Tag Archives: currency trading

Equity investors have enjoyed a sustained advance in stock prices for several months, as expectations premised upon the belief that policymakers are miracle-workers, allowed the major market averages to move sharply higher.  An overdue reality-check was sure to arrive at some point, and so it has, as corporate America’s most disappointing quarterly earnings season in many years, reveals that ‘big business’ is not immune to the troubling deterioration in global economic momentum.

The third-quarter reporting season is well underway at this stage, and the latest numbers reveal that corporate America is set to post a year-on-year decline in quarterly earnings-per-share (EPS) for the first time since the autumn of 2009.  Consensus estimates forecast a two per cent drop in quarterly EPS, as a sharp slowdown in revenue growth alongside margin compression, has sent corporate profitability into reverse.

Corporate America has enjoyed an extraordinary earnings boom over the past three years, as an intense focus on costs allowed margins to surge to record levels – more than three percentage points above their long-term mean, while a strong contribution from global operations more than offset tepid revenue growth in the US.

However, the ability to tap further cost efficiencies is largely exploited at this juncture, while the economic malaise in the euro-zone, and a marked slowdown in the pace of economic growth in emerging markets including China, means that foreign operations are no longer bolstering bottom-line performance.

The recent trends are unsettling.  FactSet reports that the percentage of companies reporting earnings above expectations thus far is in-line with historical averages at close to seventy per cent, but the aggressive reduction in earnings estimates during the pre-reporting season means that this figure is not particularly impressive.

Further, the percentage of companies posting revenues above consensus estimates at about 35 per cent, is more than twenty percentage points below recent experience, and as low as the number seen in the first quarter of 2009, when the global economy was deep in the throes of the worst downturn in generations.

The top-line disappointment is almost exclusively an international affair, with a spate of companies including GE, Ingersoll Rand, and Microsoft attributing the shortfall in sales to weak economic conditions in Europe, and others including Caterpillar and Intel, citing soft activity in China.  Currency issues were mentioned in a number of earnings reports, but this was just a minor irritation, with sluggish revenue growth stemming primarily from soft demand.

The fourth-quarter earnings season is unlikely to prove any kinder than the current reporting period, as more than three-quarters of the companies that issued forward guidance, provided an earnings outlook below the Wall Street consensus. This the highest number since FactSet began collating the data in 2006.

The negative guidance appears to have had little impact on the bottom-up analyst community, who forecast a resumption of earnings growth during the fourth quarter, with an eight per cent increase in EPS pencilled in.  The optimism continues for 2013, with a four per cent increase in revenues expected to lead to EPS growth of ten per cent.

The numbers appear fanciful as the US economy continues grow at subpar rates, the euro-zone crisis is ongoing, while structural issues could well see growth rates in emerging markets such as Brazil, China, and India that are well below recent norms.  Further, it is difficult to see how low, single-digit sales growth will propel margins any higher than they already are.

Corporate America’s good fortunes in recent years have been premised upon a concerted effort to control variable costs, with incremental revenue increases dropping straight to the bottom line.  Costs have already been pared to the bone, which means that further margin expansion is not feasible without robust top-line growth.  Indeed, revenue increases in the three to four per cent range, at such an advanced stage of the earnings cycle, have typically been accompanied by margin contraction, and not expansion.

In this regard, it is instructive to observe that current earnings have reached levels – relative to their ten-year average – that have rarely been exceeded during the past half century and typically followed by poor growth outcomes in subsequent years.  Statistical analysis reveals that corporate earnings are roughly 25 per cent above trend, and given the soft global economic picture, it would be unduly optimistic to expect double-digit percentage point gains to continue.

The third-quarter reporting season has been notable for the sluggish revenue growth that has brought an end to corporate America’s winning streak.  Wall Street remains bullish on the outlook for the remainder of this year and beyond, but a more constructive analysis suggests the boom in corporate profits is at an end.

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

I believe it was New Jersey governor Chris Christy I saw saying to his constituents before Hurricane Sandy hit something to the effect of damage was going to happen despite their best efforts because they couldn’t prevent the storm barreling through.  This is a lesson for investors.

Markets do not always do what we want them to do. That’s a fact of life as an investor or trader. We can do all kinds of great analysis, pick just the right market or security or investment vehicle but still get hit by something unexpected or unavoidable. The investors who survive these sorts of events, and even thrive coming out of them, are the ones who are prepared, while those thinking only of how much they stand to make in the markets are the ones swept away.

It all comes down to risk management. And it has become clear in recent years that the old methods of diversification through spreading money around low-correlated markets are no longer sufficient. Markets which are largely uncorrelated during good times have a tendency to becoming strongly correlated during troubled times – exactly what the old diversification systems relied on them not doing. As I shared with my Twitter and Facebook followers, even just looking at stocks we have seen big swings in the correlation of individual securities with the overall market (which interestingly has gotten low recently). This requires a different type of thinking.

And even if we get the diversification side of things right, that doesn’t completely mitigate our big picture risk. There is always something that can come along and put our hard-earned money at risk. That is where worst case scenario type analysis has to take place. This is where many in the financial sector fell flat, leading to the financial crisis. They felt comfortable with the risk of their portfolios as indicated by the Value-at-Risk (VAR) models they were using, forgetting to account for what could happen beyond the 95% confidence level – events virtually inevitable in the long run. It’s the remaining 5% they should have been worried about, as it’s in that area where they lost their business and very nearly locked up the whole financial system.

The same goes for an individual. Identify the worst and prepare of it. The tools Currensee has put in place in the Trade Leaders program definitely help do just that. You won’t be able to avoid taking some losses along the way, but if you prepare properly you can avoid seeing your financial well-being get swept out to sea.

It is almost four years since central banks in the Western world first adopted near-zero interest-rate policies – alongside the implementation of substantial quantitative easing measures – intended to halt the sharp and swift decline in economic activity that followed the acute myocardial infarction that struck at the heart of the global financial system.  The prescribed medicine successfully revived the ailing advanced economies, but failed to restore the patient to full health, as the deterioration in vital signs in the years leading up to the crisis, precluded a rapid and robust recovery, no matter how high the dosage.

The lacklustre recovery – characterised by persistently elevated levels of unemployment, and subpar business investment rates – has seen central bankers reaffirm their commitment to do “whatever it takes,” in the words of the European Central Bank’s President, Mario Draghi, to return the industrialised world to a more familiar growth-setting.  The rhetoric has been followed by action, as monetary policymakers in Frankfurt and Washington have reached into their medicine chest, and upped the dosage in an effort to remove negative fat-tail risks, and keep their economies afloat.

Return-starved investors’ anticipation of further monetary stimulus fuelled an unseasonal rally in the world’s major stock market averages during the summer that has seen prices advance to within touching distance of multi-year highs.  Surprisingly, the robust double-digit, percentage-point gain in equity values has taken place in spite of mounting evidence that suggests global economic growth has slowed to stall-speed, which is often a prelude to recession.

Further, stock market indices have moved higher on economic data, both ‘good’ and ‘bad,’ which means investors must believe central bank action will ultimately, result in a significant improvement in economic activity.  The conviction is difficult to fathom, given that the ambitious monetary policies pursued in both Europe and the U.S. post-crisis, have already failed in igniting anything like a standard economic recovery, and that further life-support operations are required simply to sustain economic growth not too far below trend.

The evidence of the past four years is virtually a carbon copy of the Japanese experience following the collapse of its twin property and stock market bubbles in the early-1990s.  The Bank of Japan reduced short-term policy rates somewhat belatedly to zero in 1996, and launched the first in a series of quantitative easing programmes early in the new millennium.

However, the unconventional policies adopted in Japan did not produce any real traction in the economy, and the nation’s economic output is now forty to fifty per cent below the level that reasonable forecasters would have projected it to be way back in 1991.  Ultra-accommodative monetary policy was unable to prevent two decades of economic stagnation, as the banking crisis and private sector deleveraging that followed the implosion of the credit-fuelled asset bubbles, seriously curtailed its potency.

Investors refuse to acknowledge the possibility that the Western world might succumb to a more than decade-long, Japanese-style stagnation, even though the starting points were much the same, and the recovery to date has followed a similar path in the presence of equally expansive monetary policies.  The notion that the advanced economies in the West merely skipped a heartbeat, and did not suffer a cardiac arrest, does not stand up to serious scrutiny.

The euro-zone, the U.S., and the U.K. all entered the current episode with non-financial private sector debt ratios that were close to those of Japan two decades ago, and well above the thresholds that have been shown empirically to retard economic growth.  Not surprisingly, the slump in property prices, alongside a severe decline in equity values, prompted a sharp drop in the private sector’s demand for credit, as both the household and corporate sectors attempted to rehabilitate their weakened balance sheets.

Just like Japan, private sector deleveraging continues in spite of historically low interest rates, as subdued growth in disposable income means prospective borrowers are in no hurry to add to their already difficult-to-manage debt burdens, while capital-constrained banks are reluctant to lend to all but the highest-quality debtors.

Further, the Japanese experience demonstrates that the continued suppression of long-term interest rates via quantitative easing, risks undermining the availability of credit even further, as the potential rewards from incremental lending fail to compensate for the risks attached.

Troublingly, years of private sector deleveraging in Japan did not prevent the combined government and non-financial private sector debt ratio from moving higher, as the improvement in corporate and household balance sheets was more than offset by the steady deterioration in public finances.

The same phenomenon has been apparent throughout the advanced economies of the Western world in recent years, as declining tax revenues, increasing unemployment benefits, not to mention sizable bank recapitalisation costs, caused fiscal deficits to skyrocket during the recession, and the subsequent recovery has not been sufficiently robust to stabilise public debt ratios.

Aggregate debt ratios remain close to or at record levels throughout the Western world, and as in Japan, the right-sizing of balance sheets is set to become even more difficult, due to an unfavourable demographic picture that is certain to lower potential growth.  The task could prove even more onerous should elevated unemployment rates and subdued investment in the capital stock, result in lower productivity.

Stock prices have staged an impressive rally on the belief that monetary stimulus will produce a self-sustaining economic recovery any day now, but round after round of unconventional programmes suggests the Western world is edging ever closer to Japanese-style stagnation.  Investors should take note.

www.charliefell.com

 

 

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Labour Day has come and gone, which means the US summer season is officially over.  Wall Street brokers have made their way back from the Hamptons, and returned to their desks to prepare for the final stretch of 2012, a year that has been kind to the owners of common stocks so far, with the Dow Jones Industrial Average delivering solid, double-digit percentage-point gains during the first eight months of the year, while the S&P 500 has returned to the levels that prevailed just before stock prices descended into free-fall in the autumn of 2008.

It is often said that bull markets climb a wall of worry, and the old, nineteenth-century adage has certainly proved true in the year-to-date.  Indeed, investors’ asset allocations appear to have been swayed more by the potential for further unconventional central bank action, rather than the myriad threats – from the persistent turbulence in the euro-zone to a rapid slowdown in Chinese economic activity – that would have been expected to keep risk appetites in check.

Long-term investors are undoubtedly cheerful, but they would be wrong to take comfort from the stock market’s relatively tranquil price action in recent months, as the latest upward move has been accompanied by a marked deterioration in technical indicators, and a growing air of complacency among the professional investment community.

The major market averages’ risk/reward profile is decidedly asymmetric at this juncture, with the potential downside far outweighing any possible upside.  As a result, a nasty surprise could well lie in wait for the increasing army of bulls, who display uncritical satisfaction with their current allocation to risk assets.

The ‘Dow Theory’ is a useful place to start given its long and rich history as a staple for wannabe technical analysts, and it reveals some discomforting divergences that question the true health of the stock market’s present condition.  Far from confirming the optimism of the diehard bulls, the study of recent price action and trading volume, suggests that the upturn in the major stock market averages has become increasingly fragile, and when some of the financial world’s savviest short-term traders hint that are they are positioning for an impending downside shock, perhaps it would be wise to take notice.

For those unfamiliar with Dow Theory, it was derived from a series of Wall Street Journal articles penned by the newspaper’s founding editor, Charles Henry Dow, from 1900 until his untimely death, aged just 51 years, in 1902.  The journalist assembled the Industrial Average in 1896 and the Railroad Average one year later, which meant that he had only a limited sample of historical data from which to develop a cohesive theory.

Dow’s failing health meant that he had little time to put all his thoughts on paper, but William Peter Hamilton, his successor at the financial newspaper, used his predecessor’s theory as the basis for the market predictions he made in more than 250 articles from 1903 until his own death in 1929.

Hamilton clarified the basic outlines of the theory in the 1922 classic, “The Stock Market Barometer,” and the study of stock price movements was further refined by Robert Rhea, who reduced the analysis to a set of theorems that an ordinary investor could understand, in 1932’s timeless, “The Dow Theory.”

Dow believed that both stock averages must confirm a trend, and Rhea noted in his text that, “The movement of both the railroad and industrial averages should be considered together…Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading.”

In this regard, it is interesting to note that the recent cyclical high in the Industrials has not been confirmed by the Transports.  Indeed, the Transportation Average reached a cyclical peak during the summer of 2011, and registered a lower high earlier this year.  Rhea warned that, “A wise man lets the market alone when the averages disagree.”

Dow argued that trading volume should confirm price trends, and Rhea believed that investing in a market that had become “dull on rallies and active on declines” was foolhardy.  The entire advance off the crisis-induced lows during the spring of 2009 stands out in this regard, as trading volume has been consistently higher on weakness.  Indeed, the coefficient of correlation between the ninety-day average of trading volume and stock prices has been a disturbing –0.84 since the cyclical bull market began, as compared with a positive correlation of 0.88 during the early years of the great 1980s bull market.

Not only has trading activity collapsed, with volume at the recent cyclical high in stock prices almost sixty per cent below the figure recorded at the 2009 bottom, but daily price changes have also declined into insignificance.  Since the crisis-induced low, stock prices have registered a percentage point move of more than two per cent once every nine trading sessions, and a more than three per cent change once every 28 sessions.  Recently however, the daily fluctuations have been miniscule; there has been just a single two per cent change in almost fifty trading sessions, and the market has not registered a daily move of more than three per cent in nine months.

Dick Arms, a respected figure in the world of technical analysis, observes that, “There are times when the market gives the impression it is fading into nothingness.  Volume becomes very low, trading ranges become very small, volatility becomes very low.  Also, there is very little change in market levels, and day-to-day fluctuations are minimal.  Looking back at history, when that happens, it is almost always a sign of a market high point.”

Investors have been warned.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

That’s the question I see popping up frequently of late. The argument is a fundamental one focused primarily on the debt crisis going on in Europe at the moment and the seeming lack of ability of anyone in power to deal with it. Even Federal Reserve member Bullard expressed pessimism about the prospects on a recent CNBC stint. So why isn’t the euro coming unglued?

First of all, as the following charts show, the single currency has been weakening pretty steadily against all the major currencies over the last year.

EUR/JPY is down about 20%. EUR/USD is currently down about 15% from its high, and the other pairs are down a comparable amount. That’s a sizeable devaluation for a major currency in that period of time. So to say the euro hasn’t fallen apart is a bit off.

Could it be worse off? Sure. There are reasons why it isn’t, though.

The biggest reason is what we saw on Wednesday after the release of the minutes of the last FOMC meeting. It indicated the prospect for further QE, or at least further monetary accommodation. This potentiality is present in many of the major economies, while the ECB has dragged its feet being as aggressive as the likes of the Fed and Bank of Japan. We always have to remember that exchange rates are reflections of relative value, not absolute. If the Fed is acting in a fashion which weakens the dollar, then issues with the euro will not be reflected so sharply in EUR/USD.

Those looking at currency valuations also need to realize that unlike stocks and bonds, which are mainly priced in terms of the value of future events, currencies themselves cannot be priced that way. With a stock we look at future earnings and whatnot to figure out what it’s worth today. With bonds we discount back all the future cash flows. In both cases expected future inflation is a factor. Inflation is also a factor in currency valuation, but unto itself a currency has no cash flows to be discounted. As a result, a currency – in spot terms – is a more immediate asset.

The immediacy element means we need to look at the euro more in terms of what it’s being used to buy and sell. The Eurozone as a whole has been running a strong positive current account balance of late, meaning more money coming in than going out. That indicates increased demand for euros, with both trade and investment flows a factor. This is supportive for the euro.

Lastly, also keep in mind the so-called risk trade. The euro has been a primary beneficiary of periods when the markets were more positive about things like economic prospects. As the chart below shows, EUR/USD has been largely well-correlated to the S&P 500.

You may not buy into the euro rallying with stocks, but if that’s what the market does then it’s the reality we have to face at the moment. Regardless, it comes down to making sure we factor in all aspects of the multidimensional forex puzzle, and don’t get caught just looking at one side of any exchange rate equation.

US stock prices have made little headway in more than thirteen years, and the cumulative real returns generated by the major market averages have lagged Treasury bonds by a substantial margin over the period.  The uber-bulls are confident however, that the more than decade-long stagnation has led to attractive valuations that should pave the way for strong returns in the years ahead, and some investment practitioners have gone as far as to predict a doubling in equity values by 2022.  Is the optimism justified?

It is important to appreciate the sources of historical real stock market returns, which can be decomposed into three building blocks – the dividend yield, real growth in earnings-per-share, and changes in valuation.  Since 1871, US stocks have delivered annualised real returns of 6.5 per cent, of which more than seventy per cent is attributable to the dividend yield, roughly one quarter to real growth in earnings-per-share, and the remainder to an increase in the valuation multiple attached to current per share profits.

Looking forward, future returns seem virtually certain to fall short of the historical experience, simply because the dividend yield is little more than two per cent today or less than half its long-term mean.  The uber-bulls will undoubtedly argue that the dividend yield understates the total payout to shareholders, due to sizable increase in share repurchase activity in recent decades.

However, share buybacks are already included in per share numbers, and adjusting the payout ratio upwards would be double-counting.  In other words, an existing shareholder can either participate in the buyback and miss out on the earnings-per-share accretion, or forego the cash distribution and benefit from the capital gain.  Thus, forecasting future returns on a per-share requires no adjustment to the dividend yield.

The second building block in estimating future returns is the real growth in earnings-per-share, which is linked to the economy’s long-term growth rate.  However, existing shareholders have a claim on publicly-quoted per share earnings and not economy-wide profits.

Initial public offerings and secondary issues account for a considerable portion of the growth in aggregate earnings through time, and as a result, the growth in per share numbers falls well short of the cumulative increase in total profits.  Indeed, real earnings-per-share have increased at an annual rate of just 1.7 per cent since 1871, or roughly half the pace of economic growth.

The optimists put forward a variety of reasons as to why earnings-per-share growth will be higher in the future, but none stands up to serious scrutiny.  It is argued that share repurchases will provide a boost to earnings, which conveniently ignores the fact that the reduction in share count through time is largely a myth.  Indeed, new share issuance in excess of buybacks has averaged 1.25 per cent a year over the past half century, and repurchases have exceeded new issuance in just eight years.

The second argument relates to the growing share of profits generated overseas in high-growth markets.  The share of revenues sourced in foreign markets has increased from about thirty per cent more than a decade ago to almost fifty per cent today.  However, roughly sixty per cent of overseas revenues come from mature European economies, with a further ten per cent coming from Canada.  All told, just one in every eight sales dollars is generated in high-growth economies, which is simply not large enough to provide a meaningful boost to earnings growth.

The bulls also fail to appreciate that globalisation is a two-way process, and just as American multinationals have made impressive share gains in overseas markets, the same is true of foreign companies in the US.  Indeed, foreign subsidiaries have captured an increasing slice of economy-wide profits over the past two decades, with the share rising from just five per cent in the early-1990s to about fifteen per cent today.

Finally, the global financial crisis and the calamitous drop in economic activity have had a lasting impact on corporate sector behaviour with elevated unemployment levels and a relatively low business investment rate threatening to lower potential future growth rates in the developed world.  All told, there is no reason to believe that long-term growth in real earnings-per-share will stray too far from its historical trend.

The final input to the return estimation process is valuation change.  The market looks reasonable value on current earnings, but the greater than twenty multiple on cycle-adjusted profits is closer to previous secular bull market peaks than bargain basement levels seen in the past.

The bulls argue that the multiple is inflated due to the collapse in corporate profitability during the crisis, but using median earnings over the past decade or a denominator based on twenty-year average earnings to correct for the recession does not paint a different picture; the stock market is expensive.

The best the bulls can really hope for is no change in valuation multiples, which could prevail if macroeconomic volatility drops from its currently elevated levels.  However, should macroeconomic volatility remain high, it is far more likely that valuation multiples will contract, and at the very least, return to their historical mean.

Careful analysis suggests that equity investors can reasonably expect annual real stock market returns of 3.5 to 4 per cent at best in the decade ahead – well below the historical experience, and could deliver far worse should valuation multiples contract.  The bullish optimism is unfounded.

 

www.charliefell.com

 

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Stock prices have been held back for at least the last two years, as the continued turbulence in the euro-zone – alongside the stop/go nature of America’s recovery from the ‘Great Recession’ – has weighed heavily on investor sentiment.

The bulls argue that the incessant focus on the well-known macroeconomic travails in both Europe and the US has seen investors ignore the stellar improvement in the corporate sector’s fundamentals since the profits cycle reached its nadir more than three years ago; the positive spin contends that the virtual sideways movement in the major stock market averages since the spring of 2010 has pushed equity valuations to the most attractive levels in more than a generation.  Is the optimism justified?

It is beyond dispute that the corporate sector’s recovery from the ‘Great Recession’ has been nothing short of impressive.  After-tax corporate profits, as reported by the Bureau of Economic Analysis, dropped by more than a third between the autumn of 2006 and the winter of 2008 – the steepest decline since quarterly data was first collected in 1947, and almost double the average of the previous ten contractions.

Record earnings seemed a long way off as stock prices plummeted towards their crisis lows during the spring of 2009, but somewhat surprisingly to say the least, corporate profits recovered their pre-recession peak by the end of the very same year.  The robust uptrend was sustained in subsequent quarters, and return on net worth reached the highest level since the late-1990s in recent times, while the corporate sector captured a record share of GDP.

The bulls’ frustration with the stock market’s refusal to move higher seems justified in light of the headline numbers concerning trends in corporate profitability.  However, a more probing analysis demonstrates that there are valid reasons behind investors’ unwillingness to attach a higher multiple to current earnings.

S&P earnings data reveals that cost-containment and the accompanying margin improvement accounts for almost three-quarters of the cumulative increase in per-share profits over the last three years, with top-line growth accounting for the remainder.  The relatively minor contribution from revenue gains has seen per-share sales fail to exceed their pre-recession peak.

By way of comparison, profit gains during the previous earnings expansion that extended from the end of 2001 to the summer of 2007, were shared relatively evenly between margin improvement and revenue growth.  Further, the quarterly year-on-year growth in sales-per-share averaged almost four per cent back then, as against just two per cent today.

It is important to appreciate that the magnitude of the economic downturn that accompanied the global financial crisis saw the corporate sector trim their cost structures to the bone.  Troubling, the subsequent lukewarm recovery has seen little let-up in this regard, and though this may well have pushed both corporate profits and cash flow generation to all-time highs, but the reluctance to reinvest the gains in either human capital or productive assets has created a negative feedback loop that threatens not only to hold economic growth below trend, but also to lower the economy’s potential future growth rate.

It is fair to say that the ‘Great Recession’ sparked serious erosion in labour’s bargaining power that is likely to persist for the indefinite future.  The unemployment rate surged to a peak of ten per cent in the autumn of 2009, as the corporate sector responded forcefully to reverse the sharp drop in profitability.  However, the high rate of joblessness combined with unsustainable household debt levels to virtually assure nothing more than a modest rebound in final demand, which in turn, has led to a relatively jobless recovery.

Subdued job growth has seen the unemployment rate persist above eight per cent for more than forty months, and the downward pressure on real wages has seen the labour share of GDP drop to the lowest levels on record.  The stagnation in household incomes means that final demand is sure to remain lacklustre, which in turn, means the unemployment rate will remain elevated.  All told, high rates of long-term unemployment and the resulting erosion of human capital could well result in a loss of productivity and lower potential future growth.

The economic downturn had a pronounced negative effect not only on the labour market, but also on net new investment in the productive capital stock.  Business investment dropped by than a fifth through the downturn, and though corporate cash flows have surged to the highest level on record, capital expenditures remain below their pre-recession peak, and have not recovered to their long-term average relative to GDP.

The current high return on corporate assets alongside historically low interest rates has not proved sufficient to generate a robust investment cycle, as high levels of macroeconomic uncertainty have kept most companies on the sidelines.  In a nutshell, the relatively low investment rate could well lead to a decline in labour productivity with a corresponding fall in the economy’s sustainable growth rate.

The upturn in corporate profitability in recent years is undoubtedly impressive, but persistently high unemployment alongside a relatively low investment rate means that the economy’s sustainable long-term growth rate is in jeopardy.  Investors are right to attach a low multiple to current earnings.

 

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Legions of investors have been schooled to believe that Treasury bond prices and the major stock market indices should move in the same direction.  In other words, changes in the valuations that investors attach to both high-quality sovereign debt and equity markets are presumed to be positively correlated.  In this context, it is not surprising that each time bond yields drop to fresh generational lows, the uber-bulls spring forth to declare that stocks have rarely looked so cheap relative to their fixed-income cousins.

The optimistic hypothesis however, is nothing more than a stale remnant of the dangerously flawed bull market thinking that dominated investment strategy during the heady days of the late-1990s.  Not surprisingly, the use of models that are without theoretical foundation ultimately proved disastrous for bottom-line investment performance.

The supposed positive relationship between bond and equity yields has not been observed in financial market fluctuations for more than a decade, as ever higher bond valuations have been greeted with lower cycle-adjusted price/earnings multiples.  Nevertheless, the tired argument continues to feature heavily in investment commentary, and few practitioners even bother to search for reasons as to why the presumed relationship may not be valid in the current climate.

It is important to appreciate that the secular trend in debt and equity valuations is regime-dependant, and what worked well in one period may not hold true in another.  The primary determinant of bond and stock market valuations is the volatility of inflation – the uncertainty regarding future inflation.  High levels of inflation uncertainty make it increasingly difficult to isolate the signal from the noise emanating from fluctuations in the general price level, and as a result, elevated inflation volatility is accompanied by relatively poor growth outcomes.

The historical record demonstrates that inflation volatility has been at its lowest when the inflation rate has been sustained in a range of two to four per cent.  This can be defined as the ‘sweet spot’ of effective price stability, and has historically been characterised by fewer and milder recessions, and higher long-term economic growth.  Once the inflation rate strays outside of the two to four per cent range, either above or below on a sustained basis during inflationary and deflationary regimes respectively, inflation volatility trends higher and negatively impacts long-run growth.

It is important to note that high inflation volatility is universally bad for equity valuations.  Investors demand a higher risk premium over and above the real risk-free rate to compensate for the greater variability in cash flows, and mark down equity valuations even further to reflect lower expected future real growth.

In other words, the high inflation volatility observed in both deflationary and inflationary regimes precipitates a secular bear market in stocks, as valuations are struck by the double-whammy of a higher real discount rate and a lower expected future real growth rate.  This is exactly the phenomenon that was observed in the deflationary 1930s, the inflationary 1970s, and once again in recent times, as inflation volatility jumped to the highest level in thirty years.

Although high inflation volatility is negative for equity valuations in both deflationary and inflationary regimes, the same is not true for Treasury bond yields.  An inflationary regime is accompanied by a secular bear market in bonds, as investors incorporate not only higher expected future inflation into yields, but also a higher inflation risk premium to compensate for the greater inflation uncertainty.

However, a deflationary regime is accompanied by a secular bull market in bonds, as investors become increasingly willing to pay a premium for financial assets that will provide insurance during poor economic states.  This effect has been particularly pronounced in recent times, as investors learned to their cost that few asset classes provided any protection whatsoever during the global financial crisis, and has been exacerbated by the relative shortage of safe assets arising from multiple sovereign rating downgrades and unconventional monetary policies.

An examination of the historical evidence reveals that the conventional Wall Street wisdom that presumes a positive relationship between changes in debt and equity yields is decidedly misplaced.  The truth of the matter is that bond and stock prices trend in the same direction only in disinflationary and inflationary regimes or roughly half the time.  In a deflationary regime, the financial assets part company, as the lower risk premium attached to safe bonds is accompanied by a higher risk premium attached to stocks.

Investment practitioners continue to insist that lower Treasury yields should result in higher equity valuations, even though debt and equity yields have moved in the opposite direction for more than a decade.  Elevated inflation volatility and the increased deflation risk calls for structurally lower equity valuations, and not higher as the uber-bulls seem to believe.  The astute will be aware that flawed thinking is bad practice.

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The prospect of having an investment industry genius strategically (and often aggressively) managing your asset allocations in an attempt to kill risk and crank out returns can be alluring. Add to that the current upsets throughout the global economy, and despite their stigmatic volatility, hedge funds are looking pretty tempting.

Unfortunately for many retail investors, the restrictions that determine who can access a hedge fund don't leave much in terms of acceptance. In order to invest in these managed funds, one must either be an accredited investor with $1 million plus in liquid assets and a $200,000+/year paycheck, or a qualified purchaser, who owns at least $5 million in investments already. This clearly narrows the investor diversity scope down a bit.

But, the shell of the hedge fund industry looks like it’s finally starting to crack. Recent findings of financial research firm Cerfulli Associates published in an InvestmentNews article last week demonstrated that money managers expect their allocations into alternative investments to increase by at least 50% over the next three years. Investors and financial advisors also have a growing desire to increase alternative investments to negate market downturns and create a divergence from the stock and bond market.

But what does this have to do with making the elusive world of hedge funds more mainstream? It seems the ripples caused by an overall increase in demand for alternative investments have reached the mutual fund industry in the form of something known as ‘alternative mutual funds’.

Funds of this sort fall into alternative sectors such as long-short equity (one of the more popular), currencies, precious metals, and commodities. Taking it to the next level, alternative mutual funds twisted and evolved a bit further into something very similar, known as hedge-like mutual funds (the two names are often even interchanged.) These funds have the potential to hedge risk and generate stronger returns using some of the same strategies and tools that hedge fund managers use.

The most attractive characteristic of investing in a hedge-like mutual fund is that now, average-income investors can access the advantages of hedge fund investing previously available only to those qualified to invest in a hedge fund. Because the SEC regulates them, hedge-like mutual funds preserve some amount of the conservatism and transparency that is demonstrated within traditional mutual funds. Unfortunately, this can also impact these funds negatively in that it restricts their flexibility and requires a greater level of liquidity.

Though these crossbreed mutual funds aren’t anything new and earth shattering, Cerulli predicts that within the next five years, their presence will increase to the point of comprising 10 percent of mutual fund assets - a 245+ percent surge. The fueling of their growth really comes down to one thing: education. Money managers who strive to educate financial advisers on their investment products are the ones seeing positive results. This is due simply to the fact that many advisers are not yet familiar with all of their options in alternatives available to them. And we all know how easy it is to fear the unknown.

The theme of taking an investment that was once unavailable to traditional investors and making it available to them is common across the alternative investing landscape. Hedge-like mutual funds have successfully done what Currensee is striving to accomplish by carrying out this theme. Just the way hedge fund management, tools, and strategies were only available to high net-worth investors at one time, not long ago the world currency market experienced the same inaccessibility. However, with the emergence of various types of trade replication software and autotrading, even those with no prior knowledge of currency trading can allocate a portion of their investments to this type of alternative.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The financial markets are in disagreement.  The yields available on high-quality corporate bonds have dropped to generational lows, as fixed income investors embrace the idea that the US economy is caught in a deflationary trap.  Meanwhile, stock markets are priced for perfection, as equity investors remain optimistic that the life-support operations provided by the Federal Reserve will ultimately reflate the economy and restore price stability.

Investors need to determine which view will ultimately win out and allocate their assets accordingly.  All else equal, the deflationary argument calls for a highly-defensive asset allocation with minimal exposure to risk assets, while the reflationary case prescribes an aggressive allocation with little investment in high-quality bonds.  A reasoned analysis on which way the dice will ultimately fall requires a comprehensive understanding of secular investment cycles through time.

Investors need to appreciate that the economy rotates around price stability or the rate of inflation that maximises the non-inflationary rate of economic growth, and at any given point in time, the economy is either moving closer to or further away from this Holy Grail.  Meanwhile, secular trends in both bond and stock valuations are determined by the stage of the cycle in which the economy currently lies.

The stages of the secular investment cycle can be classified under four general headings – disinflation, deflation, reflation, and inflation.  A disinflationary regime is characterised by falling inflation and robust growth, a deflationary regime is characterised by low and falling inflation alongside poor growth, a reflationary regime is characterised by rising inflation and strong growth, and finally, an inflationary regime is characterised by high and rising inflation alongside disappointing growth.

The historical evidence reveals that recessions are fewer and less severe in both disinflationary and reflationary regimes, while real economic growth is stronger.  During the reflationary period between 1949 and 1968 for example, the economy spent just one month in eight in recession, while the annual rate of economic growth was 4.3 per cent.  Meanwhile, during the inflationary period between 1968 and 1982, the economy spent almost 30 per cent of the time in recession, while real growth was just 2.5 per cent.

It is important to appreciate that the secular investment cycle should be employed as an important input to asset allocation, given its influence on asset prices and valuations.  Both bonds and stocks perform well in a disinflationary environment as valuations rise with the latter outpacing the former over the period.  Bonds excel in a deflationary environment as yields decline, while stocks perform miserably as valuations contract.  Stocks exhibit robust performance in a reflationary regime as valuation multiples expand, while bonds do poorly as yields rise, and finally, both fare badly in an inflationary period as valuations fall, with stocks outpacing bonds.

As an input to asset allocation decisions, it is important to identify transition points in the secular cycle.  In this regard, it is instructive to note that high-quality corporate bonds have led stocks, as the cycle transitioned from deflation to reflation, and once again, when the underlying regime switched from inflation to disinflation.

The historical record of the past one hundred years provides clear evidence of the corporate bond market’s ability to signal an impending regime shift ahead of time in 1920, 1947, and 1981.  The yield on high-quality corporate bonds peaked in June 1920 at 6.4 per cent, and registered a lower high six months later, which signalled the end of the two-decade long bear market.  The stock market’s inflationary bear market drew to a conclusion eight months later.

The yield on high-quality corporate bonds bottomed in April 1946 at 2.5 per cent, and registered a higher low thirteen months later, which signalled the end of a secular bull market that spanned almost three decades.  The stock market’s twenty-year deflationary bear market came to an end two years later, and even though the ‘buy’ signal seems quite premature, the high dividend yield available on stocks alongside the modest decline in the major market averages in the intervening period, meant that equity investors who acted upon the call earned a positive real return.

The yield on high-quality corporate bonds peaked in September 1981 at 15.5 per cent, and registered a lower high the following February, six months before the stock market’s inflationary bear market hit bottom.  Equity investors subsequently went on to enjoy the strongest secular bull market in stock market history.

The financial markets are currently enduring a tug-of-war between the deflationary fixed income view, and the stock market’s reflationary optimism.  Unfortunately for equity investors, the weight of historical evidence indicates that the bond market leads the stock market at important turning points in the secular investment cycle.

The fresh generational lows in the yields available on high-quality corporate bonds suggest the stock market’s more than decade long deflationary bear is not over.

 

www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.