, unable to find short term funding at any reasonable rate.

During that time, and still to this year, Money Market Funds moved more towards purchasing U.S. Treasuries. The demand for U.S. Treasuries is still so high that the yield is now quite low. A look at the most issued note, the 10 year U.S. Treasury, indicates the yield has fallen to under 2% and recently less than 1.6%. If the value of the U.S. Dollar (USD) falls more relative to other currencies over the next ten years, then the real return would be negative. While U.S. Treasuries may seem a safe haven in uncertain times, the Federal Reserve through Operation Twist is complicating the ability to gain a positive return over time. The real return on Treasuries is now lower than the rate of inflation.

Operation Twist involves buying long dated Treasuries and selling short dated Treasuries, with the hoped affect of lowering long term interest rates, while raising short term interest rates. Buying more Treasuries lowers the yield, effectively reducing the interest paid over time. With the Fed Funds Rate now at 0.00% to 0.25% through at least 2014, selling more short term Treasuries should lower the price, which should increase short term yields. Unfortunately with Quantitative Easing 1 and 2 (QE1 and QE2), the Federal Reserve already bought short term Treasuries, which gave them an excess supply. The market knows this all too well, so the intended affect is not working, making the yield on 2 year Treasuries near 0%. Operation Twist was recently extended until the end of 2012, making U.S. Treasuries much less appealing investments.

Some considered QE1 and QE2 as money printing, and indeed there was an increase in money supply, but only a portion of it. Under our fractional-reserve system, when banks issue loans, new sums of money are created. Recall that the short term loan market essentially dried up, so when QE1 and QE2 were initiated, the affect was barely felt in markets. The USD should have been devalued by the actions of the Fed, yet the efforts of QE1 and QE2 barely changed the value. There was a more direct affect of exchange rates, as large investors sought returns in other countries. Demand for German Bunds, or other sovereign investments in Europe, created a demand for Euros (EUR) for a time, which lowered the value of the dollar (USD). Now with growing troubles in Europe, and politicians dragging their feet on creating real solutions, the demand is shifting the other direction, and the USD is gaining in strength. In the near term we may see the EUR drop more against the USD, possibly under 1.20. This can present a buying opportunity for investors wishing to initiate investments in large international corporations who happen to be headquartered in Europe. In the longer run, over the next several years, Europe will eventually solve some of their current issues, and nimble companies there will learn how to work around the feet-dragging to generate revenues.

We may indeed see QE3 and some form of that from the European Central Bank, though I think long term investors should not consider these possibilities with a high degree of certainty. The issue behind loose monetary policy is that eventually the excess money printing will need to be recovered, and the few tests we have seen of how that will be accomplished have not looked very promising. Ideally the rate of inflation would match the rates of population growth, so that the economy could expand at the rate that ensures price stability. History has proven that this has not been precise, and as we saw in the last bubble, central banks can get policies completely wrong, which prompts a reset of the economy. Places with slow population growth, or low immigration rates limiting population growth, have shown low economic growth over long periods of time. Japan has been locked in a slow growth cycle for over a decade, and is now facing deflation, despite numerous efforts by their central bank to loosen monetary policy. The United Stated and Europe should not ignore the policy decisions of Japan, or they will be more likely to repeat them. The result of these policies is that we now see more growth in emerging economies than in developed economies. This is likely to continue for quite some time into the future.

When we look at investment opportunities in emerging economies, we sometimes find what seems to be higher risk, through geopolitical uncertainty, and at times due to a lack of currency stability. People in emerging economies tend to want better food, and there is a need for more energy resources and raw materials. Sustainable growth can run for long periods of time, if governments remain somewhat stable and do well managing their resources. China and India have become great consumers of raw materials as they build infrastructure and become more urbanized. The places in the world that supply the energy and raw materials that allow China and India to grow at a fast pace, helps drive the economies where the oil, natural gas, and raw materials are located. Australia has a booming mining industry, which exports large amounts of iron ore and coal, mostly to China. This demand has driven the Australian economy and caused the Australian Dollar (AUD) to strengthen against other currencies. Brazil, with large mining resources and oil, is also experiencing a strong export driven economy. Chile, with some of the world's largest reserves of copper, and rich in easy to access lithium reserves, has started to grow at a faster pace, somewhat helped by a more stable government. Chile also holds large reserves of minerals useful for fertilizing crops, though they are somewhat matched by a more stable Canada in that regard. Much of South America is experiencing expansion, mechanization, and modernizing of farm lands, with exports of food and grains generating increasing revenues. Short of creating more bubbles in their economies, the United States and Europe are unlikely to see the growth that emerging economies are now enjoying.

There are also frontier economies, and some large multi-national corporations are setting up in those countries, with the hope that they will become the next emerging economies. Over the last few years I have watched a great increase in oil and natural gas exploration in west Africa, and greater mining activity in other inland areas of Africa. Many of these places are not completely stable, nor do they have established central monetary policy to create long term sustainable economies. These places are much higher risk as direct investments, though it is possible to lessen the geopolitical risk through investments in corporations now working to develop these areas. Offshore oil is probably the best example of that, as Middle East tensions are causing many of the oil majors to look at developing resources in other locations. Since oil is priced in USD in most of the world, the financial stability of local economies can have a negligible affect on operating in those parts of the world. Offshore oil development is a highly specialized realm, and difficult for emerging economies to operate on their own. Even Brazil, an emerging economy with a long history of oil production and exploration, still need outside technology and companies to provide the most profitable and efficient production.

Over a long investing time period, in an actively managed portfolio, we can look at macro-economic trends around the world, and position our investments to capitalize on future areas of growth. When calculating risk, we need to be flexible, and have some of our assets positioned for more stable and predictable returns. Maintaining a cash position is important for some of that flexibility, and that can be in money market funds, bond funds, or Treasuries. Since we know the Federal Reserve will continue Operation Twist through the end of 2012, direct investments in Treasuries are unlikely to provide good returns for now, though if we look at funds that buy Treasuries, we can be more flexible moving money in or out of those funds. With the establishment of the ESF to back money market funds, most of those are also a good choice to park cash. In our investments, it may be tempting to jump onto shares of the latest company to make the news, but a longer term investment plan, backed by research into companies with good future growth prospects, may provide better long term returns.

We would be lucky to get in at the bottom of the market, or take profits at the top of the market, so making a choice of the size of a holding, and buying near a low point, should be easier to attain goals than trying to hit exact high or low levels. One thing that can help longer term investors is to acquire shares of companies that pay solid dividends. At the moment companies that pay more than 2% dividend yield are outperforming 10 year Treasuries, while some companies are generating more than 4% annual dividend yields. There are other investments outside of bonds and equities that pay fixed returns, and may be a good choice in diversified portfolios. Given the recent bankruptcies in Jefferson County, Alabama, and Stockton, California, I suggest avoiding small municipal bond investments. Even the debt of some countries should not be considered as a safe haven, nor risk free, as witnessed in the forced write-down of over 75% of Greek debt. Moving some investments to fixed return provides one source of revenues that are easier to plan over time than simply relying upon profit taking from stocks.

In future articles in this newsletter, we will look more in depth at some of the macro-economic trends identified in this article. Investing is never without risk, so readers are encouraged to do their own research, check many sources of information, and determine the path of their investments. We hope the information we provide will be a launching point for that research, and point you towards the path of being an informed and successful investor.