Research Watch

Looking back to Germany, why band-aids don’t last, what China can learn from Greece, Big Mac investing, and the richest make-believe characters.

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 long been clear that Europe’s debt crisis will come to a head in Berlin, but might it also have begun there? This week, Nomura traces the disaster back to a balance-sheet recession in Germany in the early 2000s, and what could be considered the first major bailout by the European Central Bank. “The countries of southern Europe are not to blame,” he argues. In any case, the continent still needs to formulate a lasting solution, and quickly. Researchers have illustrated just how ineffective band-aid responses are becoming, and hedge funds are already making big, contrarian bets against bunds. On the plus side for equities, alarm bells will be ringing in Omaha as Warren Buffett’s favourite valuation metric approaches his “buy” zone. RBS discovers that Asian institutional investors aren’t too optimistic about markets here, as Bespoke highlights the degree to which US stocks are outperforming their peers around the world. And if you’re considering sending some recovering Australian dollars into markets there, Jim Jubak has a list of juicy 'Big Mac’ stocks to sink your teeth into. Meanwhile, the Bank of England urges investors to reassess their liquidity strategies, Mark Hulbert abandons moving averages, and an analyst infiltrates the secret 'Google X’ headquarters in search of Silicon Valley’s next big thing. On video, Forbes ranks the wealth of Gordon Gekko, John Wayne and other members of the make-believe moneyed class in a serious analysis of fictional finances.

The German bailout that started it all'¦ “Nomura's Richard Koo says ... after the 2000 tech bubble collapsed (a bubble which Germany shared heavily in) the ECB used exceptionally loose monetary policy to stimulate the economy, so that Germany wouldn’t have to revive its economy via fiscal policy: ... “The countries of southern Europe, which had not participated in the IT bubble, enjoyed strong economies and robust private-sector demand for funds at the time. The ECB’s 2% policy rate therefore led to sharp growth in the money supply, which in turn fuelled economic expansions and housing bubbles. Wages and prices increased ... leaving those countries less competitive relative to Germany. In short, the ECB’s ultra-low policy rate had little impact in Germany, which was suffering from a balance sheet recession, but it was too low for other countries in the eurozone, resulting in widely divergent rates of inflation. As Germany became increasingly competitive relative to the strong economies of southern Europe, exports grew sharply and pulled the nation out of recession. Germany’s trade surplus quickly overtook those of Japan and China to become the world’s largest, with much of the growth furled by exports to other European markets. In 2005, a senior ECB official '¦ [told me that because] Germany could not be granted an exception on fiscal stimulus, the only option was to lift the entire region with monetary policy. In other words, there would have been no need for such dramatic easing by the ECB '¦ if Germany had used fiscal stimulus to address its balance sheet recession. The creators of the Maastricht Treaty made no provision for balance sheet recessions when drawing up the document, and today’s “competitiveness problem” is solely attributable to the Treaty’s 3% cap on fiscal deficits, which placed unreasonable demands on ECB monetary policy during this type of recessions. The countries of southern Europe are not to blame.” (Richard Koo, chief economist at Nomura, June 19).

Band-aids don’t last...

“The point Barclays is trying to make here is the declining level of confidence the markets now have in the policymakers’ abilities to devise and implement effective lasting solutions. '¦ This lack of confidence has caused the time periods between each successive 'positive’ policy announcement and the next market 'stress period’ to become shorter.” (Sober Look, June 19)

China could learn from Greece... “[Greece's] per capita income was only 28% of America’s in 1960 ... That is very roughly where China stands today. Over the next 12 years, however, the Greek economy grew at an Olympian pace of 8% a year on average, faster than China’s growth target for 2011-2015. Greece then suffered a quarter century of inflation and stagnation, before resuming its convergence after 1996. By 2008 it had caught up to 52% of America’s income level [to become a so-called 'high-income’ economy]. '¦ Its economic convergence (not to mention its democratic transition in 1974) is a European success story. Indeed, in escaping the middle-income trap, Greece achieved something that China’s policymakers still worry about pulling off themselves. In the popular imagination, China’s economy is awesome, Greece’s just awful. But the country’s economic record warrants something other than simple disdain.” (The Economist, June 19).

Hedge funds bet against Germany... “More than 50% of managers polled at an industry conference in Monaco ... said they expect Bund yields to double within a year. Gavyn Davies, the founder of hedge fund Fulcrum Asset Management, told the Gaim conference that every hedge fund’s analytical model was signalling that the German bond market was too expensive. He said Bund yields were being depressed by a big 'capital flight’ from other eurozone countries that was 'one heck of a powerful force’. However, the former Goldman Sachs chief economist said this pressure would not continue to push down yields indefinitely. '¦ Until recently, few have dared wager against German bonds, fearing the firepower of the German government and the European Central Bank. Many now view the eurozone crisis as too far gone not to impact on Germany, however. Among those hedge fund managers already shorting German bonds is John Paulson, the US hedge fund manager who rose to prominence in 2007 thanks to correctly betting that the US housing market would collapse. Bill Gross, the chief investment officer of the world’s largest bond fund, Pimco, is also bearish on the prospects for German debt.” (Financial Times, June 19).

Approaching Buffett's buying range...

“The most recent update to Warren Buffett’s favourite valuation metric is showing some fairly encouraging signs. For those who aren’t aware, Buffett is quoted saying that the total market cap vs gross national product (GNP) is one of his preferred valuation metrics. The current reading of 89% is still above his preferred buying range (70-80%), but well off the highs we’ve seen in the last 15 years. Buffett has previously explained his thinking behind the indicator: “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% – as it did in 1999 and a part of 2000 – you are playing with fire.” So stocks aren’t cheap, but they’re also not terribly expensive based on this measure. If the recent trend holds we could be nearing Buffett’s preferred buying range.” (Pragmatic Capitalism, June 19).

Asia loses its investment appetite... “We have just completed a week-long roadshow through the Asian investor base and conclude that positioning is almost universally defensive. Australian healthcare names were well-held, although valuations were acknowledged to be stretched at these levels. The Australian dollar and the two-speed economy were concerning most, with widespread concern about the competitiveness of corporate Australia. Investors were generally still encouraged by the gradual recovery of the US economy and its relatively defensive position vis a vis Europe, and were interested in Australian names with leverage to the region. On the European situation itself, most had given up following the nuances of the battle between policy and markets ... On previous visits to Asia we have always found strong views [on China] to each direction, with generally a majority view becoming clear. On this tour we rarely encountered an investor that had any opinion as to whether China was slowing down, speeding up, stimulating or reforming! Clearly, the impending leadership transition is leaving China particularly cautious, but has also probably slowed the communication flows about policy and intentions. With this lack of directional view, Australian resources were an underweight or un-held sector for most.” (RBS Morgan via Scribd, June 18).

America outpaces the world...

“The chart above shows the relative strength of the S&P 500 versus the MSCI World (Ex-US) Index. When the line is rising, it indicates US stocks are outperforming and vice versa when the line is falling. As we have noted in prior updates, US stocks have been a port of safety compared to the rest of the world. In fact, the S&P 500’s relative strength is currently at its highest levels relative to the rest of the world since September 2004.” (Bespoke Investment Group, June 18).

Big Mac investing... “If McDonald’s can find enough places to put to work the cash it earned from operations (minus what it paid for dividends and stock buybacks) at something like [last year’s] 20.8% return on invested capital in the future, investors are looking at a company that has the potential to compound the cash it generates by better than 20% a year. (And I think it can, in China.) When you’re searching for stocks that fit this paradigm, you should start by looking at cash flow from operations to see what kind of cash the company is generating internally and at the returns the company gets on reinvesting that cash. '¦ What you’d like to find is a company with a high return on invested capital/return on equity with clear prospects that point to a continued opportunity to earn those returns in the future. '¦ Size can be a huge hindrance here. '¦ If a company has collected a 20% return on invested capital in the past, it might be hard-pressed to find another opportunity with that kind of return in the future. One sector that turns up a promisingly large number of candidates that fit this paradigm is the consumer sector. Besides McDonald’s, a preliminary screen on return-on-equity turns up Diageo, Nestlé, L’Oreal and Yum Brands... These companies share a common strategy for growth – to go into the world’s big, developing economies.” (Jim Jubak via MSN Money, June 14).

Adjust your liquidity strategy... “The days of instant market pricing and limitless liquidity may be fading. The 'great moderation’ conditioned many to underestimate credit risk. It also bred a generation of traders, money managers, bankers and risk officers to presume an unfettered flow of capital and instant access to narrow bid/offer spreads. '¦ Many continue to assume that at the currently liquid end of the trading security spectrum 'liquidity’ is free and will be freely available. Short-term traders count on it; algo-trading depends on it. Long/short strategies presume you can short. Stop-loss disciplines demand you can cover – and cover quickly. But here’s the thing: confronted with sudden surges in cross border flows, elected governments will attempt to intervene in the interests of stability generally and to protect their taxpayers specifically. They may not succeed, but it is their right and duty to try. Needless to say, your well timed trading strategies will not be allowed to get in the way. Short-selling bans in Europe and bond purchase penalties in Brazil are a foretaste of the future. I recommend that you ... [visit] library to research state intervention in the post war period. It could come in handy. For like clean air and water, market liquidity is no longer limitless and no longer free.” (Robert Jenkins, member of the Bank of England's Financial Policy Committee, June 20).

Move on from moving averages... “The Dow’s recent close above its 50-day moving average provides me with the occasion to rain on yet another parade '” this time that of the bulls. '¦ A careful analysis of the historical record reveals that the stock market in recent decades did not perform appreciably better when it was above the 50-day moving average than when below. '¦ Consider the Dow’s performance on all days since Jan. 1, 2000, when this average '” as of the previous trading session’s close '” was above its 50-day moving average: All together they amount to a cumulative loss of 3.7%. '¦ According to Blake LeBaron, a Brandeis University finance professor who has extensively studied a number of different technical trading rules, moving averages of various lengths stopped working in the early 1990s, not only in the stock market but also in the foreign-exchange markets as well. Since those two markets are not linked in any obvious way that would otherwise explain why the same trend-following system would fail simultaneously in both, it seems likely that the moving average’s fading effectiveness is more than just a fluke. '¦ I am not arguing in favor of the bearish case... I am instead raising serious concerns about whether moving averages continue to be a worthwhile basis for becoming either more or less bullish.” (Mark Hulbert via MarketWatch, June 19).

What’s next for Silicone Valley?'¦ “I'm at the secret headquarters of the not-so-secret Google X, where the way-out-there projects of the search giant turn into reality. The gregarious play master, Sebastian Thrun '¦ [was first hired by Larry Page] to work on StreetView for Google Maps. But his role soon evolved: 'Larry frequently had me to dinner and every time, Larry would dream something up that was completely crazy. My gut reaction was that this makes no sense, it can’t work, it’s completely flawed. And I’d go home, do some calculations and a day or a week later I’d apologise and say: You were completely right.’ One of these ideas was for a self-driving car, not through a desert, but on the streets of San Francisco and beyond. Crazy. But Mr Thrun and 12 engineers created a car that could drive itself down twisty Lombard Street without a human driver. How did they do that? 'We should question all the rules – we should break the rules,’ he says. '¦ Mr Thrun brought in University of Washington Prof. Babak Parviz to create a set of eyeglasses that are capable of displaying Web and Google search results. Not easy – yet another cross-discipline challenge to make the device ultra lightweight and natural to use. It was announced recently as Google Glass. I tried to get the scoop on other Google X projects, but without much luck. Mr Thrun did say that 'they have to be a science challenge. The preconditions are they have to have massive influence on people, they have to have a path to become real, and we have to have massive challenges.’ Smartphone apps are too easy. 'Larry Page always encouraged me to aim high.’” (Wall Street Journal, June 15).

Video of the Week: Fictional finance... Forbes ranks the 15 richest make-believe characters, who boast a stunning aggregate net worth of $209.5 billion.

(Forbes, April 23)

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