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Dollars and Sense
Volume 4, Number 7 │March 2013
Market Update
February 2013
Month in review
Month YTD
3.5%
S&P TSX Index 1.3%
7.8%
Dow Jones Ind. 1.8%
1.4%
6.6%
S&P 500
4.9%
NASDAQ Comp 0.8%
0.2%
5.4%
MSCI World
S&PTSX Materials
2.9%
0.8%
-1.5%
3.8%
-5.4%
6.3%
3.3%
2.6%
13.8%
-8.8%
US Dollar
Euro
British Pound
3.3%
-0.6%
-1.2%
3.9%
2.8%
-3.1%
Crude Oil (WTI)
Natural Gas
Gold
Copper
Aluminum
Zinc
-5.6%
4.4%
-5.1%
-4.2%
-4.5%
-3.7%
0.3%
4.0%
-5.7%
-1.6%
-3.9%
-0.7%
S&PTSX Financials
S&PTSX Energy
S&PTSX Utilities
S&PTSX Info Tech
Income
Senior Gold Producers
Income Corp (GPC)
Can-Energy Covered
Call ETF (OXF)
Money Market Rates
Current Highest GIC rates
on the market (Mar. 5th)
1 yr
1.71%
2 yr
1.95%
3 yr
2.05%
4 yr
2.25%
5 yr
2.45%
Bond Outlook: Lower for Longer, But Not Forever
(Kathy Jones, et al)
Posted By Kathy Jones, et al, Charles Schwab and Company On March 11, 2013
Lower for Longer, But Not Forever
We’ve been in the “lower for longer” camp for quite a while, based on our view that sluggish
economic growth, tightening fiscal policy, and the Fed’s easy monetary policies would keep interest
rates low for an extended period of time. However, we’ve become more cautious about holding longterm bonds over the past year, due to our concern that the risk of being caught in an unexpected
sharp rise in interest rates was worse than giving up some of the potential capital gains to be had as
bond yields fell to new lows. We are not market timers and we still believe that laddered portfolios
with average durations1 in the intermediate term range make sense for many bond investors. But
we are often asked: what will change our view on interest rates? The following is a short description
of what we’re watching.

Follow the money, jobs and the Fed. We look for bond yields to move up when the
economy is strong enough to generate more jobs and income growth. We think it’s
surprising how many forecasters have been looking for interest rates to “normalize” before
those things happened. We don’t believe that there is a set of “normal” interest rates.
There are long-term averages and historical relationships between interest rates and
economic fundamental factors. These are useful, but we also have to factor in all of the
“abnormal” factors—such as the Fed’s zero interest rate policy and quantitative easing
program, the unfinished de-leveraging cycle in the developed world and demographic
trends. We think the three key factors to watch are the growth rate in money and lending,
employment and Fed policy.
Money and Lending. Since the onset of the financial crisis, the Fed has created an unprecedented
level of reserves in the banking system. However, the demand for money was relatively soft until
last year. Stronger demand for money tends to lead to higher interest rates and stronger spending
may lead to inflation. The pace of lending has picked up and as a result, nominal GDP growth, which
tends to track credit growth, has picked up as well. But both lending and nominal GDP are still
growing at rates near the low end of the long-term trend. That suggests a relatively slow pace of
real GDP growth, in the 2% to 2.5% region, which is what it has averaged since 2010.
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Dollars and Sense
March 2013
majority of the committee has voted in favor of their
policies since the financial crisis began. The Fed’s
official stance is that they will continue quantitative
easing until unemployment falls to 6.5% with inflation
in the 2.0% to 2.5% range. We are listening for any
shift in policy stance by Chairman Bernanke to signal a
change in the interest rate outlook.
Credit Growth and Nominal Gross Domestic Product (GDP)

Bottom line. We are still in the “lower for longer” camp
but don’t expect to be there forever. We continue to
favor a relatively cautious stance of reducing average
duration to an intermediate-term range (5-10 year
maturities, on average) based on our view that
risk/reward for long-duration bond portfolios is
unattractive.
What Drives the Corporate Credit Market?
Note: Nominal GDP is gross domestic product (GDP) figure that
has not been adjusted for inflation.
Source: St. Louis Federal Reserve Bank Credit of All Commercial
Banks (TOTBKCR), and Gross Domestic Product (GDP), percent
change from year ago, seasonally adjusted. Data as of December
31, 2012.

Jobs and Income. In the U.S., where 70% of GDP is
attributable to consumer spending, we see jobs and
income growth as important factors to watch. Since
2007, when job growth declined and median household
incomes flattened, consumer spending has slowed to an
average annual growth rate of 1.9% compared to a
3.5% annual pace for the 25 years prior to the financial
crisis. We are watching for unemployment to fall to a
level where average hourly earnings and household
incomes begin to rise again. Since the end of the
recession in June 2009, job growth has been among the
weakest of all post WWII recoveries. It could take more
time.
Investment grade corporate bonds have benefited over the past
four years from declining bond yields and tightening of spreads to
Treasuries. High prices and falling average coupons may make it
difficult to repeat the strong returns that corporate bonds have
generated over the past few years. But it seems that the risk of
rising interest rates—not just on corporate bonds, but most fixed
income investments—has been on everyone’s minds lately. We’ll
discuss how corporate bonds have tended to react in rising rate
environments, and some points to consider when holding, or
adding to, corporate bond positions.

What drives corporate bond performance?
Investors often discuss “the bond market” and the risk
that rising interest rates have on bond prices. But there
is no one “bond market”—not all bonds are the same
and there can be various reactions to rising rates.
Corporate bond yields include a credit spread, which is
additional yield above a Treasury with a comparable
maturity, to compensate for the risks holding a
corporate bond, such as the risk of default. So
evaluating corporate bonds means looking at both
Treasury yields as well as the potential for changes in
the additional yield received from a corporate versus
Treasury bond.

Credit spreads tend to fluctuate based on market
conditions. Credit spreads can be thought of as
compensation for taking on the credit risk of owning a
corporate bond. Spreads tend to fluctuate based on a
number of factors, including the outlook for economic
growth. If economic growth is expected to be strong,
investors may be willing to accept a lower credit spread
since the risk of default may be lower. If growth is
expected to slow, the opposite may occur.

Rising interest rates have tended to lead to
tighter credit spreads in the past. We think that any
significant rise in rates will be the result of a stronger
economy, which may lead to tighter credit spreads. This
can help offset the risks that rising rates have on the
price of fixed coupon bonds. If Treasury yields rise by
20 basis points, for example, but credit spreads decline
by 20 basis points, the result would be no change in
yield for corporate bonds, all else equal. While Treasury
bond prices would fall, corporate bond prices may not
since their yields remained constant. Looking at the
table below, we see that recent periods of rising rates
have led to lower spreads. We would point out that
rising Treasury yields can, and often do, lead to
negative total returns for investment grade corporate
bonds, but it can lead to outperformance relative to
securities that don’t have credit spreads.
Median Household Income in the U.S. 1984 to 2011
Source: U.S. Census Bureau, Current Population Survey, Annual
Social and Economic Supplements. Last revised on June 8, 2012.

The Fed. Not surprisingly, the Federal Reserve’s policy
of anchoring short-term interest rates at zero and
buying long-term bonds is an important component of
our interest rate outlook. Recent comments from some
Fed officials indicating concerns about the long-term
adverse affects of quantitative easing may be the first
hint that policy will be changing. However, Fed
Chairman Bernanke and Vice Chair Yellen, along with
NY Fed President Dudley, all permanent voting
members of the Federal Open Market Committee
(FOMC), are still in favor of quantitative easing, and the
• Page 2 •
Dollars and Sense
March 2013

The impact by region and state will vary. The
importance of federal grants by state varies, however,
as does the potential impact of reduced federal
spending in individual states and municipalities. The
Pew Center on the States has published a useful
interactive map estimating grants subject to sequester,
by state, as a percent of revenue. The sequester may
also be temporary, replaced by a long-term package of
more targeted budget cuts.

Reduced federal spending will be a drag on
economic growth in the short-term, in our view.
Federal employment drives 5% of economic activity
nationally, according to the Pew Center Data. But in
D.C. and surrounding areas, it drives 20% or more of
local employment. Lower federal spending will also
likely reduce national GDP growth in the short-term, in
the consensus view of economists, leading to lower
rates for longer from the Federal Reserve, transferring
through to rates on other investments including muni
bonds.

Credit spreads are at their long-term average. But
corporate fundamentals overall remain strong and
default rates remain low, so we think there could be
room for spreads to decline. In fact, the speculative
grade default rate, according to Moody’s, has come
down since the highs reached during the financial crisis
and has been under the 20-year average for the past
two and a half years. The spread of the Barclay’s U.S.
Corporate Bond Index is roughly 1.4%, or 140 basis
points. Although we don’t think they will approach their
all-time low of 51 basis points anytime soon, there is
room for compression.
Moody’s outlook is negative on 4 Aaa-rated states
and 40 local governments based on links to the
federal government. Moody’s rationale for these
negative outlooks relates more to their assessment of
the connection between these governments and the
credit quality of the U.S. government, not directly to
sequestration, according to Moody’s commentary. If the
U.S. Aaa rating is lowered, the ratings on these states
and municipalities could be lowered also. States with
Aaa ratings but negative outlooks include Maryland,
Missouri, New Mexico and Virginia.

The Bottom line. We think that tighter credit spreads
could help offset some of the interest rate risk in
corporate bonds if Treasury rates rise. But investment
grade corporate bonds can still generate negative total
returns in a rising interest rate environment. This don’t
necessarily mean corporate bond investors need to rush
for the exits, but we think it’s important to know how
various asset classes may react, and try to be
positioned accordingly.
Standard & Poor’s has said that they expect the
impact to be “uneven” across sector. Each
government will manage this “new era” of reduced
federal funding differently, in their view, just as they
adjusted to 2008/09 recession and other threats to
credit quality. They anticipate that the effects of
sequestration will be “mildly negative in broad terms,”
with potential for more impact in specific credits or
jurisdictions. But “with only a few high profile
exceptions,” state and local governments have made
cuts to preserve credit quality.

Sector views. Local municipalities and school districts
may face decreased federal grant funding for education
programs and public safety. Airports and ports may face
operational cuts and layoffs. Essential-service
infrastructure providers, such as water and sewer
systems, generally rely on user charges than federal
funds for operations, so they may be less impacted.
Medicare reimbursements to doctors and hospital will
be reduced 2%, potentially impacting not-for-profit
hospitals. Issuers in the higher-education sector may
face reduced grant funding, though most are not reliant
on these funds for debt service payments or operations.

Bottom line. Despite of threat of less support from the
federal government, most states, municipalities, and
other issuers in the muni market will adjust to the “new
era” of reduced federal spending, in our view. The
impact is another bump in the road for municipal
issuers. But we don’t suggest a change in strategy for
investors holding well-diversified muni portfolios at this
time.
Over the Past 10 Years, Rising Bond Yields Have Typically
Been Accompanied by Tighter Credit Spreads
Note: Excess Return is the curve-adjusted excess return of a
given index relative to a term structure -matched position in
Treasuries. The calculation method depends on the index type. A
portfolio, for example, may have an excess return above the
index on which it is based. It is important to note that receiving
an excess return almost always requires one to take on more
risk.
Source: Barclays, Bloomberg and the Schwab Center for Financial
Research. 10-year Treasury yield represented by the U.S.
Generic Govt 10 Year Yield Index (USGG10YR). The corporate
sector is represented by the Barclays U.S. Corporate Bond Index.
Past performance does not guarantee future results.


Sequestration’s Impact on Muni Markets
A “new era” of federal austerity has arrived, as Congress debates
spending cuts and allows sequestration—a series of across-theboard automatic spending cuts—to go into effect. Federal budget
reductions will be a part of both the short- and longer-term
revenue climate for municipal governments, in our view, whether
sequestration takes effect in its current form or renegotiated into
a series of more targeted reductions. For investors in muni
bonds, here are some points to consider.

Federal money makes up 34% of total state
spending, according to the National Conference of
State Legislatures. This seems like a large proportion of
state budgets, but the money is spread out widely
across a mix of mandatory and discretionary programs.
Medicaid is one large federal program where there is a
significant cross-over with state spending. Medicaid has
been explicitly exempted from sequestration, however,
lessening the potential impact on state budgets.
• Page 3 •
Dollars and Sense
March 2013

Keep an eye on duration—or average maturity.
Duration is a way to measure, and monitor, interest
rate risk, and is generally related to the bond’s time to
maturity. A rule of thumb is that an existing bond or
fund would be expected to fall in value by the duration
multiplied by the change in interest rates. A bond (or
fund) with a duration of 5 might fall 5% in value if
interest rates rose 1%. Schwab clients can look at the
distribution of maturities, which is generally slightly
longer than duration, of their fixed income portfolios by
logging in to Schwab.com, then navigate to Guidance >
Tools > Portfolio Checkup. Then click on the Fixed
Income tab. For the duration of an individual bond or
bond fund, talk with as Schwab Fixed Income Specialist
at 877-563-7818.

We suggest a mix of short-term and intermediateterm bonds or funds. A bond ladder mixes bonds
maturing soon with some maturing later. We prefer
ladders with maturities maxing out at about 10 years,
for most investors. For investors who prefer bond funds,
consider a mix of funds that fall into Morningstar’s
“short-term bond” category for shorter term needs
(money needed within 1-5 years) combined with
“intermediate-term bond” funds for higher potential
income earned on principal that isn’t needed soon.

Bottom line. Risk in the bond market depends on
where you invest. For investors worried about rising
interest rates and/or inflation, short-term bonds or
bond funds may fall in value if rates rise. But they are
generally less sensitive to interest rate risk, for a
shorter period of time, than longer-term bonds, all else
being equal. For this reason, they should play a part in
your bond strategy, in our view, in a low rate
environment.
Short-Term Bonds If You Think Rates Will Rise
The most common question we hear from investors is the risk to
bond investments if interest rates rise. The second most common
question is will bond returns keep up if we see inflation down the
road. Repeating a theme, it depends on bonds you hold, in our
view. An allocation to short-term bonds—meaning bonds or bond
funds with shorter maturities—make sense to us if you worry
about if and when rates rise—or if we see higher inflation longerterm. Here are our thoughts to explain our view.

The value of short-term bonds or bond funds is
less sensitive to the risk that rates rise. Two factors
tend to matter most when looking at risk in bonds: the
level of credit risk (the risk of not getting repaid) and
the level of interest rate risk (how long it takes to be
repaid). The shorter the maturity of a bond or the
average maturity of bonds in a bond fund, generally the
lower the interest rate risk, all else being equal. Shortterm bonds or funds—which we define as having a
single (or average) maturities between 1-5 years—are
generally less sensitive than intermediate or long-term
bonds, for shorter periods of time, if rates rise.

Short-term bonds can be reinvested more quickly
than long-term bonds. As a result, investors should
be able to take advantage of the higher rates more
quickly. For income-oriented investors, it may be
helpful to have some money available and ready to
reinvest when rates are more attractive. A short-term
bond ladder with maturities from 1-5 years or a shortterm bond fund can meet this objective.

The Fed will likely increase short-term interest
rates if inflation rises above 2.5%. The common
wisdom says that short-term bonds will never keep up
with inflation. That’s likely true over long time periods.
But it may not be the case during periods when inflation
rises quickly. If inflation rises at a rate above 2.0% to
2.5% annually, the Fed has said that it would raise
short-term rates. In the late 1970s and early 1980s,
when inflation (as measured by the year-over-year
change in CPI) was rising rapidly, rates on cash
investments and short-term bonds rose quickly, as
shown in the chart below. Short-term rates fell in close
relationship with inflation thereafter.
Rates on Cash Investments and Short-term Bonds: 19782013
Note: Yield to Worst is defined as the lowest potential yield that
can be received on a bond without the issuer actually defaulting.
Source: Bureau of Labor Statistics, Bloomberg, and Federal
Reserve. Data as of March 1, 2013.
Two Myths and A Legend (Hussman)
By John Hussman, Hussman Funds On March 12, 2013
In late-2008, with the S&P 500 down 40%, I noted that stocks
had become reasonably valued (see Why Warren Buffett is Right,
and Why Nobody Cares). The coupling of improved valuations
with an early improvement in market action – at least on postwar measures – was a fairly standard combination of events
warranting a constructive position, though I noted that our
approach still indicated the need to maintain a “stop loss” a few
percent below those market levels in the form of index put
options. Valuations are a far cry from reasonable today.
On the policy front, I believed in 2008 that it was appropriate for
the Treasury to provide capital to banks through the use of
preferred stock (though I would have advised the use of
Bagehot’s Rule – which would have provided that capital at much
higher yields than the Treasury accepted). However, I did not
believe that outright purchases of distressed assets were
appropriate or ethical, and I railed against the notion of a
Troubled Assets Relief Program (TARP), as well as Fed purchases
of Fannie Mae and Freddie Mac’s liabilities, FASB accounting
changes to reduce the transparency of financial reporting, and
other interventions to defend bondholders and put bad private
assets on the public balance sheet.
As the government pursued those more outrageous policies, it
became clear what I had expected to be a fairly orderly “writeoff
recession” (involving the appropriate restructuring of bad debts)
was not going to happen, and without that restructuring, that the
• Page 4 •
Dollars and Sense
U.S. economy would be chained to the burden of those debts for
a very long time. The inability of the economy to materially
accelerate in recent years, and its constant hovering at the edge
between expansion and recession, is a symptom of that failure to
restructure debt in 2008 and early 2009. One cannot account for
the full cost of defending bondholders during the crisis without
adding in the trillions of dollars in additional government debt
that has been expended in the effort to counteract that economic
drag.
I am glad that the economy has created jobs recently. But payroll
employment is not a forward-looking indicator, and is unlikely to
prevent the U.S. from joining a global downturn that is already in
progress among developed countries (chart below from Dwaine
Van Vurren). Note that U.S. recessions occurred in 1960, 1970,
1973-74, 1980, 1981-82, 1990-91, 2000-2001 and 2007-2009.
The refusal to restructure debt in 2008 and 2009 (and the
associated fear-mongering by financial institutions seeking
government bailouts) did something else. It produced economic
contraction and job losses unlike anything observed in the postwar period. The appropriate response, at least for any
responsible fiduciary, was to stress-test every investment
approach against data that included similarly deep economic and
market contraction. In the Depression, the market decline from
1929 to 1931 erased the previous overvaluation, and took
valuations to levels normally associated with prospective 10-year
total returns of about 10% annually. But from there, stocks
dropped by another two-thirds.
A run-of-the-mill bear market represents a 33% decline, a typical
cyclical bear within a secular bear market period averages a 39%
loss (which would not be surprising over the completion of the
present market cycle), and the past two bear markets each
comprised 50% losses in the S&P 500 Index. It’s very important
for investors to recognize the difference between a 20-25%
drawdown, which is reasonably easy to recover over the course
of a market cycle, and a 40% or 50% drawdown. Compounding is
brutal where deep losses are concerned: a 50% loss requires a
50% gain just to get back to a 25% loss. In the Depression, the
market’s loss grew to 85%, requiring a seven-fold gain to break
even. Once the potential for Depression-era outcomes was on the
table, ensuring the ability to successfully navigate that data was
job one.
The problem wasn’t to develop a model to “fit” Depression-era
data (which is easy, but doesn’t necessarily generalize to new
data). The problem was to develop an approach robust enough to
navigate any random subset of historical data, including holdout
data from the Depression, without the approach ever having seen
it (a task that was satisfied using what are called ensemble
methods).
Concerned by the “two data sets” distinction between post-war
and Depression-era data, we researched and implemented two
adaptations to our approach, in order to be comfortable with our
ability to properly navigate even the most extreme historical
March 2013
market cycles. We don’t get a “do-over” on the cycle from 2007
to the present, which was interrupted by that need for stresstesting, but we are certainly moving ahead with confidence in the
robustness of our approach.
That approach is not bullish here, because a century of consistent
evidence indicates that we ought not be bullish here. There are
certainly aspects of the most recent market cycle that our
present methods would have handled differently. One variation
(resulting from the ensemble methods we introduced) is to
demand a broader set of positive divergences in what we define
as “early improvement in market action” – which would move the
associated constructive shift to early 2009 when the S&P 500
was down 50%, rather than October 2008 when it was down
40%. In real time, the need to stress-test against Depression-era
outcomes, and my insistence on making our methods robust
enough to navigate extreme economic and market outcomes,
resulted in what seems – in hindsight – to be a ridiculous miss.
Fine, but understand the narrative of that miss, because it
provides no basis to dismiss our present concerns.
If you understand this narrative, it should be clear why the
period since 2009 has contributed to my reputation as a
“permabear” despite having no reluctance to advise a
constructive position near market lows when the evidence
supports it (nor did I have any reluctance to do so in early 2003,
coming out of the preceding bear market, nor in the early
1990’s). Looking ahead, the most likely constructive evidence
would be an improvement to reasonable or even moderately
elevated valuations, coupled with a well-defined, early
improvement in market action. I have little doubt that we will
observe this sequence over the completion of the present market
cycle, as that sequence has emerged in every market cycle
throughout history. Now is not that time.
As a side note, I should emphasize that we do seriously consider
and incorporate trend-following methods in our analysis.
However, it’s important to understand that simple widelyfollowed moving-average crossover methods are far less effective
than investors seem to assume, and we instead focus on the
uniformity and divergence across a wide range of market
internals. Also, we find that the effectiveness of trend-following
methods has generally vanished – on average – once the market
establishes an overvalued, overbought, overbullish, rising-yield
syndrome of conditions. Our present defensiveness is something
that we would have had during late-stage, overvalued,
overbought, overbullish bull market advances throughout history.
Emphatically, I am not encouraging investors to deviate at all
from their own investment discipline, provided that it is welldefined, well-tested, and matches their risk tolerance over the
complete market cycle. But investors who have no such discipline
– who believe that it is possible to simply “hold stocks until they
turn down” or “party until the Fed takes away the punch bowl” –
these investors are likely to be confounded by the failure of these
simplistic notions to provide the comfortable exit they
unanimously envision. Today is not 2003, and it is not 2009. The
closer analogs (partially, but not solely on the basis of the recent
overvalued, overbought, overbullish, rising-yield syndrome) are
2007, 2000, 1987, and 1972, not to mention 2011 – before a
near-20% swoon – and 1929, at least on a valuation and
technical basis.
Two Myths and a Legend
The present market euphoria appears to be driven by two myths
and a legend. Make no mistake. When investors cannot possibly
think of any reason why stocks could decline, and are convinced
that universally recognized factors are sufficient to drive prices
perpetually higher, euphoria is the proper term.
Myth 1: As long as quantitative easing is underway, stocks will
advance indefinitely.
• Page 5 •
Dollars and Sense
This first myth is embodied in statements like “since 2009, there
has been an 85% correlation between the monetary base and the
S&P 500” – not recognizing that the correlation of any two data
series will be nearly perfect if they are both rising diagonally. As
I noted last week, since 2009 there has also been 94%
correlation between the price of beer in Iceland and the S&P 500.
Alas, the correlation between the monetary base and the S&P
500 has been only 9% since 2000, and ditto for the price of beer
in Iceland (though beer prices and the monetary base have been
correlated 99% since then). Correlation is only an interesting
statistic if two series show an overlap in their cyclical ups and
downs.
If you want to talk about causation, the case for X causing Y is
more compelling if the fluctuations in X precede fluctuations in Y.
Even in that case, we say that X “causes” Y only if observing X
gives us additional information beyond previous movements in Y
itself. In the case of quantitative easing, much of what we
observe as “causality” actually runs the wrong way. Market
declines cause QE in the first place, and the result is a partial
recovery of those declines.
As I noted a few weeks ago (see Capitulation Everywhere), the
effect of monetary easing has undeniably been very powerful in
recent years. However, if you examine the data closely, this
powerful effect is almost entirely isolated to a three-step pattern:
1) stocks decline significantly over a 6-month period; 2)
monetary easing is initiated, and; 3) stocks recover the
loss that they experienced over the preceding 6-month
period.
Regardless of whether one looks historically or even since 2009,
a careful examination of the data is very clear: the essential
feature of QE has been the recovery of preceding market losses
that the market experienced in the months preceding the
initiation of QE, with the impact of QE on investor risk
preferences invariably wearing off after about 40 weeks. We
would not rely on that precise horizon, but it’s worth noting that
the relevant market low in the most recent instance was on June
1, 2012.
March 2013
The problem with investors’ excessive faith in QE is likely to
emerge at the point when sporadically emerging economic or
financial strains (Europe, global recession, U.S. fiscal policy)
weaken the inclination of investors to speculate – pitted against a
monetary policy that has no material transmission mechanism
other than to encourage speculation. As we observed in 2008,
when the Fed was aggressively slashing interest rates well before
Bear Stearns got in trouble (much less Lehman), Fed easing is
not terribly helpful in a market where risk premiums are
depressed and have not spiked materially. The same was true in
early 2002, when I noted Wall Street’s “cheerleading position” at
the time – that the economy was still too weak for the Fed to
raise rates. Again, the Fed’s easing did not prevent the market
from plunging about 30% between March and October of that
year, despite positive GDP growth and an ISM above 50.
Presently, investors are entirely ruling out the possibility that the
stock market could decline significantly in the face of continued
monetary easing by the Fed. This belief has far less basis in
evidence than investors widely believe. Still, there’s no denying
the recent market advance. So at least for a while, myth has
been more convenient and profitable than fact. I doubt that this
will remain the case much longer.
Myth 2: Stocks are reasonably valued
The second myth supporting investor euphoria here is the notion
that “stocks are cheap on the basis of forward operating
earnings.”
It’s actually very fascinating how hard this myth dies, given how
preposterously wrong the identical assertions turned out to be in
2000 and 2007 – both points where our standard valuation
methodology indicated dismal prospective returns for the market
(see The Siren’s Song of the Unfinished Half-Cycle for a historical
review of these estimates).
Part of the problem here is that year-ahead estimates for
operating earnings (earnings without the bad stuff) are typically
dramatically higher than trailing 12-month net earnings. As a
result, forward price/earnings ratios are almost always much
lower than “trailing” P/E ratios. But Wall Street conveniently
disregards this fact – the “historical norms” that analysts assert
for forward P/E ratios are really only applicable to the much
higher trailing P/E ratios. The result is that stocks almost always
look cheap relative to those inappropriately inflated “norms.”
Another technique, of course, is to use norms that are heavily
influenced by the late-1990’s bubble period – a period where
valuations were high enough to produce near-zero total returns
for investors for more than a decade. If you use a period of
overvaluation to derive your norm, then your norm is
overvaluation. How is that not obvious?
One way to reduce this problem somewhat is to compare the
forward P/E ratio of each stock to its own average forward P/E
over the previous 5-year period. This doesn’t solve the entire
problem, as we’ll see, but it’s notable that on a relative basis,
forward operating P/E ratios are at about the same point they
were at the 2000 and 2007 market peaks. The following chart is
from Morgan Stanley (via ZeroHedge):
Keep in mind that QE has no transmission mechanism other than
inducing discomfort among investors. The entire stock of
additional reserves created by QE is still sitting idle in the
banking system earning next to nothing. It’s just that someone
has to hold that zero-interest cash until it is removed from the
system, and the entire objective of QE is to make each
successive “someone” as uncomfortable as humanly possible, so
they will go out and speculate enough to drive the prices of risky
assets higher, and their prospective returns toward zero.
• Page 6 •
Dollars and Sense
The larger problem with forward operating P/E ratios is that they
purport to value a very long-term asset based on a single year’s
financial results, which is only appropriate if that single year is
adequately representative of long-term cash flows.
This is where myth and reality are strikingly out of line. At
present, corporate profits as a share of GDP are roughly 70%
above their historical norm. Despite seemingly endless
rationalizations and arguments for the permanence of this
situation, the reason profit margins are elevated is actually very
straightforward:
March 2013
Notice that elevated profit margins are also strongly meanreverting over the economic cycle. In general, elevated profit
margins are associated with weak profit growth over the
following 4-year period. The historical norm for corporate
profits is about 6% of GDP. The present level is about
70% above that, and can be expected to be followed by a
contraction in corporate profits over the coming 4-year
period, at a roughly 12% annual rate. This will be a surprise.
It should not be a surprise.
The deficit of one sector must be the surplus of another.
This is not a theory. It’s actually an accounting identity. But the
effect of that identity is beyond question. Elevated corporate
profits can be directly traced to the massive government deficit
and depressed household savings that we presently observe.
I should note that this result is the outcome of hundreds of
millions of individual transactions, so it’s tempting to focus on
those transactions as if they are alternate explanations. For
example, one might argue that corporate profits are high
because people are unemployed, many workers have been
outsourced, and government transfer payments are allowing
corporations to maintain revenues from consumers despite low
wage payments. That’s a perfectly reasonable of saying the same
thing – but the transaction detail does not change the basic
equilibrium that profits are elevated because government and
household savings are dismal. One will not be permanent without
the other being permanent.
To see this, notice that corporate profit margins have always
moved inversely to the sum of government and household
savings.
To understand how profoundly imbalanced the present surpluses
and deficits in the economy are, the following chart shows the
sum of government and household saving, as a percent of GDP.
The historical norm for the combination of these is positive, at
about 4%. At present, household and government saving sum to
a combined deficit of 5% of GDP.
• Page 7 •
Dollars and Sense
March 2013
“In my opinion, you have to be wildly optimistic to believe that
corporate profits as a percent of GDP can, for any sustained
period, hold much above 6%… Maybe you’d like to argue a
different case. Fair enough. But give me your assumptions. The
Tinker Bell approach – clap if you believe – just won’t cut it.”
- Warren Buffett, “Mr. Buffett on the Stock Market,” Fortune
Magazine 11/22/99
I started this piece referencing my 2008 comment Why Warren
Buffett is Right, and Why Nobody Cares. I’ll finish it with the
observation that today is not 2008, nor are market valuations
anywhere close to being attractive.
It should be clear from my numerous comments over the years
that I have great respect for Warren Buffett, but this respect has
always been grounded in a fairly good understanding of how he
invests, particularly on considerations of valuation, revenue
predictability, the importance of return on invested capital, and
the necessity of a sustainable competitive advantage to drive the
long-term stream of cash flows that a company can be expected
to actually deliver to its shareholders over time.
Here is the punch line. Any normalization in the sum of
government and household savings is likely to be associated with
a remarkably deep decline in corporate earnings.
Notice that over the past three years, we’ve seen a very slight
improvement in the sum of government and personal savings as
a fraction of GDP. That change shows in the following chart as a
decline in the blue line (the right scale is inverted). Accordingly,
though corporate profits are still extraordinarily elevated, we
have also observed a significant decline of earnings momentum
in recent quarters. This is not some temporary anomaly. It
should be clear from the previous chart that the normalization of
government and household savings is just getting started.
Last week, the euphoric mood of investors got an additional push
from Buffett, who commented on CNBC that “We’re buying stocks
now. But not because we expect them to go up. We’re buying
them because we think we’re getting good value for them.”
Frankly, I’m not entirely convinced that one obtains good value
by paying a 25% premium over a company’s historical valuation
norms for earnings, revenues, dividends and cash flows, unless
considerable efficiencies can be unlocked that promise to make
the course of future cash flows markedly different from that
history. What I do believe is that Buffett’s recent investments are
more indicative of competitive considerations and faith in
management than they are indicative of valuation, particularly in
the broad market. As Buffett observed more than a decade ago:
“The key to investing is not assessing how much an industry is
going to affect society, or how much it will grow, but rather
determining the competitive advantage of any given company
and, above all, the durability of that advantage.”
So with great respect, I think it’s fair to say that on Buffett’s
broader considerations, there may very well be reasonable
investments available in stocks, provided that one doesn’t expect
them to go up in the foreseeable future. That said, I am also
entirely convinced that from a valuation standpoint – certainly
the standpoint that a typical investor would have in deciding
whether to allocate capital in pursuit of an adequate expected
future return – present market valuations create dismal
prospects for investors over horizons of less than 7 years. We
presently estimate likely 10-year nominal total returns on the
S&P 500 only slightly above 3.5% annually – with the likelihood
of strikingly large market fluctuations over the course of the
coming decade.
As I noted a few weeks ago, it would be one thing if the reason
for presently elevated profit margins was even a mystery. But
there is no mystery here. Wall Street is grossly overestimating
the value of stocks based on profit margins that are 70% above
the historical norm. The expansion of profit margins is the mirror
image of the plunge in government and household savings in
recent years.
Stocks are not cheap. Forward operating P/E ratios – indeed, any
metric that does not adjust for the elevated position of profit
margins – are presenting a wildly misleading picture of market
valuation. Recognize the reasons for this now, or discover the
consequences of this later.
And a Legend
In 1999, Buffett correctly recognized the overvaluation of the
market – and the weak basis for investors’ assumptions to the
contrary – when he noted that “you have to be wildly optimistic
to believe that corporate profits as a percent of GDP can, for any
sustained period, hold much above 6%.” As should be fully
evident from both accounting identities and historical data, the
fact that corporate profits are now 70% above their historical
norms can be directly attributed to the extraordinary deviation of
government and household savings from their own historical
norms.
Indeed, the relationship between nominal GDP and corporate
profits, over the long term, is large enough to make nominal GDP
itself a useful valuation metric. In practice, of course, we
consider revenues, earnings, book values, dividends, cash flow,
and even forward operating earnings (properly normalized) in our
valuation approach. But it should be of more than passing
• Page 8 •
Dollars and Sense
March 2013
interest that Warren Buffett himself has noted that the ratio of
market capitalization to GDP is “probably the best single measure
of where valuations stand at any given moment.”
The chart below presents the ratio of market capitalization to
GDP, using Z1 flow of funds data from the Federal Reserve with
the blue line (left scale, log). The red line shows the actual
subsequent 10-year annual (nominal) total return of the S&P
500. The right scale is inverted, so higher levels are more
negative. Notice that the elevated ratio of market cap to GDP in
2000 correctly projected the negative total returns that investors
would achieve over the following decade, with a great deal of
volatility in the interim. By contrast, the lower but still-rich level
of market cap to GDP in 2003 nicely projected the most recent
10-year total return of about 8% annually. The 2009 low was
certainly nowhere close to the level of undervaluation associated
with the 1949-1952 or 1982 secular lows, but was enough to
indicate a likely return of about 10% annually over the following
decade, which has essentially been compressed into the past 4
years.
Presently, the ratio of market capitalization to GDP suggests a
likely 10-year total return for the S&P 500 of about 3%, which is
about the same estimate that we obtain from a much broader set
of fundamentals. We estimate that the first 5-7 years of this
horizon are likely to be associated with zero or negative overall
returns for a passive investment in the S&P 500.
—
Just a reminder – Last May, my friend Mike Shedlock’s wife
Joanne passed away from an aggressive form of ALS
(amyotrophic lateral sclerosis). Mike (“Mish”) is an investment
analyst whose work can be found on the Global Economic
Trend Analysis site. In Joanne’s memory, and to benefit the
Les Turner ALS Foundation, Mish has organized a conference
in Sonoma California, on April 5, 2013. I don’t often speak at
conferences or schedule media interviews, but that day, Mish,
Chris Martenson, Michael Pettis, James Chanos, John Mauldin,
and I will be speaking – for a very good cause. The Hussman
Foundation has also committed a $100,000 matching grant to
the Les Turner ALS Foundation, to match conference fees and
encourage donations to support patient services and research for
individuals with ALS. I hope you’ll join us in California. Thanks –
John
• Page 9 •
Dollars and Sense
March 2013
Chart of the Month
A Stock Market Trend Has Developed
That Coincided With The Last 3
Recessions
In a new report, ECRI's Lakshman Achuthan reiterates his thesis that
the U.S. economy is in a recession.
Among his many points was this one about how consecutive quarters
of negative earnings growth coincide with recessions. From his report:
This is a bar chart of S&P 500 operating earnings growth going back a
quarter of a century on a consistent basis, as we understand from
S&P. Others can choose their own definitions of operating earnings,
but this is the data from S&P. In this chart, the height of the red bar
indicates the number of consecutive quarters of negative earnings
growth.
It is interesting that, historically, there have never been two or
more quarters of negative earnings growth outside of a
recessionary context. On this chart, showing the complete history of
the data, the only times we see two or more quarters of negative
growth are in 1990-91, 2000-01, 2007-09 and, incidentally, in 2012.
This data is not susceptible to the kind of revisions one sees with
government data. The point is that this type of earnings recession is
not surprising when nominal GDP growth falls below 3.7%. So, even
though the level of corporate profits is high, this evidence is also
consistent with recession.
In short, earnings recessions seem to coincide with economic
recessions.
• Page 10 •
Dollars and Sense
Company Snapshot –
March 2013
Fundamental Analysis
Mar. 2013
Market Cap
Distribution
Yield
P/E ratio
Price/BV
Intel (INTC)
INTC - (March 8th) $21.30/share
Summary –
Intel Corporation designs and manufactures integrated
digital technology platforms. A platform consists of a
microprocessor and chipset. The Company sells these
platforms primarily to original equipment manufacturers
(OEMs), original design manufacturers (ODMs), and
industrial and communications equipment manufacturers
in the computing and communications industries. The
Company’s platforms are used in a range of applications,
such as personal computers (PCs) (including Ultrabook
systems), data centers, tablets, smartphones,
automobiles, automated factory systems and medical
devices. On February 2012, QLogic Corp. sold the
product lines and certain assets associated with its
InfiniBand business to the Company. In May 2012, Cray
Inc. completed the sale of its interconnect hardware
development program and related intellectual property to
the Company. In September 2012, InterDigital, Inc.’s
subsidiaries sold around 1,700 patents and patent
applications to the Company.
$107.2 billion
$0.22
4.16%
10.2x
2.1x
Technical Analysis
Longer term – quadrant 4 – Bottoming
Intermediate term – quadrant 2 - Accumulate
• Page 11 •
Dollars and Sense
March 2013
FLLC Portfolio Tracker
Current
Company
Symbol
52 Week
Initially
Added
Recent
Price
P/E
22.05
Sold
19x
Yield
Sell
Brookfield
Intrastructure
Partners LP
BIP.un
Hi
19.50
Low
15.50
Date
Feb 26, 2010
Price
17.30
SELL
Gold Participation
and Income Fund
GPF.un
12.25
10.12
10.75
12.65
Sold
6.4%
Sell
PMT
5.90
3.31
5.03
2.84
Sold
8.7%
SELL
Perpetual Energy
(formerly Paramount
Energy Resources)
New Flyer
NFI.un
11.76
7.32
9.65
11.48
Sold
11.8%
SELL
Labrador Iron Ore
LIF.un
55.80
30.03
41.60
64.25
Sold
8.7x
10.8
SELL
Maple Leaf Foods
MFI
12.06
8.47
9.21
12.21
Sold
12x
1.4%
SELL
UIL Holdings Corp
UIL
30.33
23.79
Mar 26, 2010
Sell date
Nov 3, 2010
April 27, 2010
Sell date
Aug 24, 2011
May 31, 2010
Sell date
Nov 3, 2010
June 29, 2010
Sell date
Nov 3, 2010
July 30, 2010
Sell date
Mar 5, 2011
Aug. 30, 2010
25.90
30.53
Sold
19x
5.6%
Sell
PXX
3.98
1.94
Oct 7, 2010
Sell date
Aug 24, 2011
3.90
5.02
Sold
Buy
Black Pearl
(speculative stock with
high growth potential,
NOT Blue chip)
AGF Management Ltd
AGF.b
19.25
13.36
Oct 28, 2010
16.45
12x
5.68%
SELL
Canadian Oil Sands
COS.un
33.05
24.24
26.69
17x
8.07%
Buy
Pfizer
PFE
20.36
14
Oct 28, 2010
Sell date
Mar 5, 2011
Dec 3, 2010
11.63
Sold
31.78
Sold
22X
4.25%
Buy
Home Equity Bank
HEQ
8.33
6.12
Jan 3, 2011
6.55
Buy
China Security and
Surveillance
CSR
8.89
4.09
Feb 3, 2011
4.90
SELL
Proshares Ultrashort
Euro
EUO
26.40
17.64
17.45
SELL
Nuvista Energy
NVA
12.51
8.55
Apr 6, 2011
Sell date
Sept 12, 2011
May 6, 2011
26.89
Sold
9.50
Taken
over
6.50
Taken
over
18.87
Sold
9.30
6.01
Sold
SELL
Crescent Point Energy
CPG
48.61
35.30
June 8, 2011
45.03
43.30
Sold
28x
6.28
SELL
Westshore Terminals
WTE.un
25.85
17.57
July 28, 2011
22
24.75
SOLD
16x
5.9%
Buy
Capital Power
CPX
28
22.26
July 28, 2011
23.85
21.82
22x
5.1%
16.70
*current buyout offer of $6.50
• Page 12 •
5.3%
4.27%
6.5x
Dollars and Sense
Current
Company
March 2013
Symbol
52 Week
Initially
Added
Recent
Price
P/E
Yield
10.43
7.6
9.0%
12x
5.2%
Buy
France Telecom
FTE
Hi
24.60
Low
17.21
Date
Aug 26, 2011
Price
18.50
SELL
Proshares Ultrashort
20+ year treasuries
TBT
41.54
21.86
Sept 12, 2011
22.10
19.50
SOLD
Buy
Duke Energy
DUK
71.13
50.61
57.75
64.85
SOLD
SELL
WisdomTree Europe
SmallCap dividend
DFE
48.15
31.04
33.90
37.55
SOLD
Buy
Canadian Oil Sands
COS
33.94
18.17
Oct 6, 2011
Sell date
Nov 5, 2012
Nov 10, 2011
Sell date
Nov 5, 2012
Dec 14, 2011
20.75
21.35
7x
5.62%
Buy
Telefonica SA
TEF
27.31
16.53
Feb 7, 2012
17.40
14.43
8.5x
7.5%
Buy
Canadian Natural
Resources
CNQ
50.50
27.25
Mar 7, 2012
34.70
32.10
15x
1.0%
SELL
Repsol
REPYY
34.84
14.41
15.50
19.90
SOLD
9.5x
6.8%
SELL
Eni
E
49.65
32.44
39.50
45.30
SOLD
8.0x
4.6%
Buy
Phoenix
PHX
11.70
7.75
June 5, 2012
Sell date
Nov 5, 2012
June 29, 2012
Sell date
Nov 5, 2012
Aug 7, 2012
7.85
9.10
9.9
9.14%
Buy
CME Group Inc
CME
60.92
44.94
Sept 5, 2012
55.10
62.59
12.1
3.10%
Buy
TOT S.A.
TOT
57.06
41.75
Oct 10, 2012
48
51.44
8.01
5.91
Buy
Cliffs Natural
Resources
CLF
78.85
28.05
Dec 4, 2012
29.40
23.83
5.8
7.1
Buy
Fiat SPA
FIATY
6.47
4.19
Jan 4, 2013
5.19
5.90
24
1.6
Buy
Goldcorp
G
50.17
32.34
Feb 8, 2013
36.07
33.23
17x
1.65
Buy
Intel
INTC
29.27
19.23
Mar 8, 2013
21.30
21.30
10x
4.25
5.58%
These stocks are chosen using the same techniques
as taught in the CIC course.
FLLC is not an investment advisor and is not setting any target prices or financial projections. Never invest based on anything FLLC says. Always do
your own research and make your own investment decisions. FLLC never recommends to buy or sell any stock. This email is not a solicitation or
recommendation to buy, sell, or hold securities. This email is meant for informational and educational purposes only and does not provide investment
advice.
• Page 13 •
Dollars and Sense
March 2013
Technical Analytic View
Date:
Mar. 5, 2013
TSX 60:
Long Term:
(6-18 mths)

MidTerm:
(5-10 wks)

Dow Jones Industrials:


• rally may begin to correct here
90 Day Interest
Rates:


• governments determined to keep short term rates low for now
• some symbolic increases (0.5% to 1.0%)
5 Yr Interest
Rates:
30 Yr Interest
Rates
Gold:


• rates have flattened


• rates should trade sideways for a long time




• longer term trend may have formed
• sell into next rally
• Cdn $ seems to be range bound between $0.95 to 1.05 US
Canadian
Dollar:
LEGEND

bottom forming
Comments:
• long term BUY signal has occurred, use the next intermediate
correction to buy

buy

top forming

Sell
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• Page 14 •