Confirmation Bias

None of us likes to be wrong. It’s human nature and certainly the nature of investment “aftercasting.” Friends and colleagues who are active in planning their investments may well have cornered you with a glass in hand and related their brilliant investment choices.  The worst ones lie dormant. I am still hearing about the Microsoft investment from the early 1990’s that paid for college. The best part of that decision was that the tuition bills were paid (i.e. sale was forced) before Microsoft went into a ten year slumber. I had a client who called his swimming pool, the pool that Sun Microsystems built. His wisdom lay more in when he wanted the pool than when he wanted to sell.  Sun’s stock price crashed and burned in the early 2000’s.

 The truth is that we see what we want to see and often only that. If one is a conservative, Fox news confirms our views. If liberal, Rachel Maddow of MSNBC gives every reason to confirm what we already knew.

 Reading a recent edition of Barron’s, the weekly investment newspaper, I was struck by the statement given in the opening opinion column that, “the Dow industrials, Standard & Poors 500 index and Nasdaq finished the week less than 3% from their record highs, set earlier this year.” As I write this the Nasdaq 100 is less that 2% below its record high set in March of 2000, a mere fifteen years ago. The S&P 500 is a lofty 1.3% higher than it was fifty-two weeks ago. Neither a loss of 2% in a decade and a half or a gain of less than 2% in a year strikes me as the stuff of breathless reportage.

During years in the commodities business I had ample opportunity to listen to what customers, competitors and reporters had to say about markets. People “talk their book.” They will say whatever will further their own purpose whether it is to get you to buy a newspaper or an investment. Listen carefully to what is said and not said. Even your own beliefs require harsh observation and context.

Rolling toward reality

It is not without some trepidation that I take exception to last weeks Goldman Sachs projection of S&P 500 at 2100 by year end.  I recall during the tech bubble war of 2000, the press made great import out of an apparent difference of opinion between Steve Roach, Morgan Stanley's head of research and Abby Joseph Cohen of Goldman Sachs.  The headline made them disagree, when in fact one was talking of level and the other about time.  Both were right if one cared to read what they actually said.

Following the Federal Reserve decision to leave interest rates unchanged last week Goldman presumably turned more bullish.  I doubt it. 

 This weekly chart of the S&P 500 shows the index rolling out of the remarkable bull market that has been devoid of correction since 2012.

Although I would be the first to admit that the stock market does not necessarily reflect the general economy I believe it too early to infer a disconnect yet.

The global economic outlook is moderating and forward looking indicators are not constructive.  China is still digesting a slowdown.  Valuation of the S&P is not remarkably lofty but is still on the high side of average.  Interest rate policy has created a no alternative investment climate.  If pension funds are to possibly approach their projections, fixed income investments cannot reach performance benchmarks.

The 2007 mortgage debacle was created because no fixed income investments could provide returns needed.  The investment community satisfied the need with mortgage backed securities (housing has only ever gone up was the cry).  The combination of leveraging what had previously been a conservative investment sector and destroying the quality of such loans with No-Doc and similar over engineered lending criteria (i.e. none) created a global crisis the likes of which hadn't been seen since the 1930's.

Stock market performance based in general on two psychologies.  Valuation is the first and most frequently spoken of.  When a stock is bought it is the purchase of the long term dividends of a company.

The second aspect of market movement are the animal spirits of acceptance of risk.  Recently we have been seeing a lessening of risk tolerance as shown by stock market internal indicators.  Fewer and fewer companies have been responsible for market performance.  The breadth of the market has narrowed significantly.

The daily chart indicates a broad market no longer particularly oversold, but today buyers are absent.  In order to take the market back to the 2100 level a herculean effort will be required at best.  If the S and P 500 should manage to get back to 2100, I project the sellers will come out in droves to take advantage of the temporary reprieve.  Timing is the only arguable point in the development of this equity market.

While I foresee no global meltdown a la 2007, I believe the best outcome will be a long lackluster market until we can grow into the valuations already baked into the cake.  Today's financial markets are not known for patience so an expectation of volatility to get us to "reasonable" is probably not misplaced.

Coincidentally a 38% retracement (fibonacci) takes the market back to the top of the 2007 market collapse.  Just to put my neck out, I project an S and P level of 1575 in the next six to twelve months. 

Better to be lucky than good?

Within twenty-five miles of where I sit are two casinos.   This is Pittsburgh not Las Vegas.  Anyone who is a legitimate high roller is more likely to hop a plane to Nevada rather than ramble off in the Chevy Impala to the local Western Pa slots parlor.  For the most part these casinos are alternative entertainment to the cineplex or  Steeler's game.  A group of girlfriends head down to the casino for a night of possibility or a few couples meet with understanding that the winner pays for dinner.  One's financial future is not at stake.

If one views the stock market like a casino, but the ultimate outcome determines personal future well being now is a good time to align risk with needed outcome.  The financial press is rife with pronouncements that the ten percent correction is behind us, excesses have been relieved and we can look ahead to risk free  blue skies ahead.  It is too early to assess the outcome of last weeks plunge and subsequent rebound but internal market indications are that risk tolerance is declining.  While valuation is the arbiter of long term returns, risk tolerance is the short term driver of market direction.  It appears that the market as a whole is eyeing the exits, just in case.

Current valuation of the market is still double historical norms.  The corollary of high valuation is low return.  Projecting ten year returns from current valuation still produces a calculated zero return.  In other words, "do you feel lucky?"  As the market has gone from over valued to extremely overvalued to wow!, this is a good time to review portfolios.  Speculative holdings should be assessed for fundamental strength and market sensitivity. 

Stocks with low beta should be considered as replacements for high beta speculative holdings.  The saying,  "no one ever went broke taking a profit", may be worth considering now.  Biotech stocks have had a spectacular run in recent years and while the future looks bright in the industry many analysts agree valuations are ahead of current realities.  Other market favorites such as Google, Apple and Disney have had spectacular runs and are apt to react strongly to news the market perceives as negative.  Such household names remain excellent long term holdings but should be assessed in line with an individual's timing for withdrawals and risk tolerance.  If one particular success has taken on a larger than prudent portion of a portfolio it is worth considering judicious pruning.

The market has been enamored with companies with steady histories of dividend payment.  The ability to pay and growth dividends can go a long way toward ameliorating stock volatility.  The concept of  "getting paid to wait," is worth considering.  If dividends are important to an investor, the market gyrations of a company like Exxon, Johnson and Johnson, Pepsi or Coca-Cola can be weathered adequately while waiting for broad market valuations to provide a better time to add to such holdings.

If a portfolio is your casino keep your fingers crossed.  If it's your retirement it's worth being good and not just lucky.

Zoom out

There is a saying for market observers who use charts as part of their analysis.  When in doubt, zoom out.  It is all too easy to be absorbed by the minutiae of investment information that tosses us around from one uncertainty to another.  Following a 300 point Dow drop yesterday it can feel like the end is nigh, the end is past or like the proverbial tennis shoe in the drier, it's just confusing chaos..

In the past twenty years investors have endured two mighty bear markets.  Various market pundits announced we've entered broad bear market territory.  Depending on ones constitution it is possible to think the worst is over and opportunities abound suddenly.  Maybe.  But first some visual perspective is in order.

Both the internet bubble and mortgage banking crisis make yesterday pale in comparison.  It is not necessarily too late for portfolio caution.  The chart below shows the past twenty years of the S&P 500, including yesterday up in the upper right corner.

Zoom out.  Add some distance.

Dr. Copper

For generations the market for copper has been one of the best bellwethers of the direction of the global economy. More recently other indicators, such as silicon chip sales have become popular, but copper remains important. It presages construction plans, auto manufacturing expectations and capital equipment demand. Lately Mr. Copper has been looking a little tired. In fact more contracts are being bought in anticipation of a decline in copper pricing than rising.

For all the babble over massaged retail sales figures on Black Friday and the firehose liquidity injections to European Banks the 30,000 ft view is flashing warning. Forewarned is forearmed.

A Whopper

End of day headline....Dow gains whopping 7% for the week!!

pssst...we're still 150 dow points below where we were three fridays ago. It seems nano technology has come to attention spans now.

Headlines etc

There has been no post on the blog for more than a year and as I reflect on 2011 it almost looks like I didn't miss a thing. 2011 opened with the S&P index at 1257. As I write this the S&P index, approaching the end of the year is at.....1257. Rip Van Winkle wouldn't have missed a thing but had lots of crazy dreams in the interim. A lot like the investment year in equities has been.

Of course if you didn't sleep through it you didn't miss the breathless voices on CNBC alternating between orgasmic glee and catatonic despondency. In other words much of the year could have been spent in an alcohol induced coma both in celebratory cork popping and bleary eyed single malt sipping.

It has been a traders year with breathtaking volatility and profits for the quick opportunist. For the fundamental long term position a plodding marathon. When the headline news is set against a back of reality it makes me despair of the disingenuous nature of investment market reporting. Seemingly everyday the banner headline is one not merely of hope but of gleeful cheerleading. Without an awareness of both underlying expectation and the details behind the news the reportage is less than worthless.

Today is no exception. Jobless Rate Falls to 8.6% reads the headline. The lowest level in two and a half years, spouts the Labor Department. A lower jobless rate is good, right? 120,000 jobs created. What's not to like?

The labor force participation rate is falling at an unprecedented rate. For those who pine for the good old days when June Cleaver had perfect hair, a martini waiting for her dutiful husband and a roast in the oven, be patient. We're getting there. Statistics show that it is increasingly likely it won't be June fixing dinner and waiting for the breadwinner to come home, but husband, Ward

The participation rate began a long advance following the 1970's when women entered the work force in substantial numbers. The social changes of those years meant that women who were burning their bras were also beginning to collect a paycheck.


Behind the headline number of 120,000 new jobs is another number. 315,000 people stopped looking for work or otherwise fell off the labor force rolls. If you actually work the numbers reported backwards, it looks like about 3 million people have statistically disappeared.


The graphic below charts the average period of unemployment for those in the labor force and looking for work. Clearly there is a striking structural change. For the first time since the 1930's the U.S. labor picture is of significant long term, even permanent unemployment. Left unchanged the social implications are major both in terms of average standard of living and social polarization.



Our client portfolios remain decidedly cautious and hedged which means experiencing contrarian emotions. Earlier this week when every central bank in the world announced it was opening the spigots of liquidity to banks still wider I was not a happy camper. But in a market driven by headlines there will always be times when fundamentals will be overwhelmed by fleeting events. Surfing the tsunami is not for the meek; or even for those who hang on every word that comes across the wires. So much information, so little wisdom.

Outrunning the Bear

When confronted by a hungry bear you don’t need to be faster than the bear, just faster than kid that ate all the Twinkies. Increasingly the global economy is looking similar with Europe being the bloated glutton. For all the problems in the United States the friends across the pond are looking more and more like bear food.

The problems in Greece, which in the recent past I wrote were not going to go gently into the night, rose up this week with a massive downgrade of their sovereign debt by S&P to junk status. There was political posturing to try to hold down the panic as a large piece of Greek debt was due to be rolled forward in May. It looks like that posture is unlikely to be upright as two-year interest rates on Greek bonds moved to 15% this week. The PIGS (Portugal, Ireland, Greece and Spain) are looking like crispy bacon.

In Club Med, Barclay’s analysts believe Greece needs 90 Billion Euros to get through the current crisis, Portugal, 40 Billion and Spain 350 Billion. The IMF runs dry at 200 Billion which would mean heating up the printing presses. If the other rating agencies follow S&P’s lead, the European Central Bank will not be able to hold Greek debt on its balance sheet. Or they will destroy the sanctity of the ECB, much as the Fed has done.

The crisis in Greece puts a stake in the heart of discussions of the Euro supplanting the dollar as the world’s reserve currency. The lack of a cohesive national government in time of crisis has been shown to be the weak underbelly of the European monetary union. The inability to enact independent monetary policy because of treaty obligations and mandates may well be the emperor has no clothes moment for the Euro.

If this lit fuse reaches Spain where there is serious German and British investment fireworks could ensue. The expectation of an imminent Fed rate hike is deflating by the day. If one looks back to 1997 a crisis in Thailand started the Asian crisis and quickly derailed plans for interest rate hikes.

Vampire Squid

A recent podcast by the radio program This American Life does an excellent job of describing the complexities of Collateral Debt Obligations in the episode ">The Inside Job.

Vampire Squid

Inside Job

http://feeds.thisamericanlife.org/talpodcast

Playing the Odds - to no avail

As a manager of clients whose primary focus is on long term gains and security, I have focused on risk before growth. In the past year, that was an uncomfortable focus as the stock market went on an almost unparalleled tear. Looking at historical precedent and market valuations has been off the mark this time.

Looking back to the pre-depression 1920's and analyzing markets shows just how unusual this past year has been. Using rolling time periods of just over a year, there have been 4,237 different outcomes in the market. The current gain places this period ahead of ALL market performance periods except during the Great Depression. This fact does not imply that the next period will be either positive or negative but a regression to the mean will certainly occur. Trees don't grow to heaven.





(click on image to enlarge)

This market rally was exceeded only in periods during 1933, 1934 and 1936.

John Barnyak

Pension Tsunami

When we look in practically any newspaper that reports municipal issues we find an ongoing friction between unionized public sector workers and management. Recently teachers in a local school district went on strike for improved contractual salary benefits and continued modest health care contributions that frankly make the rest of us glaze over with envy.

Behind the daily jostling for continuing generous retirement and health care benefits, on the not too distant horizon is a wall of trouble. In typical fashion we are kicking the issue down the road until the current embers turn into a fiscal inferno.

How voters and taxpayers will confront the coming crisis will be interesting to say the least because we sure aren't dealing with it adequately now. Public services we take for granted will clearly be jeopardized in years to come. In my activities on a local library board I am alarmed at the sanguine attitude that local municipal contributions for the operating expenses will continue to be available. When public pension contributions have to be increased dramatically through taxes to fund future obligations how deep will taxpayers dig for libraries, swimming pools, cultural events, fire and police protection, road maintenance etc. etc. etc?

Nationally, the municipal, state and local pension plans are currently underfunded by and estimated $2 to $2 TRILLION. Future pension plans will have to be terminated and defined contribution plans put in their place. Future benefits will become a battle royale when private sector neighbor eyes public sector neighbor with envy and anger. Let's get ready to rumblllllle.

The interactive chart below shows various pension plans in each state and their level of funding.

Powered by Tableau

John Barnyak

Jim Grant Takes on the Maestro

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Flesh eating fish and a dolphin

As I read about the developments in the national residential real estate market I am struck the images. First is the return of the flipper. Whereas five years ago every cab driver and school teacher in Florida and Nevada was playing the home edition of Monopoly and lining up houses on Baltic Avenue, today it is a more sophisticated and serious investor. Some might say vulture. They do their homework, look at distressed houses with a dispassionate eye and a full checkbook. Scores of investors with hearts of stone are nibbling like Chinchin Yu (the Chinese dead skin munching pedicure fish)on the housing market and cleaning up the dead skin.

From an economic perspective this is a good thing. Whereas the banks and government have played a game of extend and pretend with the financial side of housing, until prices reach a level for existing housing stock to clear, the pain will be prolonged.
The price of a house is that at which buyer and seller agree. It is not the price that the bank holding the amalgam of sub-prime mortgages wants it to be.

The foreclosure process forces banks to recognize an asset as worth much less than the balance sheet would like. Like the Japanese banks of the past twenty years, pretending that the underlying collateral of loans is worth as much as the debt outstanding when the market says it is not is the only thing that keeps the bank solvent and unable to lend in the interest of economic growth. There have been serious and workable solutions to the housing overhang, but they would require banks recognizing the pain and creating a "housing appreciation note." Such a vehicle would mean the possibility of the bank being made whole at some point in the future, but also of recognizing the diminished current value while trying to clear the logjam.

Rather like my wife saying to me, "you are never sick BECAUSE you never go to the doctor!" It is a system that has focused more on emergency triage than well banking care.

Emerged Markets

For the past decade the emerging market investment theme has been the most compelling long term. Traditionally the lesser developed nations have depended on export of raw materials and labor cost arbitrage. You can still build a computer more cheaply in India than in San Francisco and South African chrome, indonesian rubber jamaican bauxite still live or die with the general state of global industrial demand. Other things have changed however.

The less established political and legal framework of these erstwhile backwaters has long been an impediment to structural stability of the likes of the U.S., Europe and Japan. But now the history of IMF life support to nations in fiscal and monetary disarray is no longer the standard. It is now the developed nations which are looking like banana republics with unfunded spending and economic policies that seem set upon shifting sand.

The compelling demographics have been clearly visible for many years. The populations of the underdeveloped nations are younger and growing richer even if only by living standards much lower than our own. But the man who buys one refrigerator after a life of none or increases his caloric intake from subsistence levels to a healthier diet is of increasing global impact.

The financial data coming out of the IMF regarding the emerging markets is compelling, particularly when put next to that of the developed economy.

While we in the "industrial" economies groan under current account deficits the IMF reports the emerging markets had a current account surplus of $355 billion, forecast to grow to $550 billion this year. The developed markets have a deficit of $262 billion forecast to decline to $161 billion in 2010.

Emerging markets had GDP growth of 1.7% in 2009 and forecast to increase to 5.1% in 2010. Advanced economies had GDP contraction of 3.4% in 2009 forecast to grow 1.3% in 2010.

Emerging nations had gross national savings rates of 33% in 2009 while developed nations had aggregate savings of 17% in 2009.

The combination of cyclical and secular factors indicate a comfort with an increased allocation to emerging market is warranted including fixed income instruments. The inflation rates of emerging markets have long been where the wheels fell off. While forecast inflation in the aggregate emerging markets is higher than in the developed nations where deflation has taken hold, higher but declining inflation as forecast would not threaten bondholders excessively.

John Barnyak

Bob Farrell on the Mountain

Bob Farrell's Top Ten Market Rules

Bob Farrell was the Chief Stock Market Analyst at Merrill Lynch for 25 years and retired in 1992. The list below has been reprinted and repeated so often because it captures the human element of investing.

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an opposite excess in the other direction.

3. There are no new eras -- excesses are never permanent. (This time it's different)

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways. (The market can remain irrational longer than you can remain solvent)

5. The public buys the most at the top and the least at the bottom. (buying sizzle, not steak)

6. Fear and greed are stronger than long-term resolve.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.

8. Bear markets have three stages -- sharp down, reflexive rebound and a drawn-out fundamental downtrend.

9. When all the experts and forecasts agree -- something else is going to happen.

10. Bull markets are more fun than bear markets.

The Last Real Estate Boom

A generation ago there was a real estate boom and bust on the other side of the globe not so different than the one we have just experienced. On the last business day of 1989 the Nikkei reached 38,957. Today it sits at 11,097, less than one third the level of that day twenty years ago. Does that mean that U.S. markets will follow? According to Mark Twain, history doesn't repeat itself, but it rhymes.

The wildly excessive speculation in real estate was the catalyst to a still deeply ingrained deflationary economy and slow growth in Japan which is now entering the third decade. Unlike the typical US post WWII recession, Japan's lingering state of affairs was a credit and banking crisis. Rather than deal with the destruction of capital loaned, the bank instead kept assets on the books which were badly impaired and never to return. To confront the crisis honestly and accurately would have brought about the recognizable insolvency of the banking system. Instead it was papered over. It is at that time that we were introduced to the term "zombie banks."




(click on image to expand)

The unwillingness to treat the banks according to market rules rather than political expedience will prolong the pain, not remove the dysfunctional.

The chart above is intended not to predict the future of our own market, but to serve as an illustration of what CAN happen. The similarities are too many and the performance too similar to ignore.

“Before I draw nearer to that stone to which you point,” said Scrooge, “answer me one question. Are these the shadows of the things that Will be, or are they shadows of things that May be, only?”

Still the Ghost pointed downward to the grave by which it stood.

“Men’s courses will foreshadow certain ends, to which, if persevered in, they must lead,” said Scrooge. “But if the courses be departed from, the ends will change. Say it is thus with what you show me!”


John Barnyak

The Trend Is Your Friend.....sorta

For many the investment experience which sticks in our minds as the "norm" is the 1980's and 90's when people were checking their IRA accounts twice a day and celebrating their investment skills. The fact that the broad market was up 1000% during the period was apparently incidental to our brilliance.

One of my favorite pictures for a 30,000 ft look at the markets has long been the Rydex Historical Trend chart. For a good perspective of stock market behavior, 113 years ought to give us something usable. Regardless of the alternating cheerleading and lamentations of Money Magazine, Bloomberg and dozens of other pundits, historical precedent is not found between station breaks.

Secular markets, that is, long term markets, are born of fundamental change. This could be a change in interest rates, changes in inflation expectations or demographics or valuation. Secular markets are not overnight sensations but rather long plodding affairs both upward and down.

Back in the late 90's I doubt there was not a retail adviser who didn't tell a client, "it's not timing the market, it's time IN the market." Since about the time that aphorism was hitting its high water mark, market buy and holders have lost just a bit less than 5% in the past decade.

When the investment advertising budgets reach fever pitch listen for those idioms, they are a canary in the coal mine.



(Click on image to increase size)

Given the current valuations on longer term historical averages and the challenges still confronting global economies I wouldn't be looking for the next upward glide path to start anytime too soon. And if you weren't IN the market last year be patient, and if you WERE in the market, moving to more a defensive stance would be prudent.

John Barnyak

Mortgage Modification Program - Audio

Barry Ritholtz has been ahead of the curve over recent years. Hear what he thinks about the new mortgage modification program.

The Fox and the Price of a Chicken Dinner

In looking at markets and economies there are really a number of subjects which although interconnected are not moving in lockstep. The fear of two years ago that the financial system was on the precipice of Armageddon has abated. Whether that sanguine attitude is justified is another issue.

The palpable fear of the autumn of 2008 was clearly lessened. The eyes fixed on the coming tsunami have adjusted their gaze. Although the impending violence of the imminent implosion has passed, have the deep and stiller waters receded? I think not. The underlying issues of nonfeasance still exist. There is no more oversight into the activities financial institutions and risk assets than before.

Derivatives, what Warren Buffet called the “financial weapons of mass destruction” are still without serious oversight. The Commodity Futures Modernization Act of 2000 (CFMA), mandated that derivatives were completely exempt from ALL regulation. Whether it was Collateralized Debt Obligations (CDOs) or Credit Default Swaps (CDSs) that single act required that the fox run the chicken coop. How? The CFMA mandated it. No supervision was allowed, no reserve requirements for potential future payouts were mandated, no exchange listing requirements were put into effect, all capital minimums were legally ignored, there was no required disclosures of counter-parties. Derivatives were treated differently from every other financial asset — stocks, bonds, options, futures. They were uniquely unregulated. (And we rail about welfare to the poor?!) Our grade for dealing with the systemic problems that was the Petri dish of the breakdown is a “D.”

The second stool leg would be the investment markets. Clearly the blast off from a year ago to the current stock market levels has been impressive. It has fueled a collective sigh of relief while 75% of the public missed it. While the gnomes of Wall Street enjoyed trillions of dollars of investment liquidity, bailout funding and friendly accounting standards those on Main Street continued to focus on unemployment, diminished retirement funding by employers and fiscal panic in local economies.

This has been a trader’s market with the mantra, “the trend is your friend,” leading the charge. Our grade for market evolution over the past year is clearly a resounding “A”. The market is telling us that the economy is right behind and ready to swing into action creating jobs and profits in a typical post war recession recovery.

The final issue is value. Separating the idea of price from that of value is difficult. Ask those in the hot housing markets of the early part of the last decade. Real estate was priced at the last sale plus a profit. In most markets it delinked from such value parameters as the rental market or the cost of materials. The sky was the limit and living (and lending) was easy.

Today the stock market is again delinking from traditional historical valuation measures. With the exception of the period from 1997 and 2007 the cost of “the market” is back in bubble territory. But it is hard to be analytically cold blooded when the streets are running with soup instead of blood.

Economists are forecasting modest growth of the next several years. Although corporate earnings generally grow more quickly than the economy coming out of a recession, the aggressive forecasted earnings growth is utterly detached from historical precedent. Equity analysts are expecting earnings to grow 25% in 2010, 20% in 2011 and 14% in 2012.

Corporate sales are forecast to 5.5% this year and 7% next year which will mean record profit margins. If we assume that corporate profit margins reach unprecedented levels, the market is already at a valuation far above the norm. If profit margins revert to more historical average levels of slightly above 6% instead of the projected 10% the market would be VERY overvalued at the current level.

Regardless of mood and sentiment and trend, this is not a time to underestimate risk in investment markets.

John Barnyak
Stonehouse Asset Management