Research Watch

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.

As interest rates tick lower and alarm bells sound over the value of the Australian dollar, Goldman Sachs' so-called financial conditions clock is fast approaching 12 – that is, “loose and expanding”. Valuations will swell, the broker says, and so it might be time to adjust your allocations. Bloomberg names one North American asset class you should consider – it's outperformed all others for the first time in 17 years, and history suggests it could double again in the next two – while bond yields in Africa are also beginning to attract yield-hungry investors. Meanwhile, find out how to cash in on business appointees in public office, and why insider silence suggests extreme returns could lay ahead. US volatility suggests markets are on the verge of a new, five-year period of calm, but if you still think an impending financial collapse could destroy society as we know it, you now have the chance to own your own underground survival bunker. On video, is China growing at all?

It's time to rotate your allocations...

“While the market has been quick to re-calibrate valuations to be broadly in-line with those of similar phases, our base case is for financial conditions to be firmly within a loose setting by early to mid-2013 (75bp of rate cuts, plus >5% correction to the $A). A shift to the 12 o’clock phase (loose and expanding financial conditions), implies 13% upside to current levels across the broader market, 18% in resources and 27% across the cyclical industrials.” (Matthew Ross of Goldman Sachs, October 22)

And the most lucrative asset class is... “US stocks are beating every major asset class for the first time in 17 years even as economic growth weakens and profits rise at the slowest rate since 2009. The Standard & Poor’s 500 Index has rallied 14% in 2012, beating Treasuries, corporate bonds, commodities, the dollar and equities in Asia and Europe, data compiled by Bloomberg show. The last time that happened, in 1995, the S&P 500 was posting the biggest annual advance of the last five decades. With a price-earnings ratio close to today’s level, the index gained another 93% in the next 2 1/2 years. … Forecasts for a rebound in the US economy and the central bank’s pledge to keep interest rates near zero for years convinced bulls the S&P 500 will extend gains. Bears say political gridlock will drag down prices after monetary stimulus wears off.” (Bloomberg, October 22)

But beware, ETFs are cannibalising stocks... “Dave Lutz, a strategist who heads ETF trading at Stifel Nicolaus, is noticing a disturbing trend in his market... The ETFs that have become so popular among traders are 'cannibalising' the stocks that they are supposed to track – leading to choppier trading for investors in the underlying stock. The problem all boils down to the 'float,' or the number of shares a company issues to the public for trading on an exchange. Lutz says that all of these ETFs purchasing up shares of stocks they're meant to track is causing the actual 'tradable' float to be a lot smaller than the official number suggests, writing: 'When ETFs hold shares, some are [loaned out] for short-borrowing – but the vast majority essentially are “warehoused,” and in my opinion, should be removed from the float.' Because there are less shares of certain stocks 'warehoused' by ETFs being traded in the market, trading in those names will be less liquid than the 'float' number would normally indicate and, as a result, will be more volatile. Lutz takes his own firm, Stifel Nicolaus, as an example. The official float on Stifel stock is 49.7 million shares. ETFs hold 6% of those shares. Passive index funds hold another 16% of SF shares. That means a total of 22% of SF shares are being 'cannibalised' by the ETFs and index funds that hold them, says Lutz, and investors in individual stocks need to adjust their calculations accordingly, or get caught off guard by unexpected volatility and decreased liquidity.” (Business Insider, October 22)

Treasuries are all risk, no return...

“In the 1980s, the average yield and duration of the 10-Year Treasury was 10.6% and 6.1 years, respectively. When rates rose 100 bps, investors still made money. Today, the on-the-run 10-Year Treasury has a yield of 1.6% and a duration of 9.2 years, resulting in heightened rate sensitivity and significantly less coupon to offset principal losses during periods of higher rates.” (Goldman Sachs, October 19)

So bond investors are looking to Africa... “African countries are winning over investors scrounging for profits in a world of falling interest rates and lackluster growth. Last month, Zambia raised $750 million with a 10-year global bond in an auction that drew offers worth more than 15 times that amount. Nigeria in September sold 30 million naira ($192,000) in five-year bonds, to demand twice as high. Spurred by the heavy interest, Rwanda wants to issue a global bond by June and Kenya is planning one as early as next year. Investors' willingness to step up to buy African bonds is another sign of their thirst for yield. Efforts by the Federal Reserve and other major central banks to push down interest rates and buy developed-market bonds have driven investors further and further afield. … Yields on some African bonds are only slightly higher than the yield on the debt of some troubled European economies. Spain, which Standard & Poor's rates triple-B-minus, sold €4.6 billion in bonds at a yield of 5.3% last week. A global bond issued by Zambia, rated four notches lower, last month priced to yield 5.6%. Now the bond is trading at a yield of 5.3%, offering investors an immediate return. Falling yields mean higher prices.” (Wall Street Journal, October 23)

The revolving door pays off...

“It is common fare for people like me to point disapprovingly to the revolving door between business and government, which ensures that every Treasury Department is well stocked with representatives of Goldman Sachs. … It is certainly possible that industry experts provide valuable skills and experience to the government. But that value comes with a cost; put another way, it’s not just the public good that benefits. Using data on Defence Department appointments, Simon Luechinger and Christoph Moser measured the impact of political appointments on the stock market valuation of appointees’ former firms; they also measured the impact on firms’ stock market valuations of hiring a former government official. In both cases, the stock market reacted positively to new turns of the revolving door.” (Baseline Scenario, October 22)

Profit from this week's HK dollar intervention... “Traders increased bets Hong Kong will end a 29-year-old peg to the dollar after the currency reached the upper limit of its permitted range and triggered intervention by the city’s monetary authority. Two-year forwards strengthened 0.11% to HK$7.74 per dollar... the biggest gain since March 9, according to data compiled by Bloomberg. The Hong Kong dollar’s value is kept at HK$7.75 to HK$7.85. Hedge-fund investor William Ackman, the founder of New York-based Pershing Square Capital Management LP, said Oct. 20 he is keeping a wager that would profit if Hong Kong allows its currency to appreciate. … [Ackman] was buying Hong Kong dollar call options, which give investors the right to buy the currency at a set price by a specific date. The easiest way for the city to allow the currency to appreciate would be to change the peg to HK$6 per dollar and then link to the Chinese yuan over three to six years, he said at a conference last year in New York. … [Ackman] declined to say whether he would be adjusting the size of his wager now that the upper limit of the peg is being tested.” (Businessweek, October 22)

And insider silence implies extreme returns... “We examine the phenomenon of insider silence, periods when corporate insiders do not trade. Our evidence strongly supports the jeopardy hypothesis that regulations and fear of legal action inhibit insiders from trading on extreme information, implying a relation between insider silence and extreme future returns. First, insiders of merger targets refrain from buying in the months before the public announcement. Second, among firms that are likely to have bad news, insider silence predicts significant negative future returns, which are even lower than when insiders net sell. Further, the negative information in insider silence is gradually incorporated into stock prices, and a significant portion of it is released around quarterly earnings announcements. Finally, the price inefficiency associated with insider silence is pervasive, and market frictions make it worse.” (George Gao and Qingzhong Ma of Cornell University, October 15)

The financial crisis may finally end next week…

“If the VIX index remains at its current level (16.6) next week, furthermore, its 52-week moving average will fall below the July 2011 level to its lowest point since February 2008. Figure 1 shows the relationship between the VIX index’s long-term average (20.3 since 1990) and its 52-week moving average. We think this illustrates how its level varies between normal times and crises. … The last time the phase changed from crisis to normality was in February 2004... 27 months from the US economic bottom (November 2001) to the phase change (February 2004). This time, the current month is the 40th since the economic bottom (June 2009). The aforementioned July 2011 would have represented the same duration as in the previous cycle, but the European credit crisis caused a year's delay, as we see it.” (Hajime Kitano of JP Morgan, October 23)

But if you've given up all hope...

“Atlas Survival Shelters, whose slogan is 'Better prepared than scared,' offers survival chambers made out of 32x10-foot metal tubes. The chambers are designed to be installed 20 feet underground, far away from the possible crumbling of the world above. … Atlas's website says you can stay safe in one of their shelters in the event of 'pandemic outbreak, civil unrest, malicious mobs and biological, nuclear fallout or attacks from home grown terrorists or other nations.' … They come equipped with bunk beds, flat-screen televisions, kitchens, and even an electric toilet. … The survival shelters start at close to $50,000 and go up from there.” (Yahoo!, October 18)

Video of the Week: Challenging Chinese data... Gordon Chang, author of The Coming Crash in China, argues the nation has grossly overstated third-quarter GDP. He believes the number should be close to zero.

(Breakout, October 24)