His wiki entry: http://en.wikipedia.org/wiki/Mark_Carney

Global liquidity is an amorphous concept. The Usual Suspect for any event or dynamic too complicated to explain, global liquidity is the Keyser Söze of international finance. It has no agreed definition and, as a consequence, there has been no coherent policy approach to tame its more violent tendencies.

However here we have a quote which clearly emphasizes why smart money should continue to focus on liquidity’s impact on portfolio construction:

With increasing financial integration, the impact of global liquidity on domestic financial and economic conditions is growing.3 The recent Irish experience demonstrates how it can amplify the cyclical dynamics of domestic credit and asset prices.

The link to the full talk is: http://www.bankofcanada.ca/2011/11/speeches/global-liquidity/

Japan consumer confidence: the measure for overall nationwide consumer confidence in September climbed to 38.5, a 6 month high since bottoming in March.

Australia capacity utilization: the September figure came in at 81.3% (note in the financial crisis it bottomed around 79%, and peaked in late 2007 at 84.5%).

Auto sales in Russia and India: Car sales in Russia and India saw strong upticks in September, and on a year over year basis. Russian car sales (0.236 million), compares very favorably with the same period last year (approximately 0.175 million). India car sales for September (1.83 million) are seeing a huge uptick compared with a year ago (1.5 million).

Instead those entrusted with managing money (whether for clients or their own families) should focus on fundamentals, and not let movements dictate positioning. At Covert Analytics we always advise money managers go down the following checklist (answers are of course provided by our software )

1) What is the support for risk assets? Our GRASP (global risk asset support or pressure) model, points to still strong support for risk assets, with monetary policy loose, the money supply still growing and volatility still relatively low. One recent question mark was the S&P dropping below the 200 day moving average. Await till month end or before a material drop below, before acknowledging a new bear market.

~ still supportive of risk assets

2) Are valuations supportive of equities over bonds? Equities (cyclical risk) versus Bonds (no cyclical risk) is the age old question. Equity yields are surging far ahead of interest rates, particularly in the US with the US 10 year hitting 2.5%.

~ fundamentals favor equities

3) What are technicals telling you? Currently risk assets have experienced a tremendous short term selloff. As Barry Ritholtz points out, the 7 day RSI is even below the Feb / March 2009 bottom !  See link (http://www.ritholtz.com/blog/2011/08/rsi-at-extreme/).

~  risk assets are oversold

Each selloff has its unique features. This one is no different, what with the debt ceiling issue in the US and renewed Eurozone fears. However our base case scenario is that the debt ceiling will be resolved (actually it is a non event issue with the US Treasury taking in revenues of 200 billion monthly) and that the Eurozone crisis is not a 2011 event.

Punchline: listen to Covert Analytics … our feeling is that this year is strikingly similar to last year (when the S&P bottomed in late August) and had a tremendous end of year rally.

Higher.

Let’s start with a historical look at ten year stock market cycles.  The chart below starts (see 1) in December 1937 when the US stock market (excluding dividends) was down 40% over a full 10 year period.  Though the stock market was extremely volatile (a 20% decline followed the 40% ten year collapse, then a 50% rally, and a subsequent 40% decline – see Note).

A massive post WWII boom was experienced in America in the 1950s and 1960s, but the major stock market gains were investors who “entered the market” in the late 40s, and enjoyed the cumulative 10 year return of 300% (see 2). Markets moved gradually higher during the 1960s, and in the 70s suffered a major inflationary headwind and in real terms were down over 70%.  In nominal terms, by the late 70s stock investors had suffered a 10 year cumulative return of roughly 0% (similar to today?, see 3).

Thus began the glory days of corporate America and the global financial system.  Stock investors were handsomely rewarded for entering the stock market in the early 80s.  To give you an idea, the S&P was trading at 111 in March 1982, and by March 2000 was trading at 1,500.  The bulk of this gain was concentrated in the tech bubble of the late 90s, but still this was an amazing period for equity investors, with only one negative calendar year in 17 years on a total return basis! As such investors were handsomely rewarded with a cumulative 10 year return of nearly 350% through the end of the decade (see 4).

Now begins the dreary 2000s which had its own boom- bust cycle.  The current 10 year return (through October 2010) is currently -17%.

What is most interesting is that the historical average of  a 10 year investment in US stocks (excluding dividends) is capital appreciation of 107%.

This reminds us  of some important lessons of investment management:

1. That no matter how euphoric or demoralizing financial price trends may seem, at some point, conditions change and the markets establish a new trend.
2. It is extremely difficult to time a market top or bottom
3. Markets often correct through the mean (as you can see by the average 10 year return)

Our take from the above is that it is easy to project that the upcoming years will have very low returns: there is a historical precedent (negative annualized returns for the past decade), fundamental reasons (risk free rate near 0%, difficult earnings environment, etc), demographic reasons (the huge portion of Americans set to retire in the upcoming 10 years that will not stomach the volatility of Equities and prefer to have stable Fixed Income investments), etc.  But looking at the historical cycle tells us that experience would beg to differ.  What is clear is that after abnormally high (low) returns, one should never lose sight that stock market assets in a healthy economy will likely produce returns far below (above) the mean. What’s more, taking a lesson from Prospect Theory, we should note that humans are fallible.  As markets move for an extended period in one direction, investors will overestimate the likelihood that markets will continue in the same direction.

So, what would be a new direction? Above average returns. Let’s hope.

Note that in June 1937 Roosevelt’s administration took drastic steps in an ill fated attempt to balance the federal budget. The S&P fell 20% through March 1938.  It rallied 50% through the end of 1938, and then fell again another 40% through 1942. This was of course due to the effects of America’s war time economy subsequent to the Pearl Harbor attack and Eisenhower beginning a massive front in Europe.

Let us take a look at the indicators.  It seems that a comparison of the environments was mixed comparing 2004 and 2010

- M2 is up 2.7% yoy, versus 3.3% in August 2004
- Crude is now at $78 versus $50 back in 2004
- Fed Funds Rate is anchored at 0.25% versus “on the rise” at the same time in 2004, having been bumped from 1% to 1.75% by Sept 2004.

From a technical perspective, you can see in the chart below that the S&P 500 traded above its May – early Sept trading range with 1,125 as the top of the range. In recent weeks though it has failed to break above 1,150.

A few comments on ‘efficiency’

Market efficiency implies that all information is assimilated into the current market price, and therefore there is no possibility that you can buy assets cheap, to then sell high, because if it was truly cheap, the market would quickly jump in to buy the security, thus bidding up the price, eliminating the opportunity. Fantastic, but is it logical? This is similar to the University of Chicago line of thinking that if there was a $20 bill on the floor, it must be fake because someone would have picked it up by now. We all know that there is a very high possibility that short term inefficiencies exist. The quant funds have all but proven it: DE Shaw, Medallion, AQR Capital are all funds that trade in liquid equity markets but arbitrage short term opportunities. A hedge fund expert wittingly referred to these funds as “excess liquidity providers”.  My favorite response to anyone who says that markets are efficient is: “that is a self fulfilling prophecy” …

The Buy and Hold Debate

Buy and Hold is an “asset allocation policy” … it basically implies that the strategic asset allocation it the best guess as to what will be the best performing allocation over the investment horizon (typically 1+ years). If you do not think buy and hold works, that means you adjust the strategic asset allocation (ie shift equity weightings up and down over time) and make tactical trades (short term opportunities that present themselves in the market) to add alpha.  Dynamic asset alllocation therefore, is saying that “buy and hold” doesnt work (ie “Buy and Hope” …. .  Time varying asset allocation emphasizes that dynamically switching the asset allocation you can minimize the downside of bear markets, overweight markets that are rallying, etc. It is the holy grail of money management: “equity like returns with bond like risk”. 

Due to the increased difficulty in cranking out decent returns, it is even more important to “think dynamically”.

Performance of a 70% stocks, 30% bonds Portfolio

The chart below shows how difficult money management has been. A portfolio of 70% stocks and 30% bonds (note we are using the MSCI US Stocks Index, total return, for stocks, and the Salomon Brothers US Treasury Index, for bonds) performed as follows:

• +16.6% per year from 1985-1999, with a standard deviation of 10.9%, compared with…
• +1.8% per year from 2000-2010, with a standard deviation of 11.1% 

This is a huge drop in annualized values in an aggressive Equity portfolio (far below the risk free rate of return), with an elevated level of risk. The return to risk ratio was nearly 9x higher from 1985 – 19999 versus the past ten years.

Returns by Market (80s and 90s versus 2000s)

 There was a huge drop in asset class returns between the two periods. further strengthenting the case for a more dynamic approach to asset allocation in the 2000s. Even bonds have fared substantially worse in the past decade than the prior 15 years. 

Returns by Asset Class (80s and 90s versus 2000s)

Another asset class focused way to see the same data …

Efficient Frontier Comparison

This secular shift in returns between the different decades has produced a notable response to the buy and hold, academic oriented crowd: a notable downward push to the efficient frontier. Interpretations of the efficient frontier are as varied as how people like their eggs in the morning.  Some think it is useful, others useless, some think it is a good framework, others think it is a good tool for clients to see and not much else. Regardless, it is a mathematical approximation as to the “best, most efficient portfolios using return and covariance measures”.  Utilizing expected returns from these different periods, the following two, vastly different efficient frontiers were produced.

Conclusion

This is slicing the past thirty years into two periods, one when the business environment was booming and capital markets surged, and the other when the world suffered two disastrous bear markets and a global mini-Depression. Buy and Hold is a methodology that worked “before” and it is unlikely that it will work in the future.  After the carnage in 2008 and 2009, portfolio managers have lowered their expectations. With the world economy still unstable and risky, investors have accepted this fact, and our view is that asset allocation has to be more imaginative and dynamic.

1. tax increases by state / local governments
2. collapse in the EUR to below parity
3. aggressive tightening in China or Europe (for different reasons!)
4. policy mistake in the US

It is clear that the economy is chugging along, and that some of the biggest risks are how the markets will punish policy mistakes.  It reminds us of a quote from Schumpeter:

“As a doctor is unable to predict whether his patient will be run down by a motor car, so the economist is unable to predict in a situation in which so many political motor cars run about …”

- “Depressions, Can We Learn from Past Experience?”, Schumpeter, 1934

 

Top Chart: Rolling 12 month returns on the S&P 500

Bottom Chart: Monetary Supply (M2) divided by Industrial Production (IP)

The bottom chart is meant to imply if money supply growth is outpacing industrial production. In other words, when this index spikes (as it did in 2002 and in 2009) this means that the monetary supply is increasing due to Federal Reserve actions and this is not finding its way into the real economy. We take the decline both in both instances to represent when money growth found its way into the real economy and industrial production “caught up” with policy actions.

We think this is a positive for markets. Clearly the original impulse response (12 month return on the S&P was over 40%) is over. Now markets are in Act II, and clearly recent news from the European debt crisis imply we are in for a mid cycle slowdown. A slowdown does not imply the market and economic recovery is over. As was evident in 2003, markets rallied like crazy from their bottom, formed a stable base that finally gave way to a new bull market.

Economic fundamentals and the corporate profit picture points to a healthy recovery, even though recent market action would imply the opposite. What is going on in Greece is not pretty, and it could easily cascade to less important economies (Hungary) as well as more important economies (Spain). Just like a household that is having trouble paying its debts should not take on more debt to be able to pay its interest payments, global central banks should not throw more debt at a problem caused by too much debt.

“Put your ears to the railroad tracks. Prices move first, and fundamentals come second.”

This tells you that though reports are confirming that fundamentals are sound …

• M&A, Capex, share buybacks, dividend increases have been running at historically low levels and are just beginning to rise
• Corporates are lean, and richer in cash than they have been in decades
• Profit margins are approaching all time highs, only a year after the “Great Recession”

… the market is sending a different signal:

• Dr Copper and Dr Crude are both down about 17% (through today, May 18)
• S&P was spooked into its largest intra day loss since 1987, and is now down about 7% from April 26
• Yield curve (10s / 3Ms) has flattened by about 50 bps from nearly 380 bps to 330.

Where to from here? The Greek drama reflects a broader sovereign crisis that took us by surprise with respect to how quickly it cascaded into a crisis.  Greece was one of the weaker guys in the pack, but its amazing to us how Ireland has a deficit of -14.7%, compared with Greece’s deficit of -12.2% and little mention is made in the press of their situation. True, the total indebtedness of Greece is higher, at 124.9% of GDP compared with Ireland’s 82.9%.

And thats not all.  A massive oil spill, looming uncertainty over financial reform, civil lawsuits against the investment banks, etc.

Difficult times indeed. However we think the market is going to trade lower over the next few months. This is not to say the rally has been officially delayed, but these are major headwinds that have reminded the market that volatility is always around the corner. It is very easy to say that this has spooked a bunch of investors who have been cautiously adding to their exposure and are now reminded of the awful 2nd half of 2008.

Sincerely,

The Covert Analytics Team

The past few weeks showed an amazing resurgence in seemingly black-swan type risks. First an Icelandic ash volcano that paralyzed European travel, a massive oil spill in the Gulf of Mexico, the “smartest guys in the room” aka Goldman Sachs getting hit with civil fraud charges by the S.E.C. and now out of nowhere a -9% selloff intraday on the US stock market. It was the biggest intraday selloff in percentage points since 1987.

Today showed us that financial markets are fickle. Sentiment and risk perception often swing abruptly. Greece’s economy is small, at EUR 254 billion, particularly in an economic bloc that is nearly EUR 9 trillion or 35x its size. The Greek problem has the potential to develop into a full blown epidemic, threatening the entire European economy.

The political tension is rising: elections in the UK today with a change in leadership from Labour to Conservatives, Germany’s elections in North Rhine – Westphalia, etc. A Greece bailout is very unpopular, but so is preempting a global financial crisis. Whereas some rumors have indicated that Greece has consulted with Lazard to examine a restructuring, other rumors have hinted at G-7 coordination today (May 7) to contain the crisis.

A simple punchline is that a Greek debt default or restructuring is inevitable. Even in the event of restructuring the result is the same.  Looking back to the 1930s the Creditanstalt bank default occurred in 1931, sparking a global banking crisis, but the great crash of the Great Depression occurred 2 years before in 1929.

Regardless on the view of whether Greece will be bailed out it is difficult to envision an environment where this will be beneficial for the Euro. This is not to say that a breakup of the EUR is in order. But, countries now including the ECB will be inclined to transition into quantitative easing, ie print their currencies.

Own gold as a hedge. Stocks are a good buy given that this event will definitely leave in place accommodative monetary policy. We dont think an all out default of Greece or a disintegration of the Euro bloc will occur. If we are right, stocks will rocket from current levels with renewed stimuli and a refocusing on economic fundamentals.