Research Watch

Trading in central banks, a short view on the markets, resolving the fiscal cliff, prepare for 1987, European union, and skating in China’s ghost cities.

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.

“Don’t fight the Fed,” goes the old market adage, and the fat profits booked during the current risk-on rally indicates the rule still holds true. But as markets soar into what Mohamed El-Erian labels “bubble territory”, the PIMCO chief executive has some timely advice for investors positioning to benefit from the latest round of central bank intervention. The sentiment is also echoed by Michael Hintze and Gluskin Sheff’s David Rosenberg, who offer their own investment strategies designed to thrive in a world of overpriced assets. Beyond the QE3 caution, Goldman Sachs and Bank of America argue US fiscal cliff negotiations hold enormous upside potential, and separate research suggests the successful resolution will almost guarantee a victory by Barack Obama in next month’s presidential election. Elsewhere, on the 25th anniversary of the Black Monday market crash, Mark Hulbert warns another 1987-style plunge is imminent, while a Goldman Sachs veteran offers insights into the first days on the job. China’s two-speed economy could keep the nation afloat, high-frequency traders hit a speed bump, and you’ll find everything you need to know about a potential European fiscal union in the Financial Times’ handy, cut-out-and-keep guide. On video, youths find unlikely new value in China’s ghost cities.

Trading the central bank bubble...

“Essentially, [with QE3] the Fed is inserting a sizeable policy wedge between market values and underlying fundamentals. And investors in virtually every market segment – including bonds, commodities, equities, foreign exchange and volatility – have benefited handsomely. In the process, many asset prices have been taken close to what would normally be regarded as bubble territory, with some already there... Investors would be well advised to remember some basic truths as they continue to position their portfolios (and scale their risk exposures) on the basis of unusual central bank activity: The assets likely to be impacted the most and longest are those under the immediate influence of central bank measures – namely the securities they buy directly. The more investors venture beyond these assets (and the larger and more illiquid their risk positions), the greater their conviction that unconventional central bank policies will eventually succeed in engineering more robust economic and financial fundamentals. It is hard to pin such conviction on detailed analytics or historical experience. Central banks are neck deep in extreme policy experimentation mode, and getting inadequate support from other government entities. The longer this persists, the higher the risk that policy benefits will be offset by collateral damage and unintended consequences; and the greater the political heat on central banks. If the critical hand-off to fundamentals does not materialise, the reaction of markets will not be pleasant. Positioning on the basis of the ‘central banks’ put’ is a particularly crowded trade. Also, it involves some investors being overconfident in the powerful omnipresence of these institutions, some believing in immaculate economic recoveries, and some feeling they can wait for markets to peak decisively and then exit smoothly. … Investors should definitely pay attention to western central banks and respect the market influence of unconventional policies. But they should do so while keeping a wary eye on how far, and for how long, valuations can be divorced from fundamentals.” (Mohammad El-Erian of PIMCO, October 10)

Have markets had too much of a good thing?...

“Michael Hintze, the founder of $11.7bn hedge fund manager CQS, has used his latest letter to investors to reverse the ‘constructive’ view on markets he has held for the last three years. In the letter, Hintze wrote that he ... has positioned some portfolios to take long positions on short-maturity credit, and short positions on longer-dated credit, where there is less visibility. In equities, he has reduced net long exposure and added to certain commodities, ‘including agricultural commodities, gold and other precious metals. Non-financial corporates with good dividend cover are also of interest to me and an area we are actively analysing.’ Hintze wrote that monetary stimulus is having a diminishing effect: ‘My view is that while central bank (and government) actions may have stabilised markets and economies, they have also ‘kicked the can down the road’ and have not resolved the fundamental underlying issues that need to be tackled for a broad-based and sustainable macroeconomic recovery. Like all things in life, it is possible to have too much of a good thing.’ … Hintze suggested that the eurozone’s two main structural problems – indebtedness and fiscal discipline for member states – were yet to be properly addressed, partly because of the challenge of the short-term electoral cycle. He wrote: ‘A challenge with a two, four or five-year electoral cycle in democratic systems is that the legislative agenda must (almost) always have an eye to re-election as its political imperative. It is unclear to me whether there is sufficiently determined leadership to deal with what are serious structural matters.’ … Regarding China, Hintze wrote that ‘expectations that China is a one-direction economic powerhouse are unrealistic,’ and that ‘in the short-term there are challenges in transitioning from an export-led manufacturing economy to one where the services sector growth takes up the running’. Hintze was more positive on the outlook for the US. While the US budget deficit and the fiscal cliff are challenges, he said that employment appears to be growing and the US may surprise over the medium-term.” (Financial News, October 16)

Navigating the new normal...

(David Rosenberg of Gluskin Sheff, October 12)

What if Congress resolves the fiscal cliff?

“Most of the conversation regarding the ‘fiscal cliff’ — Fed Chairman Ben Bernanke’s term for what happens if Washington fails to address deficit reduction by year’s end — has focused on the downside. If the cliff isn’t avoided and a series of tax increases and spending cuts kicks in automatically in 2013, that will mean disaster for the economy and the stockmarket, the thinking goes. But little attention gets paid to the upside. Should Washington defy the odds and come up with a solution... the market could have a chance to build on the 2012 rally. ‘What if we came up with a situation tomorrow and there was some reconciliation, some agreement?’ Goldman Sachs CEO Blankfein said in a CNBC interview. ‘I’d be a buyer of the stockmarket.’ … Bank of America Merrill Lynch goes as far as to call for the ‘Great Rotation’ — a move out of bonds and into stocks that will be triggered in part by resolution of the fiscal cliff at some point in 2013. ‘The era of bond outperformance has ended,’ Michael Hartnett, BoA’s chief investment strategist, said in a note. ‘If the US successfully navigates the fiscal cliff, Europe continues to stabilise and Chinese growth reaccelerates, in our view 2013 could mark the start of the Great Rotation.’” (CNBC, October 12)

Obama and the S&P500...

“You don’t need to follow presidential debates to have something clever to say about the outcome on election day. All you need is to look at the US stockmarket and my forecast is that if S&P500 keeps trending upward until election day then Obama will be re-elected. If we get a major sell-off then Romney will soon move into the White House. Just see this graph – it is S&P500 and Obama’s reelection likelihood mentioned from InTrade shares on ‘Barack Obama to be re-elected President in 2012’.” (Market Monetarist, October 16)

China’s two-speed economy...

“[The San Francisco Fed] separates China into two economies: ‘Advanced’ and ‘Emerging’. They point out that historically across Asian nations, as economies move from Emerging to Advanced, their growth slows.

China’s provinces should follow the same trend of rising per capita income levels and declining growth rates.

The model projects that the recent slowdown is a structural one and growth will indeed continue to moderate. However … China’s relatively undeveloped areas may be able to grow at high rates for some time before reaching income levels associated with slowdown. This could delay a middle-income trap growth slowdown for the nation as a whole.” (Sober Look, October 15)

Another 1987-style crash is imminent...

“Researchers derived a complex mathematical formula for predicting the frequency of large daily stockmarket movements. Though they believe that their formula rests on a solid theoretical foundation, the proof of the pudding is in the eating. And they found that not only does the US stockmarket over the last century closely adhere to the formula, so do international markets. A single-session drop of at least 20%, for example, is predicted — over long periods — to occur once every 104 years, on average, but it could happen at any time. That’s why you always have to prepare for it, because you don’t know when it will occur. …  Crashes are an inevitable feature of the investment arena because every market, to a more or less similar degree, is dominated by its largest investors. When those large investors collectively want to get out of stocks, which will happen on occasion, they will find ways to circumvent myriad downside protections such as circuit breakers that may be in place. [The researchers] therefore recommend that all of us — whether individuals or large institutional investors, such as banks and mutual funds — cushion our portfolios so that a crash as large as 1987’s won’t be fatal. Unfortunately … those cushions are a drag on portfolio performance as long as the market doesn’t plunge. … The bottom line? Regulators are tilting at windmills in trying to formulate reforms that would prevent large daily market drops. Even worse, these regulatory efforts lull gullible investors into a false sense of security. Repeat after me: Another stockmarket crash as big as 1987’s is going to happen. Period.” (Mark Hulbert, October 17)

How profitable is high-frequency trading?...

“Profits from high-speed trading in American stocks are on track to be, at most, $US1.25 billion this year, down 35% from last year and 74% lower than the peak of about $4.9 billion in 2009, according to estimates from the brokerage firm Rosenblatt Securities. By comparison, Wells Fargo and JPMorgan Chase each earned more in the last quarter than the high-speed trading industry will earn this year... The firms also are accounting for a declining percentage of a shrinking pool of stock trading, from 61% three years ago to 51% now, according to the Tabb Group, a data firm. … Timber Hill, which is one of the few high-speed firms that releases its financial results publicly, provides a unique window into the trends. The firm’s founder, Thomas Peterffy, said that firms like his ‘had a field day’ in 2008 and 2009. Share prices were plummeting, and the volatile conditions were ideal for high-speed firms. In addition to the high volume of trades in those years, share prices were moving around wildly, allowing computer programs to take advantage of dislocations in prices. Timber Hill, which trades stocks but specialises in options, made a $328 million profit, before taxes, in 2009. Since then, though, the amount of stock trading done by Timber Hill fell 27% between 2009 and 2010 and 38% between 2010 and 2011.” (New York Times, October 15)

Your cut-out-and-keep guide to European fiscal union...

(Financial Times, October 17)

Fancy a Spanish villa?...

“For years, the Mar de Canet apartment complex in this beach town south of Barcelona stood empty, another casualty of a real estate crash that left this country littered with ghost towns and half-finished developments no one would buy. But recently, the communal pool at Mar de Canet was full of giggling children, and bright beach towels flapped from virtually every balcony. Mar de Canet’s 308 units were sold in less than 30 days last spring, mostly gobbled up by eager Spaniards finally getting a deal they could not resist...  Banks, which have been sitting on a pile of real estate assets or listing them at only slight discounts, are beginning to slash prices, eager to get out of the business of being landlords. … So many people showed up on the first day the Canet apartments went on sale here that Jesús Martínez and his wife, who were at work and planning to look the next day, called their parents to rush over and lay a claim for them. The couple bought a two-bedroom unit with a terrace and a parking place for $92,000.” (New York Times, October 13)

Sandwich or salad?...

“You needed to be very entrepreneurial and creative [at Goldman Sachs]. Adding value as an intern often began with getting coffee for the desk every day; frequently, interns also did breakfast and lunch runs. You would literally take a pen and pad and go around to the ten or fifteen people on the desk and take everyone’s order. It’s a strange concept, but Wall Street looks at attention to detail as an indicator of how people are going to do in their job. If a kid keeps messing up the lunch order, he’s probably going to mess up something else down the line. I remember one managing director– a few years after I’d started working at the firm– who was very sensitive about his lunch orders. He didn’t eat onion or certain other things. One day he asked an intern for a cheddar cheese sandwich, and the kid came back with a cheddar cheese salad. The kid handed it to him so proudly: “Here’s your cheddar cheese salad.” I was sitting next to the MD, so I remember the incident well. He opened the container, looked at the salad, looked up at the kid, closed the container, and threw it in the trash. It was a bit harsh, but it was also a teaching moment. The managing director joked about it with the kid afterward; he didn’t make a big deal about it. The lesson was learned.” (Greg Smith, from his book Why I left Goldman Sachs, via Deal Breaker)

Video of the Week: Skating China’s ghost cities...

“A group of skaters looks to try their tricks in a new and different environment -- only to discover a glittering, modern city devoid of human occupants. Originally built to house one million residents, the city of Ordos in northern China is now almost completely deserted. Despite China’s much-lauded building boom, soaring property prices have kept occupants at bay. Ordos is now the largest ghost town in China -- thought to be a stark example of China’s impending real estate bubble.”


Graph for Research Watch

(The Atlantic, October 10)