The Purpose of Money Printing

The ever articulate Jim Grant, publisher of the most perspicacious newsletter, "Grant's Interest Rate Observer," came on Yahoo Finance's The Daily Ticker and pondered the weighty issue of Federal Reserve's bond purchasing program with conjured dollars. Here is what he said:

"I think the Fed's actions are counterproductive," he says. The Fed's intentions to jump start growth are actually working against the economy, Grant argues.

"If it were as easy as printing money or creating credit to levitate an economy or to reactivate business activity the world would have been richer many generations ago," he says.

Of course, money printing creates no wealth. However, in 2008 the financial market faced both a liquidity and a solvency problem. If all asset prices take a dramatic enough fall, no banks in the world can remain solvent. That's what happened in 2008. By suppressing interest rate and injecting trillions of dollars into the banking system, the Fed succeeded spactacularly in levitating the prices of stocks, bonds, real estate, commodities, gold and art works. Now most banks and home owners alike have more assets than liabilities. Furthermore, their liabilities are priced so cheaply that they can actually afford the interest payment. So problems solved, liquidity and solvency. The Fed does not create wealth, but it can certain plunder from those who save to rescue those who borrow.

As individual investors, we just need to make sure we are not on the wrong side of Fed's redistribution scheme. "Don't fight the Fed." Often times, the simplest works the best.  

Q4 GDP Decreases 0.1%

The expectation for fourth quarter GDP growth certainly was not high, but the 0.1% contraction was worse than expected. The full text of news release from US Commerce Department can be found here, which always comes in the most matter-of-fact intonation:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- decreased at an annual rate of 0.1 percent in the fourth quarter of 2012 (that is, from the third quarter to the fourth quarter), according to the "advance" estimate released by the Bureau of Economic Analysis.  In the third quarter, real GDP increased 3.1 percent.

Market reaction, however, is decided muted. Even though the headline numbers look horrific, the underlying thesis of a slowly recovering economy remain unchanged. The Q4 GDP numbers were adversely effected by the 22% decrease in defense spending and the less than expected inventory accumulation due to uncertain fiscal climate during the fourth quarter. Here are the good news in the report:

Real personal consumption expenditures increased 2.2 percent in the fourth quarter, compared with an increase of 1.6 percent in the third.  Durable goods increased 13.9 percent, compared with an increase of 8.9 percent.  Nondurable goods increased 0.4 percent, compared with an increase of 1.2 percent.  Services increased 0.9 percent, compared with an increase of 0.6 percent. 

Real nonresidential fixed investment increased 8.4 percent in the fourth quarter, in contrast to a decrease of 1.8 percent in the third.  Nonresidential structures decreased 1.1 percent; it was unchanged in the third quarter.  Equipment and software increased 12.4 percent in the fourth quarter, in contrast to a decrease of 2.6 percent in the third.  Real residential fixed investment increased 15.3 percent, compared with an increase of 13.5 percent.

With personal consumption, durable goods, investments, both residential and nonresidential structures increasing at a comfortable pace, no wonder the market wasn't too worried about the misleading headline.

Consumer confidence has been gloomy over the past several months, yet consumer spending has been expanding. Looking at the consumers' balance sheets, even though deleveraging is still occurring on the surface, those numbers are now entirely due to firmer asset values instead of actual increase in savings or paying down of debts. At such low interest rate, there is strong incentive to spend, not to save. That, I believe, is the most important reason for increased level of consumption. However, with the tax increase beginning this year, consumers are now actually drawing smaller paychecks. Will such robust spending continue? That remains to be seen.

Bipolar Caterpillar

Caterpillar is one of the bellwether stocks for gauging global economic condition. It reported earnings last night. The earnings conference call transcript can be found on seekingalpha.com. Here are some highlights:

In the United States we’re becoming increasingly optimistic. The feds interest rate policies and their plan that continue injecting liquidity are in our view positive for 2013 growth. We are expecting the U.S. economy to grow at least 2.5% in 2013.

Our outlook assumes that Chinese government will maintain pro-growth policies throughout 2013, and we’re expecting the economic growth in China to be near 8.5%, a more favorable environment for construction and higher commodity demand.

We’re expecting sales and revenues to be in a range of $60 billion to $68 billion reflecting both upside and downside potential from 2012. We’re increasingly optimistic that there may be potential for better growth ahead, but we remain cautious about how quickly that improvement in going to translate into higher sales for Cat.

After expressing a rather sanguine outlook for US and emerging market economies, Cat put forth a rather pedestrian and unusually wide revenue outlook of $60 to $68 billion. In addition, its EPS guidance was an even wider $7 to $9. At the bottom of the revenue range, sales would fall close to 10%; while top of the forecast represent a mere 3% increase. Perhaps Cat was being conservative as most companies making such forecast try to do. But it does seem that even a company like Caterpillar with tentacles reaching nearly every construction project around the globe has limited visibility a few months out into the future.

Alternative Investments

InvestmentNews, an online publication for investment advisers, reported that Vanguard, the champion of low cost investing, is looking for greater exposure to alternative investments. You may read the whole article here.

The Vanguard Group Inc., a longtime champion of low-cost, passive mutual funds, is weighing a more aggressive push into alternative investments.

The company's consideration of investments outside traditional stocks and bonds is being driven mainly by demand from financial advisers. Since the 2008-09 stock market downturn, advisers have been relying more heavily on alternative investments as a way to reduce risk and volatility in their clients' portfolios

Despite the popularity of nontraditional assets, Vanguard isn't looking to jump too deeply into the alternatives pool. Instead, it is considering products aimed more at reducing risk and volatility than boosting performance.

In a time when the VIX, a common measure of stock market volatility, is languishing near the low end of its historical range and  the year 2012 had been one of the least volatile in history, investors still clamor for even lower volatility. In a time when stocks have more than doubled in value from the lows of 2009, investors are still exiting stock funds and pouring into bond funds.

Of course, Vanguard already has alternative funds in its lineup. One of them is a market neutral offering. Here is what the same article had to say,

Vanguard has proved that it is capable of running fairly sophisticated strategies on the cheap. For example, the Vanguard Market Neutral Fund (VMNFX), which it launched in 1999, has an expense ratio of 0.25%, significantly less than the 1.75% charged by the average market-neutral fund.

 

The fund has stumbled, however, in terms of performance. The Vanguard Market Neutral Fund, which was subadvised by Axa Rosenberg Group LLC for more than a decade before being taken over by Vanguard in 2010, has five-year and 10-year annualized returns of -2.69% and 1.09%, respectively, putting it in the bottom-10th percentile of the market-neutral category.  

It always seems odd to me that someone would try to construct a stock portfolio to produce bond like return. Is that what bonds are for? The result predictably failed to beat neither stocks nor bonds.

The sheepish behavior of investors over the past few years is quite understandable. After all, we had two stupendous stock market crashes over the past 12 years and stocks have delivered the most meager return over this period. However, 12 years ago, stocks were adulated and worshiped. It was afforded such a sky high valuation that essentially robbed the abysmal 2000's to pay for the abundance of 1990's.

In the world of investing, chasing glamour is hazardous to your wealth, that includes the so called alternative investments.

S&P Above 1500

The financial media is abuzz with S&P 500 closing above 1500 for the first time in five years. Here is how Wall Street Journal put it:

 The S&P 500 closed above 1500 for the first time in five years on Friday, capping its longest streak of daily gains since 2004, amid better-than-expected earnings from Procter & Gamble, PG +4.02%Halliburton HAL +5.05%and others.

The Standard & Poor's 500-stock index tacked on 8.14 points, or 0.5%, to 1502.96, its highest close since Dec. 10, 2007. The index rose for an eighth session in a row, the longest such streak since a nine-day run ended in November 2004.

Investing is a journey without a finish line. However, considering men's psyche and need to celebrate milestones, we have come to embrace round numbers of indices. Such habits are indeed harmless fun by itself less they distract us from the most important aspect of investing. The most profitable decision arrives via finding good company selling at a reasonable price, not obsessing over the short term direction of markets at essentially meaningless milestones. Whether stocks are at a high plateau or a low valley, I find nothing soothes my nocturnal somnolence better than knowing I have good companies purchased at a good price.

Now It Takes 90

Now it takes 90 yen to fetch 1 dollar and seemingly on the way to 100. Stock markets in Japan are rejoicing. Here is a Reuter's report:

Japan's Nikkei stock average .N225 also outperformed its Asian peers with a 2 percent surge as the yen hit fresh lows versus the dollar and the euro on expectations Japan will pursue bold policies to beat deflation and stimulate growth.

In the annals of economic history, I have encountered no nation who gained prosperity through competitive devaluation. It is a sad commentary on the current state of states that such actions are now considered "bold policies." The salutary effect on stocks will prove to be ephemeral.

 

Apple: Fairest No More

By now, most investors have digested a plethora of analysis on Apple's disappointing results for Q4 2012 and its low key guidance for Q1 2012. Excuse us for joining the chorus so late. Those of us on the west of coast just don't get up that early.

Compared to Apple's own guidance, the company had a blowout quarter. To wit:

Actual revenue of $54.5 billion ahead of $52 billion guidance.
Acutal EPS of $13.81per share far surpassed $11.75 guidance.

Of course, Apple has been eclipsing its own guidance by such large amount no investor now believes it.  On the conference call, it indicated that its previous earnings guidance had always been conservative, but going forward, it is now providing guidance as a range that its results will likely fall between. It is this guidance, if indeed realistic, that is the most troublesome. Apple now calls for first quarter revenue to fall between $4.1 to $4.3 billion, which represents a growth rate between 4.6% to 9.7% over Q1 2012 results. This compares to the just reported quarterly revenue growth rate of 17.6% and previous four quarters' growth rates of 27.2%, 22.6%, 58.9% and 73.3%. If the new guidance does reflect the company's true expectation, then Apple has just transitioned from a growth company to a cash flow company. Companies seldom make such transitions gracefully. However, to remain a growth company, Apple is in desperate need of a third leg so that it can re-accelerate growth. By a third leg, of course we mean a new product beyond iphone and ipad. Could that be Apple TV?

That is the $64 question.

Is Emerging Market Debt Leading Indicator for Risky Assets

While markets were close in the US on Monday, here is a report from Reuters that had not been widely noticed.

In the first week of the new year, investors put in an overwhelming $45 billion of bids for $1.75 billion of bonds offered by three junk-rated property firms from China.

But a more recent bond issue from Guangzhou R&F Properties was subscribed less than three times, while KWG Property withdrew its perpetual bond offering after it was covered just two times.

Only a little more than a week ago, on Jan 13, Agile Properties, a Hong Kong listed and Guangdong based Chinese real estate developer, brought to market a perpetual bond. The deal was originally marketed in the high 8% range, but it was 10 times oversubscribed and ultimate came in at 8.25%.

As central bankers of the world united in their quest to lower interest rate, fixed income investments of all grades have enjoyed dramatic rises over the past few years, none more spectacular than the ascension of speculative emerging market debt.

Perpetual bonds are a relative rarity in the world of fixed income investments, especially issued by non-investment grade companies. It carries the limited upside of fixed income investments, yet bears most of the total loss risk of equity investments. Moreover, if the issuer’s credit profile improves or interest rates become lower, the bonds will likely be called away and exposing investors to re-investment risk at the most inconvenient time. That is why the close cousin of perpetual bonds, the preferred stocks is mostly issued by highly rated banks and real estate investment trusts. While investors are still exposed to the interest rate risk, they can at least breathe easy on the credit front.

Pundits have rightly pointed out that the entire world of fixed income markets were in uncharted territory. From sovereign debts to junk bonds to emerging market papers, yields have all plunged and prices have all expanded awash in the nourishing succor of the central bankers. In such an environment, some have argued that investors might rotate out of fixed income securities and into equity investments. The sustained under performance of highly rated government securities must necessarily mean a rising rate environment. History and logic of asset valuation would suggest such milieu would not be conducive to the continued growth of equity prices. The calming of the junk bond froth, on the other hand, would suggest a heightened corporate default backdrop and weak economic condition. Such scenarios would seem equally harmful to stocks. While it is certainly possible for stocks to out gain bonds, it is rather implausible for stocks to advance while risky bonds decline.

In the event that the specter of fear returns to investors, all risky assets including stocks, emerging market debts and junk bonds will all be sold off. Even though Agile’s perpetual bonds came to market, unlike many other new issues, the price immediately sold off. Now investors have outright shunned the issuance of another perpetual, does that mean fear is in fact returning to emerging market debt investors? To paraphrase the words of Percy Shelley, could equities be far behind?