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Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2014

The Hoisington Investment Management quarterly review and outlook Via John Mauldin Economics

Treasury Bonds Undervalued

Thirty-year treasury bonds appear to be undervalued based on the tepid growth rate of the U.S. economy. The past four quarters have recorded a nominal “top-line” GDP expansion of only 2.9%, while the bond yield remains close to 3.4%. Knut Wicksell (1851-1926) noted that the natural rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the growth rate of nominal GDP. Interest rates higher than the top-line growth rate of the economy, which is the case today, would mean that resources from the income stream of the economy would be required to pay for the higher rate of interest, thus slowing the economy. Wicksell preferred to use, not a risk free rate of interest such as thirty-year treasury bonds, but a business rate of interest such as BAA corporates.


As chart one attests, interest rates below nominal GDP growth helps to accelerate economic activity and vice versa. Currently the higher interest rates are retarding economic growth, suggesting the next move in interest rates is lower.

To put the 2.9% change in nominal GDP over the past four quarters in perspective, it is below the entry point of any post-war recession. Even adjusting for inflation the average four-quarter growth rate in real GDP for this recovery is 1.8%, well below the 4.2% average in all of the previous post-war expansions.

Fisher’s Equation of Exchange

Slow nominal growth is not surprising to those who recall the American economist Irving Fisher’s (1867-1947) equation of exchange that was formulated in 1911. Fisher stated that nominal GDP is equal to money (M) times its turnover or velocity (V), i.e., GDP=M*V. Twelve months ago money (M) was expanding about 7%, and velocity (V) was declining at about a 4% annual rate. If you assume that those trends would remain in place then nominal GDP should have expanded at about 3% over the ensuing twelve months, which is exactly what occurred. Projecting further into 2014, the evidence of a continual lackluster expansion is clear. At the end of June money was expanding at slightly above a 6% annual rate, while velocity has been declining around 3%. Thus, Fisher’s formula suggests that another twelve months of a 3% nominal growth rate is more likely than not. With inflation widely expected to rise in the 1.5% to 2.0% range, arithmetic suggests that real GDP in 2014 will expand between 1.0% and 1.5% versus the average output level of 2013. This rate of expansion will translate into a year-over-year growth rate of around 1% by the fourth quarter of 2014. This is akin to pre-recessionary conditions.

An Alternative View of Debt

The perplexing fact is that the growth rate of the economy continues to erode despite six years of cumulative deficits totaling $6.27 trillion and the Federal Reserve’s quantitative easing policy which added net $3.63 trillion of treasury and agency securities to their portfolio. Many would assume that such stimulus would be associated with a booming economic environment, not a slowing one.

Readers of our letters are familiar with our long-standing assessment that the cause of slower growth is the overly indebted economy with too much non-productive debt. Rather than repairing its balance sheet by reducing debt, the U.S. economy is starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.

It is possible to cast an increase in debt in positive terms since it suggests that banks and other financial intermediaries are now confident and are lowering credit standards for automobiles, home equity, credit cards and other types of loans. Indeed, the economy gets a temporary boost when participants become more indebted. This conclusion was the essence of the pioneering work by Eugen von Böhm-Bawerk (1851-1914) and Irving Fisher which stated that debt is an increase in current spending (economic expansion) followed by a decline in future spending (economic contraction).

In concert with this view, but pinpointing the negative aspect of debt, contemporary economic research has corroborated the views of Hyman Minsky (1919-1996) and Charles Kindleberger (1910-2003) that debt slows economic growth at higher levels when it is skewed toward the type of borrowing that will not create an income stream sufficient to repay principal and interest.

Scholarly studies using very sophisticated analytical procedures conducted in the U.S. and abroad document the deleterious effects of high debt ratios. However, the use of a balance sheet measure can be criticized in two ways. First, income plays a secondary role, and second, debt ratios are not an integral part of Keynesian economic theory.

We address these two objections by connecting the personal saving rate (PSR) which is at the core of Keynesian economic analysis, and the private debt to GDP ratio that emerges from non-Keynesian approaches. Our research indicates that both the “Non-Keynesian” private debt to GDP ratios, as well as the “Keynesian” PSR, yield equivalent analytical conclusions.

The Personal Saving Rate (PSR) and the Private Debt Linkage

The PSR and the private debt to GDP ratio should be negatively correlated over time. When the PSR rises, consumer income exceeds outlays and taxes. This means that the consumer has the funds to either acquire assets or pay down debt, thus closely linking the balance sheet and income statement. When the PSR (income statement measure) rises, savings (balance sheet measure) increases unless debt (also a balance sheet measure) declines, thus the gap between the Keynesian income statement focus and the non-Keynesian debt ratio focus is bridged.

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The PSR and private debt to GDP ratio are, indeed, negatively correlated (Chart 2). The correlation should not, however, be perfect since the corporate sector is included in the private debt to GDP ratio while the PSR measures just the household sector. We used the total private sector debt ratio because the household data was not available in the years leading up to the Great Depression.

The most important conceptual point concerning the divergence of these two series relates to the matter of the forgiveness of debt by the financial sector, which will lower the private debt to GDP ratio but will not raise the PSR. The private debt to GDP ratio fell sharply from the end of the recession in mid-2009 until the fourth quarter of 2013, temporarily converging with a decline in the saving rate. As such, much of the perceived improvement in the consumer sector’s financial condition occurred from the efforts of others. The private debt to GDP ratio in the first quarter of 2014 stood at 275.4%, a drop of 52.5 percentage points below the peak during the recession. The PSR in the latest month was only 1.7 percentage points higher than in the worst month of the recession. Importantly, both measures now point in the direction of higher leverage, with the PSR showing a more significant deterioration. From the recession high of 8.1%, the PSR dropped to 4.8% in April 2014.

Historical Record

The most recently available PSR is at low levels relative to the past 114 years and well below the long-term historical average of 8.5% (Chart 3). The PSR averaged 9.4% during the first year of all 22 recessions from 1900 to the present. However this latest reading of 4.8% is about the same as in the first year of the Great Depression and slightly below the 5% reading in the first year of the Great Recession.

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In Dr. Martha Olney’s (University of California, Berkeley and author of Buy Now, Pay Later) terminology, when the PSR falls households are buying now but will need to pay later. Contrarily, if the PSR rises households are improving their future purchasing power. A review of the historical record leads to two additional empirical conclusions. First, the trend in the PSR matters. A decline in the PSR when it has been falling for a prolonged period of time is more significant than a decline after it has risen. Second, the significance of any quarterly or annual PSR should be judged in terms of its long- term average.

For example, multi-year declines occurred as the economy approached both the Great Recession of 2008 and the Great Depression of 1929. In 1925 the PSR was 9.2%, but by 1929 it had declined by almost half to 4.7%. The PSR offered an equal, and possibly even better, signal as to the excesses of the 1920s than did the private debt to GDP ratio. Both the level of PSR and the trend of its direction are significant meaningful inputs.

John Maynard Keynes (1883-1946) correctly argued that the severity of the Great Depression was due to under-consumption or over-saving. What Keynes failed to note was that the under-consumption of the 1930s was due to over-spending in the second half of the 1920s. In other words, once circumstances have allowed the under-saving event to occur, the net result will be a long period of economic under-performance.

Keynes, along with his most famous American supporter, Alvin Hansen (1887-1975), argued that the U.S. economy would face something he termed “an under-employment equilibrium.” They believed the U.S. economy would return to the Great Depression after World War II ended unless the federal government ran large budget deficits to offset weakness in consumer spending. The PSR averaged 23% from 1942 through 1946, and the excessive indebtedness of the 1920s was reversed. Consumers had accumulated savings and were in a position to fuel the post WWII boom. The economy enjoyed great prosperity even though the budget deficit was virtually eliminated. The concerns about the under-employment equilibrium were entirely wrong. In Keynes’ defense, the PSR statistics cited above were not known at the time but have been painstakingly created by archival scholars since then.

Implications for 2014-2015

In previous letters we have shown that the largest economies in the world have a higher total debt to GDP today than at the time of the Great Recession in 2008. PSRs also indicate that foreign households are living further above their means than six years ago. According to the OECD, Japan’s PSR for 2014 will be 0.6%, virtually unchanged from 2008. The OECD figure is likely to turn out to be very optimistic as the full effects of the April 2014 VAT increase takes effect, and a negative PSR for the year should not be ruled out. In addition, Japan’s PSR is considerably below that of the U.S. The Eurozone PSR as a whole is estimated at 7.9%, down 1.5 percentage points from 2008. Thus, in aggregate, the U.S., Japan and Europe are all trying to solve an under-saving problem by creating more under-saving. History indicates this is not a viable path to recovery. [reference: Atif Mian and Amir Sufi,. House of Debt, University of Chicago Press 2014]

Japan confirms the experience in the United States because their PSR has declined from over 20% in the financial meltdown year of 1989 to today’s near zero level. Japan, unlike the U.S. in the 1940s, has moved further away from financial stability. Despite numerous monetary and fiscal policy maneuvers that were described as extremely powerful, the end result was that they have not been successful.

U.S. Yields Versus Global Bond Yields

Table one compares ten-year and thirty-year government bond yields in the U.S. and ten major foreign economies. Higher U.S. government bond yields reflect that domestic economic growth has been considerably better than in Europe and Japan, which in turn, mirrors that the U.S. is less indebted. However, the U.S. is now taking on more leverage, indicating that our growth prospects are likely to follow the path of Europe and Japan.

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With U.S. rates higher than those of major foreign markets, investors are provided with an additional reason to look favorably on increased investments in the long end of the U.S. treasury market. Additionally, with nominal growth slowing in response to low saving and higher debt we expect that over the next several years U.S. thirty-year bond yields could decline into the range of 1.7% to 2.3%, which is where the thirty-year yields in the Japanese and German economies, respectively, currently stand.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Review and Forecast by Gary Shilling

Via John Mauldin, Mauldin Economics

It’s that time of year again, when we begin to think of what the next one will bring. I will be doing my annual forecast issue next week, but my friend Gary Shilling has already done his and has graciously allowed me to use a shortened version of his letter as this week’sThoughts from the Frontline. So without any further ado, let’s jump right to Gary’s look at where we are and where we’re going.

Review and Forecast

By Gary Shilling

In the third quarter, real GDP grew 2.8% at annual rates from the second quarter. Without the increase in inventories, the rate would be 2.0%, in line with the 2.3% average growth since the economic recovery commenced in the second quarter of 2009.

Furthermore, the step-up in inventory-building from the second quarter may have been unintended, suggesting cutbacks in production and weaker growth in future quarters. Also, consumer spending growth, 1.5% in the third quarter, continues to slip from 1.8% in the second quarter and 2.3% in the first while business spending on equipment and software actually fell at a 3.7% annual rate for only the second time since the recovery started in mid-2009. Government spending was about flat with gains in state and local outlays offsetting further declines in federal expenditures. Non-residential outlays for structures showed strength as did residential building. The 16-day federal government shutdown didn’t commence until the start of the fourth quarter, October 1, but anticipation may have affected the third quarter numbers.

Recovery Drivers

The 2.3% average real GDP growth in the recovery, for a total rise of 10%, has not only been an extraordinarily slow one but also quite unusual in structure. Consumer spending has accounted for 65% of that growth, actually below its 68% of real GDP, as shown in the second column of Chart 1. Government spending—which in the GDP accounts is direct outlays for personal and goods and services and doesn’t include transfers like Social Security benefits—has actually declined. Federal outlays fell 0.4% despite massive stimuli since most of it went to welfare and other transfers to state governments. But state and local spending dropped 0.9% due to budget constraints.



Residential construction accounted for 9% of the gain in the economy. This exceeds its share of GDP, but still is small since volatile housing normally leaps in recoveries, spurred by low interest rates. But deterrents abound. The initial boost to the economy as retrenching consumers cut imports was later reversed. So net exports reduced real GDP growth by 0.4% in the 13 quarters of recovery to date.

Inventory-building accounted for a substantial 19% of the rise in real GDP, suggesting the accumulation of undesired stocks since anticipation of future demand has been consistently subdued. Nonresidential structures fell 0.1% as previous overbuilding left excess space. Equipment spending contributed 20% of the overall growth, but has failed to shoulder the normal late recovery burst.

Nevertheless, the small intellectual property products component, earlier called software, accounted for 5% of overall growth compared to its 3.9% share of GDP. This reflects the productivity-enhancing investments American business have been using to propel profit margins and the bottom line in an era when sales volume has been weak and pricing power absent.

As we predicted over three years ago in our book The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, and in many Insights since then, economic growth of about 2% annually will probably persist until deleveraging, especially in the financial sector globally and among U.S. consumers, is completed in another four or five years. Deleveraging after a major leveraging binge and the financial crisis that inevitably follows normally takes around a decade, and since the workdown of excess debt commenced in 2008, the process is now about half over. The power of this private sector deleveraging is shown by the fact that even with the immense fiscal stimuli earlier and ongoing massive monetary expansion, real growth has only averaged 2.3% compared to 3.4% in the post-World War II era before the 2007-2009 Great Recession.

Optimists, of course, continue to look for reasons why rapid growth is just around the corner, and their latest ploy is the hope that the effects of individual income tax hikes and reduced federal spending this year via sequestration have about run their course. Early this year when these negative effects on spending were supposed to take place, scare-mongers in and out of Washington predicted drastic negative effects on the economy. But federal bureaucrats apparently mitigated much of the effects of sequestration, and the income tax increases on the rich, as usual, didn’t change their spending habits much. So the positive influences on the economy as sequestration fades and income tax rates stabilize are likely to be equally minimal.

Furthermore, small-business sentiment has fallen recently. The percentage of companies that look for economic improvement dropped from -2 in August to -10 in September and -17 in October to a seven-month low. Those expecting higher sales declined from +8 to +2 in October. Most of the other components of the index fell, including those related to the investment climate, hiring plans, capital spending intentions, inventories, inflation expectations and plans to raise wages and prices. Other recent measures of subdued economic activity include the New York Fed’s survey of manufacturing and business conditions and industrial production nationwide, which fell 0.1% in October from September.

The New York Fed’s Empire State manufacturing survey index for November fell to 2.21%, the first negative reading since May. Every component dropped—orders, shipments, inventories, backlogs, employment, the workweek, vendor performance and inflation.

Global Slow Growth

The ongoing sluggish growth in the U.S. is indeed a global problem. It’s true in the eurozone, the U.K., Japan and China. Recently, the International Monetary Fund, in its sixth consecutive downward revision, cut its global growth forecast for this year by 0.3 percentage points to 2.9% and for 2014, by 0.2 percentage points to 3.6%.

It lowered its 2013 forecast for India from 5.6% to 3.8%, for Brazil from 3.2% to 2.5% and more than halved Mexico’s to 1.2%. For developing countries on average, the IMF reduced its 2013 growth forecast by 0.4 percentage points to 5%, citing the drying up of years of cheap liquidity, competitive constraints, infrastructure shortfalls and slowing investment. It also worries about their balance of payment woes. For 2014, the IMF chopped its growth forecast for China from 7.8% to 7.3% and from 2.8% to 2.6% for the U.S.

Fiscal Drag

Fed Chairman Bernanke continually worries about fiscal drag. Without question, the federal budget was stimulative in earlier years when tax cuts and massive spending in reaction to the Great Recession as well as weak corporate and individual tax collections pushed the annual deficit above $1 trillion. But the unwinding of the extra spending, income tax increases and sequestration this year and economic recovery—weak as it’s been—have reduced the deficit to $680 billion in fiscal 2013 that ended September 30.

From here on, the outlook is highly uncertain with persistent gridlock in Washington between Democrats and Republicans. So far, they’ve kicked the federal budget and debt limit cans down the road and they may do so again when temporary extensions expire early next year. It looks like many in Congress have no intention of resolving these two problems and may be jockeying for position ahead of the 2014, if not the 2016, elections.

In our many years of observing and talking to Congressmen, Senators and key Administration officials of both parties, it’s clear that Washington only acts when it has no alternative and faces excruciating pressure. A collapsing stock market always gets their attention, but the ongoing market rally, in effect, tells them that all is well or at least that it doesn’t require immediate action.

The Fed

With muted economic growth and risks on the downside, distrust in the abilities or willingness of Congress and the Administration to right the ship, and falling consumer and business confidence, the burden of stimulating the economy remains with the Fed. Janet Yellen, the likely next Chairman, seems even more committed than Bernanke to continuing to keep monetary policy loose. The Fed plans to reduce its buying of $85 billion per month in securities but the negative reactions by stocks (Chart 2), Treasury bonds (Chart 3) and many other securities to Bernanke’s hints in May and June that purchases would be tapered and eliminated by mid-2014 made a strong impression on the Fed. Similarly, the release of the minutes of the Fed’s October policy meeting— which again said officials looked forward to ending the bond-buying program “in coming months” if conditions warranted—resulted in an instant drop in stock and bond prices.

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The Fed is trying to figure out how to end security purchases without spiking interest rates, to the detriment of housing, other U.S. economic sectors and developing economies. It’s moving toward “forward guidance,” more commitment to keep the short-term interest rate it controls low than its present pledge to keep it essentially at zero until the current 7.3% unemployment rate drops to 6.5% and its inflation rate measure climbs to 2.5% from the current 1.2% year-over-year.

The hope is that a longer-term commitment to keep short-term rates low will retard long rates as well when the Fed tapers its asset purchases. This strategy appears to be having some success. Treasury investors are switching from 10-year and longer issues to 2-year or shorter notes. This is known as the yield-steepening trade as it pushes short-term yields down and longer yields up. As a result, the spread between 2-year and 10-year Treasury obligations has widened to 2.54 percentage points, the most since July 2011. Banks benefit from a steeper yield curve since they borrow short term and lend in long-term markets. But borrowers pay more for loans linked to long-term Treasury yields. There’s a close link between the yield on 10-year Treasury notes and the 30-year fixed rate on residential mortgages.

The Fed has already signaled that it may not wait to raise short rates until the unemployment rate, a very unreliable gauge of job conditions as we’ve explained in past Insights, drops below 6.5%. Bernanke recently said that “even after unemployment drops below 6.5%, the [Fed] can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate.” At that point, the Fed will consider broader measures of the job market including the labor participation rate. If the participation rate hadn’t fallen from its February 2000 peak due to postwar baby retirements, discouraged job-seekers and youths who stayed in school since job opportunities dried up with the recession, the unemployment rate now would be 13%.

The Fed is well aware that other than pushing up stock prices, its asset-buying program is having little impact on the economy. In a recent speech, Bernanke said that while the Fed’s commitment to hold down interest rates and its asset purchases both are helping the economy, “we are somewhat less certain about the magnitude of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed’s balance sheet.” We wholeheartedly agree with this sentiment, as discussed in detail in our October Insight. Tapering Fed monthly purchases only reduces the ongoing additions to already-massive excess member bank reserves on deposit at the Fed.


Inflation has virtually disappeared. The Fed’s favorite measure of overall consumer prices, the Personal Consumption Expenditures Deflator excluding food and energy (Chart 4), is rising 1.2% year-over-year, well below the central bank’s 2.0% target and dangerously close to going negative.

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There are many ongoing deflationary forces in the world, including falling commodity prices, aging and declining populations globally, economic output well below potential, globalization of production, growing worldwide protectionism including competitive devaluation in Japan, declining real incomes, income polarization, declining union memberships, high unemployment and downward pressure on federal and state and local government spending.

With the running out of 2009 federal stimulus money and gas tax revenues declining as fewer miles are driven in more efficient cars, highway construction is declining and construction firms are consolidating and reducing bids on new work even if their costs are rising. Highway construction spending dropped 3.3% in the first eight months of 2013 compared to a year earlier. Also, states are shifting scarce money away from transportation and to education and health care. We’ve noted in past Insights that aggressive monetary and fiscal stimuli probably have delayed but not prevented chronic deflation in producer and consumer prices.

Why does the Fed clearly fear deflation? Steadily declining prices can induce buyers to wait for still-lower prices. So, excess capacity and inventories result and force prices lower. That confirms suspicions and encourages buyers to wait even further. Those deflationary expectations are partly responsible for the slow economic growth in Japan for two decades.

Low Interest Rates

With the Fed likely to continue to hold its federal funds rate close to zero, other short-term interest rates will probably remain there too. So the recent rally in Treasury bonds may well continue, with yields on the 10-year Treasury note, now 2.8%, dropping below 2% while the yield on our 32-year favorite, the 30-year Treasury “long bond,” falls from 3.9% to under 3%. Even-lower yields are in store if chronic deflation sets in as well it might. Ditto for the rise in stocks, which we continue to believe is driven predominantly by investor faith in the Fed, irrespective of modest economic growth at best. “Don’t fight the Fed,” is the stock bulls’ bellow. Supporting this enthusiasm has been the rise in corporate profits, but that strength has been almost solely due to leaping profit margins. Low economic growth has severely limited sales volume growth, and the absence of inflation has virtually eliminated pricing power. So businesses have cu t labor and other costs with a vengeance as the route to bottom line growth

Wall Street analysts expect this margin leap to persist. In the third quarter, S&P 500 profit margins at 9.6% were a record high but revenues rose only 2.7% from a year earlier. In the third quarter of 2014, they see S&P 500 net income jumping 14.9% from a year earlier on sales growth of only 4.7%. But profit margins have been flat at their peak level for seven quarters. And the risks appear on the downside.

Productivity growth engendered by labor cost-cutting and other means is no longer easy to come by, as it was in 2009 and 2010. Corporate spending on plant and equipment and other productivity-enhancing investments has fallen 16% from a year ago. Also, neither capital nor labor gets the upper hand indefinitely in a democracy, and compensation’s share of national income has been compressed as profit’s share leaped. In addition, corporate earnings are vulnerable to the further strengthening of the dollar, which reduces the value of exports and foreign earnings by U.S. multinationals as foreign currency receipts are translated to greenbacks.

Speculation Returns

Driven by the zeal for yield due to low interest rates and the rise in stock prices that has elevated the S&P 500 more than 160% from its March 2009 low, a degree of speculation has returned to equities. The VIX index, a measure of expected volatility, remains at very low levels (Chart 5). Individual investors are again putting money into U.S. equity mutual funds after years of withdrawals. “Frontier” equity markets are in vogue. They’re found in countries like Saudi Arabia, Nigeria and Romania that have much less-developed—and therefore risky—financial markets and economies than Brazil and Mexico.

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The IPO market has been hot this year. The median IPO has been priced at five times sales over the last 12 months, almost back to the six times level of 2007. And many IPOs have used the newly-raised funds to repay debt to their private equity backers, not to invest in business expansion. Through early November, IPOs raised $51 billion, the most since the $62 billion in the comparable period in 2000. Some 62% of IPOs this year are for money-losing companies, the most since the 1999-2000 dot com bubble. Some hedge fund managers are introducing “long only” funds with no hedges against potential stock price declines.

The S&P 500 index recently reached an all-time high but corrected for inflation, it remains in a secular bear market that started in 2000. This reflects the slow economic growth since then and the falling price-earnings ratio, and fits in with the long-term pattern of secular bull and bear markets, as discussed in detail in our May 2013 Insight.

High P/E

Furthermore, from a long-term perspective, the P/E on the S&P 500 at 24.5 is 48% above its long run average of 16.5 (Chart 6), and we’re strong believers in reversions to well-established trends, this one going back to 1881. The P/E developed by our friend and Nobel Prize winner, Robert Shiller of Yale, averages earnings over the last 10 years to iron out cyclical fluctuations. Also, since the P/E in the last two decades has been consistently above trend, it probably will be below 16.5 for a number of years to come.

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This index is trading at 19 times its companies’ earnings over the past 12 months, well above the 16 historic average. This year, about three-fourths of the rise in stock prices is due to the jump in P/Es, not corporate earnings growth. Even always-optimistic Wall Street analysts don’t expect this P/E expansion to persist in light of possible Fed tightening. Those folks, of course, are paid to be bullish and their track record proves it. Since 2000, stocks have returned 3.3% annually on average, but strategists forecast 10%. They predicted stock rises in every year and missed all four down years.


Residential construction is near and dear to the Fed’s heart. It’s a small sector but so volatile that it has huge cyclical impact on the economy. At its height in the third quarter of 2005, it accounted for 6.2% of GDP but fell to 2.5% in the third quarter of 2010 (Chart 7). That in itself constitutes a recession, even without the related decline in appliances, home furnishings and autos.

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Furthermore, the Fed can have a direct influence on housing. Monetary policy is a very blunt instrument. The central bank only can lower interest rates and buy securities and then hope the economy in general will be helped. In contrast, fiscal policy can aid the unemployed directly by raising unemployment benefits. But by buying securities, especially mortgage-related issues, the Fed can influence interest rates and help interest-sensitive housing. The rise in 30-year fixed mortgage rates of over one percentage point last spring probably has brought the housing recovery to at least a temporary halt. Each percentage point rate rise pushes up monthly principal and interest payments by about 10%.

Of course, many other factors besides mortgage rates affect housing and have been restraining influences. They include high downpayment requirements, stringent credit score levels, employment status and job security and the reality that for the first time since the 1930s, house prices have fallen—by a third at their low.

Capital Spending

Many hope that record levels of corporate cash and low borrowing costs will propel capital spending. And spending aimed at productivity enhancement, much of it on high-tech gear, has been robust as business concentrates on cost-cutting, as noted earlier. But the bulk of plant and equipment spending is driven by capacity utilization, and while it remains low, there’s little zeal for new outlays.

That’s why capital spending lags the economic cycle. Only after the economy strengthens in recoveries do utilization rates rise enough to spur surges in capital spending. And as our earlier research revealed, it’s the level of utilization, not the speed with which it’s rising, that drives plant and equipment outlays. So this is a Catch-22 situation. Until the economy accelerates and pushes up utilization rates, capital spending will remain subdued. But what will cause that economic growth spurt?

Government Spending

It’s unlikely to be government spending. State and local outlays used to be a steady 12% or so of GDP and a source of stable, well-paying jobs. But no more. State tax revenues are recovering (Chart 8), but the federal stimulus money enacted in 2009 has dried up, leaving many states with strained budgets.

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Pressure also comes from private sector workers who are increasingly aware that while their pay has been compressed by globalization and business cost-cutting, state and local employees have gotten their usual 3% to 4% annual increases and lush benefits. As a result, those government people have 45% higher pay than in the private sector, 33% more in wages and 73% in additional benefits. Oversized retiree obligations have sunk cities in California and Rhode Island and pushed Illinois to the brink of bankruptcy. Hopelessly-underfunded defined benefit pensions are a major threat to state and local government finances.

Municipal government employment is down 3.3% from its earlier peak compared to -0.2% for total payroll employment (Chart 9). And since these people are paid 1.45 times those in the private sector, two job losses is the equivalent of three private sector job cuts in terms of income. Real state and local outlays have fallen 9.5% since the third quarter of 2009.

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Federal direct spending on goods and services, excluding Social Security, Medicare and other transfers, has also been dropping, by 7.2% since the third quarter of 2010. Both defense and nondefense real outlays are dropping, and this has occurred largely before the 2013 sequestration. At the same time, federal government civilian employment, civilian and military, has dropped 6% from its top (Chart 10).

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U.S. Labor Markets

The U.S. labor market remains weak and of considerable concern to the Fed. Recent employment statistics have been muddled by the government’s 16-day shutdown in October and the impasse over the debt ceiling. Initially, 850,000 employees were furloughed although the Pentagon recalled most of its 350,000 civilian workers a week into the shutdown.

The unemployment rate has been falling, but because of the declining labor participation rate. We explored this phenomenon in detail in “How Tight Are Labor Markets?” (June 2013 Insight). As people age, their labor force participation rates tend to drop as they retire or otherwise leave the workforce. With the aging postwar babies, those born between 1946 and 1964, this has resulted in a downward trend in the overall participation rate—but it doesn’t account for all of the decline.

The irony is that participation rates of younger people tend to be higher than for seniors, but are declining. For 16-24-year-olds, the rate has declined sharply since 2000 as slow economic growth, limited jobs and rising unemployment rates have encouraged these youths to stay in school or otherwise avoid the labor force.

Meanwhile, the participation rates for those over 65 have climbed since the late 1990s as they are forced to work longer than they planned. Many have been notoriously poor savers and were devastated by the collapse in stocks in 2007-2009 after the 2000-2002 nosedive, two of only five drops of more than 40% in the S&P 500 since 1900.


An additional sign of job weakness is the large number of people who want to work full-time but are only offered part-time positions—”working part-time for economic reasons” is the Bureau of Labor Statistics term (Chart 11)—and these people total 8 million and constitute 5.6% of the employed. This obviously reflects employer caution and the zeal to contain costs since part-timers often don’t have the pension and other benefits enjoyed by full-time employees.

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This group will no doubt leap when Obamacare is fully implemented in 2015, according to its current schedule. Employers with 50 or more workers have to offer healthcare insurance, but not to those working less than 30 hours per week. When these people and those who have given up looking for jobs are added to the headline unemployment rate, the result, the BLS’s U-6 unemployment rate, leaped in the Great Recession and is still very high at 13.8% in October.

The weakness in the job market is amplified by the fact that most new jobs are in leisure and hospitality, retailing, fast food and other low-paying industries, which accounted for a third of the 204,000 new jobs in October. Manufacturing, which pays much more, has added some employees as activity rebounds but growth has been modest.

Real Pay Falling

With all the downward pressure on labor markets, real weekly wages are falling on balance. The folks on top of the income pile have recovered all their Great Recession setbacks and then some, on average. The rest, perhaps three-fourths of the population, believe they are—and probably still are—mired in recession due to declining real wages, still-depressed house prices, etc. Consequently, the share of total income by the top one-fifth, which has been rising since the data started in 1967, has jumped in recent years. The remaining four quintile shares continue to fall, although falling shares do not necessarily mean falling incomes.

The average household in the top 20% by income has seen that income rise 6% since 2008 in real terms and the top 5% of earners had an 8% jump. The middle quintile gained just 2% while the bottom 29% are still below their pre-recession peak. A study of household incomes over the 2002-2012 decade shows that the top 0.01% gained 76.2% in real terms but the bottom 90% lost 10.7%. In 2012, the top 1% by income got 19.3% of the total. The only year when their share was bigger was 1928 at 19.6%.

Real median household income, that of the household in the middle of the spectrum, continues to drop on balance, only leveling last year from 2011 (Chart 12). In 2012, it was down 8.3% from the prerecession 2007 level and off 9.1% from the 1999 all-time top. Americans may accept a declining share of income as long as their spending power is increasing, but that’s no longer true, a reality that President Obama plays to with his “fat cat bankers” and other remarks.

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Households earning $50,000 or more have become increasingly more confident, according to a monthly survey by RBC Capital Markets, but confidence among lower-income households stagnated, created a near-record gap between the two. Of the 2.3 million jobs added in the past year, 35% were in jobs paying, on average, below $20 per hour in industries such as retailing and leisure and hospitality. Since the recession ended, hourly wages for non-managers in the lowest-paying quarter of industries are up 6% but more than 12% in the top-paying quarter. These income disparities are reflected in consumer spending. In the first nine months of this year, sales of luxury cars were up 12% from a year earlier but small-car sales rose just 6.1%.

Consumer Spending

With housing, capital spending, government outlays and net exports unlikely to promote rapid economic growth in coming quarters, the only possible sparkplug is the consumer. Consumer outlays account for 69% of GDP, and with falling real wages and incomes, the only way for real consumer spending to rise is for their already-low saving rate to fall further.

Even the real wealth effect, the spur to spending due to rises in net worth, is now muted. In the past, it’s estimated that each $1 rise in equity value boosted consumer spending by three cents over the following 18 months while a dollar more in house value led to eight cents more in outlays. But now the numbers are two cents and five cents, respectively.

True, the ratio of monthly financing payments to their after-tax income has been falling for homeowners, freeing money for spending. Those obligations include monthly mortgage, credit card and auto loan and lease payments as well as property taxes and homeowner insurance. Nevertheless, for the third of households that rent, their average financial obligations ratio has been rising in the last two years as rents rise while vacancies drop.

Declining gasoline prices have given consumers extra money for other purchases, and are probably behind the recent rise in gas-guzzling pickup truck and SUV sales. Furthermore, the automatic Social Security benefit cost-of-living escalator will increase benefits by 1.5% in 2014 for 63 million recipients of retirement and disability payments. Still, with low inflation in 2013, the basing year, that increase is smaller than the 1.7% rise last year and the lowest since 2003, excluding 2010 and 2011 when there were no increases due to a lack of inflation. Social Security retirement checks will rise $19 per month to $1,294, on average, starting in January.

In any event, retail sales growth is running about 4% at annual rates recently, about half the earlier recovery strength (Chart 13). And a lot of this growth has been spurred by robust auto sales, allegedly driven by the need to replace aged vehicles.

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Insight readers know we’ve been waiting for a shock to remind equity investors of the fundamental weakness of the economy, and perhaps push the sluggish economy into a recession. With underlying real growth of only 2%, it won’t take much of a setback to do the job.

Will the negative effects of the government shutdown and debt ceiling standoff, coupled with the confusion caused by the rollout of Obamacare, be a sufficient shock? The initial Christmas retail selling season may tell the tale, and the risks are on the down side. Besides the consumer, we’re focused on corporate profits, which may not hold up in the face of persistently slow sales growth, no pricing power and increasing difficulty in raising profit margins.

Nevertheless, we are not forecasting a recession for now, but rather more of the same, dull, slack 2% real GDP growth as in the four-plus years of recovery to date.

Stop Investing In Hedge Funds Now! Oh No, Wait A Minute…

Here’s the other side of the hedge fund debate that has been raging in recent weeks.  In case you haven’t been paying attention, a number of well known media outlets have published articles that have argued that hedge funds aren’t all they’re cracked up to be.  I’ve been pretty hard on hedge funds as well (see here) and firmly believe that hedge funds are largely replicating many of the poor trends seen in mutual funds.  That doesn’t mean all hedge funds are bad or that all mutual funds are bad, but as a general rule of thumb I think it’s safe to say that an index of hedge funds won’t add much value over a highly correlated index fund counterpart after you account for taxes, fees and other frictions.

Anyhow, dvegadtime was kind enough to let me republish his piece from last week which I think is extremely well thought out and certainly worth a read.  As always, feel free to use the comments to discuss.

Stop Investing In Hedge Funds Now! Oh No, Wait A Minute…

By dvegadtime:

“Don’t Invest in Hedge Funds” is probably the refrain you have been hearing and reading over and over again recently. The so-called “smart money” has been under attack as it has failed to beat the market and deliver juicy returns. Some hedge fund managers were harshly criticized because of their attacks on the FED and the monetary policies it has executed in recent years. While the reasons for their hatred towards Bernanke could originate from their trading positions (as Brad DeLong explained in this post) we should bear in mind that one size does not fit all. Blaming the hedge fund category as a whole is not only wrong, but silly.

First of all, accurately quantifying the returns of hedge funds is very hard, if not impossible. For the simple reason that, the large majority of them do not disclose their performances to the public. Matthew O’Brien, in his latest piece for the Atlantic, used a performance chart looking over only ten years and the HFRX index as if this is an index of hedge funds (like the S&P 500 for stocks for example). But that’s wrong. The HFRX shows the return of an index that attempts to track broad hedge-fund performances through the most diffused hedge fund strategies. Several indices which track hedge funds strategies have been constructed to try to replicate their performances. But this is not an easy task! With a lot of limitations. Robert Frey (Professor at Stony Brook University) and myself, find the EDHEC index much more representative than the HFRX. The EDHEC index takes into account the high fees (1% fixed fee of all assets, 10% of all profits), which have been heavily criticized. This finds Matthew and myself in agreement. If we take a look at the cumulative return over the 2000-2013 time window we can see that:

EDHEC file

Chart 1 – Courtesy of Robert Frey

And if we enlarge a little bit the time horizon, here is how the hedge fund performances look like:


Chart 2 – KPMG, AIMA, Centre for Hedge Funds Research

It seems like hedge funds have performed pretty well over a longer period of time. The two charts emphasize the big losses hedge funds incurred during the financial crisis. From Chart 1, we can also see that hedge funds have recently struggled a little bit to generate “abnormal” returns against the S&P 500. One could say “but it does not tell me anything about the risk taken by the industry, performances are not risk-adjusted” and this is of course a reasonable objection. However, it is almost impossible to measure the risk-adjusted returns of hedge funds because any measure of risk-adjusted returns is hocus pocus. Hedge funds have quantitative and qualitative risks that make them unique to evaluate and analyze. Someone else could say “An equally split (50%-50%) stock/bond hedge fund would have done better than the 60%-40% stock/bond portfolio”. Reasonable too. Objections can be many! But let’s focus for a moment on the recent performances. Hedge funds lost a lot of money during the crisis and let’s admit that they haven’t been able to beat the market recently. Are those good excuses not to invest in hedge funds? In my opinion no, and here is why.

We are missing three very important points here:

1. Hedge Funds provide diversification. Investment strategies of hedge funds vary vastly. To list a few: directional strategies, market-neutral strategies, equity long/short strategies, event driven funds, macro strategies, fixed income arbitrage, short bias etc. A lot of hedge funds try to achieve positive returns using strategies that move in the opposite direction of the major market indices. They therefore suit perfectly for diversification purposes. Risk, the premier journal for risk managers, found that 10 to 15 hedge funds are needed for optimum portfolio diversification:



2. Hedge funds can improve an investor’s overall return. It’s pretty common to think of hedge funds as risky bets. But hedge funds can be used for several purposes. There are in fact, low-volatility hedge funds that can enhance returns at limited costs. Or alternatively, returns can be boosted by using hedge funds that particularly focus on high-return strategies by trading volatile products. Generally speaking, investors look at hedge funds as dynamic and flexible investment vehicles able to be traded under several market circumstances. And when implemented in a portfolio with proper due diligence and awareness of the risks involved, benefits may be several.


KPMG, AIMA, Centre for Hedge Funds Research

3. Continued interest in hedge funds has never diminished, regardless of the recent negative performances and the adverse articles on the media. The asset under management stands at around $2.375 trillion. Compared to the $100,000 first investment in the first hedge fund under Alfred Winslow Jones in 1949, that should equate to a 30.39% annualized growth rate in AUM. If hedge funds have had such a high growth rate, it would indicate much better performance over time (see Chart 2), especially given the fact that they haven’t been able to, historically speaking, advertise. Prequin data shows that 60% of institutional investors, primary source of capital for hedge funds stated in 2013 that they are looking to increase their hedge fund allocation. And this should not be surprising, given the current macroeconomic environment and how hysterically investors have looked for yield in the last year or so. Investors, in fact, are getting prepared for both growth and volatility and use hedge funds as a way to access “dynamic and interconnected markets and to mitigate the risk inherent in these exposures”. Like in point 2, the flexibility of these instruments is something that investors demand.

One big problem for the industry as whole, now that some hedge funds will be able to advertise themselves, may be the pollution coming from people who are largely incompetent, crooks, or whoever does not use the most up-to-date financial tools. An investor should be able to pick the good hedge funds. Investing in hedge funds because something is called “hedge fund” should be strongly avoided. And this is easier said than done.  An investor carries together with the trade its own risk attitude as well as its own grade of financial sophistication, with a trade-off between the two.

Dreaming double figures returns is easy. Finding ways to systematically trade is harder.

Taking Matthew O’Brien’s paradox to the extreme, what’s worse? Rich people blowing money in hedge funds that are highly inaccessible to retail investors or the same retail investors being harmed by mutual funds that take fees from them but don’t deliver alpha?

John Thain: 2008 Could Happen All Over Again

Via Bloomberg Television:

John Thain, former chairman and CEO of Merrill Lynch and COO at Goldman Sachs, told Bloomberg Television’s Erik Schatzker and Sara Eisen on “Market Makers” today that a crisis like the one in 2008 could “absolutely” happen again.” Thain said, “If anything, too big to fail is a bigger problem because the biggest financial institutions are more concentrated today than they were. Dodd Frank did not solve too big to fail.”

Thain, who is currently CEO of CIT Group, also commented on selling the company to a larger bank, saying that would be “obvious.” He said, “The big banks are awash in deposits and they can’t generate attractive assets. We, in all our businesses, are able to generate very high-yielding, attractive assets, so the logic of that is obvious.”

Thain on how comfortable we should be with what Wall Street has become since September 2008:

“If you are asking about too big to fail and can what happened in 2008 could happen again, the answer is yes, it absolutely can happen again. If anything, too big to fail is a bigger problem because the biggest financial institutions are more concentrated today than they were. Dodd Frank did not solve too big to fail.”

On why there is so much resistance from the leaders on Wall Street re: too big to fail and why anyone would put the financial system and economy at risk again by being so large and complex:

“There are different things. They push back against parts of Dodd Frank because a lot of parts of Dodd Frank have nothing to do with the financial crisis or too big to fail. Proprietary trading was not the problem in the financial crisis. There are a lot of things in Dodd Frank that don’t help the too big to fail problem. The higher capital levels do help the too big to fail problem and make the failure much less likely. Higher capital levels are fine. But the regulatory burden and all of the rulemaking that goes inside of Dodd Frank, a lot of that is not helping.”

On whether he has any desire to go back to Wall Street to run one of the largest institutions:

“I’ve been at bigger companies and I’ve been at smaller companies. The New York Stock Exchange was a relatively smaller company especially when I started. I enjoy the challenge of fixing things, whether it was Merrill Lynch, which was certainly broken when I got there, or the NYSE or CIT, it has been fun to take companies that have good core businesses that have been damaged by the prior management and fix them.”

On how Merrill Lynch today compares to the firm that it was:

“I regret having to sell Merrill Lynch because it was a great company with a great history. It had a very good culture, but in the environment we were in, it was not likely to survive. It was necessary to protect shareholders and employees.”

On whether firms like Merrill Lynch survive and thrive inside the global universal banking model differently than when they were independent:

“Merrill was already pretty broad in its businesses. It would have been better if it could stay independent. Right now it’s contributing a significant portion of Bank of America’s overall earnings, given the problems in BofA’s other business, but I think it would have been better for the company if it remained independent.”

On how Goldman Sachs is doing coming out of the crisis and trying to restore its reputation:

“I think they are doing very well. One of the things is they have gotten through the crisis in relatively good financial shape. If anything, there’s less competition for them now. I actually think they are doing fine.”

On whether he feels any sense of loyalty to the firms he used to work for:

“I worked at Goldman Sachs for 25 years. I basically grew up there. You can’t help but feel loyalty there. The New York Stock Exchange was a great place to work. I enjoyed that job a lot. I got to be on TV more. That was a big turnaround. When I left, it was in much better shape and a global player. Merrill – I wasn’t there that long, but it was a great company. I do feel an affinity to all of those places.” 

On how far along CIT is in its transformation:

“When I started at CIT, there was a tremendous amount to do. It’s basically completed — the repairing of the damage coming out of the bankruptcy. The last piece was the lifting of the written agreement by the Federal Reserve. We got that a week or so ago…it is also a symbol of the fact that we are now a bank and bank holding company that’s in good standing with all of our regulators and we are now really focused on growing our business going forward.”

On whether CIT is still in restructuring mode and whether the company will have to announce more layoffs:

“We have been bringing our expense structure down. One of the things I had to do when I first started was to shrink the company. We had to get rid of the bad assets around the balance sheet and we refinanced $31 billion of debt. We are rationalizing some of our businesses. Our expenses are a little bit too high, we are working on bringing those down, but we are also working on growing assets.”

On how big he’d like the CIT bank to be and how much of its funding should be deposit based:

“Funding was absolutely one of the first challenges. Just to give an idea, on the day I started, our senior debt paid LIBOR plus 10 with a three percent floor. So you have a commercial finance company in this rate environment trying to make money with 13% debt. That’s basically impossible. We have refinanced or repaid all $31 billion of debt that came out of the bankruptcy. The other thing we have been doing is putting almost all of our new U.S. assets in our bank. We have a Utah bank that is FDIC regulated. It has been growing very nicely. We put all of those U.S. assets in there and we now have almost a third of our overall funding coming of that bank.”

On whether he’s been approached for a takeover:

“We would not talk about that on the air or anywhere else. I get asked this question a lot. If you look at the environment, the big banks are awash in deposits and cannot generate attractive assets. We and all of our businesses are able to generate high-yielding, attractive assets. The logic of that is obvious, but we are doing well I ourselves.”

On whether he would have to do right by shareholders if presented with an opportunity such as what happened with Merrill Lynch:

“I think I have a good track record of doing right by shareholders. I know who I work for.”

On the prospects for the universal banking model given the current regulatory environment:

“It’s a very normal thing, whatever you have a crisis, that there’s an overreaction to the crisis and an attempt to say, we’ll we’re going to make sure that this never happens again. If you look over many bubbles, this is the same thing that happened after the last bubble. The biggest issue right now for big global banks is the combination of higher capital standards, which is probably a good thing, but then excessive amounts of regulation in terms of their business. You don’t really need to have both. If you have significantly higher capital standards, than a lot of the regulatory burden that comes out of Dodd Frank is an overreaction.”

On the market conditions and whether we’re in store for another 1994:

“It’s hard to know…I think there’s no question that rates will go up and they will go up over time. It’s just a question of when and how violently. I’m less worried than sometimes the market seems to be about the Fed slowing down their purchases because I think they can slow down their purchases and still maintain their balance sheet and not adversely disrupt the market.”

On whether he’s worried about the impact it will have across the banking sector:

“No actually, such low rates actually makes it difficult for the banking sector because it’s hard to generate assets with yield. If interest rates were generally higher, I think that would help the financial sector. It would help us. We are asset sensitive. Our assets would re-price faster than our liabilities, so a higher rate environment would actually help our business.”

Hulbert Gold Sentiment at Record Lows

By Tiho, Short Side of Long

If you are sick and tired of reading Precious Metals sentiment updates on this blog, I do not blame you. As an author of a contrarian blog, my job is to report as an objective view as possible of sentiment indicators developing within the various asset classes. Right now, it seems that Gold is one of the few assets experiencing negative extremes worthy of attention, from a contrarian point of view. However, some of the readers disagree. Due to overwhelming focus towards the PMs sector in recent weeks, various individuals seem to think that I have turned into a die-hard Gold Bug. Obviously this couldn’t be further from the truth. Let me explain.

Within similar context, between August 2011 and November 2011, readers of the blog also held a view that I was a perma-bull on equities. If one was to consider previous posts hereherehereherehere and here, one should understand today (in hindsight) why I pushed major attention towards stocks over other asset classes. Stocks were extremely oversold and sentiment was extremely depressed between August and November 2011. Furthermore, on relative basis, global equities were very attractive against Precious Metals, Commodities and Bonds.

However, conditions have changed since those days. Stocks, particularly in the United States, have experienced a tremendous rally over the last two years. From the lows on 04th of October 2011 at 1075 on the S&P, the index is currently up over 45% and has become extremely overbought. At the same time, margins have started to contract and revenues/earnings are also following. As majority of the investors have missed the rally, they are not paying attention to fundamentals as greed blinds their judgement. They seem to be playing the usual chasing game over the last several weeks, with sentiment obviously turning extremely euphoric.

Furthermore, over that time frame, US equities have outperformed just about every other asset class out there, including Eurozone and Emerging Market equities, Precious Metals, Commodities and Bonds. Marc Faber recently described the current conditions stating that: “US equities have become the only game in town”. And we should all know how previous “only games in town” ended (in tears).

As I analyse the current market conditions, one of the only asset classes I tend to prefer today is the Precious Metals sector. I recent weeks I have hinted at the extremely depressed sentiment including the following important indicators:

  • In early March COT reported Gold short positions reached the highest level in over a decade
  • In early March Gold’s Public Opinion reached one of the lowest levels in at least a decade
  • Last week COT reported Silver short positions reached the highest level in almost two decades
  • Last week Silver’s Public Opinion reached one of the lowest levels in at least a decade


Source: Short Side of Long

The latest development worthy of “decade extreme” or “record extreme” within the Precious Metals sector, comes to us thanks to Mark Hulbert Financial Digest. According to Mark’s latest WSJ column, there has been a huge plunge in exposure of various Gold newsletter advisors. Currently, the Hulbert Gold Newsletter Sentiment index (HGNSI) is at -31% net short, a historical record low since the inception of the survey in 1997. Essentially, this means that the average Gold newsletter advisor is telling subscribers and various other clients to be short Gold with 31% of their portfolio.

As a side note, I would also like to remind blog readers that Hulbert Nasdaq Newsletter Sentiment index (HNNSI) is currently sitting at 94% net long exposure, equalling the euphoric sentiment of March 2000 just as the tech bubble topped.


Source: Short Side of Long<

All of these indicator readings mentioned above, added to the fact that just about every investment bank in the world has Gold on a sell signal, most likely suggest that we are approaching a meaningful low for the Gold and the rest of the sector.

Bottom Line

In Similar fashion to equities during August to November 2011, Precious metals have vastly under-performed just about all asset classes, including Stocks and Bonds. While sentiment has never been the holly grail (no indicator or tool is), current universally pessimistic outlook on the PMs sector is bound to end up as an egg on the face of various Wall Street strategists, advisors, financial gurus, newsletter writers, hedge fund managers, retail investors and other speculators.

Chart of the Day: Silver Shorts Surge

By Tiho, Short Side of Long

Today’s chart refocuses on the precious metal sector and in particular investor positioning towards Silver. Hedge funds and other speculators are now so negative on the metal, that the short positions have reached the highest level in the last 17 years (possibly even longer).

So what does this mean?

Judging by the historical price action over the last two decades, whenever speculators have held such enormous bearish positions, the price of Silver was either at or near a major low. Consider the following:

  • As short bets reached 44,790 in 1997, a huge short squeeze doubled the price in coming months
  • In 2000 and 2001 short bets reached over 44,000 triggering the start of a secular bull market
  • Finally, short bets reached 45,163 in 2005 as Silver broke out, rallying for almost three years

Silver COT

Guest Post: “Sell American. I am.”

By Ben Michaud, Private Investor (originally posted on Zero Sum)

To borrow from Buffett’s 2008 op-ed, “Buy American. I Am.”, the title of my presentation is….


In summary, the bullish case for stocks as peddled by David Tepper earlier this year is as follows:

1. Stocks are cheap relative to bonds with 2014 operating earnings yield of 7.5% versus a 1.93% 10-Year US Treasury yield
2. Central banks have removed tail risk from the system – most specifically with Draghi’s “Whatever it takes” commentary in July 2012
3. The Fed’s current QE program puts a floor under equity markets – i.e. a free put, akin to the “Greenspan Put”

Just like many value investors on this forum, I’m a valuation guy – in the long-run, little else matters. At a recent price level of 1,557, the S&P 500 is projected to return 3.87% per annum over the following ten years. If we subtract the 10-year treasury yield of 1.93%, we get the so-called “market risk premium”, which is 1.94% at present. I’m going to go out on a limb and say the bull case as outlined above is currently priced into stocks.

Compare the current MRP of 1.94% to the MRP at 10/15/08, the night before Buffett penned his “Buy American. I Am.” op-ed in the New York Times…..5.89%. That was with a 4.04% 10-year treasury yield. The current MRP is with a 1.93% yield!!!! To say the least, I am VERY fearful right now with so much greed in the market.

History is fraught examples of why valuation metrics are not great “timing” metrics – look no further than GMO and Baupost sitting out a massive bull run from 1996 through 2000 (off the top of my head). If so, why do I think NOW is the “time” to short the market? Well in addition to being a valuation guy, I’m also a market guy – I’ve tried, but I am unable to plug my nose and ignore two facts: the market moves in long secular valuation cycles and the crowd is ALWAYS wrong at extremes. Thus, I like to view the risk-reward of the market with a multi-faceted approach, and not JUST valuation. So in summary conclusion, I believe the market at current levels presents an attractive asymetric short opportunity for the following reasons:

1. S&P 500 approximately 49% overvalued
2. U.S. secular bear market likely still in progress
3. Extreme optimism among fund managers with long exposure at multi-year highs

The trade has a 3.85 year duration and a projected IRR of 15.5% per annum from a recent SPX level of 1,557.
Please refer to the attached presentation for a detailed outline of the thesis.

***A note on market timing – When I say “timing”, it is not in the typical derogatory way that “market timing” critics use it – rather, I mean timing of the risk-reward equation. In other words, one can never know precisely when the market will decline, BUT one can determine the “time” the risk-reward equation is as such that the market does not sustainably rise above a particular level. For example, the market never fell back to its 1996 level of between 600 and 700 in the 2000-2002 bear market – so if you were bearish in 1996, your short position never even broke even in the decline you were ultimately looking for.***

See the full presentation here.  

Is the Lack of Bearish Sentiment Bearish?

By Tiho, Short Side of Long

It has been awhile since I discussed equity market sentiment and that is because not much has changed. Bulls continue to get more bullish, the sun is shining and everyone is singing “Kumbaya my lord“. It is worth noting that overly optimistic readings we saw earlier in the year have put a stop to a rally in variety of risk assets, including:

Eurozone Equities & Emerging Markets
European Euro & Canadian Dollar
High Grade Copper & Brent Crude Oil

Therefore, if you live outside of US, your local equity market has most likely already started to decline. On the other hand, to everyone’s amazement, the US equity market has continued to rise all on its own in vertical fashion and therefore deserves a nickname “Teflon Rally”. But can the S&P 500 stay bullet proof all on its own?

I personally doubt it. I have been bearish on the equity markets since the later parts of 2012 and yet the rally continues higher, so I won’t blame you if you are sick and tired of hearing me warn about the potential sell off.

Nevertheless, all of the warnings remain in place and sentiment conditions continue to worse (indicators point to a contrary outcome). The latest sentiment update will be arriving later on today (early morning US time), courtesy of Investor Intelligence, so I thought it would be nice to include it as today’s chart of the day. Chart 1 shows that the current level of bearish advisors has fallen to alarmingly low levels, commonly linked to major market peaks. A quick glance at the chart shows similar readings in 2007, 2010, 2011 and presently.

One of the recent Merrill Lynch research notes I received in my inbox actually discussed the same sentiment conditions, so it is worth sharing. The table above shows a two decade historical study of Investor Intelligence bearish readings relative to the equity market performance. The study assumes that when bearish readings fall below 25%, equities are considered to be overbought.

From the data above, we can make a few interesting observations:

1)  The current duration of complacency seems to be the longest in two decades and has also registered the lowest reading of all the previous conditions.
2)  Apart from the tech euphoria of 1998, the equity market tends to peak within a few days to a few weeks after extreme bearish readings occur.
3)  The average and median decline following such a streak of complacent readings by II Bears indicates a high possibility of a bear market (20% decline from peak to trough).