YoungResearch » Jeremy Jones

Employment Picture Brightens: Is it Bullish for Stocks?

Jeremy Jones — Fri, 03 Feb 2012 18:39:20 +0000

The Bureau of Labor Statistics released the monthly jobs report this morning. The headline numbers blew away expectations. Non-farm payroll employment increased by 243,000 in January compared to estimates of 140,000. The unemployment rate came in at 8.3%, 0.2% better than expectations. The big upside surprise in January’s employment numbers is likely related to the Labor Department’s annual benchmark survey and population adjustments, but there is no denying the positive trend in the labor market. Over the last three months, non-farm payrolls have increased by an average of 200,000, while the average gain in household employment has been an impressive 446,000. Over the last six months, the unemployment rate fell by 0.8 percentage points–that matches the fastest decline in the unemployment rate since the recovery began. From a cyclical perspective, the employment picture looks bright, but structural problems remain.

While the reported unemployment rate is improving, the labor force participation rate continues to plunge, exposing a weak structural underbelly to the labor market. Is unemployment really falling or are discouraged workers just dropping out of the labor force? The number of long-term unemployed also remains near record highs and now accounts for 43% of the total unemployed. The average length of unemployment is also at a record high at more than 40 weeks—double the prior peak reached during the early 1980s recession. A lower labor force participation rate and higher structural unemployment point toward a slower potential growth rate in the economy.

Today’s stronger than expected improvement in the employment numbers is undeniably bullish for the economy, but is it as bullish for stocks as today’s 150 point rise in the Dow implies? Stock markets have already priced in ultra-loose monetary policy for another three years and a third round of money printing from the Fed. If the U.S. economy continues to gain cyclical momentum there is a risk that the Fed could pull away the punch bowl sooner than stock investors expect. I’m not making a forecast here. With Dr. Bernanke at the helm of the Federal Reserve, monetary policy is more likely to err on the side of continued financial distortion and asset bubbles than it is sound money, but a more hawkish (or less accommodative) Fed is a risk worthy of your consideration.

Don’t Let This Mutual Fund Mistake Cost You Thousands

Jeremy Jones — Fri, 27 Jan 2012 16:32:59 +0000

What mutual fund mistake am I talking about? This mistake is so common, chances are you have committed it yourself—before you became a savvy, successful investor, of course. If you have ever purchased a mutual fund solely on the basis of past performance, you have made this mistake. Buying yesterday’s winners—also known as performance chasing—is a time-honored tradition for many investors. No matter how many warnings they hear on the pitfalls of performance chasing, many novice investors continue to engage in this practice.

Poll your friends and family who have 401(k) accounts. Ask them how they decide which funds to invest in. I am sure you will find, as I do, that past performance plays a principal role in their investment strategy.

According to Dalbar, Inc., a financial services market research firm, performance chasing and other misguided investment strategies can cost investors dearly. For the 20-year period ending in 2010, the S&P 500 earned an annual average return of 9.1%—enough to turn $100,000 into $570,000. During that same time period, Dalbar estimates that the average equity fund investor earned a return of only 3.8%—enough to turn $100,000 into $210,000. Over a 20-year period, performance chasing cost the average investor $360,000 or 3.6 times his initial investment. Ouch!

A close cousin of performance chasing is investing in “star” funds. You know, the funds that the financial press lionizes—the Fidelity Magellan and Legg Mason Value Trusts of the world. This mistake isn’t limited to novice investors. Experienced investors and even some professionals are guilty of chasing star funds. Star funds tend to have strong long-term performance records when the financial press starts recommending them, but they soon become victims of their own success. Once the money pours in, the performance often turns south.

Take the Legg Mason Value Trust Fund run by Bill Miller. This was a darling of the personal finance magazines for years. Miller’s claim to fame was that he outperformed the S&P 500 for 15 consecutive years. But the streak ended in 2006 after investors dumped billions into the fund, and things quickly went downhill from there. Since year-end 2006, Miller’s Legg Mason Value Trust underperformed the market by 38%. Miller even lost his touch in his smaller, more nimble fund, the Legg Mason Opportunity Fund. Last year, Legg Mason Opportunity plunged 35%. Other star funds that bombed last year include CGM Focus, down 26%; the Fairholme Fund, down 32%; and Fidelity Magellan, down 11.5%.

The takeaway: don’t be a performance chaser, and steer clear of “star” mutual funds.

Former American Express CEO Harvey Golub on Obama’s Tax Proposal, Deficit

Jeremy Jones — Wed, 25 Jan 2012 17:08:28 +0000

Jan. 25 (Bloomberg) — Harvey Golub, chairman of Miller Buckfire & Co., talks about President Barack Obama’s proposal that the wealthy pay more in income taxes. Golub, speaking with Betty Liu on Bloomberg Television’s “In The Loop,” also talks about the Republican Party’s 2012 presidential candidates and the federal deficit. (Source: Bloomberg)

The 2012 Stock-Market Outlook

Jeremy Jones — Wed, 21 Dec 2011 13:00:28 +0000

Barron’s released its 2012 stock-market outlook this weekend. In the issue, Barron’s surveyed 10 Wall Street strategists on the outlook for the U.S. stock market. Most of the strategists are the heads of equity departments at Wall Street’s biggest banks.

What are the Street’s equity strategists forecasting for the S&P 500 next year? Solid gains, of course. Would you expect anything less from the heads of equities at Wall Street’s big banks? Wall Street earnings and bonuses are highly correlated with stock-market performance. It doesn’t pay to be a bear on Wall Street. If investors don’t buy stocks, commissions plunge and it becomes difficult to distribute overpriced IPOs.

On average, the strategists surveyed by Barron’s are expecting the S&P 500 to end 2012 at 1360—for an 11.50% gain. Not surprisingly, the strategists in last year’s stock-market outlook issue were calling for similar gains this year. To wit:

Collectively, the 10 strategists and investment managers surveyed by Barron’s see the S&P 500 finishing next year [2011] near 1373, roughly 10% higher than Friday’s close at 1244. But this solid if hardly extravagant target belies their increasingly expansive view of the U.S. stock market. A majority see 2011 as the year when a sustainable economic recovery takes root, winning over skeptics and persuading both companies and consumers to relax their stranglehold on squirreled-away cash.

It gets better. Nearly all strategists in last year’s survey expected stocks to outperform bonds, especially Treasuries. Stocks, the strategists told us last year, were “the proverbial best house in the neighborhood.”

Within the equity market, Wall Street’s strategists advised Barron’s readers that in 2011 the best-performing sectors would be energy and industrials and the sectors to avoid were utilities and health-care stocks.

How did the soothsayers’ forecasts for 2011 pan out? With less than two weeks to go before year-end, the S&P 500 is trading more than 13% below the strategists’ 1373 year-end price target. Year-to-date, the best-performing sector in the S&P 500 is utilities, up an impressive 15.3%, and the third-best-performing sector is health care, up 8.9%. As for stocks being the best house in the neighborhood, that didn’t pan out too well. The Vanguard Intermediate-Term Treasury fund is up almost 10% for the year compared to a loss of about 4% in the S&P 500.

With such a dismal record, investors might do better in 2012 by not just ignoring but doing exactly the opposite of what the Street’s equity strategists advise.

Citigroup’s chief equity strategist tells us that U.S. stocks are cheap on a historical basis—especially compared to U.S. Treasuries. Sounds like another way of saying investors should buy stocks instead of bonds. You will probably want to own some bonds in 2012.

With regard to sectors, most strategists favor tech shares and recommend that investors avoid financials and raw materials. If history is any guide, financials and raw materials will outperform technology shares in 2012.

Finally, the best-performing stocks are likely to be foreign shares. Why? Because Barron’s 2012 stock-market outlook tells readers, “Given the challenges and the competition, the U.S. stock market just might be the best house on a bad block next year. It has been so this year, as the S&P 500, though relatively flat, has outperformed every other market index in dollar terms.”

Balance Sheets Deteriorate: Economy to Suffer

Jeremy Jones — Thu, 15 Dec 2011 15:51:48 +0000

The Federal Reserve released its quarterly flow of funds report last week. The Fed’s flow of funds report is one of the most valuable economic data sets kept by the government. It is a treasure trove of financial information on the household, corporate, and government sectors of the economy.

The most recent report includes data through the third quarter of this year. I’ve included three charts on a couple of the more important data points in the report. All three have implications for the medium-term economic outlook. These charts and many more are included (and updated regularly) in Young Research’s Global Investment Strategy. You can find out more about Global Investment Strategy here.

The first chart shows the percentage of equity that households have in their homes. Homeowner equity has been in secular decline for decades, but the bursting of the real-estate bubble resulted in a collapse of this ratio. Current levels of homeowner equity are bordering on record lows. And keep in mind that the ratio on this chart includes properties without a mortgage. If you count only those properties with a mortgage, the level of equity is estimated to be less than 20%. According to the most recent data from Core Logic, more than 22% of U.S. homeowners have negative equity. That is, they owe more on their home than it is worth. And another 5% have less than 5% in equity in their home.

For many Americans, their primary residence is their single largest and in some cases their only asset. With years’ worth of accumulated equity wiped out in the crash, consumers are reluctant to spend as freely as they once did. And until a meaningful amount of the equity lost in the crash is rebuilt, consumption may remain subdued.

My second chart from the flow of funds report shows the ratio of household net worth to disposable personal income. Like the home equity chart above, this chart provides insight into the behavior of consumers. The ratio of household net worth to disposable income is highly correlated with the savings rate. When the ratio of net worth to income is high, as it was during the dot-com and real-estate bubbles, the household savings rate is low. And when the opposite is true, consumers save more of their income. Today the ratio of net worth to income is near its long-term average. Based on the historical relationship of the net-worth-to-income ratio and the savings rate, consumers would normally be saving about 7% of their income.

The actual savings rate, included in the next chart, is only 3.8%. Barring a meaningful and sustained rise in the ratio of net worth to income, the savings rate is likely to rise in coming quarters. A higher savings rate will come at the expense of consumer spending, and unless the corporate sector picks up the slack, economic growth will suffer.

The Quiet Bull Market in Oil

Jeremy Jones — Wed, 07 Dec 2011 18:09:22 +0000

While the world’s attention has been focused on Europe, the price of oil has risen more than 33% from its October low. West Texas Intermediate Crude is now trading above $100 per barrel. Much of the rally in West Texas crude is due to technical factors as Brent crude, which is more of a global benchmark is only up 14% from its October low. But oil’s resilience in the face of a euro-area economy that is either in recession or about to enter recession is impressive nonetheless. Imagine where oil could be trading in a more robust global economic environment. Scary wouldn’t you agree?

Eurocrats Cry Wolf

Jeremy Jones — Mon, 28 Nov 2011 19:43:20 +0000

It seems as though the half-life of euro-zone bailouts is getting shorter. It was only a month ago that policy makers announced a bailout plan that was supposed to put an end to the region’s debt crisis once and for all. Admittedly, the details of the plan were vague and it lacked credibility, but that didn’t stop equity markets from rallying in October as rumors and speculation about the plan were leaked to the press. If euro-zone leaders were attempting to boost global equity markets by announcing a plan to make a plan weeks in the future, they succeeded. October was the best month for the S&P 500 in almost two decades. But as equity investors came to the realization that the euro-area plan was at best an incomplete solution, stocks sold off. As of Friday, the S&P 500 had given up almost 80% of its October gains and had fallen 11% from its October 27high.

With each failed bailout attempt, the crisis becomes more serious. The core of the euro area is now losing the confidence of investors. Government bond yields in France and Belgium are rising to troublesome levels, and last week a German bond auction failed. What started out as a debt problem in Greece has morphed into an existential crisis of the euro. Euro-area policy makers are now back to square one. They need to announce yet another bailout plan to save the common currency.

Financial markets see the European Central Bank (ECB) as the only credible solution, but Germany is vehemently opposed to debt monetization. Just last week, German Prime Minister Angela Merkel shot down hopes for ECB intervention and joint euro-bonds, by saying that she remained “firmly convinced” that the ECB’s mandate could not be changed and that European Commission proposals for joint bond issuance were “extraordinarily inappropriate.”

So plan B has apparently been activated. What is plan B? Prop up equity markets with the promise to announce a lasting solution to the crisis at an undetermined date in the future. It worked in October; why wouldn’t it work now?

On Thursday, Merkel, French President Nicolas Sarkozy, and Italian Acting Prime Minister Mario Monti agreed to respect the independence of the ECB by not making positive or negative demands on the bank regarding the crisis. The agreement not to comment on an ECB bailout set the stage for the rumor mill to whip stock prices around. Sure enough, before Asian markets opened Sunday night, La Stampa, an Italian newspaper, ran a story that indicated the International Monetary Fund (IMF) was planning an $800-billion bailout of Italy (backed by the ECB). The story ignited a powerful rally in Asian markets that carried through to European and U.S. markets this morning.

The IMF has since denied the report, but that hasn’t stopped speculation that policy makers are planning to deliver a credible solution to the crisis. In fact, the lead story in this morning’s Wall Street Journal is “Europe’s Leaders Pursue New Pact.” The overarching theme of the article is that a more stringent fiscal pact under negotiation by euro-area policy makers may provide cover for the ECB to fire up the printing press. The article even speculates that some ECB members plan to outvote the Germans on the board who remain opposed to debt monetization.

I can’t tell you whether the rumors and speculation in the media are just another example of European policy makers crying wolf or whether the ECB is actually planning to forcibly intervene in sovereign bond markets. The last we heard, Germany was opposed to the ECB monetizing government debt. Outvoting the Germans would be a risky strategy for the ECB to pursue, but it is also true that without ECB intervention (or a fiscal union) things could spiral out of control in Europe.

It should be clear that the eventual outcome of the euro-area debt crisis remains uncertain. Investors are welcome to take today’s stock-market rally as a signal that the euro-zone debt crisis has passed, but they may be be disappointed. Equity markets have consistently gotten it wrong when it comes to this crisis. The smart money is in the bond market. An end to the euro-zone debt crisis will likely be marked by a decided tightening in euro-area sovereign bond spreads. There has been improvement in euro-area spreads this morning, but nothing that signals an end to the crisis. A defensive investment strategy remains the mandate.

Are Stocks the Best Long-Term Investment?

Jeremy Jones — Wed, 23 Nov 2011 14:28:12 +0000

The two-decade bull market in stocks that ended in 2000 convinced a generation of investors that stocks are the best long-term investment. Dow 36,000 and Stocks for the Long Run became cocktail-party fodder. There is no questioning that stocks put up some impressive numbers in the 1980s and 1990s. From year-end 1981 to year-end 1999, the index rose at an 18.5% compounded annual rate. At an 18.5% rate of growth, you double your money every four years. Of course, the last decade hasn’t been as kind to investors, but despite a decade with almost no return, the S&P 500 has still earned a better-than-average compound annual return of 11% since 1981.

Given the impressive performance of stocks over the last three decades, you might be surprised to learn that since 1981, bonds have not only beaten but crushed stocks. My chart below compares a hypothetical investment in 30-year Treasury zero-coupon bonds (rolled annually to maintain a 30-year maturity) to the return on the S&P 500. Since year-end 1981, 30-year zeros are the clear winner. Even at the height of the stock market euphoria in 1999, the gain on a hypothetical 30-year Treasury zero investment (rolled annually) would have earned an investor more than stocks.

That is not a recommendation to buy 30-year zeros. The return in 30-year zeros over the last three decades will not be repeated. Bonds benefited from a one-of-a-kind secular decline in interest rates. Long rates are now flat on their back with nowhere to go but up.

The takeaway here is twofold. First, question the conventional wisdom. Most investors assume that you have to invest in stocks to earn the highest returns. As my chart above shows, the profit opportunities in the bond market can match and even exceed those in the stock market. Second, recognize the role that falling interest rates played in stock-market returns over the last three decades. Just as long zeros benefited from the secular decline in interest rates, so did stocks. Investors crafting all-stock portfolios on the basis of 11% long-term equity returns are likely to be disappointed. To avoid the disappointment, craft a balanced portfolio (stocks and bonds).

Not Your Father’s Stock Market

Jeremy Jones — Thu, 17 Nov 2011 13:00:38 +0000

This is not your father’s stock market. Over the last 10 years, the structure of the U.S. equity market has changed drastically. Gone are the days when the NYSE and its specialists dominated stock market trading. Today, as many as 50 different venues in the U.S. trade equities. Now, almost all stock trades are done electronically. The NYSE specialists who were once obligated to make an orderly market by providing bid and offer quotes during periods of market stress have been effectively replaced by high-frequency trading firms (HFTs).

HFTs are opportunistic traders that operate with little capital, hold small inventory positions, and are under no obligation to make an orderly market during periods of stress. These firms use ultra-high-speed and sophisticated programs to predict stock prices milliseconds into the future. The most successful HFTs are not the firms with the best insights on a company, but those with the fastest programs located closest to the exchange’s servers (co-location). HFTs don’t use fundamental analysis to make trading decisions. Instead these firms use information in order books, past stock returns, cross-stock correlations, and cross-asset correlation to make decisions.

While some might believe that HFTs are benign market participants, just the opposite is true. High-frequency trading now accounts for 70% of U.S. stock market volume—an astonishing statistic to be sure. The purpose of financial markets is to efficiently allocate capital to its highest and best use, yet a majority of the daily trading in stocks is conducted by investors with no interest in the value of the companies they buy and sell. HFTs are interested only in the price of a stock over the next second or two.

HFT proponents will tell you that high-frequency trading poses no risk to the broader market, and in fact increases liquidity and keeps transaction costs low. But the counter-argument is that HFT liquidity is transitory and shallow (large orders are hard to fill) and while HFTs have helped drive down bid-ask spreads on stocks, they are extracting those profits from investors in other ways (some of the strategies are discussed later).

Because HFTs are not under the same obligation as NYSE specialists to provide liquidity, they often pull back from the market during periods of stress, creating a liquidity vacuum, which can result in cascading prices. The so-called “Flash Crash” in 2010 was partly caused by several major HFT firms stepping away from the market in order to limit risk. Here is what a joint CFTC-SEC report on the “Flash Crash” said about the structure of today’s stock market.

The Committee believes that the September 30, 2010 Report of the CFTC and SEC Staffs to our Committee provides an excellent picture into the new dynamics of the electronic markets that now characterize trading in equity and related exchange traded derivatives. While these changes have increased competition and reduced transaction costs, they have also created market structure fragility in highly volatile periods. In the present environment, where high frequency and algorithmic trading predominate and where exchange competition has essentially eliminated rule-based market maker obligations, liquidity problems are an inherent difficultly that must be addressed. Indeed, even in the absence of extraordinary market events, limit order books can quickly empty and prices can crash simply due to the speed and numbers of orders flowing into the market and due to the ability to instantly cancel orders. Liquidity in a high-speed world is not a given: market design and market structure must ensure that liquidity provision arises continuously in a highly fragmented, highly interconnected trading environment.

More troubling than the transitory liquidity that HFT firms provide are some of the dubious strategies employed by these firms. Below are some examples of the strategies used by high-frequency trading firms—most are illegal but difficult for regulators to detect.

Front running – Using computer algorithms to detect and trade ahead of institutional orders.

Quote Stuffing – Submitting and then immediately cancelling trades in order to gain a few-milliseconds speed advantage over the competition. The computers of the HFT who submits the erroneous orders don’t have to process that information, whereas the competitors’ computers do.

Layering – Using hidden orders on one side of a trade and visible orders on another side of the trade to manipulate prices. For example, if a trader wants to buy a stock at $5.01, but the current bid is $5.02 and the asking price is $5.03, the HFT may put in an order that is hidden to buy at $5.01. It will then flood the market with orders to sell at a price higher than the current asking price, let’s say $5.05. Others will see the selling pressure and adjust their bid and ask prices lower, likely hitting the HFTs intended bid price of $5.01.

Spoofing – A trader may initiate the rapid-fire submission and cancellation of many orders, along with the execution of some trades to “spoof” the algorithms of other traders into buying or selling more aggressively, which can exacerbate market moves.

My goal is not to suggest that all high-frequency traders are unscrupulous and the practice should be banned (though I suspect few would actually miss it). But it would seem to me that high-frequency trading has become so vital to the proper functioning of today’s stock market that, at the very least, more oversight and disclosure should be required of these firms. There is enough uncertainty and volatility in today’s markets. The last thing investors need is for the HFT crowd to magnify volatility and distort the stock market. We have chairman Bernanke for that.

A Striking Divergence

Jeremy Jones — Wed, 16 Nov 2011 16:34:27 +0000

A striking divergence has emerged in global financial markets in recent weeks. During July and August as the euro-area sovereign debt crisis intensified and spreads on Spanish, Italian, and even French bonds rose, U.S. stocks plunged (point A on chart). After the European Central Bank restarted their bond buying program in early August to temporarily take the heat off of Italy and Spain, bond spreads fell. Spreads didn’t rise back to their August highs until late September. The move back up in Spanish and Italian spreads in September contributed to another down-leg in U.S. stocks. That down-leg ended with a powerful early October reversal that carried the S&P 500 to a more than 10% gain for the month. But the optimistic tone in stock prices didn’t carry through to euro-area bond markets. Since mid-October, spreads on Italian, Spanish and (most disturbingly) French bonds have blown out to record highs (Point B), yet U.S. stocks have remained impressively resilient. Is this decoupling sustainable? Maybe, but more than likely the euro-area bond market is too pessimistic or the U.S. stock market is too optimistic. Stay tuned.

YoungResearch » Jeremy Jones

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