Year End Asset Allocation Model Update

I just realized that I hadn't done one of these in about two months, but the model still just barely puts allocation at the 80% equity/20% bond split that it has since May. I will point out that the model has consistently described a positive environment from stocks and even with the summer sell-off, this has clearly been the right call in a macro sense. That being said, the signals are not as overwhelmingly bullish as they were in the summer after interest rates dropped through the floor while stocks took a 15%+ hair cut.

The aggregate composite indicator on which the allocation percentages are based was off the chart this summer in a way it had not been since March 2009 and in some respects it even exceeded those levels. Since then it has come down, though we are still in very bullish territory.

Based on this and a series of positive economic indicators, I think I very solid case can be made for a good stock market for at least the next six months barring a full-blown financial collapse in Europe, which is a possibility.

Happy New Year, and I am glad that we can end on a positive note.

Some time in the shame corner

I occasionally (and sometimes often) get things very very wrong. I once thought M&I (MI) was one of the better bank stocks out there in 2007, for instance, something that was only true if you compared it to Washington Mutual or Wachovia. In September, admittedly not knowing anything about fashion I thought Skechers (SKX) was the better buy over Crocs (CROX). That was... um.... very very wrong. Steve rightly pointed out that Skechers stores in the malls seemed devoid of customers while Crocs were still in fashion, to my utter amazement. Thank God I exercised prudence and didn't speculate in an area I knew nothing about.

If those five unheard of companies I recommended in early August were my moment of pride and joy this year (if you bought a basket of them you did quite well), this is my moment of shame, where I got a call absolutely 100% dead wrong.

One good reason to stay away from Europe generally...

http://www.businessweek.com/news/2010-12-16/imf-eu-say-latvia-needs-adjustment-for-budget-goal.html

The case of Latvia is one where the country has followed all of the advice European Union and IMF policymakers have given them... and their economy has contracted over 20% from the peak and unemployment is unspeakably high.

http://online.wsj.com/article/SB10001424052748703471904576003370480205348.html

Instead of engaging in a policy of devaluation to make its goods and services more competitive around the world in a more normal fashion, the EU and IMF have basically force-fed deflation so that wages are being pushed down in a brutal fashion, which is one way to reduce imports... I guess. To paraphrase what Paul Krugman said about this, Latvia was told not to devalue its currency or it would face economic disaster. I respond with, "What exactly is a 20%+ contraction in GDP, 18%+ unemployment and dramatically falling living standards for everyone else?". What Latvia has been put through is nearly criminal.

If this is going to Europe's continued approach all around the periphery of the continent, investors are wise to stay away for the most part except for those European companies that do little business in Europe itself. Deflationary policies are good only for the holders of credit (and even there only in the short run) and bad for just about everyone else.

Best Buy and Other Retailers

Suffice it to say that the Best Buy (BBY) warning the other day was a bit of a clarion call for retailers. I've rarely seen a stock in a solid uptrend reverse so suddenly and so severely except in asset bubbles. I would be careful about extrapolating these results across the whole of the retail sector, but I think that the run in retail stocks that we've seen since the middle of the year may have seen its best days.

The sell-off after April was largely based on the incorrect assertion that the consumer was going to lead us back into a recession or at least total stagnation. In absence of that occurring, retailers were largely undervalued. Playing retail as a group in that environment was sensible, but we are now entering a stage where one has to be quite selective. The easy money is definitely already made in this group.

The Out-performance of Silver and Asset Bubbles

 So, from the above chart you can see that the silver ETF (SLV) has recently had a huge run, far outperforming the gold ETF (GLD). Some have wondered why this is, but it's really no great mystery. As you can see, silver's movements are directionally the same as gold's, but are just much more exaggerated in the last three months. Arguably, they are both part of the same play as a hedge against dollar devaluation, inflation, financial instability and so on so why the disparate performance the favors arguably the less intrinsically valuable asset?

It's much the same reason in the late 1990s that the more detached a stock was from its fundamentals, the better. Just off the top of your head, if I asked you which stock would perform better in a huge bull market, a stock with a well established earnings history and reasonably reliable forward earnings projections or a fly by night enterprise with extraordinarily speculative earnings prospects, you would probably choose the former. However, that's not what happens. Instead, when the wind is at their backs in a particular asset class investors turn to the more speculative members of that asset class. Take GE (GE), Cisco (CSCO), JDS Uniphase (JDSU) and Microstrategy (MSTR) in the window of December 1998 through March of 2000. All of these stocks did well and all became quite overvalued, though to far differing degrees.

You can barely see GE's advance there, Cisco returned a very respectable 200% and the other two went nuts with JDSU setting the pace. The last three were all part of the same general play, which was speculation on the growth rate in technology company earnings, while GE was part of the broader bubble in stocks. In order, GE's earnings were the most stable and well known, followed by Cisco, followed by Microstrategy, followed by JDSU. In the earlier days of the bubble, the margin of out-performance of the two trashy stocks was not as large, but it really took off about September-October 1999.

In other words, the trashier the better when a bubble occurs and that would seem to indicate that the surge in silver might be a signal that we are at the apex of a precious metals bubble.

The Reason That Quantitative Easing Won't Cause Massive Inflation

I think that a lot of people who expect that quantitative easing of the amount the Federal Reserve is currently engaging in will lead to a large outbreak of inflation is that they assume that monetary velocity is a constant. We know that, empirically, it is not. If velocity was a constant, increases in money supply would lead to matching increases in nominal GDP, which, if not supported by gains in real output, would lead to a corresponding increase in the price level.

However, in the current environment it appears that the damage to monetary transmission mechanisms was so severe that large increases in money supply simply just sit around and don't actually make their way into the economy. The same thing happened in Japan after their real estate collapse where no amount of easy money policies would cause inflation.

The above chart is related to M1, but here is an alternative measure (MZM) which includes a broader measure of money supply.

Japan had a similar case during its slide into deflation:

This is the nature of a liquidity trap in that no increase in money supply will help because all that will happen is that velocity will continue to drop as there is no demand for money. If velocity drops by amounts sufficient to offset the increase in money supply, no inflation will occur. As of right now, this pattern seems to be holding.

On the Fed's Lending to Financial Institutions

I was forwarded this link today: http://www.thinkbigworksmall.com/mypage/archive/1/55002/

I think one of the misconceptions in most discussions of the Fed's interventions during the financial crisis was that they simply handed this money out and it was never heard from again. In some cases that was what happened, but for the vast bulk of it these were short term liquidity facilities that were repaid in short order. This isn't as though the U.S. Treasury issued $3.3 trillion in bonds, wrote checks to a long list of domestic and foreign institutions, and sent them out.

The overall size of the Fed's interventions was a function of the magnitude of the crisis, which paralyzed nearly every conventional lending channel during the worst of the panic. The Fed stepped into the breach and lent out money in a nearly panicked way in which it seems that it extended aid to all comers. Having followed the credit markets very closely at the time, they were so broken that municipal issuers even couldn't take their issues to market reliably, which is actually astounding. In that environment, it is easy to understand how vast amounts of Fed lending occurred.

As far as the lending to foreign institutions, the financial crisis not only paralyzed markets here, but around the world. The Fed is one of the few institutions (the only other two being the ECB and the Bank of Japan) with the resources necessary to backstop not only our own financial markets, but those around the world. As to whether or not it should be in this role, that is a legitimate discussion, but it is also one that inevitably ends in the argument that it was necessary. I'm not sure that those that have it in for the Fed will ever fully appreciate just what we were facing back in late 2008. Not every action undertaken by the Fed or the Treasury was necessary or correctly handled to be sure, but I'm willing to give a pass on the errors given the alternative.

In general, these nominal numbers get thrown around as if there was a transfer of that magnitude to executive compensation of these banks or to the bottom lines of those institutions. Nothing of the sort happened. I remember when there were headlines that combined the value of the guarantees issued on deposits with the short term lending facilities of the Fed and the value of TARP to arrive at a $13 trillion bailout. The next logical thing for people to say was "They've taken out $13 trillion of the taxpayers' money and given it to the banks!". None of that was the case, but it made for good outrage. That being said, I'm all for questions being asked over why specific loans were approved. That's fine and we may find cases where the Fed was in error and their internal control procedures failed. I have nothing against that. However, looking at the totality of the Fed's actions, I do not find fault with them.

Now, on a somewhat related issue, that is not to say that the approach taken in the aftermath of those dark days has been sound. The lack of fundamental reform has been disheartening and there were very weak efforts to ensure that the emergency relief would be used entirely for the preservation of the firms rather than the enrich the executives of those firms at the same time. Frankly, all officers of every firm that got assistance should have gotten nearly zero pay and been forced to pay back their bonuses for prior years since they clearly did not deserve that compensation. To some extent, this is the fault of hopelessly complacent shareholders who accept every proposal from the board of directors without question. However, given that our government and others had to provide such massive assistance both through the central banks and through programs such as TARP (which has to be viewed separately), the onus falls on them and the taxpayers to demand concessions and inevitably that did not happen.

It could be argued that because the Fed got us through the worst of the crisis and avoided complete disaster, we no longer have the leverage to make the changes that were needed and the impetus for true reform has been lost. In the meantime, it appears that the anger of a public increasingly weary from recession and high joblessness is being misdirected at the institution that saved the world from utter collapse rather than the actors who caused the world to get to that point in the first place.

Well, looks like we avoided a sharp fiscal contraction

http://www.nytimes.com/2010/12/07/us/politics/07cong.html?partner=rss&emc=rss

That payroll tax cut in particular is an immensely expensive, and therefore stimulative, provision. On the other hand, all talk about a sharp fiscal contraction to be more fiscally responsible just went right out the window. This is a statement by the US Congress that they do not give a damn about the deficit.

The good news is that this lays the groundwork for a decent year economically next year. That payroll tax cut provides some real oomph for consumer spending and to businesses. I'll be curious about the impact on the Social Security trust fund, but that's another discussion. Of course, this raises my concerns about the long term deficit and debt picture. Tax rate reductions are more permanent in their fiscal effect than spending increases. Spending can much more easily be frozen at current levels than tax rates can be increased. In that sense, it is much easier to work off the deficit impact of spending measures than tax rate cuts.

Tax rates will have to be revisited soon if there is to be any serious discussion of the deficit.

The Bear Market That Wasn't...(Yet)

Bloomberg has an interesting article on how, despite seemingly bad signals for equities ranging from a slow economy to an entire continent teetering on the edge of disaster, the great bear market of 2010 didn't happen.

Many might think that this is a bubble or out of line by some measure, but the reason stocks have done well is that, fundamentally, they are quite cheap. That was what provided a good underlying bid for most of the year. That, and the fact that there are very few alternatives. You can earn almost as much in blue chip stocks just on dividends as you can on U.S. treasuries.

Now that this headline is out there, we are probably destined for a collapse, but at least it didn't happen in 2010.

Stocks and Inflation

Just a real quick point about stocks and inflation because I saw an article yesterday about how you don't want to own stocks during periods of high inflation.

First off, inflation still is not anywhere on the horizon. Until there is wage inflation, there can't be any real outbreak of inflation. Anything else that occurs will be transitory. Second, stocks are priced in nominal dollars because their earnings are based on nominal dollars. This means that, all other things being constant, stocks should actually rise as a result of inflation in the long run. However, because all things are not constant, interest rates rise in the short run, which compresses the multiple that stocks can command. This is what happened during the 1970s. Corporate earnings grew quite a bit, actually, but interest rates nearly tripled during the decade.

Once the inflation subsides and interest rates drop, stocks' multiples expand on a larger earnings base. This is, to a large extent, why the 1980s were so good for stocks, particularly in the first two years of the rally. Stocks had gotten ridiculously cheap and the decline in interest rates starting in 1982 helped to provide for a robust multiple expansion.

The upshot of this is that in the long run, stocks are as much an inflation hedge as any other asset can possibly be. In the short run, however, they can take a hit due to interest rate surges. Still, this is purely an academic discussion since inflation is not a threat. Incidentally, yes, deflation is uniformly bad for stock prices.