Research Watch

QE3 amnesia, equity returns, auditing the gold stash, Bob Dylan bonds, and Roubini’s perfect storm.

PORTFOLIO POINT: This is a sampling of this 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 often thought that quantitative easing was born during Japan’s lost decades, when the Bank of Japan started buying up bonds to boost the national economy. However, BNP Paribas points to evidence that the so-called QE is older than most people realise, and was in fact pioneered by Germany’s Bundesbank to battle slow growth in the 1970s. What’s Jens Weidmann to make of that? Of course, current market hopes are pinned to Mario Draghi’s vow to save the European Union, although Citigroup charts just how difficult it will be to restore trust in the troubled institution in an eye-catching report that forecasts the rise of a new wave of extreme political parties. In markets news, Citi’s top US equity strategist, Tobias Lepvotich, shouts down doomsayers like Bill Gross, arguing equities have – and will – offer better returns than you might think. On top of that, Mark Hulbert points out stocks tend to outperform in weak earnings environments such as these. Elsewhere, The LA Times takes us five storeys beneath Manhattan’s financial district and through the 90-tonne iron doors that protect the world’s largest gold stash, which is being audited for the first time. And the search for yield leads investors to Nashville, where a small performance-rights company is selling junk bonds backed by the music of Bob Dylan. Bronte Capital’s John Hempton argues China’s ouster of Bo Xilai may collapse segments of the global luxury market, Deutsche Bank wonders if Harvey Norman is becoming a real estate play, and Nouriel Roubini’s “perfect storm” forecast gets an ETF investment strategy. On video, watch how the bourse has come to be dominated by an increasingly dangerous contingent of high-speed traders. It certainly puts the most recent Knight Capital controversy into context.

The Bundesbank’s bond-buying amnesia...

“In 1975, the Bundesbank bought around DEM 7.6bn of public bonds (post, telecom and sovereign bonds) in the secondary market. This was equivalent to around 1% of GDP.  … Interestingly, the information from that time suggests that the Bundesbank bought bonds because the economic outlook was deteriorating (GDP contracted 0.9% that year) and it was worried that further rises in long-term interest rates (from a 10.4% average in 1974) would threaten growth and drive inflation. Demand for longer-dated bonds plunged in the summer of 1975 as investors feared that soaring inflation would offset the returns on their investment. ... Note that public bond purchases were against the central bank’s mandate because it implied debt monetisation. … Hence, the Bundesbank had to tweak its own rules. Helmut Schlesinger, board member and chief economist of the Bundesbank at the time, justified the policy action as follows: ‘we can only operate open market policy in order to regulate the money market, but not to finance the public deficit’. In other words, the Bundesbank needed to purchase bonds in order to maintain monetary policy’s transmission channel. …  There are clear parallels between the situations in 1975 and 2012. At his first press confidence last year, ECB President Mario Draghi declared his ‘great admiration’ for the Bundesbank. At the time, we suspected he might be thinking about the Bundesbank’s successful inflation or monetary growth targeting... But now that Mr Draghi has announced potential ECB open market operations in order to purchase government bonds, he might actually have been thinking about 1975’s bond purchases. While it might not be surprising that Bundesbank President Jens Weidmann has the biggest objections to such a policy ... his objections to ECB bond purchases contrast with his own institution’s history.” (BNP Paribas, August 7)

Ultravox populi, vox debita...

“Public opposition to austerity measures in the periphery and bailouts in the core has intensified, foreshadowing a European UltraVox Populi and undermining a cohesive policy response. The result is not merely a ‘two track EU,’ but a two-track European electorate. We expect this sentiment will feed into elections in the Netherlands in September, and Italy and Germany expected in 2013. NEAPs (New, Extreme or Alternative Political Parties) should perform better in the next election cycle than in 2011, where mainstream opposition parties prevailed. Eurozone crisis measures could be constrained as a result.” (Citigroup, August 6)

Re-evaluating market returns... “‘It is very popular to suggest that the stock market has been a poor investment over the past decade-plus given that the S&P 500 and the Dow Jones Industrial Average are still trading below their prior highs,’ [Citigroup’s chief US equity strategist Tobias Levkovich] writes, ‘yet, a fair amount of that narrative can miss some important perspectives.’ The main points underpinning Levkovich’s argument: 1) The starting point for the measurement matters. Levkovich says that if investors got in the market after the tech bubble burst in 2002, they would have made a 70% return on the S&P 500 or 105% if dividends are factored in. 2) Small caps have done incredibly well against the broader market. The Russell 2000 is up around 70% since 2000. Levkovich writes that ‘it is crucial to note that mega caps have been the big underperformers weighing down the broad indices and that may be in the process of changing given our lead indicator model and likely corporate profit margin compression which generally favour larger companies over smaller ones.’ 3) Everyone is ignoring dividends: Capital gains was all the rage in the 1980s and 1990s, which makes dividends a very forgettable component of the investment story, according to Levkovich. He points out that ‘currently, aging baby boomers are somewhat desperate for income causing dividends to be back in vogue, but it has been 55 years since dividend yields last exceeded 10-year Treasury yields.’” (Business Insider, August 6)

Good news: Earnings growth is slowing…

“The stock market historically has performed better when earnings growth is slower than when it is faster. That at least is the conclusion reached by a study conducted by Ned Davis Research, the quantitative research firm. After analysing year-over-year earnings growth back to 1927, the firm found that the stock market tends to underperform whenever earnings growth is particularly strong. The reason for this counterintuitive finding, according to Ed Clissold and Dan Sanborn, US market strategists for Ned Davis Research and co-authors of the study: The market senses that high earnings growth is unsustainable, and is therefore discounting an imminent ‘slower earnings-growth environment.’ … The Ned Davis analysts found that the stock market historically has performed the best during periods in which year-over-year changes in quarterly earnings were either flat or falling modestly: When quarterly earnings growth was less than 5% and not worse than minus 20%, the S&P 500 index SPX -0.01%   grew at an annualized average of 12.4%. This compares to an average annualized return of just 2.4% whenever earnings growth was above 20% and 6.4% when that growth rate was between 5% and 20%.” (Mark Hulbert, August 7)

What’s in your vault?... “In New York, about $21 billion in US gold is locked inside the Fed’s vault. It’s stored alongside bullion from three dozen other countries and organisations such as the International Monetary Fund. All told, about 23% of the world’s official gold reserves are stored in the central bank’s vaults. The audit, which began in January, took place 80 feet below the Fed’s limestone and sandstone Italian Renaissance building in Manhattan’s financial district. Visitors to the vault make their way through a steel and concrete entrance where a 90-ton door rotates open. Inside, a massive scale is ringed by 122 blue cages that hold about 530,000 gold bars... The auditing team counted the US stash, selecting more than 350 bars from which to extract samples for assaying. … The bars were first weighed on a small electronic scale, then transferred to a table mounted with a long, thin drill used to burrow into the gold, said a person familiar with the operation who was not authorised to speak publicly. Workers were careful to collect any stray gold bits, the source said. Based on the market price of about $1,600 per troy ounce, the Treasury removed more than $110,000 worth of gold samples.” (LA Times, August 2)

Sell Swiss watches... “From Bronte Capital’s John Hempton: ‘The slowdown in Hong Kong (super) luxury goods is a faster decline than other Chinese data. Why so fast? I have a theory given to me by a China watcher. The theory – it turned bad sharply with the ouster of Bo Xilai and now the murder charge on his wife Gu Kailai. Gu Kailai is going to have a hard time avoiding a mobile execution unit. This changes the stakes and it is structural. A half million dollar watch no longer says “look at me”. It says “look at me, I am a kleptocrat”. Thoughts of that beautiful Van Cleef and Arpels hair clip become the last thing that runs through your brain before the bullet.’ Hempton makes the firm observation that rocketing sales of luxury goods over recent years have largely centred on Hong Kong, where favourable tax treatment has made it so worth a visit by the newly (and perhaps illegally) super rich Chinese. Post Bo, Swiss bling may not be the fashionable thing to wear. The historical parallel is Brazil in the 80s and 90s, where a run of violent kidnappings changed the face of high-end fashion.” (FT Alphaville, August 3)

From retail stock to real estate play...

(Deutsche Bank, August 7)

Invest for a perfect storm... “If Roubini’s ‘Perfect Storm’ unfolds as predicted, then even the biggest umbrella in the world won’t do you or your portfolio any good. Below we outline three ETFs that could thrive as global economic growth expectations deteriorate... 1) Physical Precious Metal Basket Shares (GLTR): Precious metals have demonstrated their ability to take on safe haven appeal when clouds of uncertainty gather over the market. ...GLTR is physically-backed, effectively steering clear of the nuances associated with futures-based commodity products. Each share of GLTR holds a basket of gold, silver, platinum and palladium in fixed weights: 47.6% of gold, 40.3% of silver, 7.3% of platinum and 4.8% of palladium. 2) Dynamic Food & Beverage (PBJ): The inherently defensive nature of consumer staples makes investments in this asset class quite appealing in times of economic turbulence. … PBJ holds 30 US food and beverage companies, including industry bellwethers like Yum Brands, Kraft Foods, McDonalds and Archer-Daniels Midland, in its top ten holdings. The top three allocations by sub-industry include packaged foods and meat, restaurants, and soft drinks companies. 3) ETRACS Fisher-Gartman Risk Off ETN (OFF): …  As the name suggest, OFF allows for investors to quickly and easily scale back on risk exposure and, as such, it makes for an appealing instrument for those looking to profit from the potential ‘Perfect Storm’ that is brewing. OFF holds short positions in risky assets like international stocks, energy and agriculture commodities, as well as emerging markets currencies. At the same time, this ETN also holds long positions in a basket of safe have asset classes, including the Swiss franc, US Treasuries and German government bonds.” (ETFdb, August 7)

The bonds, they are a-changin’... “Bob Dylan’s music was the soundtrack for the counterculture of 1960s America. Now it has become a selling point for an unusual bond offering being marketed to institutional investors and wealthy individuals. A privately held Nashville, Tenn., company is preparing a $300 million bond backed by the cut it receives as a middleman between music companies and songwriters and the outlets that broadcast their music. The company, Sesac Inc., has the exclusive rights to the public broadcast or performance of the music of Mr. Dylan, pop singer Neil Diamond, Canadian rock band Rush and jazz singer Cassandra Wilson. The bond sale is music to the ears of investors hungry for income at a time of near-zero interest rates. … Investors who have been pitched on the deal say underwriters are trying to sell the five-year bonds to yield around 5.25%.” (Wall Street Journal, August 7)

God says ‘no’ to News Corp... “The Church of England has sold all of its shares in News Corporation at the recommendation of its ethics advisory panel, citing continued concerns over the media conglomerate’s corporate governance. A year after the firm found itself embroiled in a phone hacking scandal, the church’s Ethical Investment Advisory Group said News Corporation had still not implemented necessary reforms or shown signs of a willingness to change. As a result, the church’s three investing bodies sold shares in the company worth £1.9m.” (Financial News, August 7)

Video of the Week: Rise of the HTF machines…

“This astonishing GIF comes from Nanex, and shows the amount of high-frequency trading in the stock market from January 2007 to January 2012. (Which means that the Knightmare craziness of last week is not included.) The various colours, as identified in the legend on the right, are all the different US stock exchanges. You might think there are only two stock exchanges in the US, but you’d be wrong: there are only two exchanges where stocks are listed. There are many, many more exchanges where stocks are traded. … The stock market today is a war zone, where algobots fight each other over pennies, millions of times a second. Sometimes, the casualties are merely companies like Knight, and few people have much sympathy for them. But inevitably, at some point in the future, significant losses will end up being borne by investors with no direct connection to the HFT world, which is so complex that its potential systemic repercussions are literally unknowable. The potential cost is huge; the short-term benefits are minuscule. Let’s give HFT the funeral it deserves.”

Graph for Research Watch

(Felix Salmon, August 6)

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