Research Watch

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

After a relatively calm start to the year, market volatility has once again emerged as a talking point '” so much so that Jeremy Grantham has devoted his entire quarterly letter to the topic. According to GMO's legendary money manager, markets are 19 times wilder than they should be, but there are gains to be realised if you can look past the big swings. There's also a timely warning for baby boomers betting that the market will revert to its long-term average, and an introduction to China's Zhou Xiaochuan, the central bank govenor who controls more than half of the world's new money supply and a balance sheet growing faster than the Fed's. Speaking of central banks, new research shines a light on some major shifts taking place at these institutions right around the world, including a growing appetite for the Australian dollar and, oddly, US equities. Meanwhile, Jeff Gundlach reveals his big investment themes for the weeks, months and years ahead, as Mark Mobius explains where you're most likely to find the next Coca-Cola or McDonald's. Vikram Pandit puts his house up for sale, Richard Koo cans democracy, and, on video, Robert Shiller makes the provocative argument that housing should never be treated as an investment.

Market volatility explained '¦ “The central truth of the investment business is that investment behaviour is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority 'go with the flow,' either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in 'fair value' for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend as shown below.

The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines! '¦ Missing a big move, however unjustified it may be by fundamentals, is to take a very high risk of being fired. Career risk and the resulting herding it creates are likely to always dominate investing. The short term will always be exaggerated, and the fact that a corporation’s future value stretches far into the future will be ignored. As GMO’s Ben Inker has written, two-thirds of all corporate value lies out beyond 20 years. Yet the market often trades as if all value lies within the next 5 years, and sometimes 5 months.” (Jeremy Grantham of GMO, April 2012)

Mind the mean '¦

“The reality of what 'reversion' means is grossly misunderstood by Wall Street, and the mainstream media, as witnessed by the many valuation calls that 'stocks are now cheap because the market is now trading in line with its long term average.' The power of reversion is much more than just returning back to the average (or mean) price level over time. In reality the movement is far greater. '¦ If you take a rubber band and stretch it as far as you can in one direction and release it, the band does not return back to its original starting point. What you will find is that the band will revert approximately an equal distance in the opposite direction before returning back to its starting point. '¦ In the first chart I have plotted the S&P 500 index on an inflation adjusted basis compared to its long term growth trend. '¦ Since 1900, when the market has attained excesses in one direction the reversion process has never, and I repeat never, retraced back only to the long term growth trend before starting a new cycle. Yet, this is exactly what Wall Street is telling you will happen. In the past 112 years each and every reversion process has traveled roughly an equal distance in the opposite direction much like the rubber band. '¦ Unfortunately, for baby boomers rapidly approaching retirement, the reversion process that is currently underway still has further to progress which means future stock market returns are unlikely to shore up any shortfall in savings.” (Street Talk Live, April 16)

Bernanke meets his match '¦

“It has been widely noted that China's stock of M2 (a broad measure of money, including deposits and money in circulation) is now the largest in the world – some USD 13.8trn at the end of February 2012. In our view, the much more important variable is China's contribution to global money supply. According to our calculations, China was responsible for 52% of new M2 creation globally in 2011 '¦ This is not a recent phenomenon – in the-three year period after the global financial crisis began (2009-11), 48% of new M2 globally was in Chinese yuan. Global M2 is approaching USD 50trn, and China will get us there. Forget about World Bank President Zoellick’s successor; [People's Bank of China governor Zhou Xiaochuan] is already the world’s banker. '¦ There are a few possible explanations for China’s massive money creation. The bank-based financial system, where banks are responsible for lending rather than capital markets. On a similar theme, the government uses banks to propagate stimulus funds, rather than the government budget directly. It’s flat out money-printing to defend the Rmb valuation, however, that is the key cause. Many in Beijing despair about irresponsible money printing by the Fed and ECB. One result of these measures has indeed been the expansion of these two central banks' balance sheets. However, the PBoC has a jump on both the Europeans and Americans. Its balance sheet has grown eight-fold since 2002 and ended last year at USD 4.5trn. This was against USD 3.5trn for the ECB '¦ and USD 3trn for the Fed.” (Standard Chartered via FT Alphaville, April 17)

Invest like a central banker '¦ “Twenty-nine per cent of [the 54 central banks] polled said they had reduced their exposure to the euro currency over the past 12 months, compared with 8% who had increased their holdings. Others said they planned to sell euro assets this year. '¦ More than 90% of those polled said changes in credit ratings of sovereigns were 'very important' or 'important' for their reserve management. Attitudes to the [US dollar], however, were broadly unchanged despite Standard & Poor’s downgrade of US government debt in August, with under 10% of respondents saying that this had put the dollar’s status as a reserve currency at risk. But the dollar’s dominance could eventually be challenged by other currencies: more than three-quarters of respondents said they would consider investing in Canadian dollar and Australian dollar-denominated assets over the next five years. More than 40% said the same about the renminbi and Nordic currencies. Signifying the mood of caution among the world’s central bankers, 71% of those polled said gold was a more attractive investment than it had been at the start of last year. Central banks made their largest purchases of gold in more than four decades last year and have continued to buy the precious metal in the early months of 2012. '¦ Surprisingly, equities – a relatively uncommon investment choice for central banks because of their riskiness – were viewed as a more attractive option now than a year ago for 60 per cent of those polled. The Bank of Israel said in March that it could invest up to 10% of its reserves in US equities.” (Financial Times, April 17)

Gundlach's guide to global assets '¦ (Short term: days to months; medium term: months to years; long term: years to decades)

"The bond guru also offers the following macro insights:
- His favourite investment right now is natural gas. He says it’s like buying gold in 1997;
- Buy stocks when they’re in the single digit PE range;
- QE3 is already underway in operation twist;
- He's still worried about US debt;
- Europe remains the biggest risk to equity markets;
- The Fed won’t raise rates unless inflation kicks up further;
- He believes US rates will remain low to stable."
(Jeff Gundlach of DoubleLine Funds via Pragmatic Capitalism, April 18)

John Paulson is shorting Europe '¦ “The billionaire hedge fund manager who foresaw the collapse of the US housing market is shorting German government bonds in a wager that the eurozone debt crisis will significantly deepen in the coming months. Mr Paulson told investors ... that he was betting against the creditworthiness of Germany, regarded in markets as among the safest sovereign borrowers, because he saw the problems affecting the eurozone deteriorating severely. '¦ The 56-year old hedge fund manager, who oversees $24bn at his New York-based firm Paulson & Co, believes that problems for the Spanish government will spill over to threaten the stability of the eurozone as a whole. While Spanish bond yields this week rose to multi-month highs above 6 per cent, German 10-year Bunds yields have recently traded as low as 1.66 per cent, within a whisker of record lows. Mr Paulson’s position, which includes holdings of credit default swaps written on German debt, has been in place for several months.” (Financial Times, April 17)

Koo's guide to government '¦
(Richard Koo of Nomura via Business Insider, April 16)

Euros fly to safety '¦

“In recent months, even as markets seemed calm, sophisticated investors and regular depositors alike have been pulling euros out of struggling countries and depositing them in the banks of countries deemed relatively safe. Such moves indicate increasing concern that a financially strapped country might dump the euro and leave depositors holding devalued drachma, lira or pesetas.” (Bloomberg View, April 12)

Time to buy Apple? '¦ “Goldman Sachs analyst Bill Shope has a big, bullish note out on Apple. He raised his price target to $750 from $700, and took on all the recent investor concern... On the concern that the June quarter will be a snooze because there will be no new products, and consumers will wait for a new iPhone: 'We believe recent investor concerns over a 'catalyst-light' June quarter are misguided, since this will be the first full quarter with a refreshed iPad, a lower-priced iPad 2, and a fully ramped iPhone distribution channel; in other words, the June quarter is when many of the recent catalysts begin to fully manifest into earnings power.' ...And some investors are apparently worried about Mac sales: 'On the Mac side of the equation, we believe growth will be fairly lackluster this quarter, as both sell-in and sell-through pull back ahead of a broad Mac refresh. Indeed, we now believe that annual unit growth will come in at 14%, versus last quarter’s 26% growth. With that said, we believe our estimate is above recently reduced investor expectations, as most seem to be underestimating how much international share gains will counter tepid US growth. Furthermore, we expect any weakness in Mac sales to be more than countered by iPhone and iPad strength this quarter, and we expect growth to accelerate in the June quarter.'” (SAI, April 18)

Bet on the next wave of global brands '¦ “In 2006, of the top 100 brands globally, there were only two brands from emerging countries '¦ In 2011, there were 19 from the BRIC countries and Mexico. So despite their relatively shorter time in the marketplace, emerging market brands currently represent nearly one-fifth of the top 100 global brands. If this momentum continues I think the increasing acquisitions of existing brands by emerging market businesses could position many emerging market brands as not just entering the global stage, but rather taking centre stage with a global brand audience. Why do I believe this momentum could continue? 1) Growth of the Emerging Market Consumer: '¦ The global emerging markets’ middle class is anticipated to grow from 430 million in 2000 to 1.2 billion by 2030. '¦ Such a large group of people with diverse tastes in consumer goods could be a boon to emerging brands over the long term. 2) Demographics: '¦ The workforce (population aged 15-64) for emerging markets is estimated to increase to 3 billion in 2020 from 2.7 billion in 2010, accounting for more than two-thirds of their total population in 2020. The growing brands in emerging markets appear to me well positioned to serve this demographic shift. 3) Access to Capital: Emerging market firms generally have easier access to capital than before because many emerging market economies have built operating capital markets over the last 20 years. 4) Changing Tastes: '¦ With international tourism arrivals projected to hit the 1 billion mark this year, five more people throughout the world are gaining exposure to different cultures.” (Mark Mobius of Franklin Templeton Investments, April 18)

Live like a Wall Street boss '¦

“Citigroup CEO Vikram Pandit and his wife Swati are selling their Greenwich, Connecticut, pad for $4,300,000. They reportedly bought the property in May 1999 for $3,400,000. The 5,105 square foot house has 5 bedrooms and 6.5 bathrooms, a pool (and pool pavilion), and is close to the super exclusive Round Hill Country Club.” (Clusterstock, April 18)

Video of the Week: 'Housing is not an investment' '¦ Robert Shiller says it's time to realise that, outside of a bubble, property is a depreciating asset.

(Motley Fool, April 12)