The crazy(?) bond rally

Over the past four weeks or so, the bond rally has become truly epic. I have been truly stunned by the magnitude of it.

Here is the oft-mentioned TLT, which tracks the 20 and 30 year US Treasuries.

It's charted against SPY (the S&P 500 proxy) and EEM (the emerging markets proxy). To show that the bond rally has some breadth, let's look at municipal bonds as well. Now, the MUB is not just a long maturity municipal bond fund but rather a larger aggregate so its moves aren't as dramatic, but it tells a similar tale.

The same had also held with corporates, as represented by LQD, which tracks long term investment grade corporate debt.

Now, the question that many are asking is "Is this a bond market bubble?" Well, current interest rates do seem absurdly low. In terms of the stock market, it would be the equivalent of paying 40x earnings for a company's stock (the equivalent of a 2.5% earnings yield). However, with inflation also at historic lows, the bubble might not be as big as some are claiming. If you are of the view that inflation will soon accelerate to 4%+, then yes, bonds are dramatically overvalued. If you believe instead that inflation will be between 0% and 1.5%, the overvaluation of bonds ranges between not much and only marginally overvalued. I do happen to think that, when you look at comparative stock market measures, bonds are at least moderately overpriced. That holds true so long as corporations will be increasing their earnings even at a moderate pace over the next several years.

With the Fed possibly embarking on more quantitative easing (the direct purchase of treasuries to increase the money supply), one might wonder if interest rates will be capped at these low levels or even drop further. The last time the Fed did a similar action, interest rates rose anyway because market expectations of an economic recovery picked up. At this juncture, it's hard to say which way they will go, but I think that past performance might be a decent indication. Quantitative easing is a powerful stimulative tool and if the Fed is zealous in its application, it actually might actually have the net effect of increasing interest rates through market expectations of higher growth. All of this remains to be seen, however.

Deflation or Disinvestment?

When diagnosing our present malady, I think there has been too much focus on the technical definition of "deflation". A number of economists have lazily said "Well, CPI isn't falling yet so we can't be in deflation". Fair enough, but why do we care about deflation in the first place? We care about deflation because of its effects, not its tell tale symptom. Its symptoms can be best described as "disinvestment".

Now, disinvestment has another definition that's related to economic boycotts where those who disapprove of the actions of a country or region such as what happened to South Africa under the apartheid regime. In this case, we mean a more literal definition which is the dimunition of investment and its various manifestations. In a deflationary environment, conditions are such that the owners of capital feel little need to earn a high rate of return and indeed they perceive that a high rate of return is not possible to earn. As such, they do not replace depreciating capital investments, place new equity capital into their businesses, or increase the human capital of their labor force. With low or non-existent rates of inflation, the real value of their money is not under pressure and as such there is little cause to take risks. As such, they just draw down on their existing capital, having great profits and cash flows for a little while, but their lack of investment hurts their productivity in the long run.

Further, consumers expect that goods will be at the same prices as they are now or potentially lower while they don't expect their incomes to rise so they see no reason to take on more debt. What's more is that because existing debt burdens are hard to pay down with stagnant wages, debt service becomes comparatively more onerous. While debts get paid down, they are only paid down slowly. As consumers also expect asset prices, principally house prices, to be moribund, they sit on their hands and wait for prices to drop before buying new houses and they also don't deploy their money to the capital markets.

To one extent or another, we are seeing all of these symptoms even while we still technically have some inflation. While weak consumer spending has been evident for some time, some of the business investment indicators that had been turning up are beginning to look a little soft to put it mildly. Now, we had a similar set of data disappointments in 2002 and the economy still resumed growth thereafter so it doesn't mean that we will fall apart here. Still, I think the Fed may be adopting policies with far too narrow a definition of deflation. If they paid attention to these symptoms of disinvestment, perhaps they would adopt more rigorous and also more creative approaches toward stimulus.

July Non-Defense Capital Goods

I'm in a bit of a hurry, so here's the link: http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf

I have to admit, these numbers gave me some pause. A 15% decline in machinery orders in particular made me a little queasy this morning. I'll try to have some more on this and what we have seen in the mid-month manufacturing reports later.

Prepare for Apocalyptic Home Sales Numbers

As we have been discussing for a while now, home sales are likely to be quite weak following the expiration of the home buyer tax credit. "How weak?" you might ask? Well, let's just say they could be the lowest in any relevant time span. The expectation of economists is probably way off this time as is being discussed over on Calculated Risk.

If these sorts of sales rates are maintained (if that is the proper word to use here) prices will certainly decline again, which has been our expectation here. What that means is that even now might not have been the best time to buy a house as you will not be building up equity. Of course, it depends on the market, but most will be quite weak.

Now, as for whether or not this will push us into another recession, I don't think so. Existing home sales, which are the bulk of home sales, really aren't that economically productive as they don't reflect the production of new goods. New home sales are really about as low as they can go and were probably actually depressed by the credit pushing more people into existing homes. A decline in prices may make banks a little more skittish, though it would be hard to see how they could be more tight-fisted than they are now.

More Talk of a Bond Bubble...

We discussed the issue of what a bubble in US Treasuries would mean a while ago here on Finance Monitor, but it seems that this is becoming a more popular subject. Take this MSNBC story for instance. Many of the same arguments that we have made here appear in the article which, among others, include the argument that dividend yields on high quality, consistent earning stocks are currently higher than treasury rates even before the possibility of capital appreciation.

For our earlier discussion on the matter, look here. Since the writing of that piece, yields have fallen nearly another 70 basis points.

One point I would like to make here is that bubbles in credit markets are more difficult to assess than they are in equity markets and real estate markets. Generally, I would say that if there is very robust issuance with not the slightest pressure on interest rates, that might be a sign that investors are too complacent with credit conditions. As of right now, I think bonds may be due for a serious correction, though it is uncertain how severely overvalued bonds are. So far it hasn't happened yet, despite my (and several others') repeated concerns.

Keep your eyes peeled on this one.

Do Deficits Cause Crowding Out?

This is an age old question in economics and one that causes much debate. The basic idea in classical economic thought is that government deficits are not stimulative because they supplant private capital on a 1-1 or even worse basis. Now, this is a highly political debate as well in the current time period even though Democrats and Republicans are both heavily responsible for the current fiscal imbalances, but I digress on that point.

In any case, I am interested in studying the portfolio crowding out channel, which is simply the idea that more government paper on the market increases interest rates higher than they would have been otherwise. I have to confess that I have run a hideously simple regression to study the matter as a first approximation to see if anything is there at all. The basic design is this simple:

Dependent Variables: AAA 10-year corporate bond yields - 10 year treasury bond yields and BAA 10-year corporate bond yields - 10 year treasury bond yields
Independent Variables: Government deficit as % of GDP and a binary variable indicating financial crisis or recession

I am using these two credit spread measures because theoretical speaking the market for credit instruments is a layered one. Demand is highest for U.S. treasuries, next highest for AAA corporates, and lower for BAA corporates. As such, if crowding out exists, you would expect to see deficits cause spreads to widen for the corporate securities as more demand is satiated on the high end by the burgeoning supply of treasuries. Using credit spreads as opposed to nominal rates also deals with the problem of adjusting rates for inflation as it appears there is little effect on credit spreads from inflation. On a theoretical basis, we would expect to see rates on lower end corporates expand by more than on higher end corporates as they are the more marginal investment and would have to proportionately offer more in a situation where crowding out is occurring.

I ran this from 1954-2009 and got the following (I am putting the regression in plain English terms):

For AAA - 10 year treasuries:
For every 1% of GDP the deficit expands, AAA credit spreads expand 0.11%
The presence of a recession or financial crisis causes spreads to expand 0.52%
These two variables explain approximately 28% of the variation in credit spreads over the period of 1954-2009.

For BAA - 10 year treasuries:
For every 1% of GDP the deficit expands, BAA credit spreads expand 0.17%
The presence of a recession or financial crisis causes spreads to expand 0.84%
These two variables explain approximately 50% of the variation in credit spreads over the period of 1954-2009

All results were significant at the 95% and 99% significance levels.

Now, I should have probably used a GDP growth rate as opposed to a binary variable for recession or financial crisis, though that presented problems when attempting to model the presence of a financial crisis such as in 1998 or 1987. In the future I may use stock market performance and GDP growth. The problem with a great many of these variables is that they are heavily correlated with each other so that presents difficulties. For example, recessions and deficits are highly correlated, particularly in recent history.

What I think this shows is that deficits may, and I will emphasize may, have a small effect on corporate credit spreads, though there are likely other factors. For instance, the level of corporate bond issuance is not taken into account here and that would have a bearing on these measures. In the current market, corporate spreads have been narrowing to levels that would not be explained by the variables here and that could be because corporate issuance is so low that they are able to sell at low interest rates. Still, I was encouraged that the theoretical result did emerge here which is that we do see the stratified effect on corporate spreads.

As far as how to use this information, I think what it means is that you probably shouldn't worry too much about deficits' effect on corporate bond yields and by extension corporations' ability to borrow because deficits evidently explain quite little of the movement in credit spreads. I think the odds are considerable that if I had spent more than 15 minutes on this, the effects would have been even smaller.

Early Indications of August Consumer Spending: Mixed Bag

With many economic indicators really being quite weak recently, I have been trying to look for earlier and earlier indications of data to try to get a step or two ahead of things. Given that much of the air pocket in economic growth he hit in about the middle of May was driven by consumer spending being atrocious, that is where it pays to focus at the moment.

For August, we are seeing mixed signals. As expected, housing is quite awful when you look at the weekly mortgage purchase applications. It is quite clear that consumer spending on housing and, by extension, residential investment will be quite moribund for some time to come. As housing and housing related industries comprise a large portion of consumer spending, that does bear some watching.

On the other two fronts, auto sales and chain store sales, things are looking fairly good... well, not bad at least. Early indications from Redbook are for an increase of about 1.0% month on month on a seasonally adjusted basis, which would be the first really solid month in quite a while. If we could string another one together in September, I would feel a lot better about the overall outlook. Auto sales are building off a little strength in July from early indications and may be as high as a 12 million annual rate. Put together, that would make a fairly solid month for consumer spending. http://www.dailyfinance.com/story/autos/august-auto-sales-are-zooming-along-so-far/19600754/

This is badly needed as it appears that the industrial sector is taking a significant pause by every early indication and that has been the sole driver of the economic recovery so far. If consumer demand at least appears to be out of a contractionary mode, that will give some additional impetus for inventory rebuilding and business investment. Worryingly, a great deal of consumer spending seems to be going to imports as is a good deal of business investment. Most of the second quarter weakness came from a horrid import number and if that continues we could be in trouble.

Okay, this was silly

This isn't really related to finance, but rather analytical methods generally so I think it is worthwhile. http://seekingalpha.com/article/220327-summer-employment-it-s-all-about-demand

The University of Chicago economist Casey Mulligan offered this graph to somehow demonstrate that employment is nearly entirely a function of the supply of workers available:

Basically, he is saying this seasonal pattern squelches the idea that employment declines are demand driven but are rather a function of the fact that policies at various given times restrict the labor supply (such as UI benefits and welfare checks). However, as Seeking Alpha suggested, perhaps Mr. Mulligan has never held a summer job and doesn't know how the employment dynamics work.

As someone who worked in retail in the summer for four years in a row, I can vouch for how this works and it is shown in the data as well. Retailers, probably the single largest employer of teenagers, start posting job openings around early June because during the summer, compared to January through May, sales pick up considerably. This is particularly true with the back to school season. The same traffic patterns hold for restaurants and movie theaters where summer business is better than late winter and early spring. Now, why does this translate into such a pick up in temporary employment for teenagers exclusively? That's because during most of the year the available labor pool that would fill these summer jobs is of a stable mix of age groups, but in the summer the marginal new workers are disproportionately teenagers. As such, for a set amount of hiring, teenagers are likely to be a larger proportion of that labor force.

Now, that doesn't squelch what Mr. Mulligan said yet. What does is the fact that his ratio of teenage employment to their next nearest age cohort is shifting down throughout the course of this recession. Sure, it holds the same pattern largely because the same seasonal sales patterns are there, just at lower levels. Now, what would we expect to see in terms of marginal new hiring with depressed activity? Let's say I am a store chain with 100 stores and normally I would hire 2,000 seasonal workers compared to an existing staff of about 20,000 (these are big stores for the sake of argument). I do this with my sales at an indexed level of 100. However, if my sales still follow the same pattern but are at 95 the next year, it doesn't make sense to add as many seasonal workers since my existing staff can probably deal with the lower sales volume. As such I might only hire 1,500. The next year is even worse and sales drop to a level of 90 so I cut seasonal workers to 1,000. All the while, I keep proportionately more of my experienced either full-time or consistent part-time workers since their productivity is much higher and they are less strained with the lower sales volume.

This is indeed what we have seen and Mulligan's graph demonstrates it quite well. The proportion of teenage workers to other workers has dropped with demand as there is less overall hiring of teenage workers, which is a function of what retailers have been seeing for sales. This applies to the other service industries too, but I chose to focus on retail. In a situation where demand is driving the decline, you would expect the most marginally attached workers to be affected the most. Indeed, that is what has happened.

On Germany, China, and Currencies

A little light reading on Bloomberg today: http://www.bloomberg.com/news/2010-08-17/germany-ignores-soros-as-exports-drive-record-growth-at-consumers-expense.html

One of the principal things that concerns me going forward is that there was no effort made to bring the global current account disparities into better alignment. You can't have three or four really big exporting countries (China, Germany, at times Russia) and have a few big importing countries (U.S., Italy, Spain) and expect there to be stability in foreign exchange markets or evenly distributed global prosperity.

Given the U.S.'s return to large current account deficits with the onset of economic expansion, I think we can say with some degree of certainty that the dollar is likely to be quite weak in the medium term. In the short run, it may have some loft from transitory crises, but the dollar's trajectory is more likely than not to be down, interest rate signals not withstanding. According to the interest rate theories, we can expect a stronger dollar ten years from now than we have today, which may be true, but from an investment standpoint that's not relevant.

Dynamic Asset Allocation Model: August Update

I had hoped to do these on a more regular schedule, but life has not been particularly permitting on that front. In any case, the August Dynamic Asset Allocation Model suggests an 80% weighting for equities going forward. Of course, this is the same as it has been since pretty much the end of 2008 with a few small twinges back and forth here and there.

However, August did see some interesting movement in a couple of the indicators. The yield curve measure moved down as ten year rates have continued to come in. Corporate spreads also narrowed in August, suggesting looser credit conditions for corporations, which is bearish for the model due to the contrarian intention of the indicator. The overall model remains very bullish because the earnings yield metric is at levels similar to the early 1950s as well as the bottom in 1974, which is immensely bullish for stocks.

Still, this model was based on historical patterns and a deflationary environment would ruin some well established historical relationships on which investors have relied. Principally, in our discussions of PE ratios we talked about how PE ratios work because there is the implicit assumption that earnings in the future will be higher. In a deflationary environment this isn't the case. As such, keep your eyes peeled. I still think that stocks are quite cheap on a historical basis relative to alternative investments, but it isn't as unqualified as the indicators in the model would suggest. 

End of the Brief Hiatus and on to the Deflation

Now that I have finally moved into my new abode I can recommit myself to blogging.

A general issue that I have talked to a number of people about is what to do in the event that there is persistent and nagging deflation in the economy. I will say that the one good part about the onset of deflation in the variety that we see in Japan is that you have plenty of time to recognize it before the market actually punishes you for missing it. It isn't as though "the market" wakes up one day and goes through this logical exercise "IF CONDITIONS = "DEFLATION" THEN "40% SELL OFF"".

One will have ample time to first recognize the onset of persistent deflation and then adapt policies to it. I would say that we are seeing definite signals in the equity and credit markets that market participants are quite concerned about the prospect of slow and grinding deflation. With the 10-year at approximately 2.7% and stocks seemingly rangebound, we may be getting some early signals, but there is no sense in acting harshly on this as the effects of equity and credit markets are gradual enough to allow for a very thoughtful and gradual reallocation. As of right now, as the dynamic allocation model will show when I update it later today, a healthy allocation to equities is still warranted.

Brief Thoughts on Fed Action Today

I had a couple brief, and these will actually be brief, thoughts on the Fed's action today.

I don't think the announcement that they will be reinvesting maturing MBSs in Treasuries is actually that substantive as it basically means that the Fed simply is forgoing an otherwise scheduled balance sheet contraction that would have slowly removed liquidity from the system. While that's good, it isn't overly stimulative compared to our current situation except to say that it means we won't have dramatically tightening monetary policy in the near future.

More important than the actual announcement is that the Fed recognizes that economic data has softened notably since May and that the specter we face now is deflation rather than inflation. They didn't explicitly state that deflation is a concern in the FOMC statement today, but implicitly that was there. The key here is that we had to see that the Fed was willing to do more and I was somewhat satisfied that they did. This is good for stocks on two fronts and bad on one. The positives are that the Fed will remain stimulative, helping economic growth and, by extension, earnings. The other is that by buying long term treasuries, interest rates will be depressed, helping stocks appear more attractive as an investment. The bad news is that economic data is weak enough to warrant these actions, which is bad for the earnings outlook, though we haven't heard much from companies indicating that they expect to be taking down estimates. We shall see...

EDIT 8-12-2010: The market certainly seemed to hone in on the third point I broached which is that we only got to this point due to weak economic data and the specter of deflation. I suspect over the next couple weeks that this will be the main focus of the market and every sign of deflation will be greeted with severe trepidation.

Mortgage Bond Insurers Earnings Reports

We've seen a few of them come in and because I was most bullish on MGIC (MTG), I will start with that.

MGIC's 2nd quarter results actually weren't half bad. Hell, they even turned a profit, though they seemed to indicate that they didn't expect this to continue and brief blips like this aren't uncommon in depressed industries as a general rule. That being said, they seemed to have a favorable market response even if they have dropped off a bit since then. MGIC is one of the few that actually seems to be able to provide any clarity about the future, even if that clarity is not overwhelmingly positive.

Radian (RDN), reported on the 3rd and got walloped by the market that day. "Walloped" is a technical term meaning they dropped more than 15%. There was fairly little good to say about these results and even though the stock got marked down severely it still isn't more attractive than it had been. The results were genuinely poor.

MBIA (MBI) and Ambac (ABK) both reported today and the performances of the stocks tell the tale. MBIA is up 7% while Ambac is down 17%. MBIA, like MGIC, turned a profit, albeit a paltry $14 million. Further, they seemed to indicate that there is a gradual trend of improvement. In terms of tone, their report seemed more positive than MGIC's. Ambac, on the other hand, is trash and I choose to ignore it.

Now, to my credit, I said MGIC and MBIA were the best of the sector, though I did give MGIC the tip over MBIA, which may or may not have been a mistake. In any case, here's how the stocks have performed since we mentioned them on July 22nd.

Incidentally, Ambac has performed the best so far, but that will change with tonight's earnings reports. They have generally been a bunch of dogs, particularly Radian and PMI, but I still think that the earnings reports indicate that MGIC and MBI are the winners here and maybe buying both to hedge one's bets might be a decent value play going forward.

Exploring New Frontiers: Five Stocks I've Never Heard of Before

As promised, I have done my exploring and now I am ready to discuss five companies I have never heard of before that I found to be possibly good buys.

Pentair (PNR)

This is a company whose name I seem to recall seeing at some point, but if you had put a gun to my head a few days ago and asked me what in the name of God they do to make money, I couldn't have told you. Apparently, their main businesses are water filtration systems, water pumps, and a segment broadly called "technical products" which involves cooling and enclosure products for electronic systems. They're all fairly solid businesses and Pentair has shown fairly consistent revenue and profit growth that do justify its otherwise rich 20 PE. Also, its dividend at 2.24% isn't bad, particularly when 10-year treasuries are only paying 2.82%. Growth prospects are good and they have a wonderful habit of clobbering analyst expectations.

Nu Skin Enterprises (NUS)

As you might expect, Nu Skin is a skin care and personal care products company. It engages in direct selling rather than through retailers on a number of personal care products including things like spa gels, botanical products, and so on. I know profoundly little of this sort of market, but trading at 15x earnings, consistent and high earnings growth, good growth prospects, and a 1.8% dividend to slightly sweeten the pot, I have to say that this doesn't look half bad. My only caution is that as I don't understand these sorts of markets, I will warn that these sorts of products are very vulnerable to trends that those who are not well versed in the industry aren't aware of and earnings growth could suddenly turn awful. That being said, this looks fairly promising.

Xyratex (XRTX)

This is a network storage products company that has exhibited a peculiar growth pattern of late, by which I mean its growth has gone through the ceiling in recent quarters. For years they seemed to be milling around $200-250 million in revenue a quarter. Suddenly that accelerated to $320 million and then $455 million in the last quarter. It is a tiny company with little coverage so it is hard to tell how sustainable this is. It is a favorable sector to be in and if they can even come close to replicating their recent earnings successes, the stock is quite cheap. One serious caution is that this is a small small company and can be bandied about by a single mutual fund deciding that they don't like it. They also do compete against much larger companies, but that actually means that there is a good chance that they could be bought out at some point in the future.

Companhia de San Basico (SBS)

This is fairly simple to explain. This is a Brazilan water utility in the state of Sao Paulo, Brazil's biggest state. If a Brazilian reader by some random chance was reading this blog, this company would be well-known to them, but it was completely unheard of to me. Growth prospects aren't always the best for water utilities, even in emerging markets, but given its low valuation and consistent earnings delivery, I think it is worth a shot. Brazilian companies are always hard to figure out with their dividend yields because they are so irregular or they pay monthly with big special dividends. Even though usually utilities pay large dividends, going over SBS, it doesn't seem to, which is unfortunate.

Provida Pension Fund Administrator (PVD)

This is a Chilean private pension fund administrator which is not strictly involved in conventional pensions but also defined contribution plans and what appear to be something similar to health savings accounts, though I might have to investigate further. The stock is very thinly traded, so it can be hard to complete your trades, but the fundamentals of the company appear very strong indeed. All told, I like what I see here a lot as they are essentially an asset manager in a country with a phenomenal amount of growth potential in that area. It's a good long term play and it appears very reasonably valued, though with an erratic dividend pay out history. You will see it shows a 14.3% dividend yield, but that is because it had a very large one time payout as best as I can tell.

Anyway, those are my five. I don't favor them in any particular order as I still need to do a bit more research on a couple of them to become truly comfortable. I hope this exercise has expanded your horizons as it has mine.

U.S. Banks' Exposure to Risky Countries

I've heard quite a bit of talk about contagion from some of the more toxic countries in the world and I think it is helpful to actually quantify what we are talking about. I made this table based on data from the Federal Reserve on bank exposure by country:

As you can see, most of the high risk countries do not pose particularly mortal threats to the banking system. This is certainly true when you compare them to the size of the commercial and residential real estate portfolios that they had as of Q1 2008. The spill-over countries are a different story, with the UK being the most problematic if there suddenly was a complete collapse of the European financial system. However, that event looks increasingly unlikely. By the way, I included Australia and China due to their large and out of control real estate bubbles.

As such, I don't fear the risk of a sudden financial shock as much as I do the slow grind of deflation. With 10-year treasuries well below 3.0% now, I think the market is indicating the same.

Exploring New Frontiers

I've always liked periodically going out to find stocks that I've never heard of. This has become a more and more difficult exercise over time as my knowledge of stocks out there has increased faster than the issuance of new securities, but it is always important to find new answers to the same question "What should I buy now?".

As part of this exercise, I endeavor to find five stocks that are worth buying that I have never heard of. I encourage readers to do the same as you often stumble across new and exciting prospects. For example, I found MICC during a concerted effort to find African related stocks. Of course, you also run into a lot of crap that isn't worth buying, but that's the fun of it.

Anyway, I have found the best way of doing this is to look within the industry lists of stocks that are in sectors you like. Look down the list for the smaller companies and go from there. Think of it like a Wikipedia adventure where you just keep clicking on the links.

By Sunday, I hope to have found my five. Good hunting!

China Slows and Hong Kong Likes It

This is never a good sign: http://www.marketwatch.com/story/hong-kong-shares-rise-as-china-manufacturing-slows-2010-08-01. The basic logic here is that bad data = lower interest rates = good markets. The reality always and uniformly is bad data = worse earnings = lower markets. I remember markets in the U.S. in 2000 rising on bad data toward the end of the year while awaiting Fed interest rate cuts and falling on signs the economy wasn't slowing. Of course, the recession came, earnings collapsed, and so did stocks. Same thing happened in late 2007 as well, though not as much.

I don't know why this sort of trade keeps getting executed, but oh well.