How to Fix Stuff

Posted on March 29, 2012 by HighTower

Posted By: Matthias Paul Kuhlmey

How do you fix a computer? Turn it off … and then back on. J How do you fix an economy? You cannot turn it off, that’s for sure – it only may have worked once, during the Great Depression, and the system did reset itself. Since Mr. Bernanke was recently declared a “hero,” we thought the “fixing-up” was complete. To be clear, we have no axe to grind and are most certain that our FED Chairman is attempting to do a very fine and thoughtful job; nevertheless, FED communication has been entirely confusing and, to a degree, misleading (at least for market participants that need stimulus money to make investment decisions).

This past Monday, Mr. Bernanke, during a clever publicity stunt, expressed his worries that the economic recovery could stall if the FED would end monetary stimulus too soon. So, things are not fixed? Here’s a shocker: According to “Hero B.,” the recent improvement of the unemployment situation may (only) have been reflective of “a reversal of the unusually large layoffs that occurred in 2008 and 2009,” with this process now in conclusion. Further, Bernanke told ABC news that “It’s far too early to declare victory” (on the economy, that is). Huh?

On the other side of the argument stands Charles Plosser, President of the Philadelphia FED, suggesting in an interview that he does not “think there will be any need for further accommodation, or further QEs.” Federal Reserve Bank of Dallas President, Richard Fisher, seems to agree, having stated in a recent speech that the “Federal Reserve has done its job” (in providing liquidity). But, wait, here comes San Francisco FED President, John Williams, carefully remarking that, “If the economy does need more stimulus, restarting our (the FED’s) program of purchasing mortgage-backed securities would probably be the best course of action.” His buddy, Federal Reserve Bank of Chicago President, Charles Evans, sums it up: “The central bank should step up record monetary stimulus even as the economy shows signs of gaining traction” (for a selection of other differing FED opinions, click here).

So, how do you really fix things? One idea is to agree on what has to be fixed – the economy and related unemployment, or the stock market (easy money has certainly taken care of that). Go on guys!

360: The “E” Is Wrong! (Part II)

Posted on March 26, 2012 by HighTower

Posted by: Matthias Paul Kuhlmey

Today, we have a brand-new edition of our 360 Observations, this time covering a topic that should be of great interest to the prudent equity investor: Earnings – and, ergo, the attractiveness of stocks versus other investments. Yada Yada Yada, we get it – stocks are cheap! Just to quickly refresh our memories: The attractiveness (or “cheapness”) of a stock is a function of the price a given investor is willing to pay for a future string of earnings, also expressed in the so-defined Price-to-Earnings (P/E) Ratio. In other words, with a P/E of 14.4 for the S&P 500 (using current forward-looking 12-month earnings estimates), an investor is willing to pay $14.40 to acquire $1 of earnings. Stated differently, it will take 14.4 years (on this basis alone) to reach a break-even point for this particular investment, assuming everything else stays the same. On a trailing P/E basis (using the past 12-month earnings), equity markets in the U.S. are also somewhat attractively priced with a reading of 16.2. Case dismissed?

What is important to consider is the quality or composition of “E,” as this very aspect can change the outcome for an investor quite substantially. Messrs. Graham and Dodd, in their highly acclaimed and classic text book, Security Analysis, “urged investors to focus on hard facts - like a company’s past earnings and the value of its assets – rather than trying to guess what the future would bring.” Their suggestion is that stock prices should be divided by average annual corporate earnings, based on at least five years of history, but ideally ten years; this so-derived 10-year ratio has a reliable track record: “In 2007, when many Wall Street traders and economists were claiming that stocks were still a great buy, the 10-year ratio knew better. Likewise, it helped predict the market’s rebound in early 2009, when optimists were not easy to find.” Today, the 10-y P/E, noted at 23.5, is rather expensive, when compared to the commonly used forward-looking or trailing P/E estimates discussed above.

Investors also need to be concerned about the “inputs into E,” such as profit margins that are currently at or near historic highs for U.S. companies. We have covered this aspect before, but a must-read update, What Goes Up Must Come Down, is available from James Montier, of GMO. Montier, in our words, is troubled by the fact that profits are where they are, despite the weakest economic recovery in post-war history. His paper concludes that Government expenditures significantly improved corporate profit margins, or “filled the gap,” since private investments went to insignificant levels as a result of the economic crisis. In consequence, profits are inflated and future austerity measures may be the trigger that will force necessary equilibrium. Time to panic? Not quite yet, as we “live and breathe” in an election year with everyone Buying time and GDP.

Of Maestros and Heroes

Posted on March 20, 2012 by HighTower

Posted By: Matthias Paul Kuhlmey

It was 2006, when the “Maestro” left office: The almighty Alan Greenspan! In fact, I made an effort to keep the front page of the FT that day – not exactly celebrating the act, but rather telling my wife that I was certain that the glory wouldn’t last. Only a few years later, through the events of the Credit Crisis of 2008/2009, the financial world as we knew it came to an end. Alan Greenspan, who became known as the man with the “Greenspan Put,” had gloriously fought the economic fallout from the dotcom-bubble, allowing interest rates to stay historically low (for longer than necessary). As a result, U.S. consumers never “missed a step,” venturing from one investment bubble (TNT Stocks) to yet another one – Real Estate.

CNN, in 2010, reported, “People and institutions normally at each other’s throat all seem to agree: Editorial pages from the Boston Globe on the left to the Wall Street Journal on the right, think tanks from the liberal Institute for Policy Studies to the beyond-conservative Cato Institute, Nobel Prize-winning economists including Keynesian Paul Krugman and rationalist Gary Becker – they all know who’s to blame for the mess we’re in. Four years after leaving the Fed as the Greatest Central Banker Ever, the longest-serving chairman, the Maestro, Alan Greenspan is the designated goat.”

Staying on the topic of editorial cover pages, the current edition of The Atlantic profiles the other “Maestro (or ‘Hero,’ this time around),” FED Chairman, Mr. Ben Bernanke. We will not comment on this aspect today, as only time can tell, but one thing is somewhat odd: Mr. Bernanke has studied and criticized the way Japanese monetary authorities dealt with their very own crisis, the Japanese asset price bubble, yet he has guided the FED directionally more “Japanese-style” over the past months, doing exactly what was considered to be irrelevant.

A concluding thought, coming back to Real Estate … No one was ever disappointed – and, consequently, it was a good thing (as Martha Stewart would say): Builders built and made money; the banks provided lending and made money; brokers bought and sold and made money; the end-consumer had increasingly bigger (at times multiple) houses that “made money,” and this home “equity” was used as an ATM to finance other needs. No problem, right? … Until there was a problem.

We do not exactly know how you feel about the current rally in stocks, now with the S&P having crossed another magical milestone at 1400, but one thing is for certain: Economic data and indicators are not as clear as one might think. The so-called recovery needs to be tested and re-evaluated very cautiously, just like Benny B.’s “heroic” work. Make sure to keep the cover of The Atlantic!

Behind the Curtain

Posted on March 12, 2012 by HighTower

Posted By: Matthias Paul Kuhlmey

From my days in the music industry (story for another day), I learned the somewhat inconceivable: Mega-stars would tour the world to play live concerts, and it was not uncommon for them to have a “small army” of supporting musicians playing backstage during shows. Shocker! Not really – the additional support put on stage would have left the performance “crowded,” and the audience with something to desire – it was the star (not the support staff) that they wanted to see, experience, and perceive to be responsible for all the “awesomeness.”

Now let’s pull back the curtain on economic affairs. Believe it or not, there is such a thing as the U.S. Government Accountability Office, or GAO, for short. According to a recent report, more than half of the financial institutions that were in need for emergency government funding have repaid the money that was originally provided under the Capital Purchase Program (CPP), established as the primary framework in restoring liquidity and stability to the financial system under the Troubled Asset Relief Program (TARP); this is beautiful, and very much in line with current thinking about the matter. The reality, however, is that an increasing number of financial institutions are missing scheduled dividend or interest payments and … be prepared for this one(!) … are using government money from other programs to repay their TARP obligations. A perfect “left into right pocket scenario” – nothing has really changed.

Let’s spend more time backstage. The media postulates that more and more Americans, when considered on the basis of Household Wealth, “are climbing further out of the hole they sank into during the Great Recession (of 2008/2009 that is),” and that the largest increase in consumer borrowing (November through January) in a decade(!) is clearly indicative of better sentiment and a recovering economy. The sad reality is that the biggest asset of the American household, real estate, continues to decline in value. Home values fell 1.3% in the 4th Quarter of 2011, to approximately $16 trillion, leaving the housing stock nearly 24% below its peak of December 2007. Yet, Household Wealth, over the same time period, climbed for the first time in 3 quarters, with an increase in stock prices more than compensating for the decline in home values. Great, you may think – but, please keep in mind that Benny B., the FED-man, made commitments some time ago to “propel” stock prices. What happens if his “good will” ceases to exist? Curtain please!

One more look at consumer borrowing (truly mind-boggling): According to the latest Federal Reserve’s Flow-of-Funds Report, Household Debt grew at an annualized rate of 0.25% in Q4 2011 – not a big increase, but, “until now there hadn’t been any uptick at all in household debt since the 2008 crash.” In our view, it is not an encouraging sign if one considers that nominal income has not held up with inflation – this is most likely about “filling the income gap.” With total consumer credit of $2.5 trillion and mortgage debt totaling $9.8 trillion (both Q4 2011), we can only imagine what will happen when the day of higher rates comes.

The curtain is what makes the world go round … or behind the curtain is where the world is “being rounded,” leaving front-and-center stage as an illusion or romantic notion. Be certain what side you want to “play” on before the final curtain is drawn.

Blah-g

Posted on March 8, 2012 by HighTower

Posted By: Matthias Paul Kuhlmey

There is quite a bit of “traffic” at the HighTower offices, in New York, these days. We are fortunate in that many money managers want our attention and will travel from near and far to pitch their offering – and here, I find myself, sitting through multiple presentations, gathering “multiple” views of the investment world, and what I can report is that the story being told is simply repetitive – it goes: equities are cheap – this is why you have to buy.

The most common “pro-cheapness” argument is that corporate earnings, in relation to prices of underlying stocks (Price-to-Earnings, or P/E ratios), are very attractive. With profits of S&P 500 companies having doubled since 2009, a current P/E of 14.1 is better than at every other of the previous 34 stock market peaks, dating back to 1989. One must remember, however, that profit margins have never been higher. According to First Pacific Advisors, a leading practitioner of value investing, and USD 19 billion under management, 73% of the non-financial corporate pre-tax profit margin expansion resulted from lower interest (38%) and labor (35%) costs. Is this sustainable throughout an orderly economic recovery? Nope!

The respected Jeremy Grantham, of GMO, doesn’t buy the “party line” either – in fact, Grantham’s advice (his Q4 2011 letter) is to be heavily underweight U.S. equities, with the exception of the top-quartile of high-quality firms. Based on thorough analysis of long-term data, the broad U.S. equity index has an imputed annualized return of about 1% (yes – that is only one percent – not a typo!) over the next seven years, adjusted for inflation. A pressing question, then: Why even bother with such an investment, given the associated level of volatility that comes with it?

Then, of course, there is a second prominent argument for the attractiveness of stocks, specifically when compared against bonds. We are not even going to entertain this aspect, as interest rates in the U.S. (and most other developed nations) are simply being manipulated. If measures by the FED and other Central Banks were to be “removed”, who knows what rates on Government paper would truly yield (and, consequently, what the appropriate basis for an over-/undervalued assessment would turn out to be)?

Nonetheless, somewhat complacent market participants, remain upbeat in their expectations for future returns, leaving the equity market in a somewhat overbought condition. Here is an interesting point for the overly cheery investor: According to Mr. Lakshman Achuthan, co-founder of the highly-regarded Economic Cycle Research Institute (ECRI), the U.S. will enter a recession as early as this Summer, as economic growth has slowed to such a degree that a downturn is now unavoidable. Not dissimilar to our views, Achuthan attributes the continued increase in stock prices to central banks’ infusing the global banking system and economies with liquidity. Further, he points out that the velocity of money, simply defined as the number of times a dollar is spent by consumers, has fallen to a record low in recent months, which is yet another indicator of underlying weakness to the economy.

No worries – not all is lost, as there are also interesting stories out there: Think of Asian Currencies, Local Emerging Market Debt, Infrastructure-related investments, Natural Resources. We can help, and won’t leave you bored (promise).

Weekend Thoughts

Posted on March 2, 2012 by HighTower

Posted By: Matthias Paul Kuhlmey

It is surprising to us that hardly anyone (openly) worries about the price of Oil. Sure, we hear a few voices here and there, but are made to believe that the consumer is now more resilient to the recent rise of Oil (highest since June 2008), since prospects in the job market appear to be better; this link, in our view, is not entirely logical in nature, but it is certainly a driver of confidence – and that may be it. According to BMO Capital Markets, “Gasoline accounts for about 4 percent of personal consumption in the U.S. and the price of gasoline is estimated to exceed the $5 per-gallon level, given the consistent increase in oil prices since September 2011.” It is interesting to note, however, that President Obama recently attempted to blame “burgeoning growth” in India, China, and Brazil for rising Oil prices, but without mention of the fact that significantly-increased global liquidity (provided by mainly Developed World Central Bankers) have elevated speculation, especially in Commodities, over the years. One more note: Experts warn that if the conflict around Iran were to escalate, Oil could easily trade above $150/barrel – and there is no question that, under this scenario, the outlook for the global economy and stock markets would change.

We are still worrying about Greece, and, in the meantime, one of the largest European economies is simply “hitting the wall”. As we learn today, Spain’s unemployment rate has reached a staggering 22.9%, the highest among the 17 Eurozone members. Further, the Spanish economy produced negative growth in the last quarter of 2011 and is now expected to enter into recession. The unemployment situation is even worse, when considering Youth Unemployment: In Spain, about 50% of the “around 20″ age-group is out of a job. The regional government of Valencia, one of the most indebted in the Spanish nation (recently downgraded to “junk status”), has applied austerity measures to cut electricity, water, and public funding for Schools. Violent protests among students are now common. If one may think this is a phenomenon specific to Spain, we must correct that notion. Youth Unemployment is an issue across all European Nations, with numbers in excess of 20% even for the U.K. and France … not a good basis on which to build a functioning society.

Now let’s “pull together” Oil and Employment (or the prospect of it). Two things that debt-burdened-economies undoubtedly require are growth and the related improvement of the employment situation. We know that Oil price-spikes preceded the 1973, 1980, 1991, 2001 and 2007 recessions, but did not cause a recession in 2011; this is an easy one to distinguish – Mr. Bernanke took care of the issue by providing liquidity to the system. From a different perspective, we just have to realize that change is necessary as we are caught in a “Catch 22”: Stimulus to the system creates speculative money; speculative money goes where real value is perceived or speculation is effective (Commodities, as a good example); rising commodity prices (Oil and Agriculture) burden the consumer. A fascinating paper on the topic of Oil-led Development concludes that, “More than any other group of countries, oil-dependent countries demonstrate perverse linkages between economic performance, poverty, bad governance, injustice and conflict.”

Is this another attempt to leave our readers on a negative note? No, quite the opposite – it is an opportunity to reflect on what we individually can do to foster change …