Summary of the GIC meeting – April 16, 2014

April 28, 2014 by All Round Education

Sharing this summary from my dear friend David Kotok:

Summary of the GIC meeting – April 16, 2014
April 28, 2014

The GIC (Global Interdependence Center), http://www.interdependence.org, has an annual Monetary and Trade Conference in Philadelphia, Pennsylvania. My good friend Bill Dunkelberg, chief economist for the National Federation of Independent Business, and emeritus chair of the GIC conducted the conference. Below you will find his summary of the conference proceedings. Slides and information about the GIC and presentations are available on its website.

We note a few salient points in the summary and presentations. The transition in monetary policy and whether or not the Fed (Federal Reserve) did the right thing in QE1, QE2, and QE3 is an ongoing debate. As Bill says, those who say the alternative would have been worse are arguing the counterfactual. One can argue counterfactuals forever, and people do. The prospect is that they do not mean a lot because we do not know what the outcome would have been. Also note Bill’s reference to about half of the US economy, which is driven by independent and small business, the engine of growth in jobs and economic activity. As Bill says, the sentiment indicated by his survey data is not particularly robust. It seemed the conference confirmed this as well.

Last we note the references to the interference with economic growth that occurs because of the White House. The failure to approve a pipeline and other elements, including higher taxation, all come together to demonstrate that the economic recovery so far in the US is very slow and somewhat disappointing.

We hope readers enjoy the summary and have an opportunity to visit the GIC website. Bill’s summary follows.

Recently a group of experts assembled at Drexel University to discuss the future course of U.S. monetary policy and its implications for our global neighbors. GIC’s Annual Monetary Policy and Trade Conference focused on the phase-out of “quantitative easing” and its implications for financial markets and real economic growth (see the presentations at http://www.interdependence.org). The first session provided an update on the current state of the economy and expected growth for 2014-15. Growth is expected to continue to be sub-par (as it has been since the recovery started in 2009), with real GDP growing between 2.5% and 3%. Inflation would remain below 2% and the unemployment rate would remain stubbornly high. Bright spots in the economy would continue to be energy (where all the growth has been in the private sector, not on government controlled land and the President continuing to withhold approval of the Keystone pipeline project and delay permits for more drilling, exploration and natural gas and oil exporting) and housing, where starts continue to lag expectations. Consumer spending on cars will be solid, but sluggish in other areas. Overall, not a strong outlook with the recovery now 59 months old, the average for a post-war recovery.

The causes of this anemic growth were discussed, top on the list being the uncertainty produced by the inability of Congress and the President to make any progress on top issues, the avalanche of regulations, the Affordable Care Act, tax hikes, and a loss of confidence in government (only 1 in 10 consumers think government policy is “good”, over 50% think it is “bad” [Reuters/University of Michigan]). Owners of small businesses (who produce half of private GDP) remain very pessimistic, with far more owners expecting the (or “their”) economy to deteriorate than improve in 2014 and record low numbers thinking it is a good time to expand, a third blaming the “political climate” directly. All of the “scandals” emanating from Washington are not inspiring confidence in government.

These and other more specific issues (including lingering effects from the financial crash for many consumers) are holding back the recovery, but the Federal Reserve has no tools to “fix” them beyond urging the fiscal authorities to act responsibly. But the Fed apparently decided to do what it could to “offset” the negative impacts of policies it could not fix. Thus several rounds of “quantitative easing” and “operation twist” followed the Feds initial foray into markets to guarantee the liquidity of the banking system. All together, these programs will take the Fed’s asset portfolio from $800 billion (mostly Treasury bonds) to around $4.5 trillion by the end of this year.

The Fed has now committed to ending the official QE3, “tapering” its monthly purchases from $85 billion each month to 0 in $10 billion increments. This does not mean that in the course of conducting normal monetary policy that the FOMC is precluded from purchasing more bonds which could, on balance, result in a further expansion of the Fed’s balance sheet if deemed necessary based on incoming data. Absent that, the Fed’s termination of QE3 will remove over a trillion dollars of demand for Treasury bonds and mortgage backed securities this year, a rather substantial reduction in demand. Taken alone, one might expect bond prices to fall and interest rates rise as a result. However, the supply of bonds is dramatically being reduced by a huge shrinkage in the federal deficit, by $600 billion or more (last year, the Fed purchased the equivalent of about 70% of new Treasury bond issuance). This would moderate the potential rise in interest rates, especially with the Fed’s “promise” to keep short rates low for a long period of time. Indeed, most forecasts for the rate on the 10 year Treasury anticipate only modest increases, moving toward 4% by year end.

The Fed’s policies do have major impacts on the rest of the world as well as here in the U.S. Low interest rates (which have reduced consumer interest income by half a trillion dollars) have encouraged investors to use this cheap money to find higher returns in other countries. Many of the targets of these fund flows are smaller countries with less well developed financial markets. The capital inflows to these countries induced by Fed policies have altered exchange rates and flows of exports and imports. China and Japan changed their holdings of Treasury securities very little, but transactions in Treasury securities were very volatile from the Caymans, a base for U.S. money investments. Other major central banks are conducting their own “QE” policies as well, all heavily impacting global liquidity. Their success or failure will have a significant impact on the U.S. and our policy choices will impact their economies.

Will or can monetary policy return to “normal”? With a $4 trillion dollar portfolio, it is hard to see how. Just “re-investing” the earnings means substantial bond buying. Letting the portfolio run off, as many suggest as the simplest way to reduce the portfolio (to what level? The pre-recession $800 billion or more because the economy is larger?) implies a reduction in bond buying as bond and mortgages mature and pay off. Discretionary policy must be framed around these possible scenarios of continued purchases or portfolio reductions. The Fed’s attempts to be “transparent” have produced many uncertainties and will probably continue to do so in the future. The Board of Governors has been appointed by one President, so diversity in views will certainly be muted. Many have criticized the Fed for continuing to purchase trillions of dollars of bonds with little evidence that it has made any difference for employment and unemployment, their “objective”. Supporters argue the counter-factual: it would have been worse had the Fed not undertaken QE2 and QE3. Something economists can argue about for years.

David R. Kotok, Chairman and Chief Investment Officer

Resources:
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For personal correspondence: david.kotok@cumber.com

Twitter: @CumberlandADV

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SIMAGA

April 11, 2014 by All Round Education

FROM MY FRIEND DAVID:

SIMAGA
April 11, 2014

“An expansion reaching its 59th month, as this one did in April, is anything but young. The average length of expansions, or the time between recessions, since World War II, is precisely 59 months. Curiously, none have lasted 59 months. Some expansions have been shorter and others have been longer. The past three expansions lasted an average of seven and a half years, while the longest expansion in recorded U.S. history lasted precisely 10 years. Expansions do not die of old age. Recessions typically come about due to a rapid unwinding of imbalances that have built up in the economy that typically follow some sort of monetary or fiscal policy mistake, or some sort of massive exogenous shock. Given the sluggish recovery in the labor market and housing sector, as well as the absence of inflationary pressures, the recovery still more closely resembles an economy in its adolescence…”

– Wells Fargo Securities, Economics Group, “Monthly Outlook,” April 9, 2014

The Federal Reserve (Fed) minutes are out. They affirm gradualism, patience, and offer guidance that the slowly paced tapering direction will continue for the rest of the year. Of course, everything is “data-dependent.” All indicators are that there will be no change in the Fed’s policy.

What does that mean for “Sell in May and go away” (SIMAGA)?

Many, many years of seasonality studies indicate a dangerous period of time from May through October. Some studies offer April as a starting point for trouble. Others suggest that the risky interval is between Memorial Day and Halloween. Whatever the case may be, SIMAGA musters considerable historical evidence to support the notion of a rocky period of five months encompassing the end of spring, the summer, and the beginning of autumn.

Many of those studies show that if you practiced SIMAGA on May 1 and went fishing until November 1 you were better off. If you bought the market on the November 1 and sold it on May 1 of the following year, you made an enormous amount of money. You were long stocks for somewhere around six months out of every year, and you were all in cash for the remaining portion. Lots of history supports SIMAGA.

Other studies show the reverse outcome if stocks were bought around May 1 and sold around November 1. If you had done that for the last century and stayed in cash from November 1 through the following May 1, you would have made virtually nothing over the entire century. May through October was mostly the worst time of the year to be invested.

We examined those historical periods. Then we also tested them against Fed policy. Add in what the Fed did, not what they said but what they did, and the dynamics change.

Roughly, the results are something like this. When the Fed is in a stimulative policy mode and is easing during the dangerous SIMAGA period, the effect of the easing neutralizes the seasonal impact on stock markets. Therefore, during those years in which the Fed’s policy was stimulative, SIMAGA did not apply. Other factors apply, like geopolitical risk, market valuation metrics, political cycles, earnings momentum and economic growth rates or inflation rates. The one factor that was neutralized was the seasonal factor. A stimulative Fed neutralizes SIMAGA.

When the Fed was neutral, a different result occurred. Markets struggled, but they did not get knocked hard on the head. A mild version of SIMAGA applied.

When the Fed was tightening during the spring and summer periods, it was best to avoid the stock market. Negative seasonal factors were exacerbated when the central bank was tightening policy. Don’t fight a tightening Fed in the summer time; that is when to follow SIMAGA.

What do we have today?

The Fed is stimulative. The reality is as simple as that, but perceptions are more complicated. Suppose the Fed had been at neutral initially, and then announced a program that over the next six months the Fed would buy federal mortgage-backed securities and Treasury securities and add them to its balance sheet. Suppose they announced purchases beginning at the rate of $55 billion and gradually trending down to $0 over the rest of the year. In this hypothetical model, markets would react to that announcement as a stimulative policy.

The only difference between what was just described and what is going to happen for the rest of this year is that the Fed is reducing the stimulus from a starting level of $85 billion per month, not raising it from a position of neutrality. The Fed is adding to the size of its balance sheet by outright purchases of government securities. Meanwhile, the inflation rate remains below the Fed’s target and has persisted there for a substantial period of time.

In our view, the stock market is neutrally priced. It reflects the continued application of very low interest rates, low inflation, and the likelihood of a continued gradual economic recovery. This is what Well Fargo called an “adolescent” recovery. That will lead to ongoing growth at a slow pace in the US.

At the same time, the current account and federal deficits are both narrowing. The twin deficits that used to haunt us by their enormity and persistence are both headed toward a more neutral and balanced place.

Think of it in the following way. External event balancing shows the current account deficit improving. Internal governmental fiscal policy is also headed toward balance. The shrinking federal deficit piles on top of well-behaved state and local government debt, deficit, spending, and restrictive policy. The Fed is maintaining gradualism, committing itself for the rest of this year and is being stimulative even as it heads toward neutral sometime at the end of 2014 into 2015.

All this says SIMAGA may be a mild effect this year. We may see a correction in the stock market. Three to five to seven percent corrections in the stock market can occur at any time, for any reason, and without warning. Such corrections tend to be attributed to whatever current event happens to be unfolding. Whether it is Vladimir Putin flexing Russian military might in Ukraine or an energy policy shift, it makes no difference. Markets react with single-digit corrections for any reason at any time.

Bear markets do not happen when the central bank is stimulative. Nor do they happen when the inflation rate is low, when interest rates are low, or when external shocks are contained (as with Vladimir Putin and the Ukraine crisis). They do happen when the economy faces a rising recession risk. Right now, the former seem to apply in the spring and summer of 2014.

We are holders of stocks in April 2014. We are finally seeing a long overdue correction. We do not believe it signals a new bear market. We believe that policy still favors rising asset prices and not SIMAGA.

Our new book is in preparation. It will be a second, expanded edition of the former best seller From Bear To Bull With ETFs. Stay tuned.

David R. Kotok, Chairman and Chief Investment Officer

Twitter: @CumberlandADV

Big Data

March 31, 2014 by All Round Education

Sharing from my friend David :

Big Data
March 31, 2014

A billion hours ago, modern Homo sapiens emerged.

A billion minutes ago, Christianity began.

A billion seconds ago, the IBM PC was released.

A billion Google searches ago … was this morning.

Hal Varian, chief economist of Google. “Beyond Big Data,” NABE annual meeting, September 10, 2013, San Francisco. Reprinted in Business Economics, Vol. 49, No. 1. For details on NABE see: http://www.nabe.com.

· 2000-plus: Estimated number of times the online activity of an average internet user is tracked every day

· 868: Number of websites among the 2510 most popular in the US where Twitter can track the activity of visitors

· 1205: Number of websites among the most 2510 most popular in the US where Facebook can track the activity of visitors

· $27.61: Estimated annual value to Facebook of a very active US female user’s data ($22.09 for a male)

· 700 million: Approximate number of adult consumers in the global database of Acxiom corp., a leading data broker

· 3000-plus: Number of shopping tendencies Acxiom says it can measure for nearly every US household

Sources: Acxiom Corp; AVG PrivacyFix; Wall Street Journal, March 24, 2014, R1, “Big Data”

OK, so where are we going with this?

Financial TV, radio, print, and internet-based discourse is continually saying something like, “The Fed is printing all this money, and we are going to have a big inflation, and interest rates will go shooting up, and the economy will go in the tank.”

Right-wing Tea Party Republicans continually harangue about the huge coming federal deficits and the massive cost of entitlements. Intransigent left-wing Democrats stress income inequality and the need to raise taxes on the rich in order to achieve fairness. Both of these bookends of the political spectrum are embroiled in primary political fights, after which they will try to shift adriotly toward the center for the general election in November. While making a noisy show of dueling each other and their primary opponents, they will accomplish little.

Meanwhile – and quietly – the economy of the US continues a slow recovery, interest rates stay low, the governmental deficit shrinks (under 3% of GDP now and falling), and the current account deficit falls as energy production in the US rises and displaces the marginal need to import. Inflation remains under the Fed’s minimum threshold of 2%. Stock market volatility spikes on news events and then recedes.

So where are we going with this?

The lists at the beginning of the discussion highlight evidence of sources of massive gains in productivity and how they are achieved. Read the WSJ piece and the NABE piece for more details. The bottom line is that rising productivity means low inflation pressures and higher business profits and improved quality of living for those who desire to use these productivity gains for personal consumption, medical care, and business development or for familial and interpersonal relationships. “Big Data” means productivity gains. That means we are all way more efficient at what we seek to do.

This rise in productivity is happening while the classic economic twin deficits are shrinking and stabilizing. Capitol Economics sums it up this way: “The US economy is the closest it has been to both internal and external balance in more than a decade.” We agree. Furthermore, the trends that are carrying us toward these twin balanced positions are accelerating forcefully. The external balancing is progressing on the back of the nation’s growing energy sector, which is creating thousands of jobs in many regions of the country. The internal budget balancing progresses amid the push-pull of polarized politics in this election year and through the 2016 presidential election.

We may be poorly governed. We wish Democrats and Republicans would cooperate. But if they don’t, we as a nation go on anyway, with gains in productivity that we achieve not because of our politicians but in spite of them.

All this sums up to a continuing bullish outlook for the stock markets and a prolonged period of lower inflation and lower interest rates. The best guess, and it is just a guess, is that the short-term rates in the US will be close to 1% or lower for another two years or longer. Those short rates tend to anchor the long rates. There may be a glitch in labor markets tightening faster than folks expect. Or there may be a bifurcation in the unemployed cohorts, and Alan Krueger and co-authors of the recent Brookings paper will be right. That would mean labor costs will start to rise sooner than expected. See “Are the long-term unemployed on the margins of the labor market?” Brookings Panel on Economic Activity, March 20-21, 2014.

So our somewhat benign outlook still has risks attached. There are always risks attached.

But we remain invested in the stock markets, and we remain invested in the bond markets, and we believe the flight to cash or near cash, which yields near zero, is a mistake. Markets may correct and allow for entry points, but the trend is still up. Bond markets may have volatility, but receiving more than 4% tax-free is a nice reward under current circumstances of low inflation and low interest-rate policy and improving external and internal balance in the United States.

It is springtime. One hundred million Google searches occurred during the time it took me to draft this text. It will be electronically edited twice. Then spell-checked. Citations will be verified by editors. Publication will be in a text format to reduce risk of malware infection. The message will be sent to thousands of readers and hundreds of journalists and media folks, and Twitter and Facebook will expand its reach to any who wish to read it. That entire process occurs with enormous productivity.

Happy Spring. Enjoy Big Data. It is here to stay, and we have only just begun to experience the results.

David R. Kotok, Chairman and Chief Investment Officer

Twitter: @CumberlandADV

Inflation, Crimea, Markets

March 19, 2014 by All Round Education

Shared by my friend David Kotok:

19:28 (36 minutes ago)

Inflation, Crimea, Markets
March 19, 2014

Every month the Cleveland Fed computes and publishes a median CPI and a 16% trimmed-mean estimate of the CPI. They add these calculations to the headline CPI and the CPI excluding food and energy. In a few seconds one can see the monthly rates of change for the last six months and the year-over-year rates of change.

Anyone may obtain this detail from the Cleveland Fed, which makes it available on their website (http://www.clevelandfed.org/For_the_Public/News_and_Media/median_cpi.pdf) and will send it to you as an email. (Contact Joel.Elvery@clev.frb.org.) I read this email notice monthly as it is received.

For the last six months all measures of monthly change have been either 0.1% or 0.2%. There were no expectations for a change of course. The matrix of four ways to view the CPI monthly change in each of the last six months shows 24 data points, and all of them are very benign when it comes to this approach to measuring inflation.

A second panel shows the percent change for the last 12 months. The range of the 24 data points spans 1.2% low to 2.0% high. All points fall within that band.

Let’s interpret this for financial markets and for business planning. First, markets. Inflation is clearly benign as measured by the CPI. It is in a holding pattern of somewhere between 1% and 2%, depending on how one measures it. It is not rising and it is not falling. All this is happening while the policy-setting interest rate in the United States remains near zero. As today’s Fed meeting result will affirm, there is little likelihood that the policy-setting interest rate will change any time soon. And there is little likelihood that the inflation rate will change soon, either.

Financial markets are proceeding with their advance based on this outlook continuing for some time. In the interest rate arena, expectations are that the near-zero rates will prevail for at least another year or two. That means security valuations based on shorter-term interest rates will continue to be robust. Hence, though stock markets may become more volatile and reactive to geopolitical events, they still have an upward bias.

Bond markets seem to be contained within trading ranges. Even the municipal bond market seems to have stabilized now that Puerto Rico has succeeded in its bond issuance and raised $3.5 billion in new cash. Detroit is gradually working out a settlement path. Worries about Chicago becoming the next city “shoe to drop” are in the Muniland conversation. Time will tell what will befall the Windy City. Cumberland avoids Chicago’s city debt; it may or may not become another type of Detroit event but why take the risk.

Stable inflation and lower volatility in the bond arena mean that businesses can be forward-looking in their financial planning. There is a growing sense that some capital expenditures may be made and that some financing may be undertaken. We see some of that with our clients. For planning purposes, a stable, low inflation rate is very helpful and removes the inflation distortions that happen with inventories and financial statements. Earnings portrayed in those statements are of a higher quality in reported terms since they are not distorted by inflation.

To sum up, the inflation outlook continues benign. This means little pressure on the Federal Reserve to change interest rate policy in the near term. So we expect modest but continuing economic growth in the US. It will be coupled with a Fed policy of gradualism, with scheduled tapering until a neutral central bank position is reached. And then a gradual policy shift of the maturity structure of the central bank’s balance sheet will commence.

We are fully invested in our US stock market-oriented ETF accounts.

A word on Ukraine. We expected Russia to “annex” Crimea. Our baseline case was not to raise cash unless we saw actual military movement. We would raise cash in the event of a shooting war. We did not raise cash on the bluster of political talk. Putin had the upper hand, played it, and won. The traditional Western powers had a weak hand and were without any reasonable choice. So they practiced restraint in arms and substituted lots of bluster.

So be it.

David R. Kotok, Chairman and Chief Investment Officer

Twitter: @CumberlandADV

GIC meeting in Paris

February 17, 2014 by All Round Education

Carsten Valgreen, Paris, Markets, Contagion Risk
February 16, 2014

“Just a correction … or something more sinister?” That is the title of a February 12 financial market briefing by Carsten Valgreen.

Carsten is a skilled economist, a global strategist, and a partner with Applied Global Macro Research. His colleagues include Jason Benderly, a personal friend of many years. Over those years, I have visited AGMR in their Colorado and Copenhagen offices. Their research is backed by solid mathematical models and is impressive. Carsten is scheduled to speak on March 11, 2014, at the GIC (Global Interdependence Center) meeting’s round-table discussion in Paris, France. The title of his session is “Banks: Bail-In vs. Bailout Regime.”

Readers who want details about the GIC meeting in Paris can visit http://www.interdependence.org. Details are on the home page. Spaces are still available. The dates are March 9-10-11.

Carsten’s work suggests that the ongoing stimulus applied by central banks, coupled with a reduction in risk premia, is leading to a gradual improvement in worldwide economic growth. Furthermore, Carsten expects that growth to show up in additional momentum in the profit shares of economies and hence their respective markets. Summarizing his outlook, Carsten notes, “We continue to expect the positive global equity market outcome for 2014 although the S&P 500 is likely to be up 5% to 15% in 2014 – and not 30% as in 2013. We continue to have stronger signals for the European market, which should be up 20% to 25%, and emerging markets should begin to perform in 2014 as the Asian manufacturing cycle picks up.”

His research then dissects the January corrections in various markets worldwide, analyzes growth aspects in greater detail, and supports these conclusions. We would suggest that interested, serious readers explore AGMR’s website: http://www.appliedglobalmacroresearch.com. If you happen to be in Paris on March 9-11, you can meet Carsten as well as our other participants in the GIC program.

Cumberland raised a cash reserve in January 2014. We were worried about contagion spreading out of emerging-market transactions as well as about uncertainties in the US policy arena. It quickly became apparent that the contagion risk persists but is being addressed in a piecemeal fashion worldwide. It also became apparent that central bank policy has achieved greater clarity.

Janet Yellen was successfully sworn in as Fed chair, testified, and established the new direction of our US central bank. The German court decision afforded greater clarity with regard to the European Central Bank’s position and was then supported by Mario Draghi’s commentary. The Bank of Japan continues on its trajectory of expansive monetary policy as a tool to encourage Japanese economic recovery and, secondarily, to weaken the yen. The Bank of England has clarified its policy, which includes not raising interest rates as the UK housing recovery develops.

For 2014, investors around the world can look at the G4 central banks and conclude that the issue of central bank policy can be taken off the table. We do not have to fret about monetary policy from an investor’s point of view. We can pretty much determine what interest rates will be at the front end of yield curves in the mature economies worldwide. Therefore, we can project how those factors will impact financial markets in the G-4 economies and in those smaller economies that are linked to the larger ones.

There is still plenty to worry about. There is still a contagion risk. When interest rates are raised sharply in Turkey, an economic slowdown in the Turkish economy can be projected. The financing of the Turkish economy is in part linked to European banks since the Turkish government’s borrowings took place in currencies other than the Turkish lira. The abrupt change in Turkey’s currency value and the much higher cost of servicing debt in the local currency has extended the repayment jeopardy of those loans. Contagion risk still exists. It may evidence itself in a shock at any time. For the moment, however, the risk of contagion seems to have abated.

How to measure such risks is a very difficult question. In stock markets we can look at the pricing of options. In the US, the most prominent measure is the VIX. It spiked for a brief time but has clamed down in recent trading days. Markets reflected the change and have been rising.

In the credit markets, one can look at spreads as a market-based indicator of risk and sentiment as evidenced by the actions of market agents. Puerto Rico’s debt is a good example. Compare Guam and Puerto Rico, whose credit ratings are similar. Both have an identical tax-free status in all jurisdictions within the US. Both have holders that include a number of mutual funds. So if the credit rating, tax status, and holders are nearly the same, then why is one issuer trading in the marketplace at an interest rate of 300 to 400 basis points higher than the other? The market’s assessment is clear: Puerto Rico might experience a liquidity shortage or solvency issue, while Guam appears insulated from that risk.

There is nothing a central bank’s abundant liquidity can do when a single issuer of debt has a liquidity and solvency problem. Central bank tools are applied in the broad macro sense. They can reduce interest rates, make excess reserves available to banking systems, or acquire high-grade, high-quality, special issues and sovereign debt, as they have done. But the central bank of the US cannot bail out Puerto Rico. The central bank of the Eurozone cannot bail out Greece. Greece and Puerto Rico have to fix their own chronic problems. They have spent years in a deteriorating economic framework, increasing their risky profile by piling on a debt load that cannot be sustained. At some point, the laws of economic physics prevail, and the house of cards collapses.

Greece’s house of cards finally crumbled. It is still going through aftershocks as it negotiates yet another round of assistance. Now Puerto Rico confronts similar challenges as it faces an enormously complex reconstruction. There is a reason that Puerto Rico was recently called “the Greece of the Caribbean” on the front page of a global publication. Similarities between the two countries, their relative sizes within their currency zones, and the practice of using debt instead of discipline to manage their economies have resulted in similar economic outcomes. Note Greece and Puerto Rico are both sovereign debt issuers. Both lack provisions for bankruptcy. Greek bondholders took haircuts. PR bondholders are taking them in the marketplace as resolution proceeds. The February 18 investor’s call will prove interesting.

Every time there is a financial shock anywhere in the world, whether in Puerto Rico, Greece, Thailand, or Turkey, there is a contagion risk. That is the nature of a truly global, increasingly interdependent financial system. We live with that risk and measure risk premia to see how markets are reacting to it. Note that each of the markets associated with a recent center of contagion risk has been badly hurt. But a sufficiently contained contagion means that nearby or distant markets do not get hurt.

Currently, in the US stock market, market agents are looking beyond the contagion risk. They are focused on the (1) assumed-to-be-predictable characteristics of the Federal Reserve policy direction, (2) the settlement of the debt-limit debate and (3) the more quiescent behavior of our Washington, DC, politicians in this election year. Market agents also see the decline in the federal deficit as a reduction of financing pressures for US dollar-denominated debt. And markets seem to accept the outlook for slow growth, given our gradual and tepid recovery. Those factors mean non-pressured cost in the labor markets and low, docile inflation.

Such an outlook presents marvelous opportunities for the astute investor. Contagion risks have not diminished, but those risks help make the investments that market agents pursue worthwhile. The risks continue to permit pricing such that disparities in risk premia present opportunities savvy investors can seize.

An example persists in the tax-free municipal bond market. The 30-year US Treasury obligation is fully taxable at a federal level to a tax-paying US investor. It yields approximately 3.7%. The very-highest-grade 30-year tax-free bonds of a type that have had a zero default history over the last century yield more. There is no way to justify this inverted yield unless investors happen to believe that the income tax of the US is going to be repealed. Absent a repeal of taxation, one can say the Treasury security is richly priced versus the tax-free bond. Or one can say that the tax-free bond is cheaply priced versus the Treasury security. An individual American has the option to hold either, both, or neither. Or the investor can hold the cheap one and sell the richly priced one short and position the spread. The question for the investor is, “Where is the bargain?”

If we are going to have a protracted period, measured in years, during which inflation will remain low, US labor markets will heal gradually, and central banks will provide liquidity to sustain this fragile and tepid but continuing economic recovery. In such a scenario, stock markets will remain upwardly biased. Selected bonds are attractive to investors. Cash earning zero is not the most desirable structure unless contagion risk flares its ugly head and converts risk into reality.

At this writing, Cumberland is fully invested in the US stock market using ETFs. Our international accounts are deployed in selected economies, countries, and markets where we believe results will be positive. Our bond accounts remain favorably invested toward higher-grade municipal credits that we believe are bargains.

David R. Kotok, Chairman and Chief Investment Officer

Nonfarm Payrolls -what it means

February 8, 2014 by All Round Education

Today’s Employment Report & Markets
February 7, 2014

Today’s jobs report delivers neither encouragement nor discouragement. It falls right smack in the middle of a slow recovery trend with relatively flat labor income. Do not get excited about it. Do not panic, either. The debate over whether or not to extend unemployment benefits is likewise not really relevant for the market posture. It may encourage job growth as some economist suggest since it raises the incentive to work. The debate over weather-related effects is not of much consequence.

Simply put, a slow-growing trend is the best thing for stock markets in the US. It means the Fed proceeds slowly with tapering and the politics are calmer in an election year. It means the US inflation rate stays very low and interest rates do as well.

The story is dramatically different regarding emerging markets. Without robust growth in the US and other mature developed economies, those markets remain problematic. Three factors – (1) the rollout of foreign central bank-induced rising interest rates, (2) foreign exchange currency turmoil, and (3) emerging-market growth-rate questions – are contributing to a continuing saga of uncertainty and trouble. We keep an eye on the overflow of Turkey’s debt issues and higher Turkish interest rates as those issues impact banks in Europe. We keep an eye on Asia and especially on the Negara Bank in Malaysia. We look at Brazil and question the rate of recovery in economic growth.

To us, contagion risk seems to be rising in the world. Risk assessment is not an outcome forecast. It is a cautionary warning. The world may get a shock, or it may work its way through the contagion risk without one. We do not know.

Contagion risk may even reach the US when it comes to the issue of Puerto Rico debt. We will have more to say about Puerto Rico next week. For today, the downgrade of PR by Moody’s is enough commentary.

Meanwhile, Cumberland Advisors is maintaining a cash reserve in both its US and international exchange-traded funds (ETF) accounts. We are not fully invested; however, that could change at any time. The 6-7% market correction may be enough to afford some opportunity. The global risk profile (including PR risk) says do not go all in today.

David R. Kotok, Chairman and Chief Investment Officer

Twitter: @CumberlandADV

Core ETFs in 2014

January 4, 2014 by All Round Education

Shared by my friend David Kotok.

Core ETFs in 2014
January 3, 2014

Happy New Year. As 2014 commences, we are looking forward and also looking back. In this commentary we will examine our “core” ETF strategy for the US stock market.

2013 witnessed a dramatic stock market year. Everyone in the market knows it, and those who retreated to the sidelines are kicking themselves for missing out on stellar returns. Stock portfolios that were invested in 2013 and that maintained their positions and diversified distributions have added about 30% in market value. Investors achieved this without needing to pick single “hot” stocks and without having to concentrate risk.

At Cumberland Advisors, we only use ETFs (exchange-traded funds) in the management of stock portfolios worldwide. In the US, we have a basic core position that selects broad-based ETFs. We add satellite positions in sectors and specific industries. In the modern era there are 1,500 ETFs to choose from; therefore, investors may construct ETF portfolios in almost any fashion they desire.

At the end of 2013, Cumberland’s core position comprised five ETFs. Those five ETFs expose the portfolio to approximately 3,000 different stocks in a weighting system that is derived from the contents of the ETFs. During the course of 2013, those weights changed as occasional substitutions were made in the ETF portfolios’ core section. We will not elaborate on the details of those changes since this is a proprietary technique used in our management system.

On January 1, 2014, the five different ETFs in our ETF core portfolio ranged in weight from a high of 30% to a low of 10%. While our portfolio composition and weights varied through last year, our main objective for this core investment style is to offer a low turnover with very broad diversification. Among the core five, PowerShares Dynamic Market Portfolio ETF (PWC) produced a 41% total return in 2013 and outperformed SPY by about 9%. The next two ETFs, Guggenheim S&P 500 Equal Weight (RSP) and iShares Russell 2000 Growth ETF (IWO) are each larger positions, and both outperformed SPY last year, by 3% and 11% respectively. Our last two positions, Guggenheim S&P 500 Pure Value (RPV) and RevenueShares Small Cap ETF (RWJ), are assigned smaller weights in our model. Each has outperformed the benchmark SPY in 2013, RPV by 15% and RWJ by 13%.

We start the year with these proven and promising core positions. They may change at any time. We will discuss industry and sector selections in other commentaries.

At Cumberland, the bottom line is that portfolio managers face strategic decisions daily. Managers get up each morning and have to buy, sell, or hold. That is the first and foremost action we undertake each day. Later we can write, talk, or tell someone else what we think about it all. The difference between managing a portfolio and not managing a portfolio is simple: a manager is on the firing line for what is done, not what is said.

Transition is ahead in 2014.

This year starts out with the same low interest rates at the short end of the yield curve as we saw in January 2013. The bond market is already up in terms of longer-term interest rates. The yield curve is steepening, which suggests economic growth rates will be improving. The Federal Reserve has finally commenced “tapering.”

The bond market seems to be ignoring the current low inflation statistics. In a longer-run scheme, bonds are negatively impacted by inflation that erodes the real value of the bond’s payment stream. Either the current bond market is anticipating a rise in inflation, or bond investors are shunning the bond market for the stock market and may be making a mistake in doing so. We think that is the case with tax-free municipal bonds: they still remain cheap. We do not own intermediate Treasury notes. They are not cheap.

Back to the US stock market. On the heels of 2013, 2014 is unlikely to see such stellar gains. Stocks cannot go up 30% per year for years and years. It simply does not happen.

Stock market history shows that after surges similar to the one in 2013, the subsequent year usually has a positive result. We expect that to be the case in 2014, for several reasons: the economy will continue to recover at a measured pace; inflation will continue to be subdued; interest rates in the shorter- term maturities will remain very low; and bond interest rates will not immediately spike significantly higher than present levels. The current 30-year Treasury bond yield is about 4% and the 10-year about 3%; high-grade muni yield remains over 4%, while a money market fund still pays next to zero %. Bonds can hold at near-present levels during 2014, but they are not yielding enough to steal the show from the stock market.

Thus the mix could lead to a positive stock market return in the high single digits for 2014. That would put a 2014 year-end close on the S&P 500 at 1950 or so. At the moment such a result is possible. But there are risks, and the outlook could easily deteriorate. Politics top the risk list.

2014 is an election year in the US. The Republicans have a narrow majority in the House of Representatives. The Democrats have a narrowing majority in the US Senate. As a country, we have a dysfunctional and divided government. Both Houses of Congress are in for a massive fight. Incumbents face primary threats from the extremes of their respective parties. Neither party nor chamber wants to be blamed for something going wrong. Each seeks power while being risk-averse when it comes to blame.

Despite the sharp divisions, since blame avoidance is now the word in Washington, political risk in the US due to some policy impasse has apparently eased. But that also means the penalty for failure is very high. Markets seem to be pricing in a docile political environment, one unperturbed by a government shutdown, a debt-ceiling fight, or an external shock from some geopolitical event (North Korea? Iran?) or some other politically induced catastrophe.

Such an assumption of sustained calm and stability sometimes flies in the face of history. The world is still a dangerous place. Washington, DC, is still a dangerous city from the perspective of the rest of us Americans, who have to put up with the shenanigans of the people we elect to govern us. Risk in the political arena remains high in 2014.

Looking back, we just had a terrific year. As of January 1, 2014, we remain nearly fully invested in our US ETF managed portfolios. But we must look forward with caution and navigate the year’s opportunities with a close eye on winds, weather, and the seaworthiness of our investment strategy. At Cumberland, that’s our first priority every day.

David R. Kotok, Chairman and Chief Investment Officer

Twitter: @CumberlandADV

2013 in review

December 31, 2013 by All Round Education

The WordPress.com stats helper monkeys prepared a 2013 annual report for this blog.

Here’s an excerpt:

A San Francisco cable car holds 60 people. This blog was viewed about 2,700 times in 2013. If it were a cable car, it would take about 45 trips to carry that many people.

Click here to see the complete report.

International Equities at Year-End

December 20, 2013 by All Round Education

Received from my friend David Kotok.

International Equities at Year-End: The Advanced Markets
December 19, 2013

This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, http://www.cumber.com. He can be reached at Bill.Witherell@cumber.com.

As the end of 2013 approaches, the global economy is still suffering from the financial crisis of 2008 and subsequent deep recession. Global economic growth slowed from 3.2% last year to an estimated 2.9% for 2013. Growth of the advanced economies is estimated to have been only 1.2%. Recovery in the US economy is broadening and gathering momentum but remains below the path of most past recoveries. The United Kingdom’s economy has also moved onto a solid recovery path, yet it still has a great way to go to make up for the ground that was lost. In contrast, the recovery in continental Europe is still very tentative in a number of economies, aside from Germany and several of its northern neighbors. In Japan, an unprecedented change in economic and financial policies, “Abenomics,” has aroused the world’s third largest economy from over two decades of stagnation and deflation, helped by a 16% depreciation of the currency.

Global equity markets registered much stronger returns than the above-noted modest economic performance might suggest. The MSCI World Index, in US dollars, is up 19% for the year to date (through December 17). Led by Japan (MSCI Japan up 20.8 %), the MSCI EAFE Index for advanced markets outside of North America advanced 13.7%. The MSCI US Total Market Index topped most markets with a 25.14 % advance, while Canada underperformed, with the MSCI Index for Canada essentially unchanged for the year to date (-0.05%). Also noteworthy has been the outperformance of small-cap stocks in the advanced markets. For example, the iShares MSCI EAFE Small Cap Index ETF, SCZ, is up by 20.8 %, while the iShares MSCI EFA Index ETF (large-cap) is up 13%.

The strong performance of the advanced equity markets in the face of weak macroeconomic fundamentals is likely due to several factors. Investors’ concerns about a number of risks that had been depressing markets have eased. The Eurozone appears to be addressing its problems and looks far less likely to break up; the Chinese economy seems to have avoided a sharp slowdown and to be gaining momentum; and the fiscal standoff in Washington has ended – for now. Another important factor is the stimulative monetary policies being pursued by the major central banks, with the prospect of very low interest rates continuing for an extended period. Corporate profits generally have been quite strong despite the modest economic growth. And equity markets typically look forward: investors foresee the global recovery gaining momentum in the coming year.

We, too, are generally optimistic about the advanced equity markets in 2014, although another 20+% gain seems unlikely. Two countries, Japan and the United Kingdom, and a region, Northern Europe, have the most promising prospects. In Japan the Abe government and the Bank of Japan are strongly committed to following through with their efforts to sustain the economic recovery and break deflation definitively by combining very aggressive monetary easing with a balancing act of debt consolidation and fiscal encouragement of the economy, along with far-reaching economic reforms. A test will come in the spring when the consumption tax is to increase. We expect the government to seek to partially offset the effects of this tax with a reduction in the corporate business tax and with new spending. The Bank of Japan will likely step up its monetary stimulus if that appears necessary. We expect further depreciation of the Japanese yen in 2014 and for that reason will continue to favor a Japan ETF that is hedged for changes in the yen/US dollar exchange rate: the WisdomTree Japan Hedged Equity Fund, DXJ. That ETF is up 32.3% year to date, while the unhedged iShares Japan ETF, EWJ, is up 20.31%. The longer-run performance of the Japanese economy will depend on economic reforms promised but still not clearly defined. The ultimate success or failure of “Abenomics” will likely hinge on the extent to which needed structural reforms are initiated and implemented. The jury is still out on that.

In Europe the United Kingdom economy looks now to be on firm footing and should advance at almost three times the 1% average expected for the Eurozone. The negative effects of the financial crisis and a housing overhang are declining; the government has eased off its somewhat overzealous fiscal austerity program; and the Bank of England is maintaining an accommodative policy stance. The MSCI UK Index is up 9.5% this year.

In continental Europe, Germany was one of the very few Eurozone economies to eke out positive GDP growth for the year, estimated at 0.5%. It is both the largest economy in the Eurozone and has the best macroeconomic prospects for the coming year. Positive investor expectations for the German economy and equity market lifted the MSCI Germany Index by 21.7%, considerably bettering the 16.6% advance for the French market, which has recently been losing ground to the German market.

The Eurozone continues to face substantial challenges, including further deleveraging and generally tight credit conditions as banks seek to strengthen their capital positions. Eurozone banks will face stringent stress tests in the coming months. The ECB may be faced with the threat of deflation and, if so, would likely respond with further easing. While there have been some important advances, establishment of a sustainable monetary union is still incomplete. Eurozone equity market performance in the coming year looks unlikely to match that of 2013, which was 18.9% to date for the region.

Outside the Eurozone, Sweden and Switzerland have strong, well-run economies that have been held back by the weakness of demand in their all-important European markets, as well as by their own strong currencies. The Swedish market, as measured by the MSCI Sweden Index, has gained 12.4% year to date, and the MSCI Switzerland Index is up 18.3%. These economies and markets should do well as Europe slowly recovers.

In the Asia-Pacific advanced markets, Australia, New Zealand, Singapore, and Hong Kong have all underperformed this past year. A continuation of the recent strengthening trend in China should help these markets in 2014, particularly that of Hong Kong.

Bill Witherell, Chief Global Economist

Twitter: @CumberlandADV

Crowding-in …Bonds

December 15, 2013 by All Round Education

Sharing this piece from my friend David Kotok.

Crowding In – Bond Interest Rates
December 14, 2013

We are watching bond market volatility as Treasury bonds struggle with questions about what the Fed (Federal Reserve) is going to do. Only the passage of time and improvement of communication from the new Fed leadership will resolve this issue of inadequate clarity and resulting volatility.

At the same time, we are aware that the federal deficit is shrinking. The pressure of new Treasury bond issuance is falling all the time. Markets tend to ignore this trend in the short run. In the longer run and in the past, with the federal government “crowding out” other borrowers, having to sell more bonds put more pressure on markets. The fewer bonds there are to be sold, the less pressure there is on markets. This is called “crowding in” and is a characteristic that market agents have forgotten after the recent and long period of high deficits in the United States.

In 2014, governmental crowding in has arrived in force. Its influence will be felt in markets. Coupled with restrained state and local budgets, we now have a shrinking federal deficit that is now headed under 3% of GDP and trending lower. This is a very powerful force against rising bond yields.

Greg Valliere, an expert observer of Washington, DC, politics and the dynamics of our political system, described the shrinkage of the deficit as follows: “The first two months of the fiscal year look spectacular. Data released yesterday by the Treasury Department show the deficit down by 22% compared to the first two months of last year, with receipts up by 10% to $362 billion. Cynics respond that about $30 billion of that total comes from Fannie and Freddie, which are pumping profits back to the government.” When I asked Greg for more detail about the GSE share, Greg offered this addition about “the enormous one-time tax break of about 20 billion that grossly affected the GSE contribution”: “Both Fannie and Freddie will continue to contribute to the Treasury, but not at the Oct.-Nov. pace.” Many thanks to Greg Valliere for giving us permission to share this insight.

We think Greg is right in his assessment that the falling deficit will persist. We believe it will be a force throughout the rest of the Obama term. It is quite possible that the deficit could decisively dip under 3% of GDP and even approach 2% or 2.5% of GDP. That will be a remarkable event. It will happen at the same time that the pressures on the housing agencies and mortgage finance entities are diminishing. All this coincides with rising house prices and the gradual recovery of our economy. As a nation we find ourselves on the benign recovery side of the pain that convulsed the economy during the financial crisis.

In sum, the new-issuance pressure of bonded indebtedness at all government levels is not intense and not of the nature to drive up interest rates. Instead we have crowding in, not crowding out.

Meanwhile, the issue of inflation is being ignored by bond investors. The headline personal consumption expenditure deflator is falling. Market-based priced Core PCE is falling even more. It is trending under 1%. Core CPI is also falling. Producer Price inflation is trending at about 1%. In fact, the case can be made that the collective indicators of price level changes could all trend under at or near 1% sometime in 2014.

The real interest rate in the bond market (after inflation is removed from the calculation) rises when the anticipated or measured rate of inflation falls. As we know, over time, it is the real interest rate that counts.

Rising real interest rates have a slowing effect on economic activity. Falling or lower real interest rates spur economic activity. Presently, with inflation rates not widely accepted as accurate by market players but trending lower and bond interest rates not widely accepted as bargains by market players but trending higher, a possible collision course or tension between the two indicators results. That tension could slow the pace of economic growth, and any such slowing could and would lead to a subsequent robust rally in bonds.

What bonds to buy, what bonds to hold, and what bonds to sell? When should they be swapped? These are the conundrums investors face.

Fortunately, there are good answers to be found. We have long said that the tax-free, high-grade bond sector is cheap relative to other bonds. It still is. Sectors of the bond markets that are yielding real tax-free returns of 3% and even 4% are very attractive. One can get those returns without taking a lot of credit risk. We are not talking about Detroit, Puerto Rico, or other credits in the municipal bond space that are questionable, facing bankruptcy, in bankruptcy, or otherwise under pressure. We are talking about the highest-quality credits that are available at bargain real yields and bargain relative nominal yields. Build America Bonds, the taxable cousins in Muniland, also remain cheap.

Lastly, the disposition of investors to run from the bond market continues to intensify. We see evidence week after week of liquidation of mutual fund shares. This has been going on for six months. Credit Suisse recently created an analysis of various fund flows (December 10, 2013). They ask the question, “What’s all the fuss about fund flows about?” They then dissect the various measures of fund flows. The conclusion is fairly clear. The flight from bonds has forced mutual funds to sell. They are selling as a class. That means when Fidelity sells, it has to sell its bonds, and Vanguard is not able to buy because they have to sell bonds as well.

As in an earlier period of intense liquidation, the liquidation of bonds now underway works to create bargains in the bond space as sequential investors capitulate due to fear. They extract money from the bond side and place it elsewhere. Then they wonder and second guess their actions.

Has anyone thought that the bond sell-off might be overdone? The economy and its recovery are not so robust and not so impacted by rising inflation pressures as to cause bond interest rates to spike higher.

Maybe, just maybe, we will have low inflation, lower interest rates, and gradual economic recovery that will persist for quite some time. Maybe, just maybe, the backup in home mortgage interest rates will slow the housing recovery so that it will not be robust. The recovery in the labor market may also persist slowly, as the evidence seems to show.

We are approaching the end of the year in managed bond accounts. That is a big piece of Cumberland’s activity. We resist this notion that the bond market is headed for an absolute debacle in 2014. We particularly favor the tax-free municipal bond. Where appropriate, we recommend tactical hedging as a method of dampening overall bond portfolio volatility.

At Cumberland, we do not view the world as coming to an end in bond land. When a high-grade, long-term tax-free yield of 5% is obtainable in a very low-inflation environment, we think that bond investors who run from bonds and liquidate them will look back, regret the opportunities they missed, and wonder why they did it.

David R. Kotok, Chairman and Chief Investment Officer

Twitter: @CumberlandADV