Central Banks Coordinate Easing Efforts

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I have written repeatedly in recent months about the contrast between strong stock market performance and deteriorating economic fundamentals. It’s the most important story. The market has obviously been celebrating the willingness of central bankers throughout the world to print money and resort to other non-traditional methods of rescuing both economies and markets. The past two weeks demonstrate how seriously concerned central bankers must be. Following earlier pledges of substantial easing from the Bank of England and the European Central Bank, our Federal Reserve and, most recently, the Bank of Japan have committed to potentially giant expansions of quantitative easing (QE), the popular euphemism for money printing.

These most recent rescue efforts are eloquent testimony to how dangerous central bankers consider current conditions to be. In the U.S., the Fed began the use of non-traditional methods (such as QE) only after they had dropped short interest rates essentially to zero. The extremely aggressive interest rate policy failed to prevent a major recession and a stock market collapse from 2007 to early 2009. The first iteration of QE in 2009 followed TARP and TALF as part of a coordinated government effort to prevent worldwide financial collapse. It halted the downward economic spiral and stimulated a powerful stock market rally.

When the economy began to slow and stocks slipped perceptibly in 2010, Fed Chairman Bernanke hinted at and soon followed with QE2. Another year later stocks again fell and the economy threatened to fall back into recession. The Fed once more stepped into the breach with Operation Twist. Again the economy picked up, though less aggressively than in 2010, and stocks again rallied.

All three of those non-traditional stimulus efforts were timed to rescue a slowing economy and to reenergize declining stock prices. This month’s worldwide rescue efforts similarly are designed to prop up a flagging economy. Unlike the past, however, they have been initiated when stocks were near a high, not a trough, following the earlier rescue effort.

To more carefully identify the Fed’s primary intentions, we need only listen to their language. Fed Chairman Bernanke and other Fed members have admitted that additional QE will probably do little to improve the employment picture, which is one of their dual mandates, the other being maintenance of a stable currency. They went to great pains to suggest that, despite their pledge of unlimited newly printed money, there was little imminent risk of inflation. Should significant inflation eventually rear its ugly head, they were well equipped to withdraw all this stimulus. Since no prior Fed has ever created such an outsized balance sheet, no prior Fed has ever had to withdraw such excesses. Knowledgeable analysts have grave doubts that the Fed will be able to mop up the excesses without creating severe economic dislocations, especially because debt levels remain excessive throughout the world economy. The risks of serious unintended consequences are extremely high.

Mario Draghi, head of the ECB, when asked: “What’s the first statistic you look at in the morning?” replied: “Stock markets.” Ben Bernanke has pointed with pride to the Fed’s success in raising stock prices and justifies his most recent QE as a force that should continue to lift stock prices and create a feeling of greater wealth. Chinese leaders appealed to their regional offices earlier this month to support the stock markets. It appears that stock market support has become an additional central bank mandate.

Longtime readers know that I have long suspected the Fed of directly attempting to support stocks with purchases when it served their purposes. Just this week, two well-respected analyst/commentators have voiced similar suspicions. Bert Dohmen speculated that the NY Fed uses S&P 500 futures to support markets. My old friend from La Jolla, California, Richard Russell, who has written Dow Theory Letters since the 1950s, similarly suggested that the Fed appears to be providing direct stock support.

Obviously, we can’t know how markets will proceed from here. It is potentially noteworthy, however, that the positive response to the recent central bank stimulus efforts has been tepid after a day or two of rally. Whatever the short-term response, investors run the risk that artificially inflated prices could adjust very quickly if confidence in central bank power disappears, as it has many times in the past.

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Another Step Toward Central Planning

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At the Republican convention a couple of weeks ago, we watched Clint Eastwood interviewing an open chair allegedly occupied by President Obama. That image flashed through my mind today as I watched Fed Chairman Ben Bernanke at his press conference, after pledging ongoing waves of freshly printed money.

Instead of Clint Eastwood and Barrack Obama, I pictured the chair next to Bernanke occupied by the figurative body of generations unborn. As Bernanke rattled on with his rationale for printing massive amounts of new money, I pictured the unseen figure gagged and struggling but unable to speak or be heard. In time and in overwhelming frustration, tears flowed as our unborn surrogate reflected on the dismal prospect of massive debt burdens that will be our legacy for generations to come.

Very few honest adults would consciously spend assets willed to their grandchildren to cover debts they themselves created by profligate spending, imprudent housing decisions or untimely investments. In fact, our legal system would punish them severely if they did. Most of us would condemn such an action if we were asked to be judge and jury. The majority of us, however, seem to have no moral hesitancy when the Federal Reserve Board acts in our stead to take money from future generations to paper over our financial misdeeds.

In addition to this weighty anchor that we are attaching to our heirs, we are collectively silent as we permit the Fed to exercise its rescue efforts by taking money directly from those dependent upon fixed income returns–disproportionately, the elderly retired. While small in comparison to the financial damage done to the elderly retired and generations unborn, my concerns extend also to those (myself included) who have spent decades studying the interrelation of economic and market factors and their effects on securities prices. By unleashing an unprecedented torrent of new money, the Fed has gravely distorted historically normal relationships. Analysts will suffer the consequences of that action indefinitely. The Fed has permanently altered the historical record.

One would expect that these massive ongoing Fed rescue actions would be offensive to believers in free market economics. Nowhere is the principle of free market economics more staunchly defended than on Wall Street. Ironically, when (as now) Wall Street’s ox is in danger of being gored by deteriorating fundamentals, most of its outspoken strategists have apparently swallowed their principles and have spoken out in support of continued Fed largesse.

While central bank efforts to boost asset prices have been significantly successful since 2009, such efforts have been singularly unsuccessful through major bear markets both in the past decade and in decades long past. Their success rises and falls with investor confidence, a frequently fragile condition. We cannot know how long such confidence will last in the current instance.

Whatever the near term economic and market outcome, I suspect that the invisible future generations’ surrogate sitting in the empty chair next to Bernanke is rooting strongly for a free market future rather than one controlled by central planners.

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Bailouts Continue

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The long bailout saga continued again this week. European Central Bank President Mario Draghi followed through on his recent promise to do whatever it takes to keep the Euro alive.  Over the objection of Bundesbank President Jens Weidmann, Draghi pledged unlimited ECB bond buying to support Eurozone countries so fragile that they cannot float debt in unassisted markets.  The King Report this morning humorously analogized that action “…like a guy bragging that he will watch unlimited football on TV while his wife controls the remote control.”

Draghi’s pledge, plus anticipation of Federal Reserve Chairman Ben Bernanke’s follow-on stimulus in this country, prompted an explosive worldwide stock rally late in the week as shorts ran for cover.  For the moment at least, investors expect that central bankers will be able to offset the effect of weakening fundamental conditions throughout the world.  With the vast majority of investment managers trailing market benchmarks in 2012, the “hold your nose and buy” approach appears to be taking hold.  Many short-term oriented hedge fund managers in particular cannot afford to trail such benchmarks at the risk of losing significant amounts of compensation.  With year-end in sight, the need to earn bonuses is prompting a more aggressive equity allocation.  That position may or may not result in better full year performance, depending upon how long confidence in the power of central bankers remains in place.  Bonus greed is hardly a sound criterion for increasing equity exposure.  It certainly increases the risk of dramatic portfolio declines, however, should the best central bank efforts prove ineffective.

As I have voiced many times in these entries, investors in today’s market need to evaluate carefully both their exposure to risk and their ability to withstand a potentially sharp and relatively permanent asset price decline.  Markets are not dealing with normal economic concerns.  Should ECB efforts prove insufficient, investors could wake up one morning to learn that one or more countries have left the Euro by choice or by command.  The possible effect on banking systems throughout the world is unknowable but certainly great.  And after delayed openings, securities prices could open at fractions of their prior closes.

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A Travel Retrospective

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Let me offer a few unrelated thoughts after two and a half weeks of travel, my longest time away from the office since 1985.

For good or ill, technology allows the office to travel with you wherever you go.  Actually, I enjoy the U.S. markets being open from 3:30pm to 10:00pm, as is the case in Italy and France.  It easily beats the 6:30am to 1:00pm we’re used to in Tucson.

I was struck by the absence of Italians in the restaurants and tourist attractions of Florence, Venice and Lake Como in Italy.  Americans were common, and there were large numbers of Asians (primarily Chinese) and Arabs.  The ethnic profile was clear testimony to how the flow of wealth has changed in recent years.  Hotel and restaurant employees commented that most locals could no longer afford such expenses.  European economic problems are worsening.

Train travel through the Swiss Alps affords passengers an exquisitely beautiful panorama.

Paris remains the most beautiful city in the world with endless history, variety and enjoyable restaurants.  Through the good auspices of a close family friend, our traveling party of four experienced a delightful picnic that began in a village square outdoor market about an hour and a half drive from Paris. It concluded with a guided tour of private caves outside Vailly, which were protective homes for months for U.S. troops during World War I.  Battlefields that looked like moonscapes nearly 100 years ago now are covered by well-manicured farms.

My only regret about Paris in the 21st century is the absence of fresh bakery smells that used to permeate the early morning air decades ago.  I suspect that the baking today is largely done in suburbs, with the still delicious goods being trucked into the city.

Upon arrival home this week, financial news remained essentially the same as when we left.  Most economic conditions around the world continue to deteriorate, and central bankers continue to pledge increasing amounts of rescue money.  We’ve reached the ironic situation in which bad economic news is considered positive for equity markets, because it increases the probability of additional stimulus.  Yesterday’s Financial Times reported that a major U.S. brokerage firm and investment manager has increased its exposure to equities, investment grade corporate bonds, high-yield bonds, emerging market bonds and commodities because of its expectation of “robust” central bank efforts.

So far, investors are concentrating on the promise of more stimulus rather than on the deteriorating fundamentals that are motivating central bankers to assume the risks of extraordinarily loose monetary policies. While central bankers are winning in this cycle, each new rescue effort increases the long-term risks.  No one knows when investor confidence in central planners will disappear.

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Traveling in Europe: The Gap Between Central Bank Talk and Fundamentals

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Traveling in Europe this week, I am struck by the universally negative tone in the English language press about business and economic prospects.  Article after article points to declining conditions in countries throughout Europe, even the “safe haven” countries whose short-term debt trades at negative yields.

The only positive articles are those quoting politicians or central bankers.  In the face of declining fundamentals, they continue to try to pump up confidence by pledging that the ECB will do what it must to keep the Eurozone intact.  While possible in the short run if Germany is willing to assume an additional financial burden, it is fanciful to think that Greece and probably other countries will emerge from being permanent wards of stronger northern European countries.

At best, it appears that a few more patches on a deflating balloon may keep it from crashing this year.  In the longer term, if the Eurozone is to survive as a viable entity, it will almost certainly count fewer countries on its list of members.  The primary question facing investors will be how traumatic the transition will be and when it will occur.

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Central Bankers Continue To Control Markets; Time To Audit The Fed

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Spending time in Italy provides me with an interesting perspective on the unfolding Eurozone drama.  Anecdotal discussions with Italians uncover a firm conviction that the Euro will survive, because it has to.  Since the collapse of the Euro would be catastrophic, it won’t be allowed to happen.  Such thinking indicates a profound belief in the power of governments and central bankers to control policy and to overcome deteriorating fundamentals.

Central bankers are doing their utmost to justify and encourage that belief.  Having shot all of their traditional policy arrows, they have resorted to non-traditional approaches and are relying heavily on a carefully timed and coordinated program of jawboning.

News releases and speculation on the part of such columnists and commentators as Jon Hilsenrath and Steve Leisman serve the purpose of supplying the public with desired information or innuendo between actual Federal Reserve announcements.  European and Chinese leaders have also raised encouraging voices whenever economic fundamentals appear too dire or whenever stock markets appear ready to sag.  Our Federal Reserve has boasted about its success in elevating the U.S. stock market.  In fact, it has stated that rising stock prices is one of the primary objectives of its stimulus efforts.

At least since 2009, the Fed has been remarkably successful in elevating stock prices.  Our domestic stock price increases are all the more striking when compared with China, whose economy has grown far more rapidly over the same time period.  In a span of years in which U. S. stocks have doubled, China’s have declined by 30%.  Oh, by the way, U. S. government debt more than tripled over that span of years.  The marvels of money printing!

Do we want a government-controlled market, as long as it goes up?  Can the Fed work its magic indefinitely?  Or are there consequences?  If the Fed’s approach is a good idea, why not do it all the time?  Does the piper ever have to be paid?

It’s absurd even to think that central banks could print new money with impunity and without consequence.  Ultimately, buyers of newly created debt will cry:  “No more.”  Perhaps we are seeing the beginning of that process with the upward explosion of interest rates over the past three weeks.

Do we want a country in which a few people make decisions that have a controlling impact on our economy?  Such an “oligarchy” bears no resemblance to what we have always prided ourselves in–having a great free-market economy, rewarding those with the most productive ideas and productive effort.  Currently we have the Fed picking winners and losers, which is immoral and unconscionable.

I urge you to support Representative Ron Paul’s push to audit the Fed.  Bring their dealings out into the open.  Stop rewarding giant banks at the expense of retirees and future generations.

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Wrestling With The Fixed Income Conundrum

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The following analysis is part of a consulting project prepared last week for the fixed income portfolio of a not-for-profit client.  I believe it provides helpful background for all investors puzzling over what to do to improve yield in a historically low interest rate environment.

The fixed income market has become highly polarized as major parts of the world financial system–even sovereign countries–are in danger of insolvency.  Governments and central banks are exerting massive efforts to keep banks and countries flush with liquidity to ward off runs on banks and sovereign defaults.  So far they have largely succeeded. But the debt problems are worsening and the world economy is slowing, making rescue efforts far more difficult.  It is a realistic possibility that the best efforts of governments and central bankers will fail, that major financial entities will default and that serious repercussions will be felt throughout the world.  Risk averse investors must evaluate the potential effects on their assets, should that scenario unfold.

The growing recognition of that possibility is evident in the increasing volume of assets invested in fixed income securities providing a negative yield.  Trillions of dollars are now invested in securities providing no return or even a negative return.  Clearly, many highly sophisticated investors are opting for the return of their money rather than a return on their money.

At the other end of the spectrum, higher yields are available to those willing to accept varying degrees of risk.  They range from 200+% returns on Greek government debt to low single digit returns on high quality domestic corporate debt.

The Federal Reserve has made no secret of its desire to “force” (their word) investors out of risk-free securities into riskier holdings.  In a multi-year low interest rate environment, many investors, in desperation, are fulfilling the Fed’s desire and seeking returns in riskier investments.  Unfortunately, the Fed does not stand ready to bail out investors, as they did major banks, should realized risks result in losses.

The only way to increase return is to assume more risk.  Risk-free return is virtually non-existent.  One can increase return by buying lower rated securities.  Of course, the lower the rating, the greater the risk that interest or principal will not be paid.  On almost all fixed income securities, return increases as the period to maturity lengthens.  Price volatility also increases, the longer the time to maturity.  At today’s super-low interest rates, significant price declines can occur on longer maturity bonds if interest rates rise.

Let me use the 10-year U.S. Treasury note as an example.  That security had a yield of 2.42% nine months ago, 3.22% just over a year ago, 3.75% just over a year and a half ago and 4.01% a little over 28 months ago.  If interest rates rose back to those levels in exactly the amount of time it took them to decline to the present level, the loss to the investor–even including interest paid–would be 7% in nine months, 12% in a little more than a year and 14% in a little over a year and a half.  If rates should rise back to where they were in early 2010 in an equivalent amount of time, each $1 million so invested would be worth less than $880,000 toward the end of 2014, even after counting the interest earned.

Rising interest rates destroy bond value.  In a rising interest rate environment, inflation, which erodes purchasing power, is typically present as well.  In the last rising interest rate cycle, which lasted for over four decades from the early-1940s to the early-1980s, no diversified bond portfolios beat the returns on risk-free cash over the full period, and no fixed income returns kept pace with inflation.  The last three decades have been the most productive for fixed income managers in U.S. history.  That period has lasted so long that virtually no fixed income managers today have any appreciable experience managing assets in a rising interest rate cycle.  Another one is coming; the only question is how long it will take before it starts.

While extreme levels of debt throughout much of the world are exerting a deflationary effect today, the massive amounts of new money being created by major central banks could eventually lead to inflation–even severe inflation.  In their academic classic, This Time Is Different, Carmen Reinhart and Ken Rogoff examine 800 years of financial crises throughout the world.  A great many of them unfold with governments attempting to inflate away debt problems. Central banks today appear to be attempting that solution.  Severe inflation, and the destruction of bond portfolios, were often the result of such action in the past and could be again.

Many investors suspect that they or their managers would be able to spot rising rates before they did too much damage.  For most, that’s an unrealistic assumption.  In recent months, Spain and Italy have experienced rapidly rising rates more than once.  From August to November of last year, rates on 10-year debt rose from below 5% in both countries to above 6.5% in Spain and above 7% in Italy.  Encouraging words from central bankers led to the retreat back below 5% in both countries.  As investor confidence waned, however, rates again rose from below 5% in both countries in March to above 7.5% in Spain and above 6.5% in Italy last week. Huge losses resulted in those bonds.  No one knows whether rates will descend again from here or just keep rising.  It has to be a very nervous moment for managers and investors in those bonds.  Is that even remotely relevant to investors in the United States?  Former Federal Reserve Board Governor Bill Poole recently said that when you look at the numbers, we’re just a few years behind Greece.  Our rates will stay low only as long as investor confidence remains.  So far investors trust the Fed, despite its checkered past record.  With ongoing trillion-dollar-plus deficits, a pending “fiscal cliff,” two major political parties at loggerheads, a banking system still exposed to European debt problems and the possibility that China could, for political reasons, stop buying U.S. debt, that confidence could erode quickly.

It is reasonably likely that rates can stay low for a while, even for a couple of years more, as the Federal Reserve currently intends.  Such a condition, however, is by no means certain.  It ultimately will depend upon investor confidence, and not just in this country.  Running deficits above $1 trillion per year, we are dependent upon foreign buyers in great volume to keep interest rates low.  Such buyers could disappear quickly should our economy weaken significantly, money printing become even more aggressive, our debt appear out of control or our political parties remain unwilling to deal with serious long-term debt issues.  While I believe the reward for remaining in fixed income securities is severely limited, except at very high risk levels, the risk of loss is very high.  Rates will rise again and possibly strongly; the question is when.  At present levels, it’s a dangerous risk/reward bet.

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Fed Jawbones The Market

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In the last half hour of today’s trading session, the stock market turned back down from a brief rally off the day’s lows and threatened to close below important technical support.  Suddenly, with ten minutes to go, the Dow jumped by 60 points into the close and a closing breakdown was averted.

What caused such a reversal?  Jon Hilsenrath of the Wall Street Journal has been a favored reporter with good access to Federal Reserve members.  In fact, many have accused Hilsenrath as being a mouthpiece through which the Fed plants desired stories.  His article, released in the last few minutes of today’s trading session, will do nothing to dissuade his detractors.  The headline read, “Fed Sees Action if Growth Doesn’t Pick Up Soon.”  The timing of the release gave the TV news stations just enough time to post the headline and attribute the last second market rally to the expectation of soon-to-come further stimulus.  That spurred nervous shorts to cover, gave a little push to the rally and allowed the market averages to close above important support.

When people actually read the article, they found nothing new.  The Fed might act next week or might wait until the following meeting in September.  Beyond that time line, Hilsenrath did little more than list the possible actions that Chairman Bernanke had enumerated in his recent testimony before Congress.  With nothing new to convey, what other motive but to provide market support would account for the article’s release at an unusual time just before the close?

Two or three minutes after the close, Steve Leisman, a CNBC economic reporter, came on air to explain that there was no new news here.  Leisman who typically is supportive of Fed actions on air, is another favored reporter and has been given the privilege of asking the first question at recent Fed news conferences.  Leisman’s appearance also appeared well-timed.  The story had served its purpose.  It said nothing new.  Leisman’s comments were then designed to dampen further interest.  “Let’s not dwell on this.”  The Fed wants to be able to roll out a similar “surprise” announcement when next needed.

Jawboning has long been a Fed tactic, and it helps to have accomplices in the media.  I suspect that the Fed is conflicted about more stimulus. The majority, and certainly the Chairman, seem to believe it is needed.  After seeing little positive effect on the economy from past actions and diminishing effect on stock prices with each new rescue action, they have to be concerned about the effectiveness of any additional action.  The closer the calendar creeps toward the election, the more the Fed will inevitably be accused of meddling in the political process with any new policy move.  Most worrisome, however, is probably the fear of perceived ineffectiveness.  Should they attempt QE3 or some variation and the markets fail to respond for more than a few days, they could well be seen as out of bullets.  Therefore, they are hoping that holding out the hope of future action will serve their purposes.  Thus we see news releases like today’s, and we can probably expect more to come.

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The Fed Moves The Stock Market

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I came across a truly remarkable study this past week.  I’m amazed that it has not provoked widespread commentary.

David Lucca and Emanuel Moench, economists at the New York Fed, make the case that from 1994 through the end of 2011 the effect of the Fed on the S&P 500 was huge.  The Fed study demonstrated that nearly all the net gain in that stock index for more than 17 years came on the day of the Federal Open Market Committee (FOMC) announcements of Fed monetary policy decisions plus the one day immediately preceding and the one day immediately following those announcement days.  Since there are but eight FOMC announcement days per year, the effect stems from a mere 24 market trading days each year.

The authors launched their study in 1994, when the Federal Reserve began announcing its target for the federal funds rate regularly around 2:15 PM on a pre-scheduled date.  The authors show that, without the price movement in the three-day periods including the FOMC announcements from 1994 to 2011, the S&P 500 would have finished 2011 at about the 600 level.  The actual S&P reading was above 1300.

Upon studying the graph included in the study, it appears that no appreciable variation existed until 1997, at which time the S&P 500 exceeded the 800 level.  Over the ensuing 14 years, the S&P climbed above 1300 while the index without the FOMC days descended to 600.  The vast bulk of the divergence occurred in the years after the stock market peak in 2000.

The Fed has bent every effort to support stocks in the years since the bubble near the turn of the century.  They have openly acknowledged that campaign over the past few years.

The authors note that announced Fed monetary actions have not been the primary cause of the gains, because most of the gains have occurred in the hours before the actual FOMC announcements.  It is unclear what has caused the gains.  It could be that the investment community simply has great faith in the Fed’s ability to fine-tune the economy.  Such trust, however, would not logically lead investors to concentrate their buying efforts in those three-day periods.  It could also be another example of direct governmental interference in markets.  Very possibly the government surmises that its best interests are served when investors retain a high degree of confidence in Fed actions..  To convey the impression of investor confidence, it may serve government’s interests to create an environment in which market gains appear to anticipate a wise Fed decision, followed by stability or further gains to validate that anticipatory strength.

I have long maintained that some government agency appears to be directly influencing stock market prices when it serves government’s needs.  Many have scoffed at that assertion, but there is broad conviction that the “Plunge Protection Team” stands ready to provide sizable bids at important moments.  Increasingly, the myth of free markets is crumbling.  We know that the Fed now buys 70% or more of newly minted U.S. debt.  We know that several foreign central banks have discussed their own direct equity purchases to support market prices.  We know that our government bought bank, insurance and automobile stocks as part of the 2008-09 rescue effort.  We know that governments around the world have been very willing to provide taxpayer money to cover the debt of important financial institutions.  And we are now learning that our Fed and other government entities around the world knew several years ago that banks were falsifying LIBOR rates that affected hundreds of trillions of dollars in investments and mortgages.  Don’t for a minute believe that our government won’t do whatever it deems necessary to serve its own interest relative to the equity markets.

I have not yet seen the entire New York Fed study documenting the critical three days around FOMC announcements.  I expect there will be additional fodder for discussion after a more detailed analysis.

Click here to read the Lucca and Moench study: http://www.ritholtz.com/blog/2012/07/the-puzzling-pre-fomc-announcement-drift/

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Quarterly Commentary – Second Quarter 2012

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During my 44 years in the investment business, I have never before observed a period in which governments and central banks struggled so hard to keep economies and securities markets from succumbing to deteriorating fundamentals.  So far they have largely succeeded.  With the exception of a relatively small number of European bondholders and a somewhat larger number of overleveraged real estate speculators, most investors have avoided debilitating losses.  As a result, investors throughout the world appear to have lost their fear of systemic collapse, which nearly crippled markets just four years ago.

Despite the most prodigious government rescue effort in history, the world economy is slowing perceptibly.  Europe is in recession, and an increasing number of countries are holding out their begging bowls to stave off bankruptcy.  Massive stimulus has kept the U.S. economy in expansion mode, but recent readings indicate that the threat of recession has escalated.  Perhaps most worrisome is the reality that China and the other BRIC nations, the erstwhile engines of global growth, have hit stall speed.

The Federal Reserve’s acknowledged efforts to raise stock prices have worked magnificently since the 2008-09 crisis, but more recent efforts show clearly diminishing returns.  Although stocks lost 2.8% for the second quarter, a well-timed European rescue rumor pushed our stock prices up by 2.5% on the final day of the quarter, elevating the twelve-month return for the S&P 500 to 5.4%.  Rescue efforts elsewhere in the world have been far less effective. Among major world equity markets, only the Philippines and Thailand join the U.S. in the plus column over the past year.  All other major markets are down for the last twelve months.  Of the 18 countries that I follow on a daily basis (including our own), only the Philippines and Thailand are above their 2007 peak price levels, despite massive government support.  Italy, the third largest economy in Europe, has seen its stock prices decline below the 2008-09 crisis lows.  And perhaps most ominous is the fact that China’s stock prices are down for one, two, three, four and five year time periods, notwithstanding having reported glowing economic growth numbers throughout those time periods.  Something unhealthy is not reflected in the official statistics.

Most important for investors worldwide is to recognize that we are not in a “business as usual” environment.  It’s not a question of whether stocks might be up or down by 10% in the year ahead.  If governments and central banks prove unable to solve the problems of excessive debt by issuing more debt, the entire financial system is in danger of freezing and becoming dysfunctional, as nearly happened just over four years ago.  There is no way to measure the likelihood of such an outcome.  Clearly, governments and central banks will do everything in their power to prevent it.  Markets, however, don’t necessarily wait for governments and central banks.  So far investors remain somewhat confident that government officials won’t allow markets to collapse.  History demonstrates, however, that central bankers and other government officials are far from omnipotent.  Despite best central bank efforts, stocks fell by 89% from 1929 to 1932, and by more than 50% from 2007 to 2009.  In the early 1990s, the Bank of Japan addressed problems much like those being experienced today in other parts of the world.  They offered various forms of forgiveness to keep alive banks that would otherwise have failed without government support.  They also instituted a zero interest rate policy in an attempt to revive their sluggish economy.  Tragically the Japanese economy has been moribund for the better part of two decades, and its stock market today trades more than 75% below its levels of over 22 years ago.  While investors in this country still believe that our government rescue actions will succeed–despite the fact that essentially the same actions have failed dismally in Japan–that confidence could fade quickly.  Investors should weigh carefully how much capital they can afford to put at risk of major loss.

For the past three decades bond investors have earned their best returns in U.S. history.  With interest rates now at or near all-time lows, future bond returns are far more problematic.  Short-term bills and notes of perceived secure credits yield essentially nothing.  In the past few weeks investors have been willing to accept negative returns in Germany and Denmark.  In other words, investors were willing to pay those governments to hold their money and give it back intact.  These large, sophisticated investors, who recognize how risky other interest-bearing securities have become, are opting for safety over return.  Longer term fixed income securities similarly pose problems for investors.  You can obtain double-digit returns if you are willing to bet on the solvency of various sovereign or corporate bonds.  At the other end of the risk spectrum, you can expect only about 1.5% (or less) if you are willing to loan money to the United States or Germany for ten years.  If rates don’t change, you will receive a ten-year annualized return of about 1.5% on these securities.  You could make more than that if rates decline to new all-time lows and you make a timely decision to sell at a profit.  Unfortunately, you could also lose a considerable amount of money if rates rise and you decide or have to sell at resulting lower prices.  Most bonds and notes fall in between those risk extremes.  All but the very shortest fixed income securities, however, will suffer if rates rise.  And with rates near all-time lows, it is highly probable that rates will rise within the next several years.  Ultimately, the only path to bond profits from these levels will be stable to lower rates followed by a successfully timed sale.  If rates eventually rise, it is very likely that inflation will also rise. Then bond proceeds, even if securities are held to maturity, would almost certainly have seriously reduced purchasing power.  We continue to believe that, at current interest rate levels, the reward for being right about bonds is far less than the penalty for being wrong.

In such an environment we continue to pursue a low risk investment approach.  We expect volatility to rise in most investment markets, possibly very dramatically.  Such volatility will likely provide far more attractive investment options than exist today.  We want to maintain liquidity to take advantage of those expected opportunities.  At the same time, we are attempting to maximize returns on essentially risk free short-term investments, and we continue to invest in the occasional security that appears significantly undervalued.

Because central banks have traditionally attempted to print their way out of serious financial crises, it is highly probable that the Federal Reserve will continue to pursue that policy, as it has quite aggressively over the past few years.  The European Central Bank likewise has apparently chosen the printing press solution, and Germany’s traditional objections to such an inflationary policy appear to be fading.  While the unwinding of debt is currently a deflationary force, we believe that loose central bank monetary policies will eventually produce inflation–potentially even severe inflation.  To hedge against that prospect, we have begun to add gold to client portfolios, a relatively small position so far.  With no sound method to value gold above jewelry costs, we have little confidence in outguessing speculative supply and demand forces.  Should gold prices rise from here, we will experience nice profits on a relatively small position.  On the other hand, as long as central banks continue their aggressive money printing policies, we will build a larger gold position on price declines, which could prove substantial if world debts begin to unwind even more significantly in quarters to come.

We believe that meaningful profit potential lies ahead, albeit likely from considerably lower price levels for most asset categories.  We are intent now on protecting client assets to leave them intact and able to take profitable advantage of the opportunities ahead.

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