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.

It just won't go away. After a couple of months in the closet, sovereign risk has once again reared its ugly head, but this time it’s worse. Morgan Stanley now says it’s no longer a question of whether the big debtor nations default, but when and how, and none of the options are pretty. In the market, David Rosenberg argues earnings estimates show stocks still have a way to fall – as does an eerily accurate investment diagram published 140 years ago. Charles de Vaulx tells you where he puts his money in times of volatility and low growth, and a warning about trading ETFs that hold too many illiquid stocks. Meanwhile, we uncover a lucrative haven for the amoral investor, examine how Luxembourg could spawn the next international crisis, and look at why the big research houses are picking up Cold War-style spy technology. On video this week, a sneak peek at a slick new doco that looks behind the scenes at the 2008 global meltdown.

Ask not whether governments will default, but how '¦ “Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies’ governments. On the basis of current policies, most governments are deep in negative equity.

This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take. So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss. It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies '¦

[There has been a] rapid increase in the age of the median voter in large western European countries. In principle, having governments and policies shaped by older voters ought to be favourable to bond holders, because bonds are more likely to be held by the old than the young and policies that would harm bond holders would often also harm the old (inflation for instance redistributes wealth from the old to the young). The first problem with this argument is that the constituency of the elderly is also the biggest competitor to bond holders because of the considerable size of the direct claim it has on the government balance sheet in the form of pensions, social security and health insurance, etc. The more reluctant they are to relinquish these claims, the higher the risk for bond holders ... There exists an alternative to outright default. 'Financial oppression’ (imposing on creditors real rates of return that are either negative or artificially low) has been used repeatedly in history in similar circumstances. Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection.” (Morgan Stanley, August 25)

The earnings indicator '¦ “It must be extremely frustrating for the bulls to see the market down 12% from the April peak even with 12-month trailing EPS rising 18% since then. So what’s changed for the worse? The answer is analyst earnings revisions. The Thomson IBES 12-month forward earnings estimates have been trimmed more than 7% since April. Come to think of it, the peak in earnings forecasts coincided with the peak in the market. And guess what? The forecast peak in the last cycle was in October 2007, again right when the S&P 500 was hitting its highs. Before that, earnings estimates were starting to get cut in August 2000, just ahead of the peak in the market. If you are just watching the earnings themselves, on average they are off six months from the time the stockmarket rolls off the peak. Earnings estimates seem to be a perfectly good timing device. The same holds true at bottoms. Forward estimates hit their trough in March 2009 right at the same time the market bounced off the lows. If you waited for the actual earnings to revive, which they did in November 2009, you would have missed eight months of 65% gains in the S&P 500.” (David Rosenberg of Gluskin Sheff, August 23)

Investment lessons from 1872 '¦ “Here’s a diagram that was published on a business card by George Tritch in 1872 that shows a pattern of 'Periods When to Make Money' based on a simple 16/18/20 year pattern:

• Click here for a larger image.

So, how well has Mr Tritch predicted? Since 1873, in 'down years’ the index has decreased 4.7% over five years in real terms, while the index has increased 18.9% on average over a five-year period over that same time. And now? We are still in the middle of a down period. But make sure you're ready for the next bull market in 2012.” (Economic Data, August 20)

Charles de Vaulx is big in Japan '¦ “The star asset manager expects ongoing volatility and thinks the world is going to have slow, grim growth for five or seven years. Here’s where he has his money:

• The Tokyo stockmarket. You probably forgot it was there. So has everybody else. And that's an opportunity. De Vaulx says that after 20 years of pain, many Japanese companies have rock-solid balance sheets. The market is trading at 1.1 times tangible book value. The yield is about 2% – high by historic standards there, and more than the 30 on the 30-year government bond.

• Cash, plenty of it.

• Cusp bonds. That is, bonds on the cusp between 'investment grade’ and 'high yield.’ If you pick your names right, you can get decent yields with lower risk. De Vaulx has 16% of his fund here – selected high-quality, high-yield bonds. Look for companies with strong balance sheets and lots of liquidity. If times get tough, they'll need it. And don't go too far down the yield curve. Two to seven years' maturity. Why? The economy's so weak that inflation may be subdued that long. But sooner or later it's coming, and if that happens any investor locking in a fixed income for 20 or 30 years is going to be in trouble.

• Gold. 'It should do well either way,’ says De Vaulx – meaning deflation or inflation.

(MarketWatch, August 24)

Beware Luxembourg (it’s contagious) '¦ “Let’s be honest – we can’t really explain most of this paper: 'We model the spreading of a crisis by constructing a global economic network and applying the Susceptible-Infected-Recovered (SIR) epidemic model with a variable probability of infection. The probability of infection depends on the strength of economic relations between the pair of countries, and the strength of the target country. It is expected that a crisis which originates in a large country, such as the USA, has the potential to spread globally, like the recent crisis. Surprisingly, we show that also countries with much lower GDP, such as Belgium, are able to initiate a global crisis. Using the k-shell decomposition method to quantify the spreading power (of a node), we obtain a measure of “centrality” as a spreader of each country in the economic network. We thus rank the different countries according to the shell they belong to, and find the 12 most central countries. These countries are the most likely to spread a crisis globally. Of these 12 only six are large economies, while the other six are medium/small ones, a result that could not have been otherwise anticipated.' The lucky 12: China, Russia, Japan, Spain, United Kingdom, Netherlands, Italy, Germany, Belgium (!), Luxembourg (!!), USA, and France.” (FT Alphaville, August 24)

Sin is in '¦ “The aptly named Vice Fund is beating the house in a down market. The Standard & Poor's 500 index is down 1.9% this year, yet stocks of cigarette makers are up an average 12%. The Vice Fund's three biggest holdings are cigarette stocks: Philip Morris International Inc, Lorillard Inc and Altria Group Inc. That explains why the fund is up 4.5% this year, ranking in the top 3% of its large-blend fund peers according to Morningstar. Defense contractors – another fund mainstay – are up an average 12%. Alcoholic beverages, up 6%. Vice is the lifeblood of a fund that's a counterpoint to investment products touting themselves as socially responsible because they favor companies ostensibly benefiting society. This year, those stocks aren't doing anything special. An index of socially responsible stocks, the MSCI USA Large Cap ESG, is down 1.7%.” (Washington Post, August 20)

Big Finance is watching you '¦ “As part of a growing trend among hedge funds and Wall Street firms, Cold War-style satellite surveillance is being used to gather market-moving information. The surveillance pictures are often provided by private-sector companies that build and launch satellites and take pictures for US government intelligence agency clients and private-sector satellite analysis firms '¦ UBS Investment Research recently issued an earnings preview for Wal-Mart that publicly revealed the bank had been using satellite services to gather the comings and goings of the parking lots at Wal-Mart stores '¦ By counting the cars in Wal-Mart’s parking lots month in and month out, analysts were able to get a fix on the company’s customer flow. From there, they worked up a mathematical regression to come up with a prediction of the company’s quarterly revenue each month '¦ Analysts are doing the same surveillance on several other big names in the US, including Home Depot, Lowes, and McDonald’s.” (CNBC, August 20)

Should ETFs be allowed to include illiquid stocks? '¦ “Right now, the SEC says that 70% of securities in an ETF must be 'actively traded', or 50% if the ETF includes 200 or more securities. Which means that ETFs can have up to 50% illiquid stocks, which are relatively easy to manipulate. Let’s say that you’re a predatory algo and you’re looking at activity in these ETFs with substantial holdings of small-cap stocks. When people are buying, you quickly load up on the underlyings; when they’re selling, you go short. Your activity will eat into the returns of the ETF, since you’re making it more expensive for the ETF to buy the stocks, and getting a worse price when it sells. But more to the point, it will maximise volatility and room for manipulation in the underlying stocks, as well, while minimising the useful information to be gleaned from their share price. If you buy straddles on these small companies – equity derivatives that pay off when volatility is high – then it’s easy to imagine how you can trigger payouts by playing around in the ETF space.” (Felix Salmon, August 23)

Szechuan vampire squid '¦ “Goldman Sachs, reviled in the US for its role in the financial crisis, is now getting hammered in the world's No. 2 economy with a sensationalist new book accusing the investment bank of trying to destroy China. The Goldman Sachs Conspiracy, which has sold over 100,000 copies since it was released in June, reaching popular website Sina.com's top-10 list, follows another by author Li Delin, Eliminate All Competitors – How Goldman Sachs Wins Over the World, published last year '¦ The nearly 300-page, highly dramatised account takes ample license in its attacks on Goldman Sachs. The company's ultimate goal, Li says in the first chapter, is to 'kill China'. '¦ 'Like a fox chewing a bone, Goldman Sachs knows the rules of the game and when to go for your neck,' it says. With the 'cruel character of a Manchurian tiger, the group creeps around the world, like a veteran hunter stalking its prey, when it smells blood it pounces!' the chapter says.” (Associated Press, August 25)

Video of the Week: Inside Job '¦ A slick look at the salaries, drugs and personalities behind the 2008 financial crisis.

(Sony Pictures, August 24)