Research Watch

Why QE3 will probably sink, understanding the Frogger strategy, how to build a permanent portfolio, and where to buy your own Scottish isle.

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.

It's that time of year again: Europe appears to be on the brink, global economic data is sinking alongside markets, and calls for a fresh round of monetary stimulus from the Federal Reserve are growing louder. But while analysts at Goldman Sachs and Bank of America have lifted their expectations for further quantitative easing, Morgan Stanley makes the bold call that so-called 'QE3' won't have much of an effect at all – on the economy or stocks. The bank argues that Ben Bernanke got lucky with the last two rallies, which were actually built on improved macro data, and that any QE3 uptick will probably last hours, not months. That’s not to say that markets will crash. Analysts at BNP Paribas put it best this week, when they compared the current investment environment to a game of Frogger: success might require some quick moves forwards and backwards, but gains are there to be made. But if you’re feeling particularly bearish, commentators at The Daily Reckoning think they’ve found the ultimate Australian defence strategy. Meanwhile, Cisco imagines the future of the internet, which puts bullish tech bets into perspective, while venture capital pours out of Silicon Valley and into emerging markets. Smart money is shorting Treasuries, too, as Alan Greenspan warns the dreaded bond vigilantes have their sights set on the US. And finally, there’s an upside to down markets: bankers are selling their private European islands cheaply.

Hours of stimulation... “What’s at issue now is whether unconventional policy either works to stimulate activity, or can directly boost risk asset prices. We’re sceptical on the first point. Deleveraging cycles mute the effect of monetary policy on growth. Unconventional monetary policy may be an effective shield – can defend against systemic breakdown – but not a good sword: broadly unable to encourage a return to normal credit creation, where monetary policy can work to stimulate growth. Having said that, the important issue for many investors is whether further unconventional easing can trigger a tradable rally in risk assets, even if there is little or no effect on the macro outlook. We’re doubtful. When growth is the concern, as now, tradable rallies require better macro news. That macro was critical in the QE2 rally is most obvious from looking at bond markets. Whatever else QE2 did, buying bonds should have affected Treasuries, but as the chart shows, the commencement of QE2 – as with QE1 and operation twist – coincided with rising Treasury yields. And ... Fed selling Treasuries coincided with falling yields.

We think Mr Bernanke got lucky with QE2: macro data improved almost from the moment it was flagged at Jackson Hole in August 2010. That improvement, not QE2, was in our view the key to the subsequent rally. '¦ There will be a Pavlovian reaction from markets if we get further easing ... But if macro stays weak, expect any QE3 rally to last hours or days, not weeks or months.” (Morgan Stanley via Zero Hedge, June 6)

The Frogger strategy... “The investment environment right now ... reminds me of the old arcade game of Frogger where the player had to direct their frog safely across a busy motorway and a river full of crocodiles. Despite the normal dangers, success usually required a series of forward and backward moves and sometimes several in quick succession. '¦ At any moment we can expect any number of policy decisions that could dramatically change the investment environment. Whether it is the 'Grexit’, EU deposit guarantees, ECB easing, bank recapitalisations, Fed or Chinese easing, the US 'fiscal cliff’, EU fiscal austerity or any other positive or negative catalyst, it is all a little overwhelming and is creating a lot of investor inertia. What is perhaps most under-priced by markets is that these events all turn out to be less extreme than we think now. '¦ This has occurred to several major investors met by BNPP recently too. Some have noted that they have rarely seen such light positioning and limited flow. What has become of significant concern is not the downside tail, but the chance that they have too little upside exposure. '¦ This might be an appropriate time for a variety of long gamma and modestly bullish strategies like down and in calls. Beyond some modest bullish positioning into any dips, those with limited 'risk’ on their books might look to convexity and skew as continued dislocation opportunities. We believe that despite the potential for some (probably short term) negative outcomes in the coming months, that the positioning of the market is eerily ready for this and that the negative performance of risk assets might not be as significant as some expect.” (Gerry Fowler of BNP Paribas, May 31)

The ultimate defence... “The Permanent Portfolio '¦ is an equal mix of [gold, bonds, stocks and cash], the idea being that each asset outperforms during one of four different investment environments. [In this case: 1) Greece defaults and stays in the euro; 2) Default and leave the euro; 3) Don’t default, and stay in the euro; and 4) Don’t default and leave the euro.] '¦ So what do you do with your stock market investments? '¦ You buy the kind of companies that will be around in 100 years’ time and pay a good dividend, and then you try and avoid fretting over their share price. The idea being that a recovery will come, however long away it is. And you will have been collecting a dividend in the meantime. What kind of stocks fit the bill? Food might be a good place to start. And we’re pretty sure the world won’t give up drinking if bad times come about. The company we have in mind even has the word 'cash’ in its name. There are a few other strategies that allow you to enhance your returns. For example, at what price would you be willing to buy Woolworths shares? Perhaps a few percent below the current market price? Well, you’re in luck, because someone may be willing to pay you money to buy them at that price. That is, they are willing to pay you to enter into an agreement to buy their WOW shares below the current market price. The catch is, the actual purchase only happens if the price of the WOW shares fall below the price you have agreed to buy at. But you still have to buy at the agreed price - that is above the market price. You get to keep the upfront cash payment even if the purchase doesn't go through though. So if WOW doesn't tumble, you've made a small return without buying above a price you're comfortable with.” (The Daily Reckoning, May 30)

The future of the internet...

“Annual global IP traffic will surpass the zettabyte threshold (1 trillion gigabytes) by the end of 2016. '¦ Global IP traffic has increased eightfold over the past 5 years, and will increase threefold over the next 5 years. '¦ The number of devices connected to IP networks will be nearly three times as high as the global population in 2016. '¦ Traffic from wireless devices will exceed traffic from wired devices by 2016. '¦ It would take over 6 million years to watch the amount of video that will cross global IP networks each month in 2016. '¦ Globally, mobile data traffic will increase 18-fold between 2011 and 2016 [or three times faster than fixed IP traffic].” (Cisco Visual Networking Index, May 30)

VC clone home... “The practice of backing start-ups that take an established business model and adapt it to an emerging market ... is becoming a bigger part of the venture-capital industry as competition at home forces Silicon Valley investors to look farther afield. '¦ Take Baidu, a Chinese interpretation of Google, which made early venture investors a killing; or Alibaba.com, a Chinese version of eBay, an online-auction site. Now venture capitalists are looking at other markets, including Brazil, Indonesia, Russia, South Africa and Turkey. Last year $3.4 billion of venture-capital deals were done in emerging markets, more than double the amount in 2008. '¦ Backing tested concepts mitigates the risk inherent in start-ups and means companies are likely to grow quickly, because the original firm has already worked out the kinks. Often the originator of the business does not have the expertise to enter new countries quickly, so copycats can get there first. '¦ There are different ways to play the copycat game. Rocket Internet, started by the Samwer brothers'”Alexander, Marc and Oliver'”in Germany, is a cloning 'factory’ that copies American and European businesses, hiring entrepreneurs to run them and exporting these start-ups to emerging markets as fast as possible so they are the first entrants. More traditional venture capitalists are setting up offices and selectively backing local entrepreneurs. American venture investors often prefer to bring in a local partner to provide more consistent mentorship to these entrepreneurs and give advice on how to navigate the domestic market.” (The Economist, June 2)

Why you should expect a Spexit before a Grexit... “1) Spain is too big to rescue. '¦ 2) Spain has tired of austerity already. Remember, the protests against cuts began in Madrid a year ago with the 'indignados’ movement which started sit-ins across major cities in 2011. '¦ 3) Spain has a real economy. The Greeks understandably feel nervous about life outside the euro-zone. They don’t really make anything. Spain is a successful economy with a perfectly respectable industrial base – its export to GDP ration is 26%, similar to the UK, France or Italy. '¦ 4) Spain is politically secure. '¦ [Unlike other members] it can take or leave the euro and the EU depending on whether it works or not – and right now it clearly isn’t working. 5) Spain has bigger horizons. The Spanish economy looks partly to Europe. But it looks just as much to the booming Spanish- speaking economies of Latin America (and indeed the huge Hispanic market in the US). '¦ 6) There is already a serious discussion underway in Spain about the future of the currency. Plenty of mainstream economists and pundits are arguing that the real problem is the euro – and Spain will only recover once it gets the peseta back. The taboo has been broken.” (Matthew Lynn of Strategy Economics, May 31)

Ever wanted your very own island?...

“Christian Siva-Jothy, a former Goldman trader based in London, is putting his Scottish isle on the market for $4.6 million... The island is named Eilean Righ in Gaelic, which means 'King’s Island’, and is approximately .33 square miles in land area. '¦ [It] comes well furnished, with a four-bedroom house, a helicopter hangar, a boathouse and a jetty. Siva-Jothy owned 3 planes and used to fly them from the island to London for work... Siva-Jothy started his own hedge fund, SemperMacro, after left Goldman in 2004. But he closed the $200 million fund last year due to poor performance. A $4.6 million sale could certainly help him with his finances.” (Clusterstock, June 6)

The end of the bond rally...

“Commercial traders of T-Bond futures have now moved to their biggest net short position since late 2004. They are the big money traders, and presumably the smart money, so when they get to a really lopsided net position like this, it is worth paying attention to. '¦ My guess is that [the tipping] point will arrive when the Fed's inflation of the money supply turns into actual consumer price inflation. M2 is up 9.7% from a year ago, and 36% since April 2007. Eventually all of that excess money is going to get to work pushing prices upward, and bond traders are going to realise that locking up a 2.5% yield for 30 years is not such a good deal.” (The McClellan Market Report, June 6)

Video of the Week: Greenspan and the bond vigilantes... The former Fed chairman warns investors could revolt against US spending at a moment's notice, sending interest rates soaring.


(CNBC, June 1)

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