Friday, October 24, 2014

Don't Fight The Fed?

Howard Gold, MarketWatch columnist and founder and editor of GoldenEgg Investing reports, The world’s best market timers: the Federal Reserve:
Things were looking grim last week, especially on Wednesday, when the Dow Jones Industrial Average was at one point down by 460.

The CBOE VIX indicator soared to the mid-20s for the first time in two years. Fear was palpable as investors had a classic panic attack.

But then, like the cavalry in those classic John Ford westerns, the Federal Reserve rode to the rescue.

James Bullard, president of the Federal Reserve Bank of St. Louis, said inflation far below its 2% target could lead the Fed to “go on pause on the taper … and wait until we see how the data shakes out into December.” The Fed is on track to finish “tapering” its extraordinary bond buying, or quantitative easing (QE3), at next week’s meeting.

But, he added: “If the market is right and it’s portending something more serious for the U.S. economy, then the committee would have an option of ramping up QE [in December].”

Boston Fed President Eric Rosengren later said QE3 should end next week, but he could “easily imagine” not raising rates until 2016.

Translation: We’ve got your back. Don’t fight the Fed.

Investors got the message. The S&P 500 Index advanced for three straight days and the VIX fell under 20 again.

Bullard was only the latest Fed official whose words or actions “just happened” to boost the stock market when it was down.

“They are definitely in the market-manipulation business, and nothing has changed,” said James Bianco, president of Bianco Research LLC in Chicago and a longtime student, and critic, of the Fed.

Called the “Greenspan/Bernanke put,” the Fed’s willingness to jump in when stocks fall dates back a quarter-century.

“The put option is back. If the market sells off enough, they will give us QE4,” Bianco told me.

Conspiracy theorists have pinned it on a government “Plunge Protection Team” that wants to keep stocks from crashing at all costs.

But conspiracy or no, consider these actions:

Aug. 31, 2012: In his annual speech in Jackson Hole, Wyo., Fed Chairman Ben S. Bernanke all but announced the third round of QE, extraordinary bond buying of $85 billion a month. The S&P 500, which had languished after a nearly 10% decline, rallied from 1,399 points and hasn’t corrected substantially until now.

Sept. 22, 2011: Following a 19.4% stock sell-off amid a debt crisis in Europe and the U.S., the Fed launched Operation Twist, in which it sold short-term and bought long-term securities to push down long rates. After first slipping, the S&P 500 resumed a multiyear take-off that, with a little help from the Fed, ultimately drove it 80% higher.

Aug. 27, 2010: In another famous Jackson Hole speech, Bernanke vowed the Fed would “do all that it can” and would “provide additional monetary accommodation through unconventional measures if … necessary.” After a 16% correction in the S&P 500, the Fed’s purchase of $600 billion in securities through QE2 would help push stocks 22.8% higher, according to Bianco Research.

Nov. 25, 2008: In the heat of the financial crisis, Bernanke announced the Fed’s first bond-buying program in which it wound up purchasing $1.7 trillion worth of securities. QE helped launch the new bull market and drove the S&P 500 up 50%.

“Three times they put down markers they were going to end QE,” Bianco said. “In all three cases — 20%, 17%, 10% down in the stock market — they reversed.”

As this terrific chart shows, Bianco Research estimates that during all the QEs, stocks rose by 147.5%. Subtracting periods of QE, they lost 27.5%.

Back in the fall of 1998, Alan Greenspan cut rates three times during the Asian/Russian financial crisis and after the bailout of Long-Term Capital Management. That set the stage for the 1990s bull market’s final blow-out phase.

And after the 1987 stock market crash, when the Dow fell 22.6% in a single day, Greenspan’s Fed bought $17 billion worth of bonds (a lot in those days) and declared the central bank ready “to serve as a source of liquidity to support the economic and financial system.” The panic eased and the bull continued for years.

As in 1987, the specter of 1929 still haunts the Fed. “They are afraid of the market going down and they will be blamed,” explained Bianco. If that means “guiding” the stock market, so be it.

Problem is, Congress gave the Fed a mandate to “promote maximum employment, production, and price stability”; it never explicitly authorized propping up stocks. Yet through a remarkable theoretical stretch called the “wealth effect,” that’s exactly what the Fed is doing.

Don’t get me wrong: This bull market reflects a genuine, albeit below-normal, recovery, and the U.S. is much stronger than the rest of the world. The Fed helped by giving the economy time and breathing room.

But the emergency is over and once accumulated, power is not easily shed. If this pattern continues, the U.S. economy and markets will never stand on their own feet again.

This may be the ultimate test for Janet Yellen and could determine whether she’s remembered as a great Fed chair or just another caretaker of a dead-end course if there ever was one.
It's amazing how many people are against quantitative easing (QE) and blame the Fed for distorting markets and exacerbating wealth inequality in the United States and elsewhere.

Some even think the time to fight the Fed has come:
We've had stock bubbles, high-tech bubbles and a real estate bubble. We believed central banks could solve all our problems. But now that last great bubble — faith in central banks — is bursting.

That's what Michael Gayed, chief investment strategist at Pension Partners, argues in an article for MarketWatch.

"Twenty years ago, I'm fairly sure people said 'don't fight the Bank of Japan.' Two months ago, you could have said 'don't fight the European Central Bank,'" Gayed states. "Now, with the Federal Reserve ending quantitative easing as worldwide economic data falters, it appears the time to 'fight the Fed' has come."

Conventional wisdom holds that stock markets collapsed because the Ebola virus scare and stagnant growth in Europe. But this, he says, is not a typical correction.

"Something fundamental has changed in the market's perception," he says, stressing the stocks have fallen and inflation expectations have collapsed even in the face of trillions of dollars of central bank stimulus. "So, what happens if my belief is right that the last great bubble is bursting? It likely means a significant reset could soon occur unless reflation hope kicks in with gusto. Hard to imagine."

Economic growth and a bull market coincide with rising inflation expectations. Yet central banks have been unable to prevent disinflation.

"Fight the Fed? You sure they are going to get that inflation target when the market itself is screaming they won't, at the same time quantitative easing is ending?"

The Treasury Inflation Protected Securities (TIPS) market does indeed suggest that disinflation, which can smother economic growth, may be looming, Reuters reports. Investors have been unloading TIPS, which provide protection against inflation, in recent months, due slowing global economic growth, most notably in Europe, as well as falling oil prices and a strong dollar.

The Consumer Price Index (CPI) dropped unexpectedly last month, setting off disinflation alarm bells and causing TIPS breakevens, which indicate inflation expectations, to sink.

"The CPI definitely set the tone. The stronger dollar and weaker energy prices are definitely having a major impact," Martin Hegarty, co-head of inflation-linked bonds at BlackRock, tells Reuters.

Although the world economy is currently slowing, John Williams, president of the San Francisco Fed, tells Reuters he expects the Fed to raise interest rates in mid-2015. However, it might delay a rate hike if inflation is significantly below its 2 percent target and wages remain stagnant.

"If we don't see any improvement in wages," he explains, "that would be a sign that we still have a lot of slack in the economy and we are not getting any inflationary pressure to move inflation back to 2 percent."
So is Michael Gayed right? Is the Last Great Bubble about to burst? I sure hope not because if markets lose faith in central banks, watch out, we're in for the Mother of all Busts. Unemployment will surge to unprecedented levels, government revenues will plunge and social chaos will ensue.

Go back to read my comment on whether the Fed is prepping markets for more QE where I wrote:
The Fed is basically telling Europe's big banks: "Don't worry about Angela Merkel, Wolfgang Schäuble, and the lack of major QE from the ECB. If they don't act, we will act in a forceful manner allowing you to use our balance sheet to shore up yours."

And that ladies and gentlemen is huge news for markets because it sends a strong message to short sellers salivating at the prospect of a eurozone collapse that the Fed isn't about to stand by and let it happen. Why? Because a eurozone collapse will unleash those deflation demons and ensure the U.S. and rest of the world are heading for a protracted period of debt deflation.

Even the threat of more QE from the Fed is enough to send shivers down short sellers' spines which is why you will likely see risk assets rallying during the second half of October and into year-end. Pay attention here to the ten-year Treasury yield (^TNX), the euro/USD exchange rate, crude oil prices, and small cap stocks (IWM) which have led the rally out of the selloff earlier this week.

As far as stocks, I've said it before, the real risk in the stock market is a melt-up, not a meltdown. We're going to get a massive liquidity rally unlike anything you've ever seen, then you'll need to worry about the massive hangover and protracted debt deflation, which remains my ultimate endgame.
What's the biggest risk to my scenario? A significant crisis of confidence if the Fed actually does engage in more quantitative easing and market participants think it's way behind the deflation curve. That's the scenario that keeps James Bullard and Janet Yellen awake at night but for now, I wouldn't worry about any deep crisis of confidence. 
The key here is whether the market perceives the Fed do be behind the deflation curve, not the inflation curve. As I've repeatedly warned, the real concern is about the Euro deflation crisis and whether it will spread to the United States. For now, global stock markets are not worried, bouncing back vigorously from the latest selloff, but this could change and the future of the eurozone remains very fragile.

In my recent comment on whether it's time to plunge into stocks,  I openly questioned Dallas Fed president Richard Fisher for dismissing the contagion effects from eurozone's deflation crisis and how it's influencing U.S. inflation expectations. 

Importantly, the biggest policy mistake the hawks on the FOMC are making is ignoring global weakness, especially eurozone's weakness, thinking the U.S. domestic economy can withstand any price shock out of Europe. If eurozone and U.S. inflation expectations keep dropping, the Fed will have no choice but to engage in more QE. And if it doesn't, and deflation settles in and markets perceive the Fed as being behind the deflation curve, then there is a real risk of a crisis in confidence which Michael Gayed is warning about. Perhaps this is the real reason why big U.S. banks are loading up on bonds (not just regulatory reasons).

Economists are trained to view inflation as a lagging indicator but in a deflationary environment, inflation becomes a leading indicator. Many will argue against this assertion but this is the biggest risk and I think Bullard and Yellen understand this, which is why the Fed might ease up on QE at their next meeting and leave the door open to more QE down the road.

The basic problem with developed economies today is lack of good paying jobs with benefits and very high public and private debt. In this environment, job insecurity is running high and severe under-employment is masking an even deeper structural problem in the economy. This too is complicating the Fed's decision to raise rates.

So when I listen to overpaid hedge fund gurus lambasting the Fed for engaging in quantitative easing, I roll my eyes and ignore their whining. If the Fed didn't engage in massive QE, more banks would have failed and unemployment would have surged to Great Depression levels. Some think this is a good thing but I can't understand their twisted logic.

As far as the latest rebound in stocks, it's obfuscating many well-known prognosticators. The huge volatility in the stock and bond market is something we better get used to. Forget all your technical and fundamental models, volatility will make mince meat out of them. 

There are two basic scenarios I want you to think about very carefully. First, the U.S. economy keeps growing and will lead the world out of any further weakness. If you believe this, then bet on a big rebound in oil and load up on energy (XLE), oil services (OIH), commodities (GSG) and materials (XLB).  

The second scenario is that eurozone's deflation crisis will continue wreaking havoc on U.S. inflation expectations as the mighty greenback keeps surging. If you believe this, then you will use any rally
in energy (XLE), oil services (OIH), commodities (GSG) and materials (XLB) to shed positions or short these sectors. Some are loading up on utilities (XLU) and REITs (VNQ) for extra yield but I would be careful with all high dividend plays at this stage because in a deflationary environment, some of them will get slaughtered.

Of course, if the Fed does surprise markets and engages in more QE, it will have an impact on interest rates, the U.S. dollar and risk assets across the board. This is where things get tricky and perhaps scary, especially if markets perceive the Fed as being behind the deflation curve.

I end by recommending you read Ted Carmichael's latest looking at whether the rebound in global equities is safe. Ted comments:
The question now is: with equities having rallied back, "Is it Safe?" to take a more aggressive position on risk assets. The answer is probably yes, but still with great caution.
Equities are still overvalued by reliable metrics, although a bit less so than at the end of August. Q3 earnings reports are coming somewhat mixed, but do not yet show signs of any surprising weakness.
Bonds, which were already overvalued in late August, are now more overvalued and are at risk of giving back their recent sharp price gains if US economic data remain on the strong side.
What investors need to be wary of is a series of bond sell-offs which trigger equity sell-offs. This would be the reverse of the pattern witnessed throughout the period of increasingly accommodative monetary policy as measured by the growth of the balance sheets of the US Fed and other major central banks.
I understand Ted's concerns but if deflation creeps into the system, bonds are most certainly not overvalued. They will be the only asset class that protects you from massive deleveraging. 

As far whether this rebound is safe, it really depends on which sectors we're talking about. For now, I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI). I don't see any evidence that the "Last Great Bubble" is about to burst and I still think you're better off sticking with the old adage "Don't fight the Fed."

Below, hedge fund manager Kyle Bass warns the end of QE will shake up markets. I wouldn't bet on any end to QE and think the real fireworks will come if there is more QE down the road. I also posted
a clip of Dustin Hoffman and Laurence Olivier in the movie Marathon Man (h/t, Ted Carmichael).

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Thursday, October 23, 2014

A New Pan-European Pension Fund?

Theodore Economou, the CEO and CIO of the CERN Pension, sent me an announcement a few weeks ago from Europa, New pan-European pension fund to boost researcher mobility:
Mobility of researchers in Europe received a boost today with the launch of a consortium that aims to establish a new pan-European pension arrangement. Once put in place, the RESAVER initiative would mean that researchers could move freely without having to worry about preserving their supplementary pension benefits.

The consortium plans to set up the pension arrangement in 2015. It will enable researchers to remain affiliated to the same pension fund, even when changing jobs and moving between different countries. The European Commission will cover the initial set up costs through a four-year framework contract that will be awarded before the end of 2014.

The consortium will be working as an international not-for-profit association registered in Belgium. The founding members are: Central European University Budapest; Central European Research Infrastructure Consortium (CERIC-ERIC); Elettra - Sincrotrone Trieste S.C.p.A; Fondazione Edmund Mach; Istituto Italiano di Tecnologia; Technical University of Vienna; and the Association of universities in the Netherlands (VSNU).

European Commissioner for Research, Innovation and Science Máire Geoghegan-Quinn said: "We have worked hard to boost the free movement of knowledge in Europe. Our €80 billion research and innovation programme Horizon 2020 was built with this in mind. Pensions are a serious barrier to free movement, but today that barrier has begun to crumble. I strongly encourage research organisations across Europe to join the consortium."

By participating in RESAVER, employers will be able to sponsor one single pension arrangement. It will be a highly flexible retirement savings product that corresponds to the specific needs of the research community, and is capable of delivering:
  • cross-border pooling of pension plans;
  • continuity of the accumulation of pension benefits as professionals move between different organisations and countries during their career;
  • lower overhead costs (and therefore improved member benefits) through economies of scale;
  • a pan-European risk pooling solution.
The fund will help get closer to the European Research Area (ERA), a true 'single market for research'. The second ERA Progress Report, published on 16 September 2014 (IP/14/1003), confirmed that researcher mobility has serious benefits. For example, the research impact of researchers who have moved between countries is nearly 20% higher than those who have not. They generate more knowledge, which in turn means bigger benefits to the economy.


Mobility of researchers is a driver of excellence in research. Nevertheless, researchers currently face many difficulties in preserving their supplementary pension benefits when moving between different countries. To overcome this problem, the European Commission conducted a feasibility study in 2010 on a Pan-European pension arrangement for researchers. Following the feasibility study, the Commission's Directorate-General for Research and Innovation invited a group of interested employers and employer representatives to prepare the ground for the establishment of what has become known as “Retirement Savings Vehicle for European Research Institutions” or RESAVER.

The initiative was singled out as a priority in the 2012 Communication on ERA, in which the European Commission committed itself to "support stakeholders in setting up pan-European supplementary pension fund(s) for researchers".
I thank Theodore Economou, CEO and CIO of the CERN Pension, for bringing this new pan-European pension fund to my attention.

Theodore sent me his comments along with the press release:
This is actually quite big news in the European pension landscape. For the first time, there is a perspective that a worker moving from one EU country to another could actually stay in the same pension plan. Something considered normal in the US or Canada when moving from one state/province to another, could become a reality in Europe (albeit this particular pension plan would be limited to a certain group of employers, in order to comply with practice in several European countries where pension arrangements are organized by trade).

Note that I’m obviously biased because for the past two years, I was the secretary of the task force that developed a proposal for the establishment of this pension fund.
Well, I can't think of a better person to lead such a task force. Theodore is an exceptionally bright pension fund manager who runs the CERN Pension like a global macro fund.

I welcome this new initiative as it bolsters my case for enhancing the Canada Pension Plan (CPP) for all Canadians. As I recently stated in my comment on the brutal truth on DC plans:
In my ideal world, you won't have the bcIMC, Caisse, OTPP, PSP, AIMCo, HOOPP or Bombardier, CN, Bell, Air Canada pension plans. You will only have large, well-governed public defined-benefit plans managing the assets and liabilities of all Canadians regardless of whether they work in the public or private sector. If we achieve such a monumental undertaking, we will significantly lower investment and administrative costs and do away with the issue of pension portability once and for all because people will move across public and private sector jobs knowing their pensions are safe and secure, backed by the full faith and credit of the federal government.
I stand by those comments and that's why I think this new pan-European pension fund is a very smart initiative. The only thing that worries me is the Euro deflation crisis and whether it will spread to the United States. For now, global stock markets are not worried, bouncing back vigorously from the latest selloff, but this could change and the future of the eurozone remains very fragile.

Below, I end with Prime Minister Stephen Harper's address to the nation following the attack on Parliament Hill in Ottawa where Nathan Cirrilo, a member of the Canadian Forces, was shot dead. Prime Minister Harper also addressed the House of Commons this morning in a remarkable and personal speech which ended by him thanking Kevin Vickers, Canada's Sergeant-at-Arms who shot the perpetrator dead, and by him embracing the two leaders of the opposition (watch clip below).

My thoughts and prayers go out to Cpl. Nathan Cirillo's family. The world is not a safe place but Mr. Harper and the leaders of the opposition are right, Canadians will never be intimidated and we will move on.

Wednesday, October 22, 2014

No More Irish Pensions?

Dominic Coyle of the Irish Times reports, Warning retired Irish workers not guaranteed State pension:
Irish workers cannot be sure of receiving a State pension in retirement in future generations, according to a report published this morning.

The cost of existing hidden state pension liabilities are estimated by the Pensions Authority to be €440 billion – more than double the €203 billion national debt estimate for the end of this year, a figure that already amounts to 111 per cent of GDP and requires significant reduction under European budgetary rules.

That raises doubts about the sustainability of the State pension promise, the Irish Association of Pension Funds annual benefit conference will hear today.

A study of 25 state pension systems by the Australian Centre for Financial Studies and Mercer finds that Ireland’s State pension is among the best in the world in terms of adequacy. However, Ireland’s overall score is dragged down by doubts over its sustainability, where it is ranked just 20th of 25 countries.

It is the first time that Ireland has been included in the study.

Overall, Ireland is ranked 11th of the countries surveyed in the Melbourne Mercer Global Pension Index (MMGPI) with a “score” of 62.2.

This compares to the 82.4 awarded to Denmark, which is seen as having a well-funded system, giving good coverage, a high level of assets and contributions, adequate benefits and a parallel private pension system with developed regulation.

Australia and the Netherlands are seen as having the next best state pension provision.

Ireland scores well above Denmark on adequacy - second best overall behind Australia – but dramatically poorer for sustainability, a measure that assesses the likelihood that the system will be able to provide promised benefits into the future. It ranks 15th in terms of system integrity.

Ireland is seen as on a par with Germany’s state pension system and ahead of the United States, but behind Britain.

“The Melbourne Mercer findings highlight that future generations cannot be sure of receiving a State pension [in Ireland] in line with current levels,” said Peter Burke, DC consultant at mercer who presented the findings.

“Now is the time to reform the pension system so as to reduce the risk of future pensioners facing poverty,” he said, urging the introduction of an auto-enrolment system for current workers.

Alongside suggestions that Ireland might increase occupational pension scheme coverage and introduce a minimum level of private sector pension saving, the Melbourne Mercer study says working age adults in Ireland should enjoy greater protection for their pension savings in the event of company insolvency. It also proposes that companies should be restricted more tightly in the level of in-house assets held by occupational pension schemes.

The index attributed a 40 per cent weighting to adequacy, 35 per cent to sustainability and 25 per cent to issues around integrity.
You can read the Melbourne Mercer Global Pension Index 2014 report here. All previous reports are available here.

What are my thoughts? I take the annual Melbourne Mercer Global Pension Index report with a grain of salt and use the information as describing the symptoms of a deep systemic crisis that policymakers have largely ignored. The weighting of the index is somewhat biased and doesn't represent the real strengths and weaknesses of various pension systems.

More critically, the report offers little in terms of improving global pension systems. I have firm views on what developed economies need to do to significantly improve their pension system. First, they need to admit that defined-contribution (DC) plans are an abysmal failure that will exacerbate pension poverty. The brutal truth on DC plans is they're not pension plans, they're savings plans which leave individuals vulnerable to the vagaries of public markets, thus exposing them to pension poverty if they retire during a bear market.

Second, we need to move beyond public sector pension envy and realize the benefits of going Dutch on pensions. Importantly, the benefits of defined-benefit (DB) plans are grossly underestimated for the overall economy which is a shame because as more and more people retire due to the demographic shift, they will face a new retirement reality that will severely constrain their spending and add more pressure on public finances as social welfare costs skyrocket.

Are public pensions perfect? Of course not. We need to introduce reforms implementing logical changes that reflect the fact that people are living longer and we need to introduce risk-sharing so these plans are sustainable over many years. In the United States, they need to introduce major reforms to their governance so public pensions can operate at arms-length from state governments.

As far as Ireland is concerned, four years ago I wrote a comment on why the luck of the Irish is running out, lambasting their government for using pension money to shore up Irish banks. That's exactly the type of governance which will bleed public pension funds dry!

Finally, there are no guarantees in life. When I was 26 years old, I was visiting New York City with a buddy of mine when all of a sudden I got a weird feeling under my feet. I was diagnosed with Multiple Sclerosis and it hit me like a ton of bricks, forever changing my outlook and perspective on life.

When I hear civil servants at municipal, provincial and federal agencies in Canada talk about their "constitutional right to a pension," I remind them that what is going on in Greece can happen here. And if it does, the bond market will determine their pension benefits, not the constitution (if you don't believe me, ask Greek pensioners, civil servants and private sector workers).

A lot of people roll their eyes when I say this but they're living in Fantasyland if they think their pensions are guaranteed no matter what. I'm all for universal public pensions for every citizen but let's get the governance and risk-sharing right or else the math won't add up and these pensions will implode.

Below, David Knox of Mercer's Melbourne Office discusses the findings from their global survey on pensions and the lessons we can take from Australia. I'm highly skeptical of lessons from Down Under and think Canada has the potential to surpass Australia if we bolster our public plans for all Canadians (ie. enhance the CPP!!).

Tuesday, October 21, 2014

Behind Private Equity's Iron Curtain?

Gretchen Morgenson of the New York Times reports, Behind Private Equity's Curtain:
From New York to California, Wisconsin to Texas, hundreds of thousands of teachers, firefighters, police officers and other public employees are relying on their pensions for financial security.

Private equity firms are relying on their pensions, too. Over the last 10 years, pension funds have piled into private equity buyout funds. But in exchange for what they hope will be hefty returns, many pension funds have signed onto a kind of omerta, or code of silence, about the terms of the funds’ investments.

Consider a recent legal battle involving the Carlyle Group.

In August, Carlyle settled a lawsuit contending that it and other large buyout firms had colluded to suppress the share prices of companies they were acquiring. The lawsuit ensnared some big names in private equity — Bain Capital, Kohlberg Kravis Roberts and TPG, as well as Carlyle — but one by one the firms settled, without admitting wrongdoing. Carlyle agreed to pay $115 million in the settlement. But the firm didn’t shoulder those costs. Nor did Carlyle executives or shareholders.

Instead, investors in Carlyle Partners IV, a $7.8 billion buyout fund started in 2004, will bear the settlement costs that are not covered by insurance. Those investors include retired state and city employees in California, Illinois, Louisiana, Ohio, Texas and 10 other states. Five New York City and state pensions are among them.

The retirees — and people who are currently working but have accrued benefits in those pension funds — probably don’t know that they are responsible for these costs. It would be very hard for them to find out: Their legal obligations are detailed in private equity documents that are confidential and off limits to pensioners and others interested in seeing them.

Maintaining confidentiality in private equity agreements is imperative, said Christopher W. Ullman, a Carlyle spokesman. In a statement, he said disclosure “would cause substantial competitive harm.” He added: “These are voluntarily negotiated agreements between sophisticated investors advised by skilled legal counsel. The agreements and other relevant information about the funds are available to federal regulators and auditors.”

Mr. Ullman declined to discuss why Carlyle’s fund investors were being charged for the settlement. But at least one pension fund supervisor is unhappy about the requirement that municipal employees and retirees pay part of that settlement cost.

“This is an overreach on Carlyle’s part, and frankly it violates the spirit of the indemnification clause of our contract,” said Scott M. Stringer, the New York City comptroller, who oversees the three city pension funds involved in the Carlyle deal. Mr. Stringer was not comptroller when the Carlyle investment was made.

Private equity firms now manage $3.5 trillion in assets. The firms overseeing these funds borrow money or raise it from investors to buy troubled or inefficient companies. Then they try to turn the companies around and sell at a profit.

For much of the last decade, private equity funds have been a great investment. For the 10 years ended in March 2014, private equity generated returns of 17.3 percent, annualized, according to Preqin, an alternative-investment research firm. That compares with 7.4 percent for the Standard & Poor’s 500-stock index.

More recently, however, a simple investment in the broad stock market trounced private equity. For the five years through March, for example, private equity funds returned 14.7 percent, annualized, compared with 21.2 percent for the S.&.P. 500. One-year and three-year returns in private equity have also lagged.

Nonetheless, pension funds have jumped into these investments. Last year, 10 percent of public pension fund assets, or $260 billion, was invested in private equity, according to Cliffwater, a research firm. That was up from $241 billion in 2012.

But the terms of these deals — including what investors pay to participate in them — are hidden from view despite open-records laws requiring transparency from state governments, including the agencies that supervise public pensions.

Private equity giants like the Blackstone Group, TPG and Carlyle say that divulging the details of their agreements with investors would reveal trade secrets. Pension funds also refuse to disclose these documents, saying that if they were to release them, private equity firms would bar them from future investment opportunities.

The California Public Employees’ Retirement System, known as Calpers, is the nation’s largest pension fund, with $300 billion in assets. In a statement, Calpers said it “accepts the confidentiality requirements of limited partnership agreements to facilitate investments with private equity general partners, who otherwise may not be willing to do business with Calpers.”

But critics say that without full disclosure, it’s impossible to know the true costs and risks of the investments.

“Hundreds of billions of public pension dollars have essentially been moved into secrecy accounts,” said Edward A.H. Siedle, a former lawyer for the Securities and Exchange Commission who, through his Benchmark Financial Services firm in Ocean Ridge, Fla., investigates money managers. “These documents are basically legal boilerplate, but it’s very damning legal boilerplate that sums up the fact that they are the highest-risk, highest-fee products ever devised by Wall Street.”

Retirees whose pension funds invest in private equity funds are being harmed by this secrecy, Mr. Siedle said. By keeping these agreements under wraps, pensioners cannot know some important facts — for example, that a private equity firm may not always operate as a fiduciary on their behalf. Also hidden is the full panoply of fees that investors are actually paying as well as the terms dictating how much they are to receive after a fund closes down.

A full airing of private equity agreements and their effects on pensioners is past due, some state officials contend. The urgency increased this year, these officials say, after the S.E.C. began speaking out about improper practices and fees it had uncovered at many private equity firms.

One state official who has called for more transparency in private equity arrangements is Nathan A. Baskerville, a Democratic state representative from Vance County, N.C., in the north-central part of the state. In the spring, he supported a bipartisan bill that would have required Janet Cowell, the North Carolina state treasurer, to disclose all fees and relevant documents involving the state’s private equity investments. The $90 billion Teachers’ and State Employees’ Retirement System pension has almost 6 percent of its funds in private equity deals.

The transparency bill did not pass the General Assembly before it adjourned for the summer. Mr. Baskerville says he intends to revive the bill early next year.

“Fees are not trade secrets,” he said. “It’s entirely reasonable for us to know what we’re paying.”

Reams of Redactions

It might help investors to know the fees they are paying, but when it comes to private equity, it’s hard to find out.

Consider the Teachers’ Retirement System of Louisiana, which holds the retirement savings of 160,000 teachers and retirees. It invested in a buyout fund called Carlyle Partners V, which was Carlyle’s biggest domestic offering ever, raising $13.7 billion in 2007. Companies acquired by its managers included HCR ManorCare, a nursing home operator; Beats Electronics, the headphone maker that was recently sold to Apple for $3 billion; and Getty Images, a photo and video archive.

Earlier this year, The New York Times made an open-records request to that pension system for a copy of the limited partnership agreement with the Carlyle fund. In response, the pension sent a heavily redacted document — 108 of its 141 pages were either entirely or mostly blacked out. Carlyle ordered the redactions, according to Lisa Honore, the pension’s public information director.

The Times also obtained an unredacted version of the Carlyle V partnership agreement. Comparing the two documents brings into focus what private equity firms are keeping from public view.

Many of the blacked-out sections cover banalities that could hardly be considered trade secrets. The document redacted the dates of the fund’s fiscal year (the calendar year starting when the deal closed), when investors must pay the management fee to the fund’s operators (each Jan. 1 and July 1), and the name of the fund’s counsel (Simpson Thacher & Bartlett).

But other redactions go to the heart of the fund’s economics. They include all the fees investors pay to participate in the fund, as well as how much they will receive over all from the investment. The terms of that second provision, known as a clawback, determine how much money investors will get after the fund is wound down.

In the Louisiana pension fund’s version of the partnership agreement, that section was blacked out. But the clean copy discloses an important provision reducing the amount to be paid to investors.

In order to calculate their total investment returns generated by private equity deals, outside investors must wait until all the companies held in these portfolios have been sold. Any profits above and beyond the 20 percent taken by the general partners overseeing the private equity firms are considered excess gains and are supposed to be returned to investors.

But the Carlyle agreement includes language stating that general partners must return to investors only the after-tax amount of any excess gains. Assuming a 40 percent tax rate, this means that if general partners in the fund each received $2 million in excess distributions, they would have to repay the investors only $1.2 million each. That’s bad news for the funds’ investors: They would lose out on $800,000 in repayments for each partner.

Mr. Ullman of Carlyle declined to comment on this provision.

Also blacked out in the Carlyle V agreement is a section on who will pay legal costs associated with fund operations. First on the hook are companies bought by the fund and held in its portfolio, the unredacted agreement says. That essentially makes investors pay, because money taken from portfolio companies is ultimately extracted from the funds’ investors.

But if for some reason those portfolio companies cannot pay, the Carlyle V document says, investors will be asked to cover the remaining expenses. This may require an investor to return money already received — such as excess returns — after a fund has closed, the agreement explains. One way or another, the general partners are protected — and the fund investors, who included tens of thousands of retirees, are responsible for paying the bill. (By contrast, in mutual funds, which are required to make public disclosures and have independent directors, investors are far less likely to be stuck with such costs.)

The Ohio Public Employees Retirement System holds $150 million in investments in each of the Carlyle IV and V funds. Asked about the requirement to pay the legal settlement costs, a spokesman, Michael Pramik, said he understood why such a question would be raised, but declined to comment.

Another blacked-out section in the Carlyle V agreement dictates how an investor, like a pension fund, also known as a limited partner, should respond to open-records requests about the fund. The clean version of the agreement strongly encourages fund investors to oppose such requests unless approved by the general partner.

Some pension funds have followed these instructions from private equity funds, even in states like Texas, which have sunshine laws that say “all government information is presumed to be available to the public.”

In mid-September, after receiving an information request about a private equity investment, the Fort Worth Employees’ Retirement Fund denied the request. Doreen McGookey, its general counsel, also sent a letter to the buyout firm, Wynnchurch Capital, based near Chicago, notifying it of the request and instructing Wynnchurch how to deny it by writing to the Texas attorney general, according to a document obtained by The Times.

“If you wish to claim that the requested information is protected proprietary or trade secret information, then your private equity fund must send a brief to the A.G. explaining why the information constitutes proprietary information,” Ms. McGookey’s letter states, adding that the pension “cannot argue this exception on your behalf.” Then the letter warned the private equity firm that if it decided not to submit a brief to the attorney general, that office “will presume that you have no proprietary interest or trade secret information” at stake.

In an email, Ms. McGookey said Texas law required her to notify the private equity firm of the information request.

The Fort Worth pension is not alone in opposing open-records requests for private equity documents. Calpers has also done so. A big investor in private equity, with more than 10 percent of its assets held in such deals, it has put $300 million into the Carlyle IV fund — the fund that is levying investors for the $115 million legal settlement reached by Carlyle executives.

Earlier this year, Susan Webber, who publishes the Naked Capitalism financial website under the pseudonym Yves Smith, asked Calpers for data on the fund’s private equity returns. After a legal skirmish, Calpers said last week that it had fulfilled her request. But on Friday, Ms. Webber said Calpers had provided only a small fraction of the data.

Karl Olson is a partner at Ram Olson Cereghino & Kopczynski and the leading lawyer handling Freedom of Information Act litigation in California. He has sued Calpers several times, including a successful suit for the California First Amendment Coalition, in 2009, forcing Calpers to disclose fees paid to hedge fund, venture capital and private equity managers.

“I think it is unseemly and counterintuitive that these state officials who have billions of dollars to invest don’t drive a harder bargain with the private equity folks,” he said. “A lot of pension funds have the attitude that they are lucky to be able to give their money to these folks, which strikes me as bizarre and certainly not acting as prudent stewards of the public’s money.”

‘Not Open and Transparent’

Regulations require that registered investment advisers put their clients’ interests ahead of their own and that they operate under what is also known as a fiduciary duty. This protects investors from potential conflicts of interest and self-dealing by those managers. This is true of mutual funds, which are also required to make public disclosures detailing their practices.

But, as a lawsuit against Kohlberg Kravis Roberts shows, private equity managers can try to exempt themselves from operating as a fiduciary.

The case involves Christ Church Cathedral of Indianapolis, which contends that it lost $13 million, or 37 percent, of its endowment because of inappropriate and risky investments, including holdings in hedge funds and private equity deals. The church sued JPMorgan Chase, its former financial adviser, for recommending those investments.

JPMorgan Chase said in a statement that despite market turmoil, “Christ Church’s overall portfolio had a positive return for 2008-2013, the time period covered by the complaint.”

Christ Church’s private equity foray included a small interest in K.K.R. North America Fund XI, a 2012 offering that raised around $6 billion. K.K.R., the fund’s general partner, can “reduce or eliminate the duties, including fiduciary duties to the fund and the limited partners to which the general partner would otherwise be subject,” the fund’s limited partnership agreement says. Eliminating the general partner’s fiduciary duty to investors in the private equity fund limits remedies available to the church if a breach of fiduciary duty should occur, the church’s lawsuit said.

Kristi Huller, a spokeswoman for K.K.R., initially denied that it could reduce or eliminate its fiduciary duties. But after being presented with an excerpt from the agreement, she acknowledged that its language allowed “a modification of our fiduciary duties.”

Linda L. Pence, a partner at Pence Hensel, a law firm in Indianapolis, represents the church’s endowment in the suit. She said she had been shocked by the secrecy surrounding some of her clients’ investments. “On one hand they say they don’t owe you the duty,” she said, “but everything is so confidential with these investments that without a court order, you don’t have any idea what they’re doing. It’s not open and transparent, and that’s the kind of structure to me that’s ripe for abuse.”

Some investors who are privy to the confidential agreements have walked away from these deals. A recent survey of institutional investors by Preqin, the research firm, found that 61 percent indicated that they had turned down a private equity investment because of unfavorable terms.

“It is apparent that private equity fund managers are not doing enough to appease their institutional backers with regards to the fees they charge,” Preqin said.
This is an excellent article which shows you there is still way too much secrecy in the private equity industry, and much of this is deliberate so that PE kingpins can profit off dumb public pension funds that hand over billions without demanding more transparency and lower fees. This is why I played on the title and called it an "iron curtain."

Go back to read my comment on the dark side of private equity where I discussed some of these issues. I'm not against private equity but think it's high time that these guys realize who their big clients are -- public pension funds! That means they should provide full transparency on fees, clawbacks and other terms. They can do so with a sufficient lag as to not hurt their "trade secrets" but there has to be laws passed that require them to do so.

And what about the Institutional Limited Partners Association (ILPA)? This organization is made up of the leading private equity investors and it has stayed mum on all these transparency issues. If they got together and demanded more transparency, I guarantee you all the big PE funds would bend over backwards to provide them with the information they require.

Interestingly, all the major private equity funds have publicly listed stocks, many of which have sold off recently during the market rout (and some offer very juicy dividends!). Go check out the charts and dividends of Apollo Global Management (APO), Blackstone (BX), Carlyle Group (CG), and Kohlberg Kravis Roberts & Co. (KKR).

On its Q3 conference call, Blackstone's management pointed out that during the past four years, its growth had been limited only by how much capital it can manage efficiently, not by how much capital investors have been willing to provide.

But as valuations keep inflating, it will be even more difficult for these alternative investment managers to find deals that are priced reasonably. And if deflation settles in, I foresee very difficult days ahead for all asset managers, including alternative investment managers.

Below, David Woo, head of global rates and currency research at Bank of America Merrill Lynch, Monica Dicenso, U.S. head of equity strategy at JPMorgan Private Bank, and Bloomberg’s Michael McKee discuss how global economic concerns are impacting equity markets. They speak on “Street Smart.”

And Westwood Capital's Dan Alpert, author of The Age of Oversupply, talks with Yahoo's Aaron Task. Alpert argues the global economy is suffering an oversupply of labor, capital and productive capacity relative to demand. He called it a "reverse supply shock." I'm afraid he's absolutely right.

Monday, October 20, 2014

Time to Plunge Into Stocks?

Heather Pelant, Managing Director of Blackrock comments, An investing Secret for When the Market Drops:
Back in August, I wrote a piece called “Why Cash is Not a Strategy.” I confessed then that like many people, I was sitting on more cash than I knew was good for me. Well, here’s an addendum: I’ve started moving off the sidelines.

Yesterday I rode the market roller coaster with countless other investors, wondering how low it would go and how to react. Shock set in when the 10-year Treasury yield – a key economic indicator – dipped below 2%. Practicing what I preach, I decided to take the cash I’d been keeping on the sidelines and bought in when I saw the Dow drop 245 points. But it wasn’t easy particularly as I watched the images of red faced traders trying to make it through what turned out to be one of the worst days in the market in the last 4 years. My stomach flipped again when I saw the market had dipped further down 460 points and I thought should I have waited a little bit longer? When all was said and done, however, I felt secure in my decision to take action and I know I’ll hold what I bought for the next 20 years. Not a bad result for a three-hour emotional roller coaster.

Of course, investing is an intensely personal decision, based on your own goals, age, risk tolerance, and so forth. But I do think that bursts of volatility are “teachable moments” about your emotional motivators and ways to potentially overcome them. Here are a few ideas to think about:

This is what buying low feels like

Buying when the market is dropping can be intimidating. It requires jumping in when everyone is selling. This is especially daunting for an investor just starting to test the waters and getting acquainted with the market. But think of it this way: buying on market dips is similar to buying something on sale. You’ve wanted it for a while, you know it is worth more than the sticker price and you’re getting a big discount. If we apply this principle to the market, it is the working definition of “buying low, selling high”. Taking a contrarian action is essentially what buying low means.

It’s a good time to start moving your cash

For those of you (or us) sitting in cash, a selloff may be the perfect opportunity to dive in at the right price. We can take an example from the playbook of savvy investors. BlackRock data indicates that when the market dipped yesterday, a number of them bought in, putting their money into core exchange traded funds (ETFs) to the tune of more than $2B. These key players know how and where to seek value – you may want to follow their lead.

Be prepared for more

Getting into the habit of buying in when the market hits a bump may be a good idea. My colleague Russ Koesterich highlights in a recent Blog post that volatility is likely here to stay for a while. We can see yesterday’s tumultuous ride as a lesson for the next dip. Stick to your long term view and don’t worry so much about the right now. Take advantage of discounted stock prices and hold on for the long haul.
Similarly, Tracy Ryniec, Value Stock Strategist at Zacks comments, Why Great Investors Love This Market:
For the first time in three years, stocks have sold off big, with the Russell 2000, the small cap index, falling over 10% and the Dow Industrials plunging as much as 450 points in one session.

It's been a rocky few weeks that has left investors shaken and on edge.

But that's the thing about stock market corrections. They create buying opportunities.

During bull markets, it's fairly easy to post solid numbers year-after-year in a portfolio. But who is still standing when the stuff hits the fan?

Great Investors Are Made Through Adversity

When market sentiment turns negative, those with the guts to get in are rewarded. Two of the greatest investors in the last 75 years, both value investors, were tested in both bear and bull markets.

Was it always easy? Heck no.

John Templeton, the founder of Templeton mutual funds, was shaped by the stock market of the Great Depression. In the same vein, Warren Buffett made his fame by going on a buying binge during the Super Bear Market of 1972-1974.

Great investors emerge when the going gets tough because that's when the greatest profits can be made.

Do You Have What It Takes?

Looking at the careers of Buffett and Templeton, three criteria for being a great investor emerge:

1) Be a contrarian 2) Timing is everything 3) Patience

Be a Contrarian: Buy When Others Are Not Buying

The classic definition of a value investor is someone who buys companies that are not on everyone else's radar. They are out of favor or, frankly, mocked. Both John Templeton and Buffett are known for being value investors.

John Templeton put himself through college during the Great Depression and then set out to start his career on Wall Street during the worst possible time.

It was the late 1930s and stocks, which had crashed during the Great Depression in 1929, still hadn't fully recovered.

In 1939, with the world going to war, he decided to buck the convention that stocks stunk. He borrowed money to buy 100 shares each of 104 companies that were selling at $1 a share or less.

Some might have thought he was crazy as 34 were in bankruptcy at the time.

But the risk paid off.

Ultimately, only 4 of the companies ended up being worthless and the rest went on to large profits.

Timing is Everything

Warren Buffett hasn't always been 100% invested in stocks.

In 1969, as stocks were heating up, Buffett cashed out of all of his holdings, telling Forbes Magazine in 1974: 'When I got started the bargains were flowing like the Johnstown flood; by 1969 it was like a leaky toilet in Altoona.'

But by 1974, after two years of stock market carnage during the super bear market of 1972 and 1973 which made stocks cheap, Buffett was back in the game.

Forbes asked him what he felt about the markets that year: 'Like an oversexed guy in a harem,' he shot back. 'This is the time to start investing.'

By the time the interview was set to run in the magazine, the markets had rallied 15% and Forbes asked him if he was still feeling the same way.

'I don't know what the averages are going to do next,' he replied, 'but there are still plenty of bargains around.' He told Forbes that the situation reminded him of the early 1950s.

Sound familiar?

Recently, Buffett was back to his predicting ways, telling CNBC on Oct 2, 2014 that he had just bought stocks after they sold off big the day before.

'The more it goes down, the more I like to buy,' he said.

Patience is a Virtue for Great Investors

Patience is also critical to being a great investor because market conditions don't always change on a dime. You have to be prepared to stand by your convictions, which can mean waiting a long time for sentiment to move your way.

Buffett added to his positions in 2009 in the middle of the doom and gloom of the financial crisis and he just added to his positions again this month.

Templeton held his 1939 investments on average for 4 years, despite a World War.

Do You Dare to Be a Great Investor?

Volatile markets are opportunities to elevate your investing game.

The investing lessons of John Templeton and Warren Buffett are there for the taking.

Both were value investors who looked for bargains when times got rocky.

That's exactly the market conditions that we find ourselves in right now. Suddenly, some stocks that were trading at all time highs are down double digits and look attractive again.

But with all the noise from television talking heads and the Internet and with thousands of stocks to choose from, how can you know where to even begin to find the right value stocks?

Finding the Best Value Stocks

Instead of going it alone to find the values, we can do the work for you. We offer a service that combines the most powerful value criteria like the PEG ratio with the timeliness of the Zacks Rank. It's a great way to catch value stocks at the right time - just as the market begins to recognize their real worth. We're not talking about cheap $1 stocks with risky fundamentals, but the kind of extremely undervalued stocks that later soar in price.

This proven strategy outperformed the S&P 500 with an overall gain of +36% in 2013. Our success accelerated in the first and second quarters of this year as the market punished overvalued stocks.

Currently Value Investor includes 24 stocks that are 'on sale' right now and are likely to head a lot higher in the months to come. Even more important, I'm currently tracking undervalued sectors with companies who show solid fundamentals, and today is the perfect time to get aboard at the ground floor for the full ride upward. This is a value service, so I am glad to report that starting today you can receive our best value stocks, plus recommendations from all of Zacks' portfolio services, for a full month at a total cost of just $1.
Every Saturday morning, I sit in front of my computer and look at snapshots of over 2000 stocks in about 100 sectors, industries and themes I track. Here is a small sample of the industries and themes I track (click on image):

I've built a large database over the years and keep adding to it. I can then screen various stocks and see which ones are overbought/oversold or if there is strength/weakness in a particular sector.

In addition, I regularly look at the YTD performance of stocks, the 12-month leaders, the 52-week highs and 52-week lows. I also like to track the most shorted stocks and highest yielding stocks in various exchanges.

What else? I'm a macro guy and love reading macro articles from various sources. In these markets, macro matters a lot more than an individual company's fundamentals and those who ignore the macro environment are doomed to underperform.

I was recently contacted by Seeking Alpha to post some of my market thoughts on their site (was on there years ago but hardly posted). I try to read as much as possible and comment as well. A few articles on macro caught my attention.

First, my former colleague from BCA Research and now partner at MRB Partners, Mehran Nahkjavani, wrote an insightful comment on the winners and losers in emerging markets as oil prices tumble. Mehran focuses on excess supply of oil but as you'll read from my comment at the end of his article, I believe the drop in oil prices has more to do with eurozone's deflation demons spreading to the rest of the word, including the United States. If that's the case, all emerging markets are in big trouble.

Second, Michael Gayed, co-CIO at Pension Partners, wrote a comment on why the real correction is to come, stating "the intermarket movement thus far has been reminiscent of the Summer Crash of 2011, though not as violent nor severe yet." (Make sure you read Michael and Charles Bilello's paper, An Intermarket Approach to Tactical Risk Rotation: Using the Signaling Power of Treasuries to Generate Alpha and Enhance Asset Allocation).

In his comment, Michael notes the following:
Inflation expectations, as shown by the TIP/TENZ ratio, now sits at support. If they break down from there, the Fed may be in trouble, as it suggests domestic deflationary fears would be rising. Small-caps could continue to outperform purely because of how oversold they are relative to large-caps this year, but there have been plenty of instances historically where equities fall even though small-caps are outperforming into the decline. Credit spreads on both the sovereign level and in the corporate space are the canaries in the coal mine. A continuation of their widening means the current correction is likely not over, could result in a panic, and bring a thematic change to how investors perceive not only the future, but central bank power to direct it. Should that occur, that would be the real correction to be afraid of.
I commented the following at the end of that article:
Michael, I agree with you, too many people are ignoring eurozone's deflation crisis and its potential impact on inflation expectations in the United States. I happen to think that inflation expectations are going to drop significantly and that's why the Fed is prepping markets for more QE.

Interestingly, Dallas Fed president Richard Fisher was on CNBC this morning scoffing at the idea of more QE but he's a hawk and is underestimating contagion effects.

One area where I disagree with you is on timing. I believe the real risk is the stock market right now is another melt-up, especially in biotech, small caps and technology. Once we get through this liquidity rally, then deflation will set in and hammer all risk assets. But this could be a few years away, imho. 
Timing is everything here. I'm actually amazed at how many people are ignoring the contagion effects of eurozone's deflation crisis and what this means for Fed policy going forward. Let me be blunt here, if inflation expectations in the United States continue to drop, the Fed will once again entertain the possibility of engaging in more quantitative easing ahead.

Most commentators dismiss the possibility of more QE ahead but watch, if things get uglier in Europe and inflation expectations keep dropping around the world, I guarantee you more QE is on the way. And I think markets are starting to realize this which is why you're seeing risk assets take off after the latest selloff.

But as I wrote in my last comment on the Fed prepping markets for more QE, you have to be very careful here or risk getting slaughtered. I would steer clear of energy (XLE) and materials (XLB) which are prone for more weakness ahead. They're bouncing back after suffering steep losses but use any relief rally to shed your positions in these sectors.

I especially want you to be very careful  of some energy companies where you can easily fall into the classic "value trap" thinking the worst is over and the fundamentals justify buying the dip or adding to your positions. 

Have a look at the one year chart of SeaDrill Limited (SDRL) by clicking on the chart below:

The stock is unquestionably oversold and it's tempting to buy it here because it's due for a bounce and you can even collect a 17% dividend yield to cushion any further weakness in the price per share. You'll read an article on drilling for dollars that tells you now is the time to buy this stock.

It's a no-brainer, right? WRONG! What this guy doesn't tell you is that other oil drilling stocks like Ensco (ESV), Noble (NE), and Transocean (RIG) have all been pummeled in the latest selloff and they all have high dividends which they will be forced to cut if the price of oil drops further. Also, some of these companies have weaker balance sheets than others, putting their dividends at higher risk (and if they cut their dividend, shares are going lower).

Sure, these stocks can bounce up from these oversold levels but I would use any relief rally here to shed positions, not initiate or add to your positions. I can say the same thing about plenty of other energy and commodity stocks. Be very careful buying the dips here because there will be further weakness in these sectors, you will end up regretting it.

And it's not just energy and commodities. This market is becoming more and more selective. I tell all my friends and family to be careful with a lot of stocks, especially high dividend stocks. I think some will outperform in a deflationary environment (because rates will remain low for many years) but others are going to get slaughtered.

Closer to home, there are a lot of Canadians invested heavily in Canadian banks because of the dividends they offer and their nice outperformance since the financial crisis erupted but there too, I would be very careful. I remain short Canada and think much darker days lie ahead as oil prices continue to tumble and euro woes hit us too.

There are a lot of things on my mind right now. A lot of scenarios playing out in my head and I'm trying to gauge the risk of each one of them. I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI) that have sold off lately. These are extremely volatile and risky but there is a great secular story here that will play out for many years to come. 

Keep an eye on companies like Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Seattle Genetics (SGEN), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA). I would take advantage of the latest selloff to add to some of these biotechs. I also like Twitter (TWTR) and see a bright future for this social media stock.

Are there other stocks I like at these levels? Yes but I'm waiting to see what top funds bought and sold in Q3 before delving into more stock specific ideas. All I can say is tread carefully here and know when to buy the dips and more importantly, when to sell the rips.

Below, Richard Fisher, Dallas Fed president, says the U.S. economy is improving and he sees no reason not to raise interest rates by spring of 2015. I'm amazed at how Fisher, a well-known hawk, completely dismisses the contagion effects from eurozone's deflation crisis and how it's influencing U.S. inflation expectations. He's wrong and the threat of deflation will force him to change his views in the months ahead.

Friday, October 17, 2014

Fed Prepping Markets For More QE?

Bullard Says Fed Should Consider Delay in Ending QE:
The Federal Reserve should consider delaying the end of its bond-purchase program to halt a decline in inflation expectations, said St. Louis Federal Reserve Bank President James Bullard.

Bullard, who helped lay the intellectual groundwork for the Fed’s quantitative easing program, said U.S. economic fundamentals remain strong, and he blamed recent financial-market turmoil on downgrades in the outlook for Europe.

“Inflation expectations are declining in the U.S.,” he said in an interview today with Bloomberg News in Washington. “That’s an important consideration for a central bank. And for that reason I think that a logical policy response at this juncture may be to delay the end of the QE.”

Bullard is the first Fed official to publicly suggest the central bank should extend its asset-purchase program when policy makers meet later this month. U.S. stocks erased losses and Treasury yields rose on expectations the Fed will take action to insulate the U.S. from global economic weakness.

“We are watching and we’re ready and we are willing to do things to defend our inflation target,” Bullard said.

Fed officials are scheduled to next gather on Oct. 28-29 and have said they expect to end asset purchases after that meeting. The program has already been wound down to combined monthly purchases of $15 billion of Treasuries and mortgage backed securities, from $85 billion in December 2012.

Committee Intentions

“Fifteen billion by itself is not that consequential,” Bullard said. “But what is consequential is committee intentions on future QE, and we have certainly seen through the taper tantrum how important those can be.”

He was referring to an episode last year when Treasury yields shot up after then-Chairman Ben S. Bernanke said the Fed would start slowing bond-buying sooner than expected.

Bullard said he continues to forecast the first Fed interest-rate increase at the end of the first quarter, based on the expectation that the current global market turmoil won’t affect U.S. prospects. Economic growth could be bolstered by declines in oil prices and long-term interest rates, he said.

A pause in tapering would protect against “downside risk” and bolster inflation expectations, he said. “We could react with more QE if we wanted to.”

The Standard & Poor’s 500 Index (SPX) rose 0.4 percent to 1,870.25 at 1:37 p.m. in New York after dropping as much as 1.5 percent. U.S. 10-year Treasury yields rose two basis points, or 0.02 percentage point, to 2.16 percent.

Bullard Paper

Bullard, who doesn’t vote on policy this year, has been seen as a bellwether because his views have sometimes foreshadowed policy changes. He published a paper in 2010 entitled “Seven Faces of the Peril,” which called on the central bank to avert deflation by purchasing Treasury notes. That was followed by a second round of bond buying.

“Bullard is a very practical voice at the Fed, and changes in his views often reflect the swing in the balance of risks in the economy,” said Mark Vitner, senior economist at Wells Fargo Securities LLC in Charlotte, North Carolina.

“The Fed is highly attentive to the outlook for the economy, and the outlook for the global economy has deteriorated,” Vitner said. “Inflation looks like it has decelerated and may decelerate further.”

Stocks, Oil

The 10-year Treasury yield fell below 2 percent yesterday for the first time since June 2013 as weaker-than-forecast economic data added to concerns that economic growth is slowing. That worry has helped push down stocks, oil prices, and measures of inflation expectations, while increasing the value of the U.S. dollar relative to trading partners.

The Fed aims for 2 percent inflation, as measured by the personal consumption expenditures price index, which was 1.5 percent in August and hasn’t exceeded 2 percent since March 2012. Expectations of future inflation, which are important because they can affect spending by businesses and households, have dipped in recent months alongside a decline in oil prices.

A Bloomberg measure of market forecasts for average inflation over the next five years was 1.49 percent at 1:41 p.m. in New York, compared with 2.1 percent in June.

The Fed has said its policies are dependent on evolving economic data as it seeks to steer the economy to full employment and stable prices.

“I am saying today that maybe we should invoke the data dependent clause on the tapering,” Bullard, 53, said. “I think that is our simplest step that we can take in this circumstance.”

On the other hand, he said U.S. economic fundamentals remain strong, and he hasn’t downgraded his forecast for growth of 3 percent or more in the second half of 2014 and 2015.

“The hard data on the U.S. is good,” he said. “The last jobs report was quite strong.” The jobless rate fell to 5.9 percent in September, and payrolls expanded by 248,000.
This is the most important event during this wild and volatile week. Why? Because the Fed is telling market participants it is very worried about Europe's deflation demons spreading to the United States and elsewhere and it stands ready to act fast if deflation creeps into inflation expectations.

The most important thing Bullard said yesterday during this Bloomberg interview was this: “We could react with more QE if we wanted to.”

Now think about it. You've got Mario Draghi who is constantly being warned by German leaders not to engage in massive quantitative easing, effectively limiting the European Central Bank's response to fight deflation in the eurozone.

What Draghi is proposing is some form of asset purchases but these measures are considered mostly cosmetic which is why shares in Europe plunged earlier this week before rebounding once markets caught wind that the Fed is standing ready to move.

And European bank shares led the late week rally after selling off strongly earlier this week. Why? Because if the Fed delays its tapering, or engages in more QE, it will basically aid them into shoring up their weak balance sheets. They can basically buy U.S. bonds, lock in the spread and improve their liquidity.

The Fed is basically telling Europe's big banks: "Don't worry about Angela Merkel, Wolfgang Schäuble, and the lack of major QE from the ECB. If they don't act, we will act in a forceful manner allowing you to use our balance sheet to shore up yours."

And that ladies and gentlemen is huge news for markets because it sends a strong message to short sellers salivating at the prospect of a eurozone collapse that the Fed isn't about to stand by and let it happen. Why? Because a eurozone collapse will unleash those deflation demons and ensure the U.S. and rest of the world are heading for a protracted period of debt deflation.

Even the threat of more QE from the Fed is enough to send shivers down short sellers' spines which is why you will likely see risk assets rallying during the second half of October and into year-end. Pay attention here to the ten-year Treasury yield (^TNX), the euro/USD exchange rate, crude oil prices, and small cap stocks (IWM) which have led the rally out of the selloff earlier this week.

As far as stocks, I've said it before, the real risk in the stock market is a melt-up, not a meltdown. We're going to get a massive liquidity rally unlike anything you've ever seen, then you'll need to worry about the massive hangover and protracted debt deflation, which remains my ultimate endgame.

In this environment, you have to pick your spots carefully or risk getting slaughtered in the stock market. I would steer clear of energy (XLE) and materials (XLB) which are prone for more weakness ahead. They're bouncing back after suffering steep losses but use any relief rally to shed your positions in these sectors.

I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI) that have sold off lately. These are extremely volatile and risky but there is a great secular story here that will play out for many years to come. Keep an eye on companies like Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Synergy Pharmaceuticals (SGYP), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA). I would take advantage of the latest selloff to add to some of these biotechs. I also like Twitter (TWTR) and see a bright future for this social media stock.

What's the biggest risk to my scenario? A significant crisis of confidence if the Fed actually does engage in more quantitative easing and market participants think it's way behind the deflation curve. That's the scenario that keeps James Bullard and Janet Yellen awake at night but for now, I wouldn't worry about any deep crisis of confidence. 

Below, Federal Reserve Bank of St. Louis President James Bullard talks about monetary policy, U.S. economic fundamentals and the global economy. Bullard, speaks with Michael McKee on Bloomberg Television's "Market Makers." Take the time to listen to this interview, it's by far the most important market event of the week.