Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Saturday, March 26, 2011

What Ails Cisco?

One of the most amazing things about the rally since July is how some of the companies that formed the technology sector's old vanguard have not participated at all. Microsoft (MSFT), Intel (INTC), and Cisco (CSCO) have all been tremendous dogs, trailing the S&P 500 and their fellow tech brethren by wide margins over that period. In particular, Cisco has been atrocious.

I need do little more than put this chart before you all:

Cisco is normally a company one would associate with participating in a broad-based recovery in IT expenditures, but it hasn't. Earnings are up, yes, but investors are less than impressed. Every single earnings report in the last year has led to a significant sell-off in the stock. Click on the image above to see the little green arrows indicating earnings releases. A couple of interesting trends you will notice are the following:

1. All releases are preceded by rallies in anticipation of the results.
2. Each pre-release peak is lower than the one before it (more or less)

I think that what we are generally seeing is a reflection of analysts doing a good job of hyping the stock, long  a darling of the community, without really doing their homework. Cisco is an "overweight" by analyst consensus, meaning that they expect it to outperform the market. They have kept this rating for... well, as long as I can remember. I think that the stock is, only partially, the victim of a lousy expectations management game. In addition, their enterprise business is being badly damaged by cutbacks in public IT expenditures as part of ongoing budget stress. Their home networking business should be doing reasonably well, but unlike a pure play like Netgear (NTGR), the business has relatively little impact on their earnings.

That being said, Cisco is beginning to look awfully cheap at very low double-digit PE multiples, a discount to the overall market. Even a bad stock begins to look good when it drops enough. Still, one has to wonder if the ongoing multiple compression here represents something more ominous for Cisco.

Mortgage Insurers Hit a Wall

We have examined, on a few different occasions, the possibility of a recovery for mortgage bond insurers including MBIA (MBI), MGIC (MTG), and PMI (PMI). At one point, back in July, I recommended MGIC as being among the "best" of what was admittedly a shoddy group with MBIA on its heels. The rest I wasn't so sure of to put it mildly. As it turns out, MBIA and MGIC have been the better performers, in that order, but the sector in general has lagged the market. You didn't get killed by playing either of these, but you did underperform an impressive recovery in the broad market.

This is a little surprising at first blush because it would appear that the sector's fundamentals are improving. However, the simple fact is that the stocks had already priced in simple survival and were already looking ahead to meaningful improvement in earnings and balance sheets to justify more than just a dead cat bounce. Though reports have been encouraging with respect to survival, neither MBIA nor MGIC have shown much indication of sustained growth that would propel the stock prices beyond where they are right now. The fact that there is no sustained recovery in housing in the future to improve originations and that a renewed price decline may increase defaults seems to be what keeps these stocks under wraps.

Perhaps the proper analogy for these stocks can be found in the home builders like Toll Brothers (TOL) and D.R. Horton (DHI) that cratered early on, recovered a little bit, and have now stayed there, forever hampered by the nasty overhang of the housing bubble. I think, in both cases, that a recovery from "death" pricing to "survival" pricing may be all that you get for a while.

Wednesday, March 16, 2011

Japanese Markets Tumble Again

After a decent sized gain yesterday, the Nikkei is down over 2% again as of the time of this posting. As bad as the news is regarding the nuclear situation there, I am surprised it is not worse. I'm not sure that this is the market reflecting better information than we are getting out of the press or if it is simply that, after some serious declines earlier in the week, the market is as low as it will go. I'm not prepared to test that particular proposition yet, but I think it bears watching.

One thing that has surprised me in all of this is that the yen has actually strengthened and not weakened. I saw a couple of articles suggesting that Japanese residents and institutions would start repatriating funds rather than seeking to park their money oversees because they need those funds to pay for damages. Apparently that is at work here. It is what I would call a secondary effect where the primary effect of market weakness pushing the yen down gave way to the actual mechanical action of domestic Japanese investors redeeming oversees assets.

The real economic effects are still being assessed at this point and they are difficult to fully quantify. Obviously, there are the losses to insurers, which are being quoted at around $25 billion. Disruptions for various electronic component manufacturers are another source of significant strain. Of course, Japanese consumer confidence is going to be seriously depressed, and rightfully so, after seeing such horrors unleashed on them by a merciless earth. Similarly, the already clammed up Japanese business community is unlikely to unleash its purchasing power either. Those are all in the short term and are unavoidable. However, I would generally say that nations tend to recover from these sorts of incidents more rapidly and more vigorously than most predict. The one caveat here is that serious nuclear contamination is a different animal and it is very difficult to quantify those economic effects. As long as the situation remains (relatively) contained, it will not seriously hamper the recovery. At this point, all we can do is pray for those working in and near the reactor to subdue the situation there. Those workers are the bravest individuals in the entire world at the moment.

Sunday, March 13, 2011

Larry Kudlow Was Right, But Very Wrong

The human toll from the Japanese earthquake is indeed far worse than the economic toll, though we should not be grateful for that. I would have rather $250 billion in property be destroyed and supply chains for global commerce ruined for months than see 10,000+ people die.

That being said, while it is crass to speculate on the effects on Japanese markets, I shall do so anyway. Due to both weakness in the underlying markets and the yen, Japanese stocks will be a poor investment in the short run. However, barring a much worse than expected nuclear incident, Japanese stocks will present a good buying opportunity for those who do not have qualms on speculation in such incidents. The sell-off has been and will continue to be fairly uniform as will be the inevitable short-term recovery and EWJ is a decent way to play that after a few more days. Unfortunately, Japan still has serious long-term structural issues that need resolving and the debt incurred as a necessary expense to rebuild from this disaster will only make matters worse. Hopefully, the international community will not simply leave Japan to its own devices because it is a "rich" country.

I do not endorse this form of speculation as I generally find it distasteful, but in case anyone has the urge to do so, that is my best guess at the moment.

Government Compensation's Effect on Private Sector Compensation

You might scoff at the very notion that there is an effect, unless you have an understanding of economics. I assure you that what follows is not just because I work in government, but it is in the spirit of good analysis.

It is useful to think of the labor market as being two discrete parts: a public sector and a private sector. This is a gross oversimplification as there are sub-sectors in each that are more numerous than a blog post can readily accommodate as a forum for discussion, but it will serve our purposes. The demand schedules for labor in both are driven by the demand for their services as well as the ability of both to compensate workers for those services. Nothing earth shattering there. Their supply schedules, too are fairly similar, and they are functions of each other to a certain extent.

To explain that point a little more clearly, it can be fairly reasonably said that if public sector compensation is increased, all other things being held constant, that workers at the margin will go to the public sector instead of the private sector. In that shift, what you will see is that the marginal workers that shift from the private sector to the public sector are of a talent level that the private sector would otherwise liked to have had, assuming both markets were in equilibrium previously. In order to secure the same quality of labor that the private sector had previously, private firms, on average, will increase wages to drive a shift in labor supply back to the private sector. Conversely, a decline in government compensation that is determined exogenously (by elected officials, for example) will shift the labor supply for government in while shifting the labor supply for the private sector out, which reduces wages in the private sector.

The illustration of this is fairly simple in the event of an exogenous reduction in public sector compensation (CLICK ON PICTURE FOR LARGER IMAGE):

Some might say that a reduction in public sector wages will simply reduce the amount of labor supplied in the public sector and there will be no additional bleed-over. The problem with that is that labor supply is not all that elastic. It's part of the reason that tax cuts don't generate more revenue than they cost and why tax increases actually do raise revenue. In extreme cases of, say, a 90% tax increase or a 50% wage cut, you will see the supply of labor decline. Interestingly, it is unlikely that private sector employers would increase their demand for labor since the primary determinants remain mostly unchanged.

As I said at the outset, this is fairly over-simplified as there are a lot of little nuances here and there. For instance, many in the public sector are trained in fields that do not have, in the terms of private sector human resources advisors, "transferable" skills to the private sector. For instance, fire fighters and teachers both would have a difficult time finding equivalent private sector jobs, though teachers would find a narrow number of opportunities in private sector schools. As such, many public sector workers may have a difficult time switching between the two sectors.

The long and the short of it is that the recent efforts to roll back public sector compensation at nearly all levels will likely further add to the deflationary tendencies in the labor markets that exist right now.

Thursday, March 10, 2011

Beware USO For Long-term Holdings

One of the popular oil plays is the ETF USO, which is the U.S. Oil Fund. Basically, it is meant to track the price of oil itself, rather than derivative stock plays. Sounds good, right? Well, the problem is, like with many ETFs that track commodities, it doesn't really get the job done the way you think it might. 

So, oil is approximately 2/3s as high as it was at the peak in 2008. USO is at, oh, about 1/3 of the price. Due to the vagaries of how ETFs are often priced, these things don't track how they should over the long-term. You will see, however, that the long-term tracking issues have not dissuaded investors from piling into USO recently as seen by the volume spike. If you feel compelled to speculate on Middle East stability, this is fine in the short run, but bail as soon as you hit a target price, if you are so lucky. 

More Nonsense About Public Pensions


What follows does not represent the views of the State of Wisconsin, the Department of Administration, or the State Budget Office. 

Let me be blunt. Joshua Rauh, the Northwestern University professor behind nearly all of the scare-mongering on public pensions, is a malignant tumor and a fairly heavily metastasized one at that. His basic premise has been that public pensions are much more poorly funded than they look because they use unrealistic assumptions about rates of return. He claims that you should use a risk free rate of return, rather than a balanced portfolio's rate of return (historically nearly 8%), to discount future pension liabilities. For the uninitiated, discounting future liabilities at a lower interest rate makes your future liabilities a good deal larger. 

His real claim to fame was an article he published, along with a University of Chicago professor, at the pits of the stock market's decline in the most recent bear market where assets of the pensions funds were measured at fair market value (artificially depressed by nearly 50%) and compared it to liabilities discounted using 10-year treasury rates at the time (roughly 3.5%). I'm not actually sure that I need to explain what is wrong with this, but I will anyway because it actually offended me. In essence, what he did was take an artificially depressed portfolio and then assume an artificially low return from an artificially low level and say "My God! These things are horribly underfunded!". I would actually be curious what the fair market value measures would look like right now.

In any case, we all know that the assets of these funds have recovered sharply. That is evident in the Federal Reserve's Flow of Funds Report. Since Q1 2009, the assets of state and local government pension funds have recovered nearly $800 billion, or over 35%. What is more troubling is his bizarre assertion that pension liabilities should be discounted at a risk free rate of return. My simple response is: Why? That actually makes no sense. Why should long term assets be discounted at a rate that would only make sense if we expected to need them at short notice? His choice quote is “If you don’t want to count on the stock market to pay for all this, this is what you’re going to have to contribute.”. All I have to say is "Huh?!".

I wonder what the "unfunded liabilities" of 401(k)s look like if you compare current balances to future liabilities (i.e. your retirement expenses) if you discount them back at 10-year treasury rates. They are absolutely dependent on stock market returns after all. All of these plans rely on the stock market. Nothing else provides the returns reliably enough (yeah, I know what the response to this is). No person earning up through an upper middle class income could possibly afford to save enough through fixed income securities, even if they lived like a monk. If Rauh was honest, that's what he would say, but he doesn't. 

Wednesday, March 9, 2011

I'm not sure that these people care about the price of gasoline


I always love to thumb through this list to see if there are some executives of companies that have not been performing too well on here. Michael Dell jumps out. That he has almost $15 billion is a crime considering that stock performance. There are also always the Walton kids who simply won the genetic roll of the dice. Rupert Murdoch hasn't delivered much to his shareholders in nearly 20 years and yet still seems to do just fine, somehow.

The other thing I always find amazing on these lists are the numbers of brothers, twins, or other relations that pop up. There are the Kochs, Ziffs, Waltons, and Strungmmanns among others.

Then, of course, there is my personal favorite, which is George Lucas, sitting atop his $3.2 billion. Frankly, I think he should take about half of that and reimburse people for seeing his awful prequel trilogy, but we all decided to pay him the price of admission... and the price of the DVDs... and the price of various computer and video games. Okay, he deserves every dime he has. The man's a genius at making money.

Silver Blowing Away Gold (Again)

With geopolitical instability continuing to be a pressing issue, it is no surprise that the previous metals are performing well once again. As was the case a few months ago, silver continues to trounce gold.

About 90% of the time, in speculative markets you will find that the "lesser" product outperforms. 

Sunday, March 6, 2011

Asset Allocation Model Update - March 2011

Since we have seen a particularly large run up following the last update of the asset allocation model, I thought it would be wise to assess what it is currently saying while the market seems to have stalled for a bit under the weight of both its own advance and a spike in oil prices due to the Middle East coming apart at the seems. 

While the allocation signal has shifted slightly away from stocks, it has not yet crossed the threshold to indicate that you should start moving into bonds. Part of the reason it has not yet shifted from the 80/20 split that we have seen for more than a year is that bonds yields became so depressed that they still have not normalized even after a serious drubbing since August. Bear in mind, this model is not necessarily a predictor of stock market returns in the aggregate, but rather where you should be positioned in stocks vs bonds. As of right now, it is still giving very favorable readings for stocks, though not nearly as favorable as in the summer of last year.

Incidentally, in July and August of last year, the model registered some of the strongest positive readings for a heavy stock allocation that the model has ever produced. Indeed, the reading given was just as strong as in March of 2009, indicating that stocks were poised to dramatically outperform bonds. 

It is gratifying to know that the big call has panned out correctly, especially since things looked a little hairy at the lows there. Barring dramatic global upheaval, which isn't a great bet these days, I would expect stocks to continue to modestly outperform bonds from now through the end of the year. 

A More Permanent Return

So, thankfully, most of the budget work is out of the way. If you have not been paying attention, Wisconsin's budget has been drawing a bit more controversy than usual this year and, as one of the Governor's budget analysts, my workload has been a bit much. However, we are now past the worst of the crunch and I can get back to my hobbies.