Bob Carlson

The bond market’s gone haywire ever since Ben Bernanke’s May congressional testimony, when he indicated that the Fed would change monetary policy “in the next few meetings.” I’ve expressed previously the belief that the market over-reacted to and misinterpreted Bernanke’s remarks. Here’s a good summary of what the bond market appears to be telling the Fed. It might be a little bit technical or jargon-filled for some of you, but I think it is accessible to most of my readers.

One thing the market is saying is that inflation expectations are low. In fact, the bond market seems to be saying that deflation is a real possibility. Bonds also are saying that short-term rates are likely to rise sometime in 2014. The Fed probably didn’t intend that, expecting long-term rates to rise before short-term rates do. Another thing the bond market is saying is that the Fed is likely to make the same mistake it has made many times in the past: It will tighten too rapidly once it decides to tighten. Take the classic case of 1994, the worst year for bonds, when the Fed surprised investors with its tightening and then increased interest rates rapidly.

Ben Bernanke will try to clarify things today.

The “lower for longer” message on rates, which has been so carefully crafted by the FOMC’s forward guidance, seems to have been thrown overboard by the bond market with remarkable alacrity as soon as the Fed has indicated that it may slow the pace of policy easing. The reason for this is that past history is replete with episodes in which the Fed has tightened policy very rapidly once its enthusiasm for easing has started to wane.

The 1994 example, when the Fed failed to guide the markets about the likely pace of tightening, is of course part of the folklore of the bond market. Less well remembered is the example of 2003, when the first signal that the Fed was slowing the pace of easing was followed by a 100 basis point rise in bond yields within a few months, even though the Fed’s forward guidance about tightening at a moderate pace was increasingly explicit.

The problem is that, once the market starts to believe that the Fed is “done”, it will inevitably start to build into the yield curve a rising probability that the FOMC will embark on a normal path of tightening before too long. In order to mitigate this, Mr Bernanke is likely this week to remind the markets that the intention to slow asset purchases “in the next few meetings” is contingent on events in the labour market, is not the start of policy tightening, and is completely distinct from any intention to start raising rates.

The Federal Reserve’s policies will kill risk taking and eventually the economy. That seems to be the warning in the latest monthly essay from Bill Gross of PIMCO. Gross admits that quantitative easing was necessary to stabilize the economy. But it hasn’t translated into normal economic growth, much less above-average growth typical of recoveries. Gross says the central bankers believe that higher asset prices eventually will generate higher growth, but Gross says there isn’t a lot of empirical support for that theory. Add to that the negative effects of low interest rates, and Gross says there are a lot of reasons to be worried.

Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk. Granted, some investors may switch from fixed income assets to higher “yielding” stocks, or from domestic to global alternatives, but much of the investment universe is segmented by accounting, demographic or personal risk preferences and only marginal amounts of money appear to shift into what seem to most are slam dunk comparisons, such as Apple stock with a 3% dividend vs. Apple bonds at 1-2% yield levels. Because of historical and demographic asset market segmentation, then, the Fed and other central banks operative model is highly inefficient. Blood is being transfused into the system, but it lacks necessary oxygen.

Ever since the Fed started quantitative easing, I hear from people who are concerned about inflation. I haven’t been and have expected inflation to stay under control. Deflation is more of a risk than inflation. Here’s another summary of reasons to believe that by David Kotok.

Meanwhile, low inflation is a very healthy environment for the stock market. It means that inflation distortions in reports of earnings are nearly nonexistent. That implies that the quality of earnings reports is very high, since they do not contain the distortions that occur in accounting systems when inflation is high.

Higher-quality earnings justify higher price/earnings multiples and higher stock prices. There is a consistent linkage between very low inflation and very strong asset pricing. This is particularly so when interest rates are very low and likely to stay low for a very long time.

You’re exposed to a lot of discussion about how the average mutual fund or money manager underperforms selected stock indexes. But not many people are aware that over the years, studies demonstrated that the averaged defined benefit pension plan earns higher returns than the average 401(k) account. Here’s one discussion of that. One way to take advantage of this information is to consider how defined benefit pension plans are investing their money. You can’t invest in hedge funds and private equity funds, but you can match most of a fund’s asset allocation. Having better asset allocation is the most likely step to improve your investment returns.

The study also found that bigger pension funds beat smaller ones, and that participants in large 401(k)s did better than participants in small plans.

The takeaway? If you leave a large company, you might want to leave your money in the 401(k) plan instead of rolling it into an individual retirement account, suggests Dave Suchsland, a senior consulting actuary with Towers Watson. You still can’t take the kinds of risks a large pension fund might, but you can take advantage of better deals on mutual funds.

Last week I linked to Mohammed El-Erian’s essay summarizing PIMCO’s anual secular outlook and investment recommendations for the next three to five years. Here are notes from a presentation on the same topic El-Erian gave to an investment group in New York. It includes some more casual remarks and observations that aren’t included in the essay I linked to last week. But the ideas are the same. PIMCO believes we are in a period of stable disequilibrium. That means things are stable right now, but there are imbalances in the global economy that can’t continue. Each region of the world will have to take a turn, and PIMCO can make the case now for both positive and negative turns. It isn’t comfortable saying either direction is unlikely. PIMCO’s bottom-line recommendation is to reduce risk.

Mohamed talks a bit about these T-junctions he sees ahead. The description comes from the roads in England where at the end there is a T-like split, you can go left or right but no longer forward. This is his metaphor for the coming decision-points faced by all of the world’s major economies but Europe’s T-junction is coming up on us the fastest. “Europe cannot persist with the stability bought by central banks while the underlying economies have no possible growth.”

The US faces a T-junction of its own but further out and more manageable. In one direction, we can grow the economy and reach escape velocity (3%-plus GDP) which will allow for true deleveraging to occur and costs to be rightsized. Obviously, the other direction is a continuation of the trap, where we never poke above stall speed.

China’s T-junction appears to Mohamed as a big wild card. He notes that this hand-off that China is attempting from government-funded infrastructure and exports to the emerging middle class consumer is not a given. Never before in history has any other society achieved this in the timeframe that China is attempting it in.

The investment world is full of those who say one or more assets are in bubbles or bubble territory. It’s exciting talk, but not very useful to investors. Bubbles are extremely rare, and overvalued assets can remain overvalued for a long time. Tyler Cowen of Marginal Revolution provides some clear thoughts on all the bubble talk. Take a look, and refer to it any time you see some other claim about bubbles.

1. I don’t find most predictive discussions of bubbles interesting, while admitting that such claims often will prove in a manner correct ex post.  “OK, the price fell, but was it a bubble?  I mean was there froth, like on your Frappucino?”  Or to quote Eisinger, it might also have been “dangerous signs of prebubble activity” (what happens between the “prebubble” and the “bubble”?  The “nascent bubble”?  The “midbubble”?  The “midnonbubble”?)

2. Good news and improving conditions may well bring more bubbles or greater likelihood of bubbles, but that is hardly reason to dislike good news and improving conditions.

The annual Secular Forum at PIMCO is an exciting event. All the professionals at PIMCO gather with some outside speakers to evaluate where the economy and markets are and where they are likely to head over the next three to five years. It was at the Secular Formum that PIMCO came up with the concept of the New Normal that is widely accepted and has played out largely in line with the forecast back in 2009.

The 2013 Secular Forum recently wrapped up, and Mohammed El-Erian presents the conclusions. What’s interesting is that El-Erian says this year’s discussions and analysis is the most difficult he’s been involved in. That’s interesting, because my communications with individual investors indicate they are more confused and uncertain than ever. PIMCO concludes that we are in a stable period but with disequilibrium. It can’t continue. At some point in the next few years, the economy will transition into either a normal, self-sustaining, growing economy, or it will turn into something bad. The big issue for investors is that because of stimulative monetary policy, the prices of many assets are not in line with fundamentals, but they could be very quickly if sustainable economic growth takes hold.

You should read the entire essay to see how the conclusions are developed and decide if you agree with them. I largely agree with the analysis, and it is consistent with what’s been guiding our recommendations at Retirement Watch. I repeat what I said in our recent webinar and in the June issue. Don’t fall for scary stories or extreme arguments. They are only going to paralyze you or cause you to make risky one-way bets.

Second, and related to the first factor, growth dynamics are notably heterogeneous and most growth models need to evolve. In the West, endogenous healing and significant short-term innovation accelerators are limited mainly to the U.S. – albeit a country still confronting headwinds from incomplete deleveraging and a dysfunctional Congress. Others face stronger self-made and exogenous headwinds. And some lack growth models altogether, and have low probability of successfully implementing new ones in the next three to five years.

This issue of growth models (as distinct from just growth) is an important one.⁵ Whether it is China with its transition from export-led to consumption-led growth, or the West in the aftermath of the global financial crisis, many countries need to evolve their engines of job and income generation. And while central banks are doing their utmost to buy time, their involvement can inadvertently push countries back toward old and exhausted growth models.

I am deluged by a lot of information explaining why stocks are a bad investment. The most common basis for being bearish is that stocks are overvalued. Some analysts like to compare stocks to their highs in 2007. Others point to the big market peak in 1999.

Here’s a good analysis that I think explodes the comparison to 1999. If that’s your standard, stock definitely aren’t overvalued today. The piece also takes apart what’s known as the Shiller CAPE valuation formula that uses 10 years of normalized earnings. Bottom line on that: the steep drop in earnings following 2007 was temporary and an anomaly. It distorts the 10-year data. The article is a good antidote to a lot of the sloppy data and analysis floating around.

The bottom line is, it’s stupid. Anyone can find similarities in the stock market action of different years. It’s not complicated – stocks can really only do some combination of three things, up, down or sideways. But this type of comparative analysis is, as always, a function of what details you choose to leave out. I can compare my house to the Taj Mahal if I choose to leave out quantitative factors like square footage or qualitative factors like its location or historical significance.

I want to remind you about some peculiarities from 1999 that you may have forgotten – some major market differences between then and now that I believe demolish the comparison.

Imma strangle this thing in the crib before it screws your head up.

The Federal Reserve is pumping up the money supply. So is the Bank of Japan. So, why is gold tumbling? Shouldn’t gold be rising on fears of inflation? Here’s a good review of the likely reasons for gold’s decline. One reason, of course, is that inflation isn’t rising. It takes more than money supply expansion to cause inflation, and a lot of people overlook that. They’ve been expecting higher inflation since the Fed started quantitative easing in 2008, and they’ve been wrong. They’ll continue to be wrong for a while longer. Add in low wages, a strong dollar due to a steady U.S. economy, and few alternatives outside the U.S., and it’s not hard to see why gold stopped rising.

Various reasons are offered for the latest move down. There’s chatter that investors had to liquidate some of their precious-metals positions to cover margin calls on their dollar-yen positions, after the Japanese currency rallied overnight. Some think it’s because bad weather is affecting the start of the Indian wedding season, a time of strong demand for the physical metal. Or maybe Indians are going off the metal because it’s just become too expensive, or the economy’s not doing so well.

Or maybe supply is starting to put a dent in the market. After all, relentless price rises tend to boost investment in extraction. It’s worth bearing in mind that shares in gold-mining companies have performed even worse than the metal–the Market Vectors Gold Miners exchange-traded fund is now down 60% from its September 2011 highs.

Michael Price is one of the great value investors. He ran the Mutual Series of mutual funds (now part of Franklin/Templeton) and achieved excellent returns. He sold the fund complex for a bundle so he could manage his own portfolio full-time. He recently spoke at a value investors’ conference. You can find notes of all the conference speakers here.

There was an interesting passing reference in Price’s talk that deserves more attention. Price said that in developing investment strategy we all need to forget about 2008. That makes a lot of sense. The crisis in 2008 was an anomaly. It isn’t likely to happen again because it required a large number of mistakes by investors, business managers, and government officials to create the meltdown of the financial markets. While such a thing could happen again, it is a very low probability event. You can manage your portfolio based on that low probability. Also, it takes time and a series of events to leads to a 2008 result. If such an event is percolating, you’ll have enough notice to adjust your portfolio.

Don’t invest your portfolio based on what worked in the 1980s and 1990s. Those days are gone. We’re in a different market and economic environment. But you also can’t invest with 2008 in your mind all the time. Instead, be diversified and balanced. Follow market momentum and Fed policy. And have a sell plan in place so you’ll be out of risky investments long before the worst of a 2008 event (or even something more mild) occurs, yet you’ll stay in the markets if things continue to heal.