FOFViewForm Object
(
    [form:protected] => FOFForm Object
        (
            [model:protected] => LegacyinterfaceModelCommentaries Object
                (
                    [default_behaviors:protected] => Array
                        (
                            [0] => filters
                            [1] => access
                        )

                    [__state_set:protected] => 1
                    [_db:protected] => JDatabaseDriverMysqli Object
                        (
                            [name] => mysqli
                            [nameQuote:protected] => `
                            [nullDate:protected] => 0000-00-00 00:00:00
                            [_database:JDatabaseDriver:private] => joomla
                            [connection:protected] => mysqli Object
                                (
                                    [affected_rows] => 1
                                    [client_info] => mysqlnd 5.0.11-dev - 20120503 - $Id: 15d5c781cfcad91193dceae1d2cdd127674ddb3e $
                                    [client_version] => 50011
                                    [connect_errno] => 0
                                    [connect_error] => 
                                    [errno] => 0
                                    [error] => 
                                    [error_list] => Array
                                        (
                                        )

                                    [field_count] => 1
                                    [host_info] => Localhost via UNIX socket
                                    [info] => 
                                    [insert_id] => 0
                                    [server_info] => 5.5.46
                                    [server_version] => 50546
                                    [stat] => Uptime: 8208076  Threads: 1  Questions: 3292205  Slow queries: 9  Opens: 160  Flush tables: 1  Open tables: 153  Queries per second avg: 0.401
                                    [sqlstate] => 00000
                                    [protocol_version] => 10
                                    [thread_id] => 297409
                                    [warning_count] => 0
                                )

                            [count:protected] => 17
                            [cursor:protected] => 
                            [debug:protected] => 
                            [limit:protected] => 0
                            [log:protected] => Array
                                (
                                )

                            [timings:protected] => Array
                                (
                                )

                            [callStacks:protected] => Array
                                (
                                )

                            [offset:protected] => 0
                            [options:protected] => Array
                                (
                                    [driver] => mysqli
                                    [host] => localhost
                                    [user] => joomlauser
                                    [password] => default
                                    [database] => joomla
                                    [prefix] => ap_
                                    [select] => 1
                                    [port] => 3306
                                    [socket] => 
                                )

                            [sql:protected] => 
SELECT COUNT(*)
FROM (
SELECT `#__legacyinterface_commentaries`.*
FROM `#__legacyinterface_commentaries`
WHERE (`access` IN ('1','1'))) AS a
                            [tablePrefix:protected] => ap_
                            [utf:protected] => 1
                            [errorNum:protected] => 0
                            [errorMsg:protected] => 
                            [transactionDepth:protected] => 0
                            [disconnectHandlers:protected] => Array
                                (
                                )

                        )

                    [event_after_delete:protected] => onContentAfterDelete
                    [event_after_save:protected] => onContentAfterSave
                    [event_before_delete:protected] => onContentBeforeDelete
                    [event_before_save:protected] => onContentBeforeSave
                    [event_change_state:protected] => onContentChangeState
                    [event_clean_cache:protected] => 
                    [id_list:protected] => Array
                        (
                            [0] => 0
                        )

                    [id:protected] => 0
                    [input:protected] => FOFInput Object
                        (
                            [options:protected] => Array
                                (
                                )

                            [filter:protected] => JFilterInput Object
                                (
                                    [tagsArray] => Array
                                        (
                                        )

                                    [attrArray] => Array
                                        (
                                        )

                                    [tagsMethod] => 0
                                    [attrMethod] => 0
                                    [xssAuto] => 1
                                    [tagBlacklist] => Array
                                        (
                                            [0] => applet
                                            [1] => body
                                            [2] => bgsound
                                            [3] => base
                                            [4] => basefont
                                            [5] => embed
                                            [6] => frame
                                            [7] => frameset
                                            [8] => head
                                            [9] => html
                                            [10] => id
                                            [11] => iframe
                                            [12] => ilayer
                                            [13] => layer
                                            [14] => link
                                            [15] => meta
                                            [16] => name
                                            [17] => object
                                            [18] => script
                                            [19] => style
                                            [20] => title
                                            [21] => xml
                                        )

                                    [attrBlacklist] => Array
                                        (
                                            [0] => action
                                            [1] => background
                                            [2] => codebase
                                            [3] => dynsrc
                                            [4] => lowsrc
                                        )

                                )

                            [data:protected] => Array
                                (
                                    [start] => 820
                                    [limitstart] => 820
                                    [option] => com_legacyinterface
                                    [view] => commentaries
                                    [Itemid] => 616
                                    [layout] => 
                                    [task] => browse
                                    [directionTable] => asc
                                    [sortTable] => published_on
                                    [filter_order] => published_on
                                    [filter_order_Dir] => desc
                                    [savestate] => 1
                                    [base_path] => /var/www/html/apcms/components/com_legacyinterface
                                )

                            [inputs:protected] => Array
                                (
                                    [get] => JInput Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                    [start] => 820
                                                )

                                            [inputs:protected] => Array
                                                (
                                                    [get] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
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                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [start] => 820
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [post] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [cookie] => JInputCookie Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                    [get] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                    [start] => 820
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [post] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [cookie] => JInputCookie Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [files] => JInputFiles Object
                                                                        (
                                                                            [decodedData:protected] => Array
                                                                                (
                                                                                )

                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                    [get] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [tagsMethod] => 0
                                                                                                    [attrMethod] => 0
                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => applet
                                                                                                            [1] => body
                                                                                                            [2] => bgsound
                                                                                                            [3] => base
                                                                                                            [4] => basefont
                                                                                                            [5] => embed
                                                                                                            [6] => frame
                                                                                                            [7] => frameset
                                                                                                            [8] => head
                                                                                                            [9] => html
                                                                                                            [10] => id
                                                                                                            [11] => iframe
                                                                                                            [12] => ilayer
                                                                                                            [13] => layer
                                                                                                            [14] => link
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                                                                                                            [16] => name
                                                                                                            [17] => object
                                                                                                            [18] => script
                                                                                                            [19] => style
                                                                                                            [20] => title
                                                                                                            [21] => xml
                                                                                                        )

                                                                                                    [attrBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => action
                                                                                                            [1] => background
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                                                                                                            [3] => dynsrc
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                                                                                                        )

                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                    [start] => 820
                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [post] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [tagsMethod] => 0
                                                                                                    [attrMethod] => 0
                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => applet
                                                                                                            [1] => body
                                                                                                            [2] => bgsound
                                                                                                            [3] => base
                                                                                                            [4] => basefont
                                                                                                            [5] => embed
                                                                                                            [6] => frame
                                                                                                            [7] => frameset
                                                                                                            [8] => head
                                                                                                            [9] => html
                                                                                                            [10] => id
                                                                                                            [11] => iframe
                                                                                                            [12] => ilayer
                                                                                                            [13] => layer
                                                                                                            [14] => link
                                                                                                            [15] => meta
                                                                                                            [16] => name
                                                                                                            [17] => object
                                                                                                            [18] => script
                                                                                                            [19] => style
                                                                                                            [20] => title
                                                                                                            [21] => xml
                                                                                                        )

                                                                                                    [attrBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => action
                                                                                                            [1] => background
                                                                                                            [2] => codebase
                                                                                                            [3] => dynsrc
                                                                                                            [4] => lowsrc
                                                                                                        )

                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [cookie] => JInputCookie Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [tagsMethod] => 0
                                                                                                    [attrMethod] => 0
                                                                                                    [xssAuto] => 1
                                                                                                    [tagBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => applet
                                                                                                            [1] => body
                                                                                                            [2] => bgsound
                                                                                                            [3] => base
                                                                                                            [4] => basefont
                                                                                                            [5] => embed
                                                                                                            [6] => frame
                                                                                                            [7] => frameset
                                                                                                            [8] => head
                                                                                                            [9] => html
                                                                                                            [10] => id
                                                                                                            [11] => iframe
                                                                                                            [12] => ilayer
                                                                                                            [13] => layer
                                                                                                            [14] => link
                                                                                                            [15] => meta
                                                                                                            [16] => name
                                                                                                            [17] => object
                                                                                                            [18] => script
                                                                                                            [19] => style
                                                                                                            [20] => title
                                                                                                            [21] => xml
                                                                                                        )

                                                                                                    [attrBlacklist] => Array
                                                                                                        (
                                                                                                            [0] => action
                                                                                                            [1] => background
                                                                                                            [2] => codebase
                                                                                                            [3] => dynsrc
                                                                                                            [4] => lowsrc
                                                                                                        )

                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [files] => JInputFiles Object
                                                                                        (
                                                                                            [decodedData:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [options:protected] => Array
                                                                                                (
                                                                                                )

                                                                                            [filter:protected] => JFilterInput Object
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                                                                                            [data:protected] => Array
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                                                                                            [inputs:protected] => Array
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                                                                                    [env] => JInput Object
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                                                                                            [filter:protected] => JFilterInput Object
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                                                                                            [data:protected] => Array
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                                                                                            [inputs:protected] => Array
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                                                                                    [request] => JInput Object
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                                                                                            [filter:protected] => JFilterInput Object
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                                                                                            [data:protected] => Array
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                                                                                                    [option] => com_legacyinterface
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                                                                                            [inputs:protected] => Array
                                                                                                (
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                                                                                        )

                                                                                    [server] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
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                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
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                                                                                                        )

                                                                                                    [attrArray] => Array
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                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
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                                                                                                    [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate
                                                                                                    [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                                    [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8
                                                                                                    [HTTP_IF_MODIFIED_SINCE] => Sun, 18 Mar 2018 23:21:17 GMT
                                                                                                    [PATH] => /sbin:/usr/sbin:/bin:/usr/bin
                                                                                                    [SERVER_SIGNATURE] => 
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                                                                                                    [REMOTE_ADDR] => 54.198.119.26
                                                                                                    [DOCUMENT_ROOT] => /var/www/html/apcms
                                                                                                    [REQUEST_SCHEME] => http
                                                                                                    [CONTEXT_PREFIX] => 
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                                                                                                    [SERVER_ADMIN] => ben@hubtech.tv
                                                                                                    [SCRIPT_FILENAME] => /var/www/html/apcms/index.php
                                                                                                    [REMOTE_PORT] => 44138
                                                                                                    [GATEWAY_INTERFACE] => CGI/1.1
                                                                                                    [SERVER_PROTOCOL] => HTTP/1.0
                                                                                                    [REQUEST_METHOD] => GET
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                                                                                                    [REQUEST_URI] => /?start=820
                                                                                                    [SCRIPT_NAME] => /index.php
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                                                                                                    [REQUEST_TIME_FLOAT] => 1527336558.913
                                                                                                    [REQUEST_TIME] => 1527336558
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                                                                                            [inputs:protected] => Array
                                                                                                (
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                                                                                        )

                                                                                    [session] => JInput Object
                                                                                        (
                                                                                            [options:protected] => Array
                                                                                                (
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                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
                                                                                                    [tagsArray] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [attrArray] => Array
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                                                                                                    [tagBlacklist] => Array
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                                                                                                )

                                                                                            [data:protected] => Array
                                                                                                (
                                                                                                    [__default] => Array
                                                                                                        (
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                                                                                                            [session.timer.start] => 1527336559
                                                                                                            [session.timer.last] => 1527336559
                                                                                                            [session.timer.now] => 1527336559
                                                                                                            [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                                            [registry] => Joomla\Registry\Registry Object
                                                                                                                (
                                                                                                                    [data:protected] => stdClass Object
                                                                                                                        (
                                                                                                                            [com_legacyinterface] => stdClass Object
                                                                                                                                (
                                                                                                                                    [commentaries] => stdClass Object
                                                                                                                                        (
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                                                                                                                                            [filter_order] => published_on
                                                                                                                                            [filter_order_Dir] => desc
                                                                                                                                        )

                                                                                                                                )

                                                                                                                        )

                                                                                                                )

                                                                                                            [user] => JUser Object
                                                                                                                (
                                                                                                                    [isRoot:protected] => 
                                                                                                                    [id] => 0
                                                                                                                    [name] => 
                                                                                                                    [username] => 
                                                                                                                    [email] => 
                                                                                                                    [password] => 
                                                                                                                    [password_clear] => 
                                                                                                                    [block] => 
                                                                                                                    [sendEmail] => 0
                                                                                                                    [registerDate] => 
                                                                                                                    [lastvisitDate] => 
                                                                                                                    [activation] => 
                                                                                                                    [params] => 
                                                                                                                    [groups] => Array
                                                                                                                        (
                                                                                                                            [0] => 9
                                                                                                                        )

                                                                                                                    [guest] => 1
                                                                                                                    [lastResetTime] => 
                                                                                                                    [resetCount] => 
                                                                                                                    [requireReset] => 
                                                                                                                    [_params:protected] => Joomla\Registry\Registry Object
                                                                                                                        (
                                                                                                                            [data:protected] => stdClass Object
                                                                                                                                (
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                                                                                                                        )

                                                                                                                    [_authGroups:protected] => Array
                                                                                                                        (
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                                                                                                                        )

                                                                                                                    [_authLevels:protected] => Array
                                                                                                                        (
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                                                                                                                            [1] => 1
                                                                                                                        )

                                                                                                                    [_authActions:protected] => 
                                                                                                                    [_errorMsg:protected] => 
                                                                                                                    [_errors:protected] => Array
                                                                                                                        (
                                                                                                                        )

                                                                                                                    [aid] => 0
                                                                                                                )

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                                                                                                )

                                                                                            [inputs:protected] => Array
                                                                                                (
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                                                                                        )

                                                                                    [jrequest] => JInput Object
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                                                                                                (
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                                                                                            [filter:protected] => JFilterInput Object
                                                                                                (
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                                                                                                    [attrArray] => Array
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                                                                                                    [attrBlacklist] => Array
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                                                                                            [data:protected] => Array
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                                                                                            [inputs:protected] => Array
                                                                                                (
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                                                                                        )

                                                                                )

                                                                        )

                                                                    [env] => JInput Object
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                                                                                (
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                                                                            [filter:protected] => JFilterInput Object
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                                                                                )

                                                                            [data:protected] => Array
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                                                                            [inputs:protected] => Array
                                                                                (
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                                                                        )

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                                                                        (
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                                                                                        (
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                                                                                )

                                                                            [data:protected] => Array
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                                                                                    [view] => commentaries
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                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [server] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
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                                                                            [filter:protected] => JFilterInput Object
                                                                                (
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                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
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                                                                                    [tagsMethod] => 0
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                                                                                        (
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                                                                                    [attrBlacklist] => Array
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                                                                                )

                                                                            [data:protected] => Array
                                                                                (
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                                                                                    [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate
                                                                                    [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                    [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8
                                                                                    [HTTP_IF_MODIFIED_SINCE] => Sun, 18 Mar 2018 23:21:17 GMT
                                                                                    [PATH] => /sbin:/usr/sbin:/bin:/usr/bin
                                                                                    [SERVER_SIGNATURE] => 
                                                                                    [SERVER_SOFTWARE] => Apache/2.4.16 (Amazon) PHP/5.5.31
                                                                                    [SERVER_NAME] => apdev.hubtech.tv
                                                                                    [SERVER_ADDR] => 10.28.13.29
                                                                                    [SERVER_PORT] => 80
                                                                                    [REMOTE_ADDR] => 54.198.119.26
                                                                                    [DOCUMENT_ROOT] => /var/www/html/apcms
                                                                                    [REQUEST_SCHEME] => http
                                                                                    [CONTEXT_PREFIX] => 
                                                                                    [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms
                                                                                    [SERVER_ADMIN] => ben@hubtech.tv
                                                                                    [SCRIPT_FILENAME] => /var/www/html/apcms/index.php
                                                                                    [REMOTE_PORT] => 44138
                                                                                    [GATEWAY_INTERFACE] => CGI/1.1
                                                                                    [SERVER_PROTOCOL] => HTTP/1.0
                                                                                    [REQUEST_METHOD] => GET
                                                                                    [QUERY_STRING] => start=820
                                                                                    [REQUEST_URI] => /?start=820
                                                                                    [SCRIPT_NAME] => /index.php
                                                                                    [PHP_SELF] => /index.php
                                                                                    [REQUEST_TIME_FLOAT] => 1527336558.913
                                                                                    [REQUEST_TIME] => 1527336558
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                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [session] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
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                                                                                            [1] => body
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                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                    [__default] => Array
                                                                                        (
                                                                                            [session.counter] => 1
                                                                                            [session.timer.start] => 1527336559
                                                                                            [session.timer.last] => 1527336559
                                                                                            [session.timer.now] => 1527336559
                                                                                            [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                                            [registry] => Joomla\Registry\Registry Object
                                                                                                (
                                                                                                    [data:protected] => stdClass Object
                                                                                                        (
                                                                                                            [com_legacyinterface] => stdClass Object
                                                                                                                (
                                                                                                                    [commentaries] => stdClass Object
                                                                                                                        (
                                                                                                                            [limitstart] => 820
                                                                                                                            [filter_order] => published_on
                                                                                                                            [filter_order_Dir] => desc
                                                                                                                        )

                                                                                                                )

                                                                                                        )

                                                                                                )

                                                                                            [user] => JUser Object
                                                                                                (
                                                                                                    [isRoot:protected] => 
                                                                                                    [id] => 0
                                                                                                    [name] => 
                                                                                                    [username] => 
                                                                                                    [email] => 
                                                                                                    [password] => 
                                                                                                    [password_clear] => 
                                                                                                    [block] => 
                                                                                                    [sendEmail] => 0
                                                                                                    [registerDate] => 
                                                                                                    [lastvisitDate] => 
                                                                                                    [activation] => 
                                                                                                    [params] => 
                                                                                                    [groups] => Array
                                                                                                        (
                                                                                                            [0] => 9
                                                                                                        )

                                                                                                    [guest] => 1
                                                                                                    [lastResetTime] => 
                                                                                                    [resetCount] => 
                                                                                                    [requireReset] => 
                                                                                                    [_params:protected] => Joomla\Registry\Registry Object
                                                                                                        (
                                                                                                            [data:protected] => stdClass Object
                                                                                                                (
                                                                                                                )

                                                                                                        )

                                                                                                    [_authGroups:protected] => Array
                                                                                                        (
                                                                                                            [0] => 1
                                                                                                        )

                                                                                                    [_authLevels:protected] => Array
                                                                                                        (
                                                                                                            [0] => 1
                                                                                                            [1] => 1
                                                                                                        )

                                                                                                    [_authActions:protected] => 
                                                                                                    [_errorMsg:protected] => 
                                                                                                    [_errors:protected] => Array
                                                                                                        (
                                                                                                        )

                                                                                                    [aid] => 0
                                                                                                )

                                                                                        )

                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                    [jrequest] => JInput Object
                                                                        (
                                                                            [options:protected] => Array
                                                                                (
                                                                                )

                                                                            [filter:protected] => JFilterInput Object
                                                                                (
                                                                                    [tagsArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [attrArray] => Array
                                                                                        (
                                                                                        )

                                                                                    [tagsMethod] => 0
                                                                                    [attrMethod] => 0
                                                                                    [xssAuto] => 1
                                                                                    [tagBlacklist] => Array
                                                                                        (
                                                                                            [0] => applet
                                                                                            [1] => body
                                                                                            [2] => bgsound
                                                                                            [3] => base
                                                                                            [4] => basefont
                                                                                            [5] => embed
                                                                                            [6] => frame
                                                                                            [7] => frameset
                                                                                            [8] => head
                                                                                            [9] => html
                                                                                            [10] => id
                                                                                            [11] => iframe
                                                                                            [12] => ilayer
                                                                                            [13] => layer
                                                                                            [14] => link
                                                                                            [15] => meta
                                                                                            [16] => name
                                                                                            [17] => object
                                                                                            [18] => script
                                                                                            [19] => style
                                                                                            [20] => title
                                                                                            [21] => xml
                                                                                        )

                                                                                    [attrBlacklist] => Array
                                                                                        (
                                                                                            [0] => action
                                                                                            [1] => background
                                                                                            [2] => codebase
                                                                                            [3] => dynsrc
                                                                                            [4] => lowsrc
                                                                                        )

                                                                                )

                                                                            [data:protected] => Array
                                                                                (
                                                                                )

                                                                            [inputs:protected] => Array
                                                                                (
                                                                                )

                                                                        )

                                                                )

                                                        )

                                                    [files] => JInputFiles Object
                                                        (
                                                            [decodedData:protected] => Array
                                                                (
                                                                )

                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [env] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [request] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [start] => 820
                                                                    [limitstart] => 820
                                                                    [option] => com_legacyinterface
                                                                    [view] => commentaries
                                                                    [Itemid] => 616
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [server] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [HTTP_AUTHORIZATION] => 
                                                                    [HTTP_HOST] => apdev.hubtech.tv
                                                                    [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate
                                                                    [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                    [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8
                                                                    [HTTP_IF_MODIFIED_SINCE] => Sun, 18 Mar 2018 23:21:17 GMT
                                                                    [PATH] => /sbin:/usr/sbin:/bin:/usr/bin
                                                                    [SERVER_SIGNATURE] => 
                                                                    [SERVER_SOFTWARE] => Apache/2.4.16 (Amazon) PHP/5.5.31
                                                                    [SERVER_NAME] => apdev.hubtech.tv
                                                                    [SERVER_ADDR] => 10.28.13.29
                                                                    [SERVER_PORT] => 80
                                                                    [REMOTE_ADDR] => 54.198.119.26
                                                                    [DOCUMENT_ROOT] => /var/www/html/apcms
                                                                    [REQUEST_SCHEME] => http
                                                                    [CONTEXT_PREFIX] => 
                                                                    [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms
                                                                    [SERVER_ADMIN] => ben@hubtech.tv
                                                                    [SCRIPT_FILENAME] => /var/www/html/apcms/index.php
                                                                    [REMOTE_PORT] => 44138
                                                                    [GATEWAY_INTERFACE] => CGI/1.1
                                                                    [SERVER_PROTOCOL] => HTTP/1.0
                                                                    [REQUEST_METHOD] => GET
                                                                    [QUERY_STRING] => start=820
                                                                    [REQUEST_URI] => /?start=820
                                                                    [SCRIPT_NAME] => /index.php
                                                                    [PHP_SELF] => /index.php
                                                                    [REQUEST_TIME_FLOAT] => 1527336558.913
                                                                    [REQUEST_TIME] => 1527336558
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [session] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                    [__default] => Array
                                                                        (
                                                                            [session.counter] => 1
                                                                            [session.timer.start] => 1527336559
                                                                            [session.timer.last] => 1527336559
                                                                            [session.timer.now] => 1527336559
                                                                            [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/)
                                                                            [registry] => Joomla\Registry\Registry Object
                                                                                (
                                                                                    [data:protected] => stdClass Object
                                                                                        (
                                                                                            [com_legacyinterface] => stdClass Object
                                                                                                (
                                                                                                    [commentaries] => stdClass Object
                                                                                                        (
                                                                                                            [limitstart] => 820
                                                                                                            [filter_order] => published_on
                                                                                                            [filter_order_Dir] => desc
                                                                                                        )

                                                                                                )

                                                                                        )

                                                                                )

                                                                            [user] => JUser Object
                                                                                (
                                                                                    [isRoot:protected] => 
                                                                                    [id] => 0
                                                                                    [name] => 
                                                                                    [username] => 
                                                                                    [email] => 
                                                                                    [password] => 
                                                                                    [password_clear] => 
                                                                                    [block] => 
                                                                                    [sendEmail] => 0
                                                                                    [registerDate] => 
                                                                                    [lastvisitDate] => 
                                                                                    [activation] => 
                                                                                    [params] => 
                                                                                    [groups] => Array
                                                                                        (
                                                                                            [0] => 9
                                                                                        )

                                                                                    [guest] => 1
                                                                                    [lastResetTime] => 
                                                                                    [resetCount] => 
                                                                                    [requireReset] => 
                                                                                    [_params:protected] => Joomla\Registry\Registry Object
                                                                                        (
                                                                                            [data:protected] => stdClass Object
                                                                                                (
                                                                                                )

                                                                                        )

                                                                                    [_authGroups:protected] => Array
                                                                                        (
                                                                                            [0] => 1
                                                                                        )

                                                                                    [_authLevels:protected] => Array
                                                                                        (
                                                                                            [0] => 1
                                                                                            [1] => 1
                                                                                        )

                                                                                    [_authActions:protected] => 
                                                                                    [_errorMsg:protected] => 
                                                                                    [_errors:protected] => Array
                                                                                        (
                                                                                        )

                                                                                    [aid] => 0
                                                                                )

                                                                        )

                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                    [jrequest] => JInput Object
                                                        (
                                                            [options:protected] => Array
                                                                (
                                                                )

                                                            [filter:protected] => JFilterInput Object
                                                                (
                                                                    [tagsArray] => Array
                                                                        (
                                                                        )

                                                                    [attrArray] => Array
                                                                        (
                                                                        )

                                                                    [tagsMethod] => 0
                                                                    [attrMethod] => 0
                                                                    [xssAuto] => 1
                                                                    [tagBlacklist] => Array
                                                                        (
                                                                            [0] => applet
                                                                            [1] => body
                                                                            [2] => bgsound
                                                                            [3] => base
                                                                            [4] => basefont
                                                                            [5] => embed
                                                                            [6] => frame
                                                                            [7] => frameset
                                                                            [8] => head
                                                                            [9] => html
                                                                            [10] => id
                                                                            [11] => iframe
                                                                            [12] => ilayer
                                                                            [13] => layer
                                                                            [14] => link
                                                                            [15] => meta
                                                                            [16] => name
                                                                            [17] => object
                                                                            [18] => script
                                                                            [19] => style
                                                                            [20] => title
                                                                            [21] => xml
                                                                        )

                                                                    [attrBlacklist] => Array
                                                                        (
                                                                            [0] => action
                                                                            [1] => background
                                                                            [2] => codebase
                                                                            [3] => dynsrc
                                                                            [4] => lowsrc
                                                                        )

                                                                )

                                                            [data:protected] => Array
                                                                (
                                                                )

                                                            [inputs:protected] => Array
                                                                (
                                                                )

                                                        )

                                                )

                                        )

                                    [post] => JInput Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                )

                                            [inputs:protected] => Array
                                                (
                                                )

                                        )

                                    [cookie] => JInputCookie Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                )

                                            [inputs:protected] => Array
                                                (
                                                )

                                        )

                                    [files] => JInputFiles Object
                                        (
                                            [decodedData:protected] => Array
                                                (
                                                )

                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
                                                            [11] => iframe
                                                            [12] => ilayer
                                                            [13] => layer
                                                            [14] => link
                                                            [15] => meta
                                                            [16] => name
                                                            [17] => object
                                                            [18] => script
                                                            [19] => style
                                                            [20] => title
                                                            [21] => xml
                                                        )

                                                    [attrBlacklist] => Array
                                                        (
                                                            [0] => action
                                                            [1] => background
                                                            [2] => codebase
                                                            [3] => dynsrc
                                                            [4] => lowsrc
                                                        )

                                                )

                                            [data:protected] => Array
                                                (
                                                )

                                            [inputs:protected] => Array
                                                (
                                                )

                                        )

                                    [env] => JInput Object
                                        (
                                            [options:protected] => Array
                                                (
                                                )

                                            [filter:protected] => JFilterInput Object
                                                (
                                                    [tagsArray] => Array
                                                        (
                                                        )

                                                    [attrArray] => Array
                                                        (
                                                        )

                                                    [tagsMethod] => 0
                                                    [attrMethod] => 0
                                                    [xssAuto] => 1
                                                    [tagBlacklist] => Array
                                                        (
                                                            [0] => applet
                                                            [1] => body
                                                            [2] => bgsound
                                                            [3] => base
                                                            [4] => basefont
                                                            [5] => embed
                                                            [6] => frame
                                                            [7] => frameset
                                                            [8] => head
                                                            [9] => html
                                                            [10] => id
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                                    [fulltext] => 

During the first round of Brazilian presidential elections on October 5, the incumbent Dilma Rousseff of the Workers’ Party received 42% of the votes while Aecio Neves of the Social Democracy Party received 34%.  Since none of the candidates received more than 50% of the vote, the second round of runoff elections will be held on October 26.  Currently, Rousseff leads the polls, signaling a likely continuation of state-centric policies.

The results from these elections are significant for the Brazilian domestic economy as well as foreign investors.  Whether Rousseff or Neves wins, the next president will inherit a low growth and high inflation environment.  Additionally, the incoming president will have to deal with high government spending while maintaining the high social spending that the ruling party has relied on for populist support.  The growing domestic middle class is demanding an end to corruption and better social services. 

Foreign investors are also closely watching these elections as a win for Neves could signal a more market-friendly political environment with better government fiscal responsibility and political transparency.

This week, we will look at the Brazilian presidential elections along with the current political and economic environment in the country.  We will briefly describe the recent political history of the country and look at the specifics of Brazil’s economic development.  As usual, we will conclude with market ramifications.

Recent History

Brazil’s population of 199 million makes it the fifth largest country in the world in terms of population.  Population growth has been rapid as the absolute number has doubled over the past 30 years.  Brazil is the seventh largest country in terms of total economic size. 

We need to remember that Brazil is still very new to the international markets as well as democracy.  The country was ruled by the military from 1964 to 1985.  During this time, civil rights were severely repressed while the military tried to implement economic reform.  In 1985, the military peacefully ceded power to civilian rulers, and the country held its first democratic election in 1989 with great enthusiasm.  The new government was able to get inflation under control through onerous reforms.  The constitution was ratified in 1988 and its new currency was introduced in 1994. 

Over the past decade, Brazil has benefited greatly from the surge in commodity prices.  The wealth effect was multiplied by capital inflows and credit expansion. Recently, discontent has grown as economic growth has slowed and inflation has risen.

Brazilian economic growth has mostly faltered due to weakening global commodity demand.  The Brazilian central bank forecasts that Brazilian GDP growth will be 0.7% in 2014.  The chart below shows the yearly GDP growth rates, which topped at

9.1% in 2010, when commodity demand from China boosted growth. 


Brazil’s recent growth has relied on commodity exports, especially soy beans, iron ore and oil.  With grain prices falling on increasing supplies and industrial metals prices falling on soft demand, Brazil’s main exports have been hit on both price and quantity.

At the same time, Brazilian manufacturing has become less competitive and its importance has been overshadowed by its reliance on commodities. Additionally, the country’s strong currency and structural inefficiencies have made Brazilian companies uncompetitive in the export markets.  Trade barriers, direct competition from China and inherent difficulties brought on by Brazil’s lack of infrastructure to accommodate for its size and difficult terrain have also hindered export growth.

Infrastructure has remained a constant bottleneck for the country as railway systems are in their infancy, the river system is not accessible enough for reliable transportation and the roadway systems remain in poor condition.  This is especially relevant since the country produces many low value-to-weight commodities. 

Mercosur, the South American trade bloc which includes Brazil, is likely to remain a drag on the economy due to its trade barriers.  Additionally, Mercosur’s charter has limited Brazil’s ability to sign trade agreements with other countries as a new agreement for any member country requires unanimous approval from all the member countries.

Commodity Addiction

Given the importance of commodity exports to the country, the political process is also shaped by the needs of commodity producers.  The crops that have historically done particularly well in the country are coffee and sugar, neither one of which is easily mechanized.  Therefore, both industries need large pools of low-skilled labor.  Due to this need there is a great disincentive to advance educational opportunities, resulting in a small pool of skilled workers and a large number of unskilled workers, in turn creating labor and infrastructure bottlenecks.  During periods of strong growth, the lack of skilled labor tends to cause capacity constraints, making it difficult to boost productivity.  Thus, Brazil faces persistent inflation pressures.

Historically, Brazil has been one of the highest inflation and lowest growth countries among emerging economies.  For example, inflation reached 2,000% per year in the 1980s.  The solution to this high inflation was an arduous path for the country, with capital controls, heavy bank regulation and deep cuts to the government’s budget.  In the early 2000s, investors dove into emerging markets; this, coupled with Brazil’s falling inflation as a result of deep-seated reforms, resulted in large inflows of capital into the Brazilian markets.  As a result, the Brazilian currency, the real, has appreciated and in turn made Brazilian manufacturing uncompetitive.  It is important to remember that the Brazilian economy is mostly commodity related and low skilled, so exports need to compete on pricing rather than the value-added sphere. 

Inequality

Brazil has successfully lifted about a quarter of its population into the middle class category in the past 10 years.  This is no small feat.  By comparison, China moved the same proportion of people out of poverty over the course of 30 years.  Brazil has been successful in alleviating poverty for the elderly as a result of comprehensive pension reform.  However, this has left little money for educational reform, and commodity dependence has created a need for a large, low-skilled labor pool.  However, in order to sustain the pace of improvements in living standards and support social mobility and equality, the availability and quality of education is crucial.  Additionally, Brazil has been undergoing slowing population growth rates since the 1960s, which will soon lead to a significant demographic transition.  The aging population and current low investment levels into human capital could hinder growth possibilities.

That being said, the country’s large middle class supports the growing domestic market demand and makes the economy more robust.  This is not the case for many emerging markets.  A study by the Brookings Institute indicates that about half of Brazil’s population is now considered middle class compared to 10% in China.

Even through the recent economic slowdown, the expanding middle class has maintained its expectations for uninterrupted economic growth.  Given the country’s commodity reliance and the slowdown in end market demand, it is unlikely that either candidate will be able to meet these enhanced expectations. 

Government

Brazil’s government spending is large, approximately 40% of GDP.  Government spending in comparable countries stands at about 25%.  At these levels, public funds crowd out private investments.  Since government investment is centrally controlled, it is generally less market efficient than its private counterpart.  Although the country needs huge infrastructure improvements, the government is spending only about 2% of its funds on infrastructure.  As a comparison, emerging markets in general are spending about 5%, with China as an outlier at 10%.  Additionally, Brazil spends 5% of GDP on pensions for civil servants, more than twice the amount of infrastructure spending.

The issues cited above are unlikely to improve quickly.  Reforms are implemented slowly in Brazil and oftentimes favoritism and vested interests keep the country from implementing the changes needed.

Infrastructure spending is technically difficult due to geography, and requires large amounts of investment and high levels of expertise.  However, linking the interior and the various coastal cities would sustain growth and encourage further foreign direct investments.  Many regulatory hindrances remain in place; as the World Bank reports, it takes an average of 119 days to set up a business in Brazil, the fifth longest period in the world.    

Another public grievance is widespread corruption.  Most recently, two people confessed to being part of a corruption ring involving the state oil company, Petrobras.  Allegedly, 3% of the company’s budget finances corruption.  Some observers claim that corruption has become institutionalized under the current government. 

Rousseff

Dilma Rousseff is the incumbent presidential candidate for the Workers’ Party.  She has been involved in left-wing politics for most of her political career.  She fought against the military dictatorship under the Marxist movement and was jailed under the regime.  She is one of the founders of the Democratic Labor Party, serving in several regional positions for the party.  In 2000, she left the party after an internal dispute to join the Workers’ Party.  She became the energy minister before running for president in 2010. 

She has gained popularity during her presidency for lowering energy and food tax rates.  In the beginning of her presidency, the country benefited from rising Chinese demand for Brazilian commodities and rising prices for those commodities.  This allowed the government to increase public spending without addressing economic inefficiencies.  The slower global growth environment has now surfaced these inefficiencies and discontent among her constituents.  Corruption, slow growth and inflation are only some of the concerns.  At the same time, unemployment has trended lower, maintaining support for Rousseff.

Neves

Aecio Neves is the presidential candidate for the Brazilian Social Democracy Party.  He is an economist by training, and was the governor of the Minas Gerais region for seven years before being elected to represent the region in the Brazilian Federal Senate.  His grandfather was elected president but died before taking office.  Rousseff’s campaign has used Neves’ family background to accuse him of favoring the political elite at the expense of the working class.  However, it does not appear that he has done so during his political career.

As governor, Neves introduced reforms to balance the local government’s budget, known as the “Management Shock” program, which was aimed at reducing government spending and improving the quality of services and productivity of state institutions. Neves also promoted private investment, especially in infrastructure.  On the education front, he initiated a program to boost high school graduation rates.

As president, Neves has promised to address corruption, introduce fiscal responsibility and design policies to control inflation.

Ramifications

None of the limitations that hamper Brazil’s economy can be removed in the near term, no matter which candidate is in office.  In the short run, however, the outcome of the presidential election will signal the country’s willingness to reform and become fiscally responsible and politically transparent, which will determine the direction and strength of capital flows.  If Neves wins, capital inflows would increase in anticipation of economic reform.  Brazilian markets rose after a poll showed that Rousseff and Neves are now tied in the runoff elections, whereas Neves had lagged in prior polls. 

Brazil faces economic difficulties that are related to its dependency on commodities and manufacturing weaknesses, especially in a slower global growth environment.  For foreign investors, Brazilian domestic economic indicators are just as important as the strength of the economies that import Brazilian commodities, especially China.  If the Chinese economy is slowing, we are likely to see a disproportionately larger deceleration in Brazilian economic growth.  For these reasons, Brazil is often referred to as the “end of the whip” in global economic growth.  On the other hand, if the Chinese government decides to pursue further investment growth, we could see limited strength in the Brazilian economy.  However, given the global inventory overhang of industrial metals and oil, the boost in growth could be delayed.  Lacking significantly stronger commodity demand from China, Brazilian commodity exports are likely to remain subdued.

Domestically, controlling inflation and continuing social welfare programs are key priorities in avoiding social unrest.  Rousseff has used social spending to placate dissatisfaction, but if the government is serious about getting its spending under control then these social programs may have to be reduced and thus cannot be used to pacify the masses.  If Neves wins, we could see increasing instability from the region if the country moves to limit its social programs.  Additionally, if government subsidies for fuel and electricity are cut, inflation could rise further.  If inflation picks up, a foreign investor should pay close attention to the central bank’s response.  Tightening monetary policy could constrain economic growth in the already weak manufacturing sector. 

Corruption has also soared under Rousseff, a practice which Neves has promised to tackle.  This could introduce further social instability.  Thus, we could see increased geopolitical risk from the region under Neves as the country moves to reform itself.

At the same time, under the incumbent Rousseff, reform and possible social unrest would likely be delayed as she would continue her social policies.  We would see further capital outflows from the country under Rousseff as foreign investors might fear that Brazil will follow in Argentina’s path.

Kaisa Stucke and Bill O’Grady

October 13, 2014

This report was prepared by Bill O’Grady and Kaisa Stucke of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Confluence Investment Management LLC

Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri.  The firm provides professional portfolio management and advisory services to institutional and individual clients.  Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach.  The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives.  The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication.  

© Confluence Investment Management

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You don’t need a weatherman
To know which way the wind blows.

– Bob Dylan, “Subterranean Homesick Blues,” 1965

Full fathom five thy father lies.
Of his bones are coral made.
Those are pearls that were his eyes.
Nothing of him that doth fade,
But doth suffer a sea-change
Into something rich and strange.

– William Shakespeare, The Tempest

Did you feel the economic weather change this week? The shift was subtle, like fall tippy-toeing in after a pleasant summer to surprise us, but I think we’ll look back and say this was the moment when that last grain of sand fell onto the sandpile, triggering many profound fingers of instability in a pile that has long been close to collapse. This is the grain of sand that sets off those long chains of volatility that have been gathering for the last five years, waiting to surprise us with the suddenness and violence of the avalanche they unleash.

I suppose the analogy sprang to mind as I stepped out onto my balcony this morning. Texas has been experiencing one of the most pleasant summers and incredibly wonderful falls in my memory. One of the conversations that seem to occur regularly among locals who have a few decades under their belts here, is just how truly remarkable the weather has been. So it was a bit of a surprise to step out and realize the air had turned brisk. In retrospect it shouldn’t have fazed me. The air has been turning brisk in Texas at some point in October for the six decades that my memory covers, and for quite a few additional millennia, I suspect.

But this week, as I worked through my ever-growing mountain of reading, I felt a similar awareness of a change in the economic climate. Like fall, I knew it was coming. In fact, I’ve been writing about it for years! But just as fall tells us that it’s time to get ready for winter, at least in more northerly climes, the portents of the moment suggest to me that it’s time to make sure our portfolios are ready for the change in season.

Sea Change

Shakespeare coined the marvelous term sea change in his play The Tempest. Modern-day pundits are liable to apply the word to the relatively minor ebb and flow of events, but Shakespeare meant sea change as a truly transformative event, a metamorphosis of the very nature and substance of a man, by the sea.

In this week’s letter we’ll talk about the imminent arrival of a true financial sea change, the harbinger of which was some minor commentary this week about the economic climate. This letter is arriving to you a little later this week, as I had quite some difficulty writing it, because, while the signal event is rather easy to discuss, the follow-on consequences are myriad and require more in-depth analysis than I’ve been able to bring to them on short notice. As I wrestled with what to write, I finally came to realize that this sea change is going to take multiple letters to properly describe. In fact, it might eventually take a book.

So, in a departure from my normal writing style, I am going to offer you a chapter-by-chapter outline for a book. As with all book outlines, it will be simply full of bones but without much meat on them, let alone dressed up with skin and clothing. I will probably even connect the bones in the wrong order and have to go back later and replace a leg bone with a rib, but that is what outlines are for. There is clearly enough content suggested by this outline to carry us through the next several months; and given the importance of the subject, I expect to explore it fully with you. Whether it actually becomes a book, I cannot yet say.

I should note that much of what follows has grown out of in-depth conversations with my associate Worth Wray and our mutual friends. We’ve become convinced that the imbalances in the global economic system are such that the risks are high that another period of economic volatility like the Great Recession is not only likely but is now in the process of developing. While this time will be different in terms of its causes and symptoms (as all such stressful periods differ from each other in many ways), there will be a rhyme and a rhythm that feels all too familiar. That should actually be good news to most readers, as the last 14 years have taught us a little bit about living through periods of economic volatility. You will get to use those skills you learned the hard way.

This will not be the end of the world if you prepare properly. In fact, there will be plenty of opportunities to take advantage of the coming volatility. If the weatherman tells you winter is coming, is he a prophet of doom? Or is it reasonable counsel that maybe we should get our winter clothes out?

Three caveats before we get started. One, I am often wrong but seldom in doubt. And while I will marshal facts and graphs aplenty to reinforce my arguments, I would encourage you to think through the counterfactuals presented by those who will aggressively disagree.

Two, while it goes without saying, you are responsible for your own decisions. It is easy for me to say that I think the bond market is going to go in a particular direction. I can even bet my personal portfolio on my beliefs. I can’t know your circumstances, but if you are similar to most investors, this is the time to make sure you have a truly balanced portfolio with serious risk management in the event of a sudden crisis.

Three, give me (and Worth, whom I am going to draft to write some letters) some time to develop the full range of our ideas. To follow on with my weather analogy, the air is just starting to get crisp, and winter is still a couple months away. Absent something extraordinary, we are not going to get snow and a blizzard in Dallas, Texas, tomorrow. We may still have some time to prepare, but at a minimum it is time to start your preparations. So with those caveats, let’s look at an outline for a potential book called Sea Change.

Prologue

I turned publicly bearish on gold in 1986. At the time (a former life in a galaxy far, far away), I was actually writing a newsletter on gold stocks and came to the conclusion that gold was going nowhere – and sold the letter. I was still bearish some 16 years later. Then, on March 1, 2002, I wrote in Thoughts from the Frontline that it was time to turn bullish on gold. Gold at that time was languishing around $300 an ounce, near its all-time bottom.

What drove that call? I thought that the future directions of gold and the dollar were joined at the hip. A bit over a year later I laid out the case for a much weaker dollar in a letter entitled “King Dollar Meets the Guillotine,” which later became the basis for a chapter in Bull’s Eye Investing. As the chart below shows, the dollar had risen relentlessly through the early Reagan years, doubling in value against the currencies of America’s global neighbors, causing exporters to grumble about US dollar policy. Then the bottom fell out, as the dollar made new lows in 1992. From 1992 through 2002 the dollar recovered about half of its value, getting back to roughly where it was in 1967. Elsewhere about that time, I predicted that the euro, which was then at $0.88, would rise to $1.50 before falling back to parity over a very long period of time. I believe we are still on that journey.

One of the biggest drivers of economic fortunes in the global economy is the currency markets. The value of your trading currency affects every aspect of your business and investments. It is fundamental in nature. While most Americans never even see a piece of foreign currency, every time we walk into Walmart, we are subject to the ebb and flow of global currency valuations, as are Europeans and indeed every person who participates in the movement of goods and services around the globe. In fact, globalization means that currency values are more important than ever. The world is more tightly interconnected now than it has ever been, which means that events which previously had no effect upon global affairs can trigger cascades of events that affect everyone.

I believe we are in the early stages of a profound currency-valuation sea change. I have lived through five major changes in the value of the dollar in the 45 years since Nixon closed the gold window. And while we are used to 40% to 50% moves in the stock market and other commodity prices happening in just a few years (or less), large movements in major trading currencies typically take many years, if not decades, to develop. I believe we are in the opening act of a multi-year US dollar bull market.

Chapter 1 – The Boys Who Cry Wolf

We all know the story of the boy who cried “Wolf!” once too often. I have been pounding the table about a dollar bull market for about three years now. I see eyes roll when I speak at conferences around the world and boldly forecast that the dollar is going to get stronger than anyone in the room can possibly fathom. All the signs have been pointing to it, and indeed we’ve seen the dollar move upward in a rather herky-jerky fashion off the lows of 2010, but not in a way that has been all that dramatic (except, arguably, against the Japanese yen). Indeed, the relative trading range of the dollar has been relatively constrained over the past six to seven years, pivoting around 80 on the DXY (symbol for the US dollar spot index).

This is in contrast to the true doom-and-gloomers, who are forecasting “the Demise of the Dollar.” At the same time, they are calling for an unseemly rise in interest rates, and many of them believe the Federal Reserve will push us over the brink into hyperinflation. Needless to say, then, you should buy massive amounts of gold and get your money out of the country.

I have had long conversations with many who believe in such a scenario. I call some of them close friends, even if we disagree on something as fundamental as the future of the dollar. I’ve come to the conclusion that their conviction is a lot like a religious belief.  I’m not going to change them, and so I make very little effort to try. So, fair and friendly warning: if you think the US dollar is headed to oblivion, you are not going to like this book outline or the next few months of my letter.

(Sidebar to those of you who, like me, own gold. You do not have to be a dollar bear to be constructive on gold and believe that it belongs in a diversified portfolio. But more on that front if we do a chapter on gold.)

Getting back to portents of winter, this week saw two side comments by Federal Reserve members that put a distinct chill in the air.

The first is from William Dudley, the president of the Federal Reserve Bank of New York and a permanent voting member on the FOMC. In a speech at Rensselaer Polytechnic Institute, he pushed back on the idea that it is time to raise rates. While acknowledging the relatively positive stance of the Federal Reserve in its forecast, he said:

While I believe that the risks around this consensus forecast are reasonably well balanced, I also believe that the likelihood that growth will be substantially stronger than the point forecast is probably relatively low. [my emphasis]

He went on to cite weaker than expected consumer spending and the expectation that consumer durable purchases will be weaker in the future (by which I assume he means automobiles, which have been on a blistering, back-to-the-all-time-high pace due to supereasy credit, much of it subprime and with durations beyond five years.) He faults mortgage lenders for the substandard housing recovery, as if the last massacre of lenders was not enough to scar their collective psyche for decades.

(Sadly, he might have a point. Somewhat humorously, Ben Bernanke tells us he was turned down for a mortgage because his income is somewhat unsteady. He did not fit the “check-the-box” protocol of his local mortgage lender. I sympathize. I was turned down multiple times earlier this year before finding willing lenders who actually competed for my business. My business life does not accord with a standard check-the-box mortgage. I read about another business owner who noted that any of his 300 employees could get a mortgage, but he could not because his income was not stable enough. Go figure.)

Each of Dudley’s points was covered in long paragraphs. And then he delivered a short, throwaway line that caught my attention. He cited the growth in the exchange value of the dollar over the last few months as a reason for downside risk. Really? Go back and look at the chart above and see the relatively minor dollar moves of the past few months. Why should dollar strength show up in a list of reasons for upcoming weakness in the US economy?

The next day saw the release of the minutes of the previous month’s FOMC meeting. In the part labeled “Staff Review of the Financial Situation,” the staff mentioned “… responding in part to disappointing economic data abroad, the US dollar appreciated against most currencies over the inter-meeting period, including large appreciations against the euro, the yen, and the pound sterling.”

While there are precedents for the staff review to mention the dollar, it doesn’t happen often. (In January 2002 the staff notes included concern about the strength of the dollar. That concern went away rather quickly. Coincidence? Hat tip, Joan McCullough.) The strengthening dollar is clearly on the minds of the members and staff of the Federal Reserve. Hmmm…

The key here is to note that the strength of the dollar (or lack of it) is not traditionally a Federal Reserve concern. The relative value of the dollar is the purview of the US Treasury, while the Federal Reserve is responsible for maintaining stable purchasing power (interest rates and money supply, etc.). Both organizations are careful not to tread on the other’s territory.

What if we are at the beginning of another 10-year bull market in the dollar? Is it unthinkable that the value of the dollar could rise back to 120 on the index over that time? Let’s look at that chart again:

From a very long-term perspective, 100 on that index is certainly a possibility, and 120 is not without precedent. But if the dollar rises to those levels, even in the very short-term, volatile patterns of the past, it changes everything it touches. And the value of the dollar touches everything. So let’s think about some of the consequences over the long term of a rising dollar.

Chapter 2 – A Monkey Wrench for the Fed

A rising dollar is almighty inconvenient for a Federal Reserve that would like to eventually raise interest rates. Multiple regional Fed presidents and Fed governors would really like to see inflation in the 2% range prior to raising rates.

A dollar that is rising against the currencies of our major trading partners is inherently disinflationary, if not outright deflationary. (Pay attention to how often that word deflation occurs in this outline.) The current inflation rate is 1.7%. The Dallas trimmed-mean PCE inflation rate was actually negative in August and has been falling for the last five months, more or less coinciding with the rising dollar.

The makeup of the Federal Reserve FOMC voting membership next year is going to be decidedly “dovish.” Dallas Fed President Richard Fisher will retire, and his voice will no longer be present. Yellen and the entire team (with two notable exceptions) have been out and about using the words data-dependent, with Minneapolis Fed President Kocherlakota arguing that raising rates anytime in 2015 would be a mistake.

Look at what Federal Reserve unemployment and inflation-rate predictions are as of September 17:

Fourteen of the 17 members of the Fed (including the 12 regional presidents) anticipate that rates will be raised in 2015.  Most observers think the first rate increase will happen at the June meeting.

What happens if unemployment continues to fall toward 5.5% and inflation drops below 1.5%? Can this Fed – not you or I, but the aggressively Keynesian members sitting on that board – justify raising rates if inflation is only 1.5% and falling? Which is the more important data number, unemployment or inflation? Or do they both need to click into place?

If the dollar were to continue to rise and thus allow Europe and Japan to export their deflation to the US, it is not clear that the Fed would raise rates in June.

A rise in the dollar from its current 85 on the DXY to 120 over the next six or seven years will throw a monkey wrench into the plans of the Federal Reserve.

Chapter 3 – Every Central Bank for Itself

A rising dollar presents all sorts of problems and opportunities for the central banks of the world. Japan has chosen the most aggressive monetary policy in the history of the world and will, I believe, work to see the value of the yen cut in half over time. Notice in the chart below that it was only 20 years ago that the yen was at 250. It touched 150 less than eight years ago. Forty years ago it was at 357. Is it so unthinkable that the yen could retrace half that move? Not to the Japanese. That would take it into the range of 200 to the dollar. I made the case for such a move in Endgame and doubled down on the prospects for Japan in Code Red. Japan is a bug in search of a windshield. The yen is embarked on a multi-year decline.

Europe would clearly like to see a weaker euro against the dollar and other major trading currencies. Ditto for almost every central bank in the world. But a rising dollar creates special problems for China and some emerging markets, problems we will look at in later chapters.

In an important speech on Saturday, October 11, Fed Vice-Chairman Stan Fischer outlined the mechanisms for the international transmission of monetary policy. Fischer says the international effects of monetary policy “spill back” onto the US, and the central bank cannot make “sensible” choices without taking them into account.

[T]he U.S. economy and the economies of the rest of the world have important feedback effects on each other. To make coherent policy choices, we have to take these feedback effects into account.

He ended with an assurance to all that the Federal Reserve would provide liquidity to the world in the event of another crisis. Because it is in our interest, he says. This will be the ultimate test of game theory, where it might take years to find the Nash equilibrium.

The bottom line? It’s every central bank for itself. No matter how much pleading there is from peripheral central banks, there will be no true coordination among the major central banks. (Hat tip to David Kotok for alerting me to Fischer’s speech as I was writing. He also pointed out that the unintended consequences of the feedback effect means that policymaking can be dangerous.)

Chapter 4 – The Man Behind the Euro Curtain

Was it only a few years ago that Mario Draghi uttered his famous line, “We will do whatever it takes”? Interest rates in Europe have collapsed since then, as the European bond markets believed that Mario had their back. He has not had to do anything of true significance to back up those words, and what he has done has been lackluster.

This week Mario was up on the stage in Washington DC, where he essentially said that the problems in Europe cannot be fixed by monetary policy but are fiscal and regulatory and require actions from governments, not from central banks. The Bundesbank has clearly held sway, at least so far as the prospects for European quantitative easing go. While Draghi hinted that he would like to do €1 trillion worth of QE, it is not clear exactly how he would go about that.

Mario is like the Wizard of Oz. He talks a good game and puts on a good show, but it is soon going to become apparent that he really doesn’t have any magic, at least not until the Germans allow him to open up his trunk of tricks. Right now they’re keeping it safely stowed away in Berlin.

German intransigence is going to precipitate a crisis in Europe. Italy has been in a recession. France is crossing into one. Spain is barely holding on. Even German exports are slowing. France and Italy are balking at meeting the 3% deficit targets mandated by the EU treaty. Germany has drawn a line in the sand; France and Italy fully intend to cross it. This should be interesting; but however it turns out, I don’t think it will be good for the euro.

How long can interest rates in Europe stay at the irrationally low levels where they are today? We touched on that question in past letters, so I won’t cover that ground again, other than to say negative interest rates in Ireland and France are as indicative of dysfunctional markets as anything one might postulate.

When Draghi loses the narrative, or his ability to simply jawbone the market to where he would like it to be, all hell is going to break loose in the European bond market. Exactly what will the safe-haven currency be? The Swiss can’t print enough francs. Even Norway doesn’t have that many kroner. It will be the US dollar. Implications in a later chapter.

Chapter 5 – The Wrong Side of the Trade

Close to 50% of sales and profits for the S&P 500 come from outside the US. A strong dollar will put a strain on those dollar-denominated profits. Not an insurmountable problem, as Japanese businesses have figured out how to thrive in a rising-yen environment for decades. But old US business dogs are going to have to learn new tricks in a rising-dollar world.

But a strong dollar is not just a problem for US exporters. It is particularly a problem for countries that are financed by the dollar carry trade. Multiple trillions of dollars have left the US courtesy of quantitative easing and have ended up financing all manner of trades and investments around the world. As long as the dollar is neutral or falling, that’s a good thing for dollar carry-trade investors.

If you are a Chinese businessman and you can borrow dollars (which you certainly can) and you believe that your government is going to make the yuan stronger over time, you will be able to pay back cheaper dollars and make the difference on the carry (the difference between what US bonds pay and returns that can be earned in China). But what happens if the yuan begins to fall? That trade unwinds swiftly and negatively. And it unwinds at a time that is particularly inconvenient for China. Flood the market with too much money, and inflation becomes a problem. (The Chinese are in a different phase of the monetary cycle than the US is, so the problems are not the same.)

It is not just China. Those dollars have filtered into every nook and cranny of the world; and now, if those trades are unwound, investors and most specifically hedge funds are going to have to buy dollars to unwind their trades. That will force the dollar ever higher against various currencies; and while any one currency is not significant enough to create a structural difference that can impact global trade, together they will have a significant effect.

There is a crisis brewing in emerging markets. Most of the world’s hedge funds and investors are on the wrong side of the dollar trade. Unwinding that trade is going to be a bitch (that is a technical economics term). Worth Wray will be writing about that very topic in a few weeks. You do not want to miss that letter.

Chapter 6 – The Texas Carry Trade

A rising dollar is going to put pressure on oil prices in particular and on energy prices in general. And falling oil prices have a strong secondary effect on Federal Reserve interest-rate policy. Pay attention, there will be a quiz.

Over at The National Interest, Sam Rines of Chilton Capital writes that Texas has been the engine of growth for the US for the past five years:

Job creation might be a good place to start. Texas has created jobs – there is little arguing that point. For instance, we know the U.S. economy only recently gained back the jobs lost in the Great Recession. This is not true of Texas. While the United States dropped about 6 percent of employment, Texas lost 4 percent and recovered them all by August 2011 – nearly three years before the United States as a whole.

Here is where the numbers get interesting. From its peak in January 2008 through today, the United States has created only 750,000 jobs. Texas created over a million jobs during that same period – meaning that the rest of the country (RotC) is still short 300,000 jobs. During the recovery, job creation has been all Texas or – at the very least – disproportionately Texas.

Choosing a different starting point – for example, in the trough of job losses – changes the extremity of the story. And there are all sorts of reasons for this disparity between Texas and the rest of the country, most of which miss the main point. In a conversation with Worth, Rines called the disparity the Texas Carry Trade. I like that.

The Texas story is by and large an oil story. We are far more diversified that we were in the ’80s, but oil is clearly the driver. Texas has been at the forefront of job creation because our borders happen to contain the mostly inhospitable scrubland known as the Permian Basin in West Texas, not to mention the coastal plays and those in East Texas. Much (not all) of the growth in oil has come from horizontal drilling and fracking. And while there are enormous amounts of energy in Texas, it is not necessarily cheap energy – not like it was in the “good old days.”

Seventy-dollar oil considerably restrains the enthusiasm of Texas oil companies, let alone the banks and individuals that finance them.

And it is not just Texas companies. The Marcellus play in the Northeast is responsible for hundreds of thousands of jobs. And it’s much the same story all over the US. Oil has been a significant portion of the growth of US GDP for the past five years. If you take the massive oil boom away, the US looks a lot like Europe in terms of growth and job creation. Which is to say, anemic.

Seventy-dollar oil starts to show up in the unemployment rate, which makes it more difficult for the Federal Reserve to raise rates.

I was talking with Joe Goyne, president of Pegasus Bank in Dallas. He is one of those entrepreneurial bankers who actually analyzes a loan personally rather than letting some computer determine whether it fits the criteria. (The country would be better off with a lot more Joes running the banking industry, but that’s another story.) Joe’s customers are a who’s who of Dallas. We were discussing my convictions about a strong dollar and what that would do to the price of oil. Joe offered, “You won’t believe the pain in Dallas if oil falls to $60.” We went on to discuss some details. Does $60 oil sound far-fetched? Joe and I both remember $15 oil. Texas has been through numerous oil busts. The running joke in the late ’80s was “Would the last person leaving Houston please turn out the lights?”

The late ’80s was an ugly time for Texas. Will the Saudis ever allow oil to dip below $60 again? Can they afford to cut their production that much? What will happen to Russia if Brent drops to $80, let alone $60? It’s not just Texas. And while the world might benefit from lower energy prices, they would create havoc in a few key regions. And throw another monkey wrench in Federal Reserve policy. And in terms of the oil price, gods forbid that peace breaks out in the Middle East. But, sadly, given current circumstances, it doesn’t look like we have to worry about that.

Chapter 7 – The Bond Bull Comes Stampeding Back

Many of us in the US look at Europe and wonder how interest rates can fall to such insane levels. And the answer is that bond markets have rationales all their own. The unwinding of carry trades means the demand for dollars will rise just as the Federal Reserve cuts off the spigot. Some people look at Japan’s flooding the market with yen as an antidote and hope that the ECB, too, will soon start printing; but that is not going to reduce the demand for dollars to unwind the carry trade.

Whatever Japan and Europe do, the growth of global liquidity is still likely to fall over the next few years; and that is an inherently deflationary event, especially in dollar terms.

In addition, when – not if – there is a renewed crisis in Europe, the flight to safety is going to put pressure on the dollar and further downward pressure on US interest rates. While it is not altogether certain that China will have a major crisis – although reasonable economic historians would suggest that is the probable case – if it happens it will put further upward pressure on the dollar as a safe-haven currency. God forbid those two events – crises in Europe and China – happen at the same time. Our necks would snap at the severity of the acceleration in the value of the dollar. The convergent crises would also trigger a global recession.

We’re going to see a return of the bond bull market with a vengeance. Almost the entire world has hedged its bets for a rising interest-rate environment and assumes a benign dollar market. Almost no one expects a falling interest-rate environment, yet that is precisely what we will get if the dollar continues to rise and we have a crisis or two.

Chapter 8 – The Third Leg of the Secular Bear Market

I was writing about secular bear markets in 1999. I was early to the party, as usual (although my friends will note that I’m often late to real-time, real-life parties). I noted in Bull’s Eye Investing that it typically takes three events to completely wash out a trend. We have had two significant corrections since April 2000, accompanied by two recessions. I think the next recession will give us that final third leg of the secular bear market, hard on the heels of another correction that tests (but maybe doesn’t quite touch) the lows of 2009.

At that point I will trade my secular bear beret for a snappy new secular bull Panama. And while we may see a significant correction out of the current volatility, I don’t think the final dénouement of the secular bear will come without a global recession.

Since most of you have been through this before, you can probably figure out what strategy you should choose; but I would suggest at least thinking about having some type of hedge/moving average/risk-dispersion strategy in your toolkit.

The point is to get through this next crucial phase with as much of your capital intact as possible, in order to be able to take advantage of the coming secular bull market, when it will be anchors aweigh. Remember, we always get through these things. It is almost never the end of the world, and betting on the end of the world is a losing proposition anyway. Specifics to come later (maddening, I know, but there are space limits).

Chapter 9 – Commodities in a Dollar Bull Market

This book outline is running a little long, but a quick word on commodities. In general, commodity prices are going to face downward pressure, at least in dollar terms. That includes copper, most of the base metals, oil, etc. Silver has clearly been in a very ugly bear market. I would continue to accumulate insurance gold, but I would invest in gold only in terms of yen or another depreciating currency. Bear in mind that precious metals – along with other commodities – can and will fall precipitously in the event of a deflationary shock… although the inflationary effects of an aggressive central bank response may ultimately drive the yellow metal far above its current price.

Chapter 10 – The Return of Volatility

The final chapter and conclusion pretty much end as you would expect: the demise of monetary policy’s ability to soothe the soul of the markets and the return of volatility. We hopefully get a full-fledged restructuring of the sovereign debt markets. The Fed and sister central banks will try the same tired tools they have been using. Except they have already been to the zero rate boundary and have wasted the opportunity they had to increase rates so that they could lower them later. Another round of quantitative easing? Quite possible if we get a true deflation scare or a global recession. But I don’t think it will have the same results. The unintended consequences and the unknown spillovers will only increase eventual volatility.

For new readers, I invite you to read my books (co-authored with Jonathan Tepper) Endgame and Code Red. They pretty much lay out the background you need in order to understand what will be happening in the future. We are seeing the end of the debt supercycle and the beginning of currency wars. We’ll experience the throes of hyper-indebted nation-states trying to survive what they will see as irrational attacks by a bond market. “How can you not have faith in the government? We are doing our best to try to make everything work out just fine. As long as you cooperate.” Which bond markets have a nasty habit of not doing. Oh, you can placate them in the short term, but ultimately they want to be paid back in risk-adjusted buying power. And that is the one currency that many nation-states will no longer have. Now without major reforms and a significant restructuring of the social order.

A final thought. Businesses will keep on doing what they do, in spite of the machinations of governments and monetary authorities. Entrepreneurs will adjust. New inventions will be made. Over the medium term, life on earth will get better. I honestly do see a return of the secular bull market and a pretty cool third decade, an updated version of the Roaring Twenties. Only this time there will be no need for speakeasies. I fully intend to be around to enjoy it and am looking forward to being relatively optimistic about the future. I really don’t get much personal pleasure from writing these Debbie Downer letters. But my role is to not think about the world as it should be or as I want it to be, but to be as right as I can about the direction we are going. The ride could just be a little bumpier in the short term of the next few years. Fasten your seatbelts.

And for those of you looking for specific advice, let me point you to Jared Dillian, the new editor of my own Bull’s Eye Investor service. He has been finding ways to trade and invest in this market. Last Friday he wrote:

Guys, the price action has been bad for a while. And it is getting worse. The market is demonstrating repeatedly that it can’t hold its gains. In my 15 years of doing this, I’ve only seen worse price action twice: 2000, and 2007.

You can read about Jared and appreciate his baleful glare of a photo right here. Want to sit on a trading desk across from him? I want him on MY side of the table. See if you might want him in your corner as well.

Chicago, Athens (Texas), Boston, Geneva, and Atlanta

I have one more week to enjoy Dallas, and then I’m back on the road. I will go to Chicago for a speech, fly back to a meeting with Kyle Bass and his friends at the Barefoot Ranch in Athens, Texas, and then fly out to Boston to spend the weekend with Niall Ferguson and some of his friends at his annual briefing. I am sure I will be happily surfing mental stimulus overload that week. I fly from Boston to Geneva for a few days and then more or less directly to Atlanta for a day (board meeting), before heading back to Dallas.

Next Saturday is wedding day. It has been years since I’ve been to a wedding, and next Saturday I will go to two. I fly to Houston to watch my young associate, Mr. Worth Wray, tie the knot with his lovely fiancée, Adrienne. You have to admire a young man for playing above his weight class. He gets married in the morning, and that afternoon we fly back to Dallas to attend the wedding of David Tice’s daughter Abigail.

Next Monday evening I get to spend some time with Woody Brock here in Dallas before I launch my travels. I’ll be back in time for Halloween.

It’s time to hit the send button. I smell stir-fry chicken and vegetables simmering on the stove and need to find a piece of mindless entertainment with which to relax with family and friends. Have a great week,

Your ready to find his sweaters analyst,

John Mauldin
subscribers@mauldineconomics.com

 

The article Thoughts from the Frontline: Sea Change was originally published at mauldineconomics.com.
[description] => The final chapter and conclusion pretty much end as you would expect: the demise of monetary policy’s ability to soothe the soul of the markets and the return of volatility. We hopefully get a full-fledged restructuring of the sovereign debt markets. The Fed and sister central banks will try the same tired tools they have been using. Except they have already been to the zero rate boundary and have wasted the opportunity they had to increase rates so that they could lower them later. Another round of quantitative easing? Quite possible if we get a true deflation scare or a global recession. [author] => John Mauldin [legacyinterface_firm_id] => 287 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 01:12:42 [created_by] => 945 [modified_on] => 2014-10-14 13:47:47 [modified_by] => 951 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1678 [hits] => 0 ) [2] => stdClass Object ( [legacyinterface_commentary_id] => 1613 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14854 [apv_conversation_id] => 2527 [content_type] => market-commentary [title] => The Eurozone Plots Its Long Road to Recovery [slug] => franklin_101414 [fulltext] =>

We at the Franklin Templeton Fixed Income Group believe Europe in general will be in a slow-growth, low-inflationary environment for a considerable time. With that backdrop, we think a long-term, accommodative approach is needed to help spur the economy.

While the European Central Bank (ECB) has a role to play in the eurozone’s economic recovery, we think the core economies should do a bit more to achieve necessary reform. We don’t think the authorities are doing nearly enough in France, for example. Their deficit is quite high, and, in the latest draft budget, the French government has effectively said it can’t meet the deficit target and will try to meet it at a later date. The country needs economic reform, in our view, and it doesn’t appear to be working hard enough on it.

Germany, we believe, is meeting its fiscal requirements very well. Still, when most other countries in Europe are in fiscal austerity, maybe Germany can afford not to be so austere.

I think some of the eurozone’s core countries could take a lesson from the so-called periphery economies. In many of the periphery countries, the authorities have enacted necessary reforms. They have put plans into place that successfully reduced their budget deficits. I’m not saying some of the periphery countries shouldn’t do more, but many reforms have been passed, and we’re starting to see them implemented.

Still in Europe, but outside the eurozone, the UK economy is moving in a positive direction, in my opinion. Growth is good, inflation appears to be under control, and the country’s central bank is in a very different place than the eurozone’s. The central bank—the Bank of England—is considering raising interest rates, and we believe it’s not a matter of if, but when it will raise rates. I think that’s a good sign for the UK economy and, as a result, we don’t believe UK Gilts offer a lot of value. For UK investors, there may be a case for looking at opportunities elsewhere in Europe because the economies appear to be moving in different directions.

DZahnBox_US ver

Common Bonds

Looking globally, I believe the eurozone has more in common with Japan than with the United States or the UK at this point, and I think that trend will likely continue. Inflation in the eurozone is running at 0.4%, which is a far cry from the ECB’s 2% target. My team and I expect inflation will likely rise a little next year, but it’s likely not going anywhere near 2%. I think that’s what ECB President Mario Draghi is primarily concerned about. He has said the ECB is fully behind undertaking whatever measures are necessary to combat low inflation.

I expect the Bank of Japan (BOJ) and the ECB should likely continue to be accommodative to combat deflation and low inflation in their respective countries. Much has been made about the amount of liquidity the US Federal Reserve Bank (Fed) has pumped into the US economy during its quantitative easing (QE) program. But, when you take into account what Japan and Europe combined are currently contributing to their QE programs, it probably more than matches what the United States was doing. So, on a global scale, we have probably just as much or more liquidity being created now than when the Fed was acting alone.

Divergent Paths

Meanwhile, the US economy has been performing relatively well. In the United States, the Fed has indicated it is going to stop its QE program this month, and its next focus will be on when to raise interest rates.

That’s a strong differential to make, and it has ramifications for the currencies. I think the euro should probably weaken against the US dollar and, to a lesser extent, the British pound—it has already weakened quite a bit against the pound—because the economies are on different trajectories.

That might suggest to investors that European bonds may be a good place to look for potential opportunities. In the fund, we have taken a long-duration posture in Europe.1

David Zahn’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

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What Are the Risks?

Franklin Global Government Bond Fund

All investments involve risks, including possible loss of principal. Changes in interest rates will affect the value of the fund’s portfolio and its share price and yield. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. Special risks are associated with foreign investing, including currency rate fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Derivatives, including currency management strategies, involve costs and can create economic leverage in the portfolio, which may result in significant volatility and cause the fund to participate in losses (as well as enable gains) on an amount that exceeds the fund’s initial investment. The fund may not achieve the anticipated benefits, and may realize losses when a counterparty fails to perform as promised. Currency rates may fluctuate significantly over short periods of time, and can reduce returns. The fund is also non-diversified, which involves the risk of greater price fluctuation than a more diversified portfolio. These and other risk considerations are discussed in the fund’s prospectus.

Investors should carefully consider a fund’s investment goals, risk, charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor, call us at (800) DIAL-BEN®/342-5236 or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money.


1. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. It is expressed as a number of years.

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http://us.beyondbullsandbears.com

[description] => Growth in much of Europe is slow—some observers even say the economy is moving sideways. Lately, the eurozone seems to have more in common with Japan, whose economy has been idling for years, than it does with the UK or the United States. The European Central Bank (ECB) has recently launched programs to inject capital into the economy, and David Zahn, head of European fixed income and portfolio manager, says they’re a good start. He urges a long-term approach driven by both the ECB and the governments of individual countries, which all have to do their part to get the European economic engine running on all cylinders. [author] => David Zahn [legacyinterface_firm_id] => 163 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 01:28:56 [created_by] => 945 [modified_on] => 2014-10-14 01:29:20 [modified_by] => 945 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1679 [hits] => 0 ) [3] => stdClass Object ( [legacyinterface_commentary_id] => 1614 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14855 [apv_conversation_id] => [content_type] => market-commentary [title] => Assessing the Economic Impact of Hong Kong’s Occupy Central Movement [slug] => invesco_101414 [fulltext] =>

The Occupy Central (OC) movement was officially launched on Sept. 28, starting with members from the Occupy Central with Love and Peace (OCLP), the HK Federation of Students and Scholarism groups staging a sit-in in Central and Admiralty that blocked traffic in key commercial and business districts in Hong Kong. The objective of this campaign is to display the organizers’ determination to have “real” universal suffrage for the chief executive (CE) election in 2017, and more importantly, to demonstrate their discontent over the National People’s Congress’ decision to require that CE candidates be screened by a nomination committee, which is expected to be composed of pro-China members, and therefore lacking broad-based representation.

Our assessment

Below, we attempt to provide an assessment of the outcome of the OC movement and its impact on the various aspects of the economy under three separate scenarios:

Scenario 1

The Hong Kong government performs a violent crackdown

We think this scenario is unlikely. After the tear gas incident, which was perceived as violent, we have observed a change in the attitude of the police. They have become more accommodative toward the protesters, and their response has been more restrained. We feel that the Hong Kong government is very conscious of the public disapproval over the police’s actions and does not want the press and international community to portray the police as using force against peaceful demonstrators fighting for democracy.

On the campaigners’ part, we believe the majority of them realize that this is a long-term pursuit and that hostility will not yield a turnaround in Beijing’s decision overnight. Reaching an opportunity for dialogue with the Hong Kong government will be a first step toward a constructive outcome. In the process of trying to achieve this, the movement may attempt to test the government’s tolerance.

As a result, when “sensible” demonstrators meet “restrained” police, a sharp deterioration of the current situation is unlikely, in our view.

Scenario 2

Dialogue between the campaigners and the Hong Kong government fails, no resolution is reached, and the demonstrators lose public support and sympathy. In turn, the police step in and restore order quickly. Status quo remains.

This seems quite possible at this stage in time. Though this is a less-than-perfect outcome for the protesters, at least public order would be restored and everything would go back to business as usual.

Scenario 3

A dialogue between the campaigners and the Hong Kong government yields some positive results, and both parties declare they have reached a “win-win” situation.

We assign a relatively high probability of this outcome. We have seen the Chief Secretary Carrie Lam’s tone soften, and she has offered to meet with student leaders to discuss electoral reform. Government officials have also reiterated that there is room for discussions over key issues, such as how the formation of the nomination committee can offer better public representation. We believe the government is willing to offer some sort of moderate compromise after all, and that they are working toward a deadline to get Beijing’s proposal passed by the Legislative Council and start the second phase of the consultation process by Oct. 8.

Having said that, the current situation is very fluid, and emotional eruptions have started in certain parts of the occupied areas among the demonstrators and some anti-OC protestors. Fighting has broken out and resulted in some people getting injured. This is sad, but at the same time we believe it was inevitable, as maintaining full control over a movement of this scale is realistically a difficult task. However, we are still hopeful that the overall situation will remain peaceful. We have also seen some blocked areas in Causeway Bay and Tsim Sha Tsui being cleared out without the use of force, which is positive.

Impact on the economy

The sectors that are most affected in the immediate term are retail, restaurants and hotels. The China National Tourism Administration has stopped signing off on package tours to Hong Kong from Oct. 1 to 7 (and up to Oct. 10 for some regions). As Chinese visitors traveling via package tours accounted for 30% of total Chinese visitations year-to-date (January to August), a loss in retail sales in the near term is certain.

On a longer-term basis, we believe the stoppage of package tours is only temporary and does not point to a structural change in the Chinese government’s policy toward Hong Kong. We also disagree with some suggestions that this may even end up with China cutting the Individual Visitors Scheme (IVS). Our opinion is that the IVS policy should not be viewed merely as a “gift” from the Chinese government, but part of China’s bigger scheme of integrating Hong Kong with the mainland. Over the years, we have witnessed aspects of trade, finance and people flows being opened up. Cutting off tourism does not fit in with the overall plan.

On a fundamental basis, with Hang Seng Index (HSI) constituent stocks that have pure Hong Kong exposure (i.e., excluding all Chinese and multi-national companies) accounting for only 20% of the total market cap, we do not think this will lead to a broad-based earnings downgrade of the HSI.

Impact on 2014 Hong Kong gross domestic product (GDP)

Despite retail sales being disrupted, we believe the other core GDP components, such as trade and fixed capital investment, will not be impacted. As such, we maintain our 2014 GDP growth forecast at 2.0%.

Background

Since early 2013, the pro-democracy camp has been petitioning the Chinese and Hong Kong governments to create an electoral system that satisfies the international standards of universal suffrage. These standards, they argue, include an equal number of votes, an equal weight for each vote and no unreasonable restrictions on the right to stand for election. It also stipulates that the final proposal for the electoral reform be decided by means of a democratic process. On the other hand, the Chinese government has repeatedly declared that the chief executive (CE) must conform to the standard of “loving China and loving Hong Kong” to ensure that the chosen CE will not be a candidate with an anti-Beijing stance.

To that end, the Hong Kong government, strongly backed by Beijing, reiterated that CE nominees have to be screened by a "broadly representative nominating committee," and there was no provision for civic nominations. The position was reaffirmed in a State Council decision announced on Aug. 31, 2014.

Sequence of events

At the time of this writing, the OC movement has continued for more than a week with the situation evolving on a daily basis. The following provides a recap of the major events:

Sept. 28 — The Occupy Central (OC) movement was officially launched. Large crowds of protesters took to the streets and occupied key financial areas in Admiralty and Central.

Sept. 29-30 — Police attempted to disperse the crowds by firing tear gas at the public. However, not only did they fail to regain control of the districts blocked by the campaigners, this action provoked public anger and criticism over the use of unnecessary violence, and earned the OC movement more supporters. A new crowd gathered in major shopping and commercial district Causeway Bay.

Oct. 1— Students demanded that Chief Executive C.Y. Leung step down and that Beijing retract its decision on the 2017 CE nomination process.

Oct. 2 — Chief Secretary Carrie Lam offered to meet with representatives of the Federation of Students to discuss political reform.

Oct. 3 — Street violence broke out among the demonstrators and anti-OC protesters in another shopping and commercial district called Mongkok.

Important Information

The Hang Seng Index includes the largest companies of the Hong Kong stock market and is considered the main indicator of the overall market performance in Hong Kong.

China remains a totalitarian country with the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.All data provided by Invesco unless otherwise noted.

©2014 InvescoLtd. All rights reserved.

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With the Fed’s recent remarks regarding their near term plan or lack thereof for short term rates, investors continue to be surrounded by uncertainty as to the timing and velocity of future interest rate movements. This uncertainty creates the question of how one can protect one’s capital base, while earning decent returns.

One of the ways to answer this question lies in recalling some of that high school math we never thought we’d need in real life. Remember when x and y axes were introduced, and the concepts of points in two-dimensional space were a real challenge? Today, if you’re building roofs or making stairs, you’re intimately familiar with “run and rise”, the triangles that show how high you go vertically for every unit of horizontal movement. For us bond folks, it’s the slope of the yield curve we get when we plot the same parameters of how far and how high.

Unlike in carpentry, our slopes change. It’s in this change that we can find some solutions to the dilemma of uncovering value. Let’s take a look at the curves as they are now and see if we can come up with ways to both protect principal and earn decent returns.

The chart above illustrates that the front end of the municipal curve slopes sharply upward until just at year eight (2022). After year eight, the curve begins to flatten until it becomes virtually horizontal out in year 23 (2037). In absolute terms, for each year of extension out to 2022, you pick up 22 basis points for AAA, 28 for AA, and 31 for A rated municipal bonds. At 20 years ,the numbers drop to 14, 16, and 17 respectively until they become one or two a year.

So does any of this mean anything to investors? Well, if you want to protect yourself it certainly does. You’re not rewarded much for extending into the long end of the municipal yield curve, so why do it? You expose yourself to greater losses in dollar value for each basis point in higher yields, and time is less of an ally as well. If you stay inside the eight-year range, then you’ll earn at least 2%, while limiting your exposure to the possibility of rising interest rates.

The variables associated with all municipal bonds are: coupon, maturity, yield to maturity, and rating. Having argued that the best value and most defensive maturities in municipal bonds fall in the eight year and shorter range, we now turn our attention to the other factors.

Virtually all-individual investors and many of their advisors prefer those bonds referred to in the trade as “current coupons”. That is to say, they buy bonds priced at or near par, which is exactly the wrong thing to do. An aversion to and misunderstanding of the premium paid for the larger coupons prevents them from earning the much higher total returns available with those larger coupons.

Mutual fund managers and other large fund investors insist on those larger coupons because they understand the net total return is always larger with premium bonds, even after netting the amortization. In fact, the benchmark scales published daily by Municipal Market Data, a Thompson Reuters company, presume a 5% coupon. The reason for the preference expressed by the professionals is quite simple. The cash flows from the larger coupons more than offset the amortization paid in every case. So, total return is largely determined by cash flow, premium bonds act better in declining markets, and owners of premium bonds will never run afoul of the IRS de minimis rules for discounts, which is a whole other topic.

One of the professional money manager’s key tools to manage interest rate exposure is “Duration”, which may be defined as the weighted average maturity of a security’s cash flows, where the present value of the flows serve as the weights. The greater the Duration, the higher the percentage price volatility. Simply stated, duration gives you the change in dollar price for every one basis point change in yield. Inasmuch as higher coupons generate higher cash flows, they produce lower durations. Buy bigger coupons.

Briefly, yield to maturity is the offering yield, which produces a dollar price resultant from a present value calculation of that yield. It goes without saying that one should seek the highest yield one can, while taking into consideration that the dealer offering the bonds may or may not be willing to adjust the price to accommodate your interest. It never hurts to ask.

Finally, ratings. A plethora of books and articles have discussed the rating agencies and their role in the collapse of markets in 2008, and this is not a forum to go over old ground. Rather it is a place to discuss, in brief, their presence in the municipal market and how to use the ratings to your advantage.

There are three major agencies providing municipal bond ratings at present, Moody’s, Standard & Poor’s (S&P), and Fitch Ratings. These firms are all recognized as quite competent, have excellent research analysts, and usually issue ratings that are virtually identical. The four highest categories range from AAA to BBB, with gradations in each category below AAA. Examples are AA+, A-, BBB+, etc.

For the average investor, we do not recommend the purchase of BBB rated bonds. This is not to suggest that there may not be value in the category, but rather that the analysis of the risks associated with these bonds requires more sophistication and analytical tools than normally available to the average investor.

There are two major types of municipal bonds: 1) those secured by some tax pledge, either general obligation or by some specific tax, and 2) revenue bonds secured by a stream of cash flows from some governmental enterprise. Revenue bonds normally receive their income from water, sewer, and electric, and other local utilities. These are frequently referred to as “essential service” revenue bonds to differentiate them from other revenue issues, and they usually provide real value for investors.

In general, investors really don’t need the protection afforded them by AAA bonds, and there are better rewards found in dipping down to AA and A rated issues. The spread between AAA and A rated bonds in our 2022 maturity is 50 basis points, and if one looks hard for the right A rated essential services revenue bond, the rewards may even be better. So, that’s the conclusion: a 5% coupon A rated revenue bond inside 2022 for the time being. Let the Fed do its thing and earn all that nice tax tree income in the meanwhile.

And, finally, remember that not all bonds are created equal.

Good Fortune!

Bob Andres is editor of The Andres Review and founder of Andres Capital.  Bob’s career includes stops as: chief investment officer at Merion Wealth Partners, chief investment strategist at Envestnet (PMC division), co-founder at Martindale Andres & Co., a firm he grew to $2.4 billion before its sale, President at Merrill Lynch Mortgage Capital, etc.   He has been quoted and featured in various media: CNBC, Fox Business, Barron’s, Institutional Investor, etc.

© Andres Capital Management

[description] => With the Fed’s recent remarks regarding their near term plan or lack thereof for short term rates, investors continue to be surrounded by uncertainty as to the timing and velocity of future interest rate movements. This uncertainty creates the question of how one can protect one’s capital base, while earning decent returns. [author] => Bob Andres [legacyinterface_firm_id] => 498 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:22:12 [created_by] => 948 [modified_on] => 2014-10-14 14:23:31 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1681 [hits] => 0 ) [5] => stdClass Object ( [legacyinterface_commentary_id] => 1616 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14857 [apv_conversation_id] => [content_type] => market-commentary [title] => Tracking the Market with Social Media [slug] => downside_101414 [fulltext] =>

The Trade Followers Momentum indicators for the S&P 500 Index (SPX) continue to confirm lower prices with a series of lower highs. After trying to bounce, SPX broke through the 1955 support level that has been important on the Twitter stream for several weeks. It closed Friday near the next major support level of 1905 with 7 day momentum painting a small positive divergence with price. This divergence is a result of market participants tweeting that it’s time for a bounce. Many people are mentioning the 200 day moving average that hasn’t been touched in almost two years. Others are comparing this dip to previous declines during the long term rally. This suggests that a short term bottom is near. 

Once that low is in place it will be again time to watch the bounce. Since this bounce is coming from an obvious support level I’d like to see 7 day momentum paint a higher peak than the last two to indicate higher prices are ahead. A break of the current down trend line will provide hope, but not confirmation of a sustainable rally.

If the market continues to fall and 7 day momentum paints a lower low it will confirm the down trend and suggest that a larger correction is underway where rallies will likely fail.

Breadth from StockTwits and Twitter continue to deteriorate with fewer bullish stocks making the cut and at the same time more bearish stocks showing up in the lists. Last week I mentioned that finance, health care, and technology were holding up and that their performance gave some hope to the bulls. Unfortunately, those sectors experienced heaving selling on Friday with many of the stocks that had held up suffering declines of 5% or more. Without their support it will be difficult for the market to rally into the end of the year.

As mentioned above, 1905 on SPX is a strong support level. Below that there are scattered tweets, but nothing definitive. The lack of tweets below the market indicates hope and optimism from market participants. This can be dangerous near a strong support level because any break lower will turn hope into uncertainty and fear. 1905 on SPX is a must hold support level or we could see a cascade that carries price quickly to 1880 or 1850 where a small number of traders are tweeting support. Above the market 1955 and 2010 are the most tweeted levels with a small cluster near 1975. Watch those areas as likely resistance.

Sector strength shows positive readings in all of the defensive sectors and in financials, technology, and industrials as well. However, much of the strength in leading sectors came early last week. Friday saw a large decline in support for those sectors.

Overall social media is suggesting that traders are expecting a bounce near current levels. However, a break below 1905 on SPX would likely cause a swift drop before the market could catch. The nature of the next bounce should give us a direction for the rest of the year.

Blair Jensen is president of Trade Followers. The Trade Followers algorithm quantifies social media and creates stock market indicators that track the momentum of the crowd on Twitter and StockTwits.

© Downside Hedge

            

[description] => The Trade Followers Momentum indicators for the S&P 500 Index (SPX) continue to confirm lower prices with a series of lower highs. After trying to bounce, SPX broke through the 1955 support level that has been important on the Twitter stream for several weeks. It closed Friday near the next major support level of 1905 with 7 day momentum painting a small positive divergence with price. [author] => Blair Jensen [legacyinterface_firm_id] => 515 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:29:43 [created_by] => 948 [modified_on] => 2014-10-14 14:30:03 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1682 [hits] => 0 ) [6] => stdClass Object ( [legacyinterface_commentary_id] => 1617 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14858 [apv_conversation_id] => [content_type] => market-commentary [title] => How’s the Market Feeling These Days? [slug] => eaton_101414 [fulltext] =>

SUMMARY

  • Three of our preferred metrics for tracking investor sentiment and consensus portfolio positioning are the AAII BULL/BEAR ratio, BofA/Merrill Lynch’s Fund Manager Survey and attendance levels at investor conferences.
  • Recent investor sentiment readings suggest that lingering fear from the 2008 financial crisis has abated somewhat, and that sentiment has finally begun to catch up with market performance.
  • We see volatility potentially picking up in the fourth quarter of 2014, particularly with the midterm elections approaching in November.
  • Longer term, we continue to believe the market can deliver modest, middle-single-digit returns over a multiyear period.

It is almost tautological to say that investors seeking to earn excess returns must do something different from the general consensus of the market. Successful investors regularly find themselves lonely when attending the proverbial cocktail party where investment tips are being shared. The act of discussing one’s favorite controversial holdings or contrarian market views is frequently met with sideways looks and frowns. It is precisely this disgust or neglect on the part of the broad market that may allow security prices to reach an attractive enough valuation level where it becomes possible to achieve excess returns.

We use several metrics to track investor sentiment and consensus portfolio positioning. We do this not to reflexively position our portfolios against the consensus, but to understand where there might be hidden investment risks or opportunities. Three of our preferred sentiment indicators are:

  • The AAII BULL/BEAR ratio
  • BofA/Merrill Lynch’s Fund Manager Survey
  • Attendance levels at investor conferences
  1. AAII BULL/BEAR Ratio

Each week, the American Association of Individual Investors (AAII) surveys its members to ask if they are bullish, bearish or neutral on stocks over the next six months. By subtracting the percentage that is bearish from the percentage that is bullish, a net bullish score can be calculated. When this AAII BULL/BEAR figure rises to elevated levels, it can be a sign that there is too much enthusiasm for stocks and that the market may be due for a pullback. The reverse is often true as well, where excessive bearishness can signal a buying opportunity for investors.

This sentiment indicator had reached an exuberant level in late August 2014. Not surprisingly, stocks had a tough September, with the S&P 500 Index shedding 1.40% for the month on a total return basis (but still up 1.13% for the third quarter of 2014 and 8.34% year-to-date). Investor sentiment quickly reverted to more “normal” levels in September, as shown in Exhibit A below.

  1. BofA/Merrill Lynch’s Fund Manager Survey

Each month, Bank of America Merrill Lynch (BofA/ML) surveys professional fund managers to understand their preferences in terms of asset classes, geographic regions, economic sectors and industries. When professional investors have a strong consensus around their portfolio positioning, it is often the case that there are no incremental buyers/sellers to join them, and even a minor piece of disconfirming news about a given asset category can sometimes be enough to send security prices in the opposite direction.

Global fund managers’ latest preferences are shown in Exhibit B above. According to the September 2014 BofA/ML Global Fund Manager Survey (FMS), relative to history, equities in general were “overowned” by fund managers, whereas bonds were “underowned.” The most overowned economic sectors were the more cyclical consumer discretionary and technology groups, revealing many managers’ recent desire for some economic sensitivity in their portfolio exposure. Similarly, the less cyclical telecom and utilities sectors were both underowned.

  1. Attendance levels at investor conferences

Tracking attendance levels at investor conferences has long been a popular tool for gauging sentiment, and we have found it to be a useful indicator of both neglect and excessive enthusiasm, particularly at the industry and individual company levels.

September is typically the busiest month of the year for investor conferences, with many companies eager to get in front of shareholders before the books are closed on the quarter, and many investors keen on receiving an update post the summer lull in news flow. Our analysts and portfolio managers have attended numerous conferences over the past several weeks and came away with a few noteworthy observations regarding recent investor interest levels.

Consumer discretionary companies, particularly media names, have continued to attract heavy investor interest. At a recent media conference, one well-known company spoke to an audience of some 400 investors. The day before, one of the country’s largest real estate investment trusts (REITs) was able to garner an audience of only 20 investors in a room with 150 chairs.

Key takeaways

As of September 30, 2014, the stock market, as measured by the S&P 500 Index, was up more than 200% from its bear market low on March 9, 2009. For much of that five-and-a-half-year period, the market’s rise occurred despite lackluster investor sentiment and persistent retail outflows from domestic equity mutual funds. To a large extent, retail investors’ reluctance to embrace the bull market reflected their lingering fear in the wake of the 2008 financial crisis.

However, this fear has abated to some degree in 2014. Although domestic equity funds have continued to see net retail outflows, recent investor sentiment readings have been more normal or even somewhat elevated. This suggests that sentiment has finally begun to catch up with market performance.

Looking ahead

For many contrarian investors, the recent improvement in investor sentiment toward equities is cause for some concern, especially given how fickle retail sentiment can be. (Sentiment among institutional investors is less susceptible to the headlines of the day.) In this sense, the market’s slowdown and increased volatility in September 2014 was no surprise, as sentiment had started to become rather frothy leading up to that point.

So, what will the final months of 2014 bring? Was September just a brief hiccup in a sustainable market rally, or the beginning of a new trend of renewed market volatility and diminished equity returns?

Investors should bear in mind that prior to September, volatility for most of 2014 had been quite muted, and that could not be expected to last indefinitely. We see volatility potentially picking up in the fourth quarter, particularly with the midterm elections approaching. Historically, October has often been a volatile month for stocks.

That being said, our broad market outlook has not changed materially. Shorter term, we expect the U.S. market to finish 2014 firmly in positive territory. Longer term, we continue to believe the market can deliver middle-single-digit returns over a multiyear period – more modest than in recent years, but respectable. Bottom line: Investors should remain wary but not fearful and should try to maintain a long-term perspective with regard to their equity portfolios.

The S&P 500 Index is an unmanaged index commonly used to measure the performance of the broad U.S. stock market. It is not possible to invest directly in an index. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. Historical performance of the index illustrates market trends and does not represent the past or future performance of any fund.

About Risk

Investments in equity securities are sensitive to stock market volatility. Equity investing involves risk, including possible loss of principal. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant.

Past performance is no guarantee of future results.

About Eaton Vance

Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors.

The views expressed in this Insight are those of Edward J. Perkin and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.

This Insight may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.

©2014 Eaton Vance Distributors, Inc. | Member FINRA/SIPC | Two International Place, Boston, MA 02110 | 800.836.2414

[description] => Recent investor sentiment on the equity market – and what conclusions might be drawn. Recent investor sentiment readings suggest that lingering fear from the 2008 financial crisis has abated somewhat, and that sentiment has finally begun to catch up with market performance. [author] => Edward Perkin [legacyinterface_firm_id] => 124 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:37:55 [created_by] => 948 [modified_on] => 2014-10-14 14:39:03 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1683 [hits] => 0 ) [7] => stdClass Object ( [legacyinterface_commentary_id] => 1618 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14859 [apv_conversation_id] => [content_type] => market-commentary [title] => Everything Is Not As It Seems [slug] => hanlon_101414 [fulltext] =>

As of September 25, 2014 the NASDAQ Composite index is up 6.95% year-to-date, despite the recent downturn in the market. The darling tech stocks continue to come up with new and innovative ideas for products and services to drive their bottom lines. The NASDAQ is only down -2.86% from the high it made on September 2, 2014. One could conclude that the NASDAQ is indeed solid and that this is just another passing correction before it pushes on to higher levels.

What if I told you that 1,251 (48.9%) of the 2,558 stocks in the NASDAQ Composite index were down 20% or more from their 52-week high as of September 25? Would you still think that the NASDAQ seemed healthy? What if I told you that 852 (33.3%) of the stocks were down 30% or more from their 52-week high? You may be surprised.  These statistics are in the following table.

It would be natural to question this information because the two ideas don't seem to fit together. The NASDAQ just hit a recent high, yet here we find that 48.9% of the stocks are down 20% or more from their 52-week highs. The former suggests that the index is strong and ready to push higher. The latter sounds like an index in the midst of a bear market. You may wonder how this could be.

The answer is market capitalization, which is a total dollar market value of all of a company's outstanding shares and is commonly used to determine its size.  The NASDAQ is a market capitalization based index. This means that the larger the market capitalization of any given stock, the more the returns of that stock count for in the index's performance. The largest stock by market capitalization in the NASDAQ Composite index is Apple, with a 7.3% representation. That's a very large portion of return.

To further show the disparity between the larger capitalization and smaller capitalization stocks in the NASDAQ composite index, let's take the top 200 and bottom 200 stocks by market capitalization as of September 25, 2014. Each group of 200 represents approximately 7.8% of the 2,554 stocks in the NASDAQ composite index by number. The top 200 stocks in the NASDAQ Composite index by market capitalization, while being 7.8% by number, represent just shy of 75% of the entire market capitalization for the NASDAQ. This means the remaining 2,354 stocks, just a bit over 92% of the stocks in the index, represent only 25% of the index's market capitalization. That's heavily skewed.

If we look at the year-to-date returns from these two groups of stocks, we see something even more amazing. The top 200 market capitalization stocks have an average year-to-date return of 13.92%. Meanwhile the bottom 200 market capitalization stocks have an average year-to-date return of -10.49%. Yes, that is a negative. There is a pretty drastic difference between the two groups of stocks at the opposite ends of the market capitalization spectrum.

You may think that if we included more stocks from the lower market capitalization levels, the results will improve. Let's see. If we include all the other stocks with year-to-date returns, excluding the top 200 market capitalization stocks, we end up with a return of -1.97%. Yes, the return did improve, but -1.97% is still a far cry from the +13.92% of the top 200 market capitalization stocks.

What does this tell us? First, the larger capitalization stocks count for much more than the smaller stocks even though there are far more of the smaller stocks in number. In fact, the year-to-date returns for the top 8% of stocks by number are carrying the index for the remaining 92%. The market capitalization effect is making the index appear to be strong by hitting new highs when it is actually weak, based on an average numerical basis.

When a few large darling stocks carry the index higher while the rest lag, we refer to it as a narrow rally in stocks.  Narrow rallies are a sign of weakness and are an insight into the true health of the market at large.

We saw a similar narrowing of the stock participation in the NASDAQ Composite index in the time leading up to the market crash back in 2008. As of December 31, 2007, the NASDAQ was up 9.81% year-to-date. In the following table, we see that 75% of the stocks by number in the NASDAQ composite index were down 20% or more from their 52-week highs as of December 31, 2007. 58% of the stocks by number were down 30% or more from their 52-week highs. This is similar to the narrowing we are seeing today. It can be seen as an early indication that something is amiss and careful monitoring is called for.

Sincerely, 

Sean Hanlon, CFP®

Chairman, CEO and Chief Investment Officer

The NASDAQ Composite Index is an unmanaged, market-weighted index of equities traded on the National Association of Securities Dealers Automated Quotation System. Past performance is not a guarantee of future results. This Market Commentary is limited to the dissemination of general information pertaining to its investment advisory services and is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock and bond markets involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice. Hanlon has experienced periods of underperformance in the past and may also in the future. The returns represented herein are total return inclusive of reinvesting all interest and dividends. Hanlon Investment Management ("Hanlon") is an SEC registered investment adviser with its principal place of business in the State of New Jersey. Hanlon and its representatives are in compliance with the current registration and notice filing requirement imposed upon registered investment advisers by those states in which Hanlon maintains clients. Hanlon may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by Hanlon with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Hanlon, please contact Hanlon or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Hanlon, including fees and services, send for our disclosure statement as set forth on Form ADV from Hanlon using the contact information herein. Please read the disclosure statement carefully before you invest or send money. Not all Hanlon clients are in the strategies discussed herein.

© Hanlon Investment Management

[description] => As of September 25, 2014 the NASDAQ Composite index is up 6.95% year-to-date, despite the recent downturn in the market. The darling tech stocks continue to come up with new and innovative ideas for products and services to drive their bottom lines. The NASDAQ is only down -2.86% from the high it made on September 2, 2014. One could conclude that the NASDAQ is indeed solid and that this is just another passing correction before it pushes on to higher levels. [author] => Sean Hanlon [legacyinterface_firm_id] => 193 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:41:50 [created_by] => 948 [modified_on] => 2014-10-14 14:42:47 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1684 [hits] => 0 ) [8] => stdClass Object ( [legacyinterface_commentary_id] => 1619 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14860 [apv_conversation_id] => [content_type] => market-commentary [title] => What If We “Crash”? [slug] => charter_101414 [fulltext] =>

US equities are deeply oversold by many measures, and are likely to bottom here.  But what if we “crash”?  While market crashes are impossible to predict, it’s wise to be prepared for the occasional plunge from deeply oversold territory. 

From the perspective of implied volatility, there were ten occasions over the past sixteen years when volatility spikes were more than temporary.  These cases are illustrated in the chart below.

Here, a crash is defined as an event in which implied volatility (VXO) spikes above its 200-day moving average for five or more trading sessions.  This hasn’t happened yet, but if it does, the table below might come in handy.  The median crash generated greater-than-2-sigma volatility for 22 non-consecutive trading sessions.  The median price loss was 9%, counting from the first 2-sigma observation.

If the median crash were to repeat here, SPX would drop to 1760 before bottoming in early November.  Remember, this is not a prediction, but something to keep in mind if the unexpected should happen.  A move to 1760 would constitute a 13% correction from the September 2014 top and a re-test of the February 2014 bottom.  In other words, a fairly normal event by market standards.

Contemplating a hypothetical crash based on historic parameters is a useful exercise.  While a crash is unlikely, it’s wise to remember the old scout saying: “Be prepared.” 

© Charter Trust Company

[description] => US equities are deeply oversold by many measures, and are likely to bottom here. But what if we “crash”? While market crashes are impossible to predict, it’s wise to be prepared for the occasional plunge from deeply oversold territory. [author] => Mark Ungewitter [legacyinterface_firm_id] => 81 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:45:20 [created_by] => 948 [modified_on] => 2014-10-14 14:48:16 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1685 [hits] => 0 ) [9] => stdClass Object ( [legacyinterface_commentary_id] => 1620 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14861 [apv_conversation_id] => [content_type] => market-commentary [title] => You Ain't Seen Nothin Yet [slug] => smead_101414 [fulltext] =>

Someone recently asked a group of us which band we saw at our first rock concert. My answer was the Canadian band, The Guess Who, in 1975. With hits like “No Time,” “Undun” and “These Eyes,” The Guess Who hit the perfect balance between my 17-year old testosterone driven aggressiveness and my urge to romance the woman of my dreams. The key members of the band in the 1960’s and 1970’s were Burton Cummings and Randy Bachman.

Fortunately for this writer, Randy Bachman left the band in the early 1970's to form Bachman-Turner Overdrive (BTO). Their two biggest hits were “Takin' Care of Business” and “You Ain't Seen Nothin' Yet.” Today's equity market harkens back to the period 1983-1987 in the U.S. stock market which we alluded to in our 2014 outlook piece. As we look to the fourth quarter of 2014, we will quickly review what happened in the first nine months of the year, see how it compares with 1983-84 and consider what went on from 1984-1987. At Smead Capital Management, we believe “You Ain't Seen Nothin' Yet!”

By the middle of 1983, the U.S. economy was in the early stages of an elongated growth period. Small-cap stocks and fast-growing conceptual tech stocks were all the rage. Small-caps had a nine-year run of outperformance over large-caps under the idea that their earnings were more likely to grow faster than the persistently high double-digit inflation. From July 26, 1983 to June 30, 1984, the Russell 2000 small-cap index fell 20.21% from peak to trough and high-flying techs fell even further. The S&P 500 Index’s peak loss was around 10%, a significant outperformance.

As we write this letter in late September of 2014, the S&P 500 has gained close to 9% and the Russell 2000 has lost over 4% year to date, a spread almost identical to the rhyme we drew on from history. We think investors were overcommitted to small-caps in 1983 due to the "well known fact" surrounding persistently high inflation. At the beginning of 2014, a new "well known fact" seemed just as entrenched in investors’ minds: historically riskier small-cap indexes outperform the larger-cap indexes over long stretches of time.

At our firm, we believe valuation matters dearly and the historical advantage small-cap stocks normally have in the marketplace is very attractive. The advantage is that they are usually cheaper than their bigger and substantially more stable large brethren. By the end of 2013, we saw a 14-year run of small-cap domination come to an end. The great small-cap run was triggered by how much cheaper the Russell 2000 was in early 2000 than the S&P 500. Tech was all the rage and ridiculously expensive at the end of 1999. The Russell 2000’s tech exposure was higher than normal, but didn’t include the glamorous dot-com companies that traded at massive market capitalizations. Large traded at 27 P/E and small traded at closer to 15 P/E. A long period of success for small caps was bred.

As we entered 2014, the S&P 500 traded for around 17 P/E and the Russell 2000 was around 29 P/E. We aren’t the only ones looking at the severe over-pricing and over-capitalization of smaller cap companies. Market Historian, Hayes Martin said this in a September 23rd, 2014 Marketwatch.com interview:

Valuation: The area of the market whose valuation is most troubling, according to Martin’s work, is secondary stocks. His indicators, which focus on several valuation metrics such as the price-to-earnings and price-to-sales ratios, show the Russell 2000 index to be more overvalued today than at any time since it was created in 1984. In fact, Martin believes that, had the Russell 2000 index been around before 1984, you’d have to go back all the way to 1968 to find a time when secondary stocks were more overvalued than they are today. Martin adds, ominously, that 1968 was “the grandaddy of small-cap market peaks.”

Ironically, The Guess Who was making some of their best music in 1968. It is not just prices which tell the story of a "well known fact" and major over-capitalization. You need other evidence.

First, as we entered 2014, investments in hedge funds and private equity led to a massive over-capitalization in alternative investments led. We think hedge fund managers are much more likely to attempt to find an advantage in under-researched securities. The largest private equity investment is in leveraged buyouts, transactions which are mostly likely to occur in small and mid-cap companies. Since investors have drowned both of these alternatives with money (mostly coming from net liquidation of large-cap investments) it is easy to see how over-capitalization would occur. See the NACUBO study from the end of 2013 for the asset allocation of the nation’s foundations and endowments totaling over 1 trillion in investable dollars as representative of U.S. institutional investors as a whole:

Second, to top the whole thing off and truly lay the groundwork for seven to ten years of small-cap misery, you needed the equivalent of the Sports Illustrated curse. This came in the form of passive investing guru, Dr. Eugene Fama, receiving the Nobel Prize in Economics for emphasizing the historical outperformance of small-caps in indexing and asset allocation. He is a big believer in the idea that active management is for the birds compared to passive investments, especially the "smart beta" passive indexes which his company propagates. Bachman-Turner gave you all the asset allocation advice you need in this set of thoughts:

And now I'm feelin' better

'Cause I found out for sure

She took me to her doctor

And he told me of a cure

He said that any love is good love

So I took what I could get

Yes, I took what I could get

And then she looked at me with them big brown eyes

Returning to 1984 and You Ain't Seen Nothin' Yet, we all need a "cure". The S&P 500 went on to beat the Russell 2000 by 48% in the four-year stretch from June 30th, 1983 to June 30th, 1987. Each up market move saw large beat small and each down market especially punished small-cap stocks. Interest was also significantly diminished in glamour techs, a warning sign for owners of today's exciting and frothy darlings. In our opinion, when the wholesaler promoting alternatives shows up at your office, you better claim to be on vacation. When the doctor with those “big brown eyes" comes trumpeting small-caps and “smart indexes,” don’t make eye contact. Smead Capital believes only meritorious and undervalued securities are "good love".

We think investors should join CALPERS (who ditched hedge fund investments) in a pull back of capital (love) from hedge funds and reduce or eliminate commitments (love) to private equity while they wait for the big-time debacles to show. We believe this will lead to a mass exodus back to less expensive large-cap stocks, a process in the early stages. Some bear markets cure concentrated over-capitalization of asset classes like 2000-2003 and some clean out everything in total liquidation like 2007-09. We at Smead Capital believe the next cure will be centered in small-cap stocks, frothy conceptual tech stocks, hedge funds, private equity and high yield bonds/loans attached to them. Since we can't stutter in the process of writing, we'll share our last thought in BTO lyrics:

You ain't seen nothin' yet

B-b-b-baby, you just ain't seen n-n-nothin' yet

Here's something, here's something your never gonna forget

baby, you know, you know, you know you just ain't seen nothin' yet

© Smead Capital Management

[description] => Someone recently asked a group of us which band we saw at our first rock concert. My answer was the Canadian band, The Guess Who, in 1975. With hits like “No Time,” “Undun” and “These Eyes,” The Guess Who hit the perfect balance between my 17-year old testosterone driven aggressiveness and my urge to romance the woman of my dreams. The key members of the band in the 1960’s and 1970’s were Burton Cummings and Randy Bachman. [author] => William Smead [legacyinterface_firm_id] => 392 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:50:40 [created_by] => 948 [modified_on] => 2014-10-14 14:51:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1686 [hits] => 0 ) [10] => stdClass Object ( [legacyinterface_commentary_id] => 1621 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14862 [apv_conversation_id] => [content_type] => market-commentary [title] => Can The Market Make A Comeback? [slug] => fpi_101414 [fulltext] =>

Although I’m a Detroit Lions’ fan and thoroughly enjoyed my team’s rare, 19-to-7 triumph over Green Bay’s football team last month, I’ve always respected the Packers. (Maybe because as a Lions’ season ticket holder since the 80s, I probably have seen the Lions lose to them more than anyone else.) They epitomize what football is all about.

They always seem to be a contender (with thirteen league championships – the most in the NFL, four of which were Super Bowl victories), the team is a non-profit operation owned by its fans (to the point where it’s hard to tell where the stadium ends and the town begins), and its past stars are legends. The Lombardi teams of Starr, Tayor, Hornung, Kramer, Davis, Nitchke, and Aderley were a regular part of the season each fall during my childhood.

So I was delighted to see the Packer’s come-from-behind victory on Sunday, even though it meant they stayed in a tie for the North Division leadership with the Lions. Trailing 24-17 with just 4:09 to go, they scored a field goal to make it 24-20 and tighten things up. Then with just three seconds left in the game, the Packers’ perennial standout quarterback, Aaron Rodgers, reached back and tossed a perfect pass to tight end Andrew Quarless standing in the end zone. Game over, Packers’ victory! The few cheeseheads in the Florida stands exploded.

Last week’s stock market was a lot like Sunday’s game. Yesterday the lead changed hands three times. First Green Bay surged ahead, then the Dolphins, and back and forth again before Green Bay put on the final surge. In the stock market, 1.5%-plus up and down days occurred back and forth throughout the week. Overall, the Dow advanced and declined over 2000 points in the last week alone. But this time it was the bears (and not the Chicago variety) that came out ahead.

Stocks were down severely in September, and it’s been more of the same so far in the fourth quarter, so investors have to be asking: “Can the stock market make a comeback?”

With Ebola now spanning the Atlantic, recession worries shaking Europe, growth concerns in China, and earnings reports looming, most investors must feel like the punt returner who just caught the ball on the one-yard line and the entire opposing team is bearing down on him. Yet every weekend we see this occur, and every week some team marches 90-plus yards and scores a touchdown. I think this year is likely to end up in the same manner in the markets.

Like yesterday’s Packers’ game, though, I think we’ll take a field goal first before the touchdown. By that I mean, if we follow seasonal patterns, stocks should bounce this week, then regroup before moving higher around the end of the month until year’s end. Check out our Political Seasonal Index, which tracks over 100 years of the Dow Jones Industrial Average’s history. Some of the mid-month gains projected arise from this being an options expirations week. These weeks are usually positive and, with the market being so oversold, a bounce seems likely.

Longer term, interest rates may hold the key. Certainly the fact that rates are down so far this quarter (making bonds along with gold one of the few winning investments in the period) is a positive short term for stocks. But increasingly I am coming around to the view that rates may stay low longer than most on Wall Street believe is possible.

With the aforementioned economic weakness abroad, global investors have few havens for their funds other than the US, if they are seeking safety. And, of course, the rising Dollar is a plus here as well. In addition, the news on inflation is encouraging. While there have been signs of inflation creeping up, it is not soaring. If inflation is under control, what is the rationale for the Federal Reserve to raise interest rates? If this is the case next spring and the weakness abroad continues, it’s likely that the Fed might just wait a bit longer before it jacks up our interest rates. Notice how the Fed has reacted each time inflation prospects got this low:

Source: Bespoke Investment Group

As further evidence of inflation’s failure to heat up as yet in this recovery; check out the change in the price of gasoline. It’s been falling since July, and if seasonal tendencies exert themselves, gas prices could have much lower to go. I actually paid $2.97 per gallon today. Not only does that put less inflationary pressure into the markets, but it means consumers have more discretionary money to save or spend.

Source: Bespoke Investment Group

Economic reports have been generally underperforming expert predictions and have been one of the reasons why we have been forecasting the current set back in this newsletter for the last month, but last week we finally got a positive majority from the reports. While it was just a 4-2 split between the better-than-expected and less-than-expected economic missives, it was the first upturn in a while and could give some support to stocks, especially if the heavy number of reports on Wednesday and Thursday continue the positive trend.

Finally, earnings reports started off with a bang last week for the third quarter reporting season. Alcoa, always the first to report, outperformed analyst estimates. While there has been little predictive magic to Alcoa’s past performance vis-à-vis the rest of the market’s performance for the remainder of past earnings seasons, it is noteworthy that Alcoa is a multi-national corporation with overseas sales that seems not to have been hurt by the European or Chinese weakness – a big concern expressed by market bears.

Secondly, Alcoa’s performance may be reflecting what will perhaps become a trend this earnings season. Analysts have been unmerciful over the last month in downgrading the earnings expectations for stocks. As Bespoke Investment Group points out in its usual excellent investment analysis, when analysts are generally negative, they tend to lower the bar to the point that most stocks surprise to the upside with their earnings reports, i.e. they beat the lower expectations. And when most stocks beat their earnings expectations, stocks as a whole tend to rise.

As the chart below illustrates, since 2009, whenever analysts lowered expectations on more stocks than they raised them on, more often than not the S&P has completed the earnings season higher rather than lower. (And, conversely, when more raised expectations, stocks underperformed.) Going into this earnings season there were 12% more S&P 500 company earnings downgrades than upgrades.

Source:  Bespoke Investment Group

Stocks are oversold, seasonality is changing from negative to positive, yields are falling not rising, the economy here is humming, earnings reports (which won’t come in heavily for two more weeks) seem likely to provide pleasant surprises, and Green Bay rallied to a win. If you know a cheesehead (like Michiganders they’re everywhere), take him or her to lunch and say congratulations – comebacks are possible.

All the best,

Jerry

© Flexible Plan Investments

[description] => Although I’m a Detroit Lions’ fan and thoroughly enjoyed my team’s rare, 19-to-7 triumph over Green Bay’s football team last month, I’ve always respected the Packers. (Maybe because as a Lions’ season ticket holder since the 80s, I probably have seen the Lions lose to them more than anyone else.) They epitomize what football is all about. [author] => Jerry Wagner [legacyinterface_firm_id] => 156 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:59:50 [created_by] => 948 [modified_on] => 2014-10-14 15:00:05 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1687 [hits] => 0 ) [11] => stdClass Object ( [legacyinterface_commentary_id] => 1622 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14863 [apv_conversation_id] => [content_type] => market-commentary [title] => Rising Rate Strategy Performance in a Falling Rate Environment [slug] => wisdomtree_101414 [fulltext] =>

In financial markets, there is no free lunch. After a difficult market environment for bond investors in 2013, the prevailing consensus to start the year was that long-term bond yields would continue to rise in 2014. This view has yet to materialize in the markets. However, the market reprieve for assuming interest rate risk has provided us with valuable information about the performance of various bond strategies. In the following analysis, we attempt to explain the costs of hedging and their impact on total returns in a less-than-ideal market for rising rate strategies.
 
YieldDuration and Recent Performance for “Rising Rate” Indexes


For definitions of terms and Indexes in the chart, visit our glossary.

The table above highlights how hedged and negative duration variants of traditional fixed income indexes have performed in a falling interest rate environment compared to long-only strategies. In the case of zero duration strategies strategies, investors were primarily rewarded by assuming credit and prepayment risk but did not necessarily benefit from falling U.S. interest rates. Since these strategies seek to reduce or modify exposure to movements in nominal U.S. interest rates, it should stand to reason that returns will generally be lower than long-only strategies as rates fall. Interestingly, even though returns have lagged, both zero duration strategies generated positive total returns. In the case of the high-yield strategy, underperformance was less pronounced, given the lower costs of hedging. Even though it did not pay to hedge over this time period, we now have the ability to quantify the risk versus reward relationship in real time.

Shifting the focus to the negative duration strategies, we believe that these strategies make sense for investors who have a greater degree of conviction about rising rates. In the most recent period, as interest rates fell, these approaches underperformed due to losses on their short positions. In the case of the high-yield strategy, this approach lost value on both sides of the trade as credit spreads widen and interest rates fell. However, in both approaches, returns from income were able to help offset or finance a portion of these losses. Total returns from negative duration strategies didn’t lose as much as the strategies gained from the move in rates. This can largely be attributed to the fact that the long bond portion helps to defray some of the costs associated with maintaining these positions.

While examining these strategies independently can give some insight into the future drivers of total return, we believe that the real value of these strategies is how they can be incorporated into a broader portfolio of interest rate sensitive assets. As shown above, hedging interest rate risk during periods in which rates actually fall is likely to create a drag on investment returns. This is to be expected; hedging risk incurs a cost. However, with investors relatively complacent about rising rates, we believe that these strategies can offer valuable cover when the Fed starts to shift policy.

Important Risks Related to this Article

Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

© WisdomTree

[description] => In our view, exchange-traded funds (ETFs) can provide powerful tools for fixed income investors both big and small. Even some of the most sophisticated investment managers have used ETFs to gain broad-based exposure to certain subsets of the fixed income market. [author] => Rick Harper [legacyinterface_firm_id] => 494 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:02:08 [created_by] => 948 [modified_on] => 2014-10-14 15:02:25 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1688 [hits] => 0 ) [12] => stdClass Object ( [legacyinterface_commentary_id] => 1623 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14864 [apv_conversation_id] => [content_type] => market-commentary [title] => Forecasting the Market: A Thought Experiment Revisited [slug] => pieh_101414 [fulltext] =>

With Q3-14 reported earnings just beginning, here is the latest update of my ongoing "thought experiment" for forecasting the S&P 500 price based on earnings fundamentals. The chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor's website as of October 9th, 2014. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort's monthly valuation update for instructions on downloading the spreadsheet.

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Here are the key assumptions in the calculations:

  • The 10-year average of nominal TTM earnings is 65.52 as of September 2013, rising to 78.02 by the end of 2015, based on "as reported" earnings forecasts.
  • The average nominal cyclical P/E10 is currently 18.26.
  • The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
  • Standard & Poor's estimates of TTM earnings for Q4 2013 through Q4 2015 consist of the following:
  • The months between the quarterly earnings estimates are linear interpolations.

The blue line represents Standard & Poor's TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2014 year-end earnings of $111.71 and an average nominal P/E of 18.26, we would see the S&P 500 at 2040. At this level, the nominal P/E10 would be 28.58, and the index would be about 54% above a hypothetical price multiple of the extrapolated 10-year earnings average (1312).

The red line represents a hypothetical S&P 500 price that is a multiple of the average nominal P/E10 of 18.26 and the 10-year average earnings of 66.85 for December 2013. The monthly index price estimates thereafter are linear extrapolations based on average 10-year earnings growth and earnings estimates from Standard & Poor’s.

The optimistic view (blue line) would put us around 1997 in the S&P 500 at the end of October, the assumptions being that the Standard & Poor's earnings forecasts are correct the nominal P/E10 ratio is the multiple we see.

The pessimistic view (red line) is a reversion to the historic earnings and nominal P/E10 multiple.

But history shows us that, regardless of your preferred earnings divisor (nominal or real, TTM or the 10-year average TTM), the P/E ratio has never hovered around the average. The market swings above and below its long-term average valuation in erratic arcs that can last for many years. For a long-term perspective on valuation extremes, Four Market Valuation Indicators and the compelling research of Ed Easterling on the history of earnings per share.

Check back next month for a new progress report.


Note from dshort: For some interesting comparisons, here are Chris's charts from the last several months, based on the then current Standard & Poor's spreadsheets.

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[description] => With Q3-14 reported earnings just beginning, here is the latest update of my ongoing "thought experiment" for forecasting the S&P 500 price based on earnings fundamentals. The chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor's website as of October 9th, 2014. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort's monthly valuation update for instructions on downloading the spreadsheet. [author] => Colonel Chris Turner [legacyinterface_firm_id] => 516 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:05:48 [created_by] => 948 [modified_on] => 2014-10-14 19:41:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1689 [hits] => 0 ) [13] => stdClass Object ( [legacyinterface_commentary_id] => 1624 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14865 [apv_conversation_id] => [content_type] => market-commentary [title] => Finally, a Five Handle! [slug] => cleary_101414 [fulltext] =>

Last Friday’s jobs report was significant in that for the first time since July of 2008 the unemployment rate dipped below 6%. The September report indicated that the unemployment rate fell from 6.1% to 5.9%. While we have seen improvement in labor markets for some time now, the Fed still seems to want to take their time reducing stimulative policy.


Yellen Dashboard
We know that the Federal Reserve has been reducing their bond purchases all year. The program should come to an end by the end of 2014. The question now weighing on bond investors’ minds is when will they begin to raise short-term interest rates. The Fed Funds rate is pegged near zero and, based on Fed Funds futures, it doesn’t appear that the market believes it will rise much before the third quarter of 2015. The October 2015 Fed Fund futures are trading today near 0.55%.

In order to understand why the Fed feels the need to remain cautious about raising rates, we can look at the Yellen dashboard for some clues (dashboard hyperlink courtesy of Bloomberg). It provides a view of where each factor was before the recession, how it changed during and where it is today.  This is a set of labor market indicators used by Fed Chairwoman Janet Yellen to look beyond the unemployment rate to get a better characterization of what is really going on in the U.S. labor market.

The dashboard has a number of indicators that provide more clarity on who is finding jobs, how are people being paid and what is the quality of the labor improvement. It includes measures such as the number of people hired as well as laid off as a percentage of paid workers. It also includes the number of people that have quit and the number of job openings available.

The data in her dashboard also provides more color on the unemployment rate because it includes the number of people working part-time who would rather be working full time if they could find full time employment. It also provides information on the number of people that have been unemployed for more than 27 weeks and the number of people participating in the labor market as a percentage of those that are eligible.

This last piece of information seems to be the most troubling. The participation rate currently stands at 62.7%, up from its low but still nowhere near the better than 66% rate we had pre-recession. There are a number of reasons that appear to be at play here. Most of them have more to do with secular shifts in the economy than specifically related to the recession or the meagre recovery we’ve experienced since. Because they are secular in nature it is possible that the Fed may decide to either remain on hold longer with respect to policy, or they may begin to communicate that the dashboard features have changed so that they can begin raising rates sooner. It seems more likely that the latter will be the case.

Secular Trends
One of the biggest secular trends is the aging of the work force. As older baby boomers remain in the work force longer, both because they want to and in some cases because they have to, the underemployment rate among younger workers is intractably high. At the same time the unemployment rate among older workers in their late 50’s is particularly low, especially among college educated workers. Because the baby boom generation is very large, it is likely that this issue will take some time to work through and as a result we may see the numbers related to people feeling under employed remain high for some time. It is possible this is also why we see such a slack recovery in housing.

Employment Level – 55 years and over

Another secular trend in the labor force is the lower participation rate. Federal programs to provide assistance to those without work have remained in place much longer and in a manner that provides greater assistance than in periods before the recession. As a result, it may have been possible for those people to remain out of the labor force longer, thereby reducing the participation rate.

Price Stability
The Fed seems very focused on the labor market as a justification for their policies. However, their primary objective is price stability. So far, the economy has muddled along at a slow rate of real growth, less than 3% over the last five years, so that inflation hasn’t been a problem. There are also global deflationary forces at work that have provided the Fed a tail wind. Deflation in Japan and Europe and a big slow-down in Chinese economic growth have reduced the pressure on capacity utilization around the world. As a result, the Fed hasn’t had to really fight inflation with higher interest rates.

Germany just posted the lowest level of industrial production they’ve experienced since 2009. China is likely to see slower growth, in the mid-single digits, as a result of their transition to a consumer driven economy. Japan, even with the latest round of Abenomics, can’t seem to get their inflation rate moving in the right direction. With these headwinds, the rate of global growth may continue to be slower even though the U.S. is experiencing some improvement in our own growth rate.

This suggests that, for now, the Fed Funds futures market may have it right. The Fed doesn’t need to be in a hurry to raise rates and probably won’t be.

© Cleary Gull

[description] => Last Friday’s jobs report was significant in that for the first time since July of 2008 the unemployment rate dipped below 6%. The September report indicated that the unemployment rate fell from 6.1% to 5.9%. While we have seen improvement in labor markets for some time now, the Fed still seems to want to take their time reducing stimulative policy. [author] => Brian Andrew [legacyinterface_firm_id] => 491 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:20:19 [created_by] => 948 [modified_on] => 2014-10-14 15:20:43 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1690 [hits] => 0 ) [14] => stdClass Object ( [legacyinterface_commentary_id] => 1625 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14866 [apv_conversation_id] => [content_type] => market-commentary [title] => Oracle’s Present State Looks Great But Challenges Lie in Wait [slug] => ycharts_101414 [fulltext] =>

You may think of Oracle (ORCL) as a company that sells software. In fact, at its core, it is a company that sells software updates.

Oracle has four other segments-including "New Software"-but all of them are simply shovels used to feed business into the mighty furnace of Oracle's Updates & Supports segment.

The Updates & Support business-comprising nearly half of Oracle's revenue stream-is phenomenally profitable, with operating margins of close to 90%.

Because Oracle's traditional enterprise database software is such an integral part of highly-critical accounting and other business systems, and because millions of dollars is spent customizing Oracle's software to a given client's needs, once a client has committed to using an Oracle product, they are tied into an inexorable upgrade cycle.

Every time the cycle turns, Oracle generates huge profits. You can see this at a single glance at this chart, showing per-segment earnings before interest and taxes (EBIT) contribution.

Operational Leverage

You may notice that the "Hardware Products" piece of the EBIT pie is almost diminishingly small. Pundits attacked Ellison for structuring the 2010 acquisition of high-performance hardware firm, Sun Microsystems for this very reason. "What good could come," they asked "if high-margin Oracle buys a low margin hardware business?"

However, as this author pointed out in the first YCharts Focus Report on Oracle, we do not think it is mere chance that ever since Oracle bought Sun, Oracle's vitally important Updates & Supports business experienced an enormous uptick in operating leverage.[1]

Analyzing the most recent financial statements of Oracle in our most recent report, it is clear that the operating leverage boost we identified in our last report has continued, though to a somewhat less-pronounced degree.

This crooked smile ending with a value of 18% means in practice that while Software Updates' segment revenues increased by (a still robust) 6% in fiscal year 2014, the segment's profits grew even faster—at a rate of 7%.

The fact that operational leverage continues to be strong in comparison with prior years is, in this author's opinion, a positive sign that speaks to the continued success of the Sun acquisition for Oracle and its shareholders.

Future Challenges

Oracle is doing what it does best-generating huge amounts of profits using its dual pacemaker/disposable razor strategy.

Hardware sales look to have stabilized and, as explained above, Oracle's most important segment is converting revenues to profits increasingly efficiently. If Oracle were a machine, it would be humming along at peak performance.

However, this does not mean that an investment in Oracle is a fire-and-forget affair. In fact, the company is reaching a critical transition point, underscored by founder Larry Ellison turning the CEO reins over to Hurd and Catz.

As is obvious in the chart below, Oracle began an acquisition binge about 10 years ago, when its organic growth had begun to slow.

Over the past several years, it has spent an average of about half its Owners' Cash Profits (which we define as Cash Flow from Operations, less an estimate of the money required to maintain the firm as a going concern[2]) on investments designed to boost future profit growth.

While profits continue to grow, they are growing more slowly, and we think this means Oracle's investments are giving it less and less of a boost. When you're small, all you need is good ideas. When you're big, you need good big ideas, and those are rarer.

It is at this stage in a company's existence that it can either make a bold, transformative move to redefine itself [e.g., Apple (AAPL) turning from a manufacturer of niche computer systems into a designer and marketer of consumer products] or it must take its foot off the investment gas pedal and start to return more profits to shareholders.

The risk with the first course is that the bold, transformative move will fail [e.g., Ron Johnson's JC Penney (JCP)], permanently damaging the company. The risk with the second course is that it takes too long for management to realize that its investments are no longer creating value. In this case, the stock runs the risk of becoming "dead money" until management figures out the mistake and corrects it.

Oracle: Dead Money Candidate?

Of the two risks, this author is relatively more worried about the latter. Oracle's capital expenditure requirements are very low. With its present Owners' Cash Profit margin level in the mid-30% range, its present average investment spending implies a Free Cash Flow to Owners level in the sub-20% range (we define Free Cash Flow to Owners as Owners' Cash Profits less money spent on investments designed to boost future profit growth[3]).

If Oracle could gracefully cut its investment level to somewhere around one-fifth of its owners cash profits (i.e., cutting its present rate of expenditures by more than half), it could materially increase the amount of FCFO it is generating, even if revenues were slow growing and profit margins stabilized.

But if it were going to cut something, what would it cut?

Its acquisition strategy ties into its critical Software Updates business-acquired technology is incorporated into future rounds of updates to Oracle's products. So cutting back on these acquisitions would potentially hurt Oracle's most important business line.

However, we estimate that roughly 40% of its "investment" dollars are going to fund anti-dilutionary stock buybacks (i.e., back-door compensation to executives and other employees). Cutting into these expenditures will not be easy either.

This issue will most likely affect medium-term growth rates since the impact of today's corporate acquisitions are greatest a few years after they are made and integrated. Changing assumptions about these growth rates can have a large effect on valuations.

In our valuation analysis, a feasible worst-case scenario generates a valuation in the upper-$20 range. This scenario--in which Oracle continues to make increasingly hard-to-integrate acquisitions that make increasingly diminishing improvements to the company's profit growth without appreciably boosting revenue growth--is not dissimilar to the case of networking giant Cisco Systems (CSCO).

Cisco is the poster child of Old Tech Dead Money--a dubious title it won from Microsoft (MSFT) since the end of 2010.

Could the same fate befall Oracle? Without the new CEOs Catz and Hurd making hard decisions about future investments and growth strat



[1] Operating leverage means that as additional dollars of revenue flow in, the firm becomes increasingly efficient at converting those revenues into profits.

[2] For a full explanation of Owners’ Cash Profits (OCP), please see our Valuation Methodology webinar replay.

[3] For a full explanation of Free Cash Flow to Owners, again, please see our Valuation Methodology webinar replay.

© YCharts, Inc.

[description] => You may think of Oracle (ORCL) as a company that sells software. In fact, at its core, it is a company that sells software updates. [author] => Erik Kobayashi-Solomon [legacyinterface_firm_id] => 479 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:30:49 [created_by] => 948 [modified_on] => 2014-10-14 15:31:35 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1691 [hits] => 0 ) [15] => stdClass Object ( [legacyinterface_commentary_id] => 1626 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 0 [apv_conversation_id] => [content_type] => market-commentary [title] => Rocking the Lifeboat - Comments on the Recent Stock Market Volatility [slug] => rocking-the-lifeboat-comments-on-the-recent-stock- [fulltext] =>

The cruise ship sank.  The passengers are gathered in the lifeboat.  The officer in charge knows how to reach safety, just over the horizon.  If the passengers trust him, sit in their seats, pull on the oars and bail when necessary, all will make it home.  The problem is one passenger, let’s call him Mr. CNBC-FOX-CNN-MSNBC, who is a hysteric.  If the waters are calm, he’ll focus on other issues (ISIL, Ebola, the mid-term elections, where is Kim Jong Un?)  But the moment some waves hit the boat, he panics and starts jumping from one side to the other of the lifeboat.  As he thrashes, other passengers panic with him.  Soon the whole lifeboat is rocking side to side (up 1.7% one day, down1.9% the next day.)  If the rocking becomes violent enough, some passengers may decide to jump out of the lifeboat and try to swim for shore by themselves (we don’t go back for those passengers.)

We’re surprised less by the recent volatility, surprised more that markets have been so calm over the last three years.  To help explain market volatility, we show this chart to prospective clients:

  • Housing Bubble inflates and bursts
  • Bear Stearns fails
  • Lehman Brothers fails
  • Great Recession of 2009, and March 2009 stock market collapse
  • Greece fails once
  • Greece fails a second time
  • Italy and Portugal nearly default

And then, most curiously, a three year stretch through August 2014 where the US Stock Market had almost no volatility at all.  Since no media outlet can remember events of more than 6 months ago, the recent return to NORMAL volatility is headlined as “The End of the World!”

We tell our prospects, “We’re reasonably confident MORE horrible events WILL happen over the next 15 years.  But we’re also reasonably confident your money will double, possibly triple in the same time frame – why wouldn’t you take that bet?”

The reason why investors DON’T take the bet is because our national media is dedicated to scaring you silly every day.  If it’s not stock market volatility, then you should fear Islamic terrorists, Russian hackers in your bank account, West African diseases coming through the airports, South American children swarming the borders of Texas and New Mexico.

Well, STOP!

Here’s the deal.  People who work for General Electric or McDonald’s or Pfizer watch the same bad news as you.  And then these employees go to work every morning to build better turbines, or better hamburgers or better Viagra, or they don’t get paid a salary.  And thus corporate revenues grow, thus earnings, thus stock prices, thus our clients’ portfolios.

The third of our clients who are retired and dependent on their portfolios for their lifestyle continue to receive their monthly draw without fail.  How?  Because we have a year’s worth of retirement income in “near cash” investments and four years of income in bonds.  We reload the cash and bond buckets a couple of times a year from the “risk bucket” which contains US, international stocks, and commodities.  If, as we saw in 2009, the “risk bucket” collapses in value, we simply suspend the transfer until risk asset prices recover.  We have NEVER reduced a clients’ monthly draw in the 20+ years we have run this firm.

The Short Term Explanation of Volatility

US stocks have come far and fast in recent years – 202% since the March 2009 low, 39% since January 2013.  Investors raised cash to purchase Alibaba stock last month by selling stocks that did very over the last 5 years.  The temporary downturn caused the “weak hand” investors to sell additional stock through the end of September, while other investors booked profits coming into quarter end.  The magnitude of the recent pullback of the same magnitude as NINE OTHER pullbacks over the last three years.  Each time, stocks moved to new highs within a month or two. 

We would totally EXPECT the market to “back and fill” for a few months given the age of the current bull market.  Fed policy STILL remains accommodative with interest rates STILL at multi-generational lows.  Inflation STILL remains contained at 1.5-2%.  The employment rate continues to drop, now 5.9% (yes, the labor participation rate is still too low, but the US economy will add 2.4 million jobs this year.)  2nd Quarter US GDP was a blistering 4.6%, reversing Q1’s decline of 2.1%.  On a year over year basis, the US economy is growing at about 2.2%, which is on the low side, but also means no risk of inflation.  More good news for inflation – energy prices are down sharply with oil at the lowest level in two years.  Gas station prices will fall in a month, throwing extra cash consumers as we head into holiday shopping.

Our biggest concern is that earnings growth is in a lull right now, with Q3 2014 numbers to show only 1.5% growth year over year.  For much of the year, the median stock price traded about 5% above Morningstar’s fair value estimate.  With the recent pullback, stocks are now at 2% discount.  We would need to see stocks trading 10% above fair value to cut back positions, or 10% below to buy aggressively.  At present, we are simply rebalancing accounts in line with our target allocations.

Portfolio-Level Performance Disclosure

The portfolio-level performance shown is hypothetical and for illustrative purposes only. Investor returns will differ from the results shown.

The benchmark is 80% S&P 500/20% Barclays Aggregate Bond index.  

© Heron Financial

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“Abrupt market weakness is generally the result of low risk premiums being pressed higher. There need not be any collapse in earnings for a deep market decline to occur. The stock market dropped by half in 1973-74 even while S&P 500 earnings grew  by over 50%. The 1987 crash was associated with no loss in earnings. Fundamentals don't have to change overnight. There is in fact zero correlation between year-over-year changes in earnings and year-over-year changes in the S&P 500. Rather, low and expanding risk premiums are at the root of nearly every abrupt market loss.

“One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals… I've noted over the years that substantial market declines are often preceded by a combination of internal dispersion, where the market simultaneously registers a relatively large number of new highs and new lows among individual stocks, and a leadership reversal, where the statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions.

“This is much like what happens when a substance goes through a ‘phase transition,’ for example, from a gas to a liquid or vice versa. Portions of the material begin to act distinctly, as if the particles are choosing between the two phases, and as the transition approaches its ‘critical point,’ you start to observe larger clusters as one phase takes precedence and the particles that have ‘made a choice’ affect their neighbors. You also observe fast oscillations between order and disorder in the remaining particles. So a phase transition features internal dispersion followed by leadership reversal. My impression is that this analogy also extends to the market's tendency to experience increasing volatility at 5-10 minute intervals prior to major declines.”

Market Internals Go Negative, Hussman Weekly Market Comment, July 30, 2007

“We've started to see the pattern of abrupt jumps and declines at 10-minute intervals that is often a hallmark of nervous markets. My continued concern is that numerous market plunges have been indifferent to both interest rate trends and even valuations, with the main warning flag being deterioration in the quality of market internals, as we observe at present. Both in the U.S. and internationally, ‘singular events’ tend to occur well after internal market action has turned unfavorable, and prices are well off their highs.

“Though I don't want to put too much emphasis on intra-day behavior, if you examine tick data or daily ranges before major declines both in the U.S. and elsewhere, you'll generally see price movements become chaotic at increasingly short intervals even before the event itself. One way to describe it without mathematics is to spin a quarter on the table and watch (and listen to it) closely - you'll observe a similar dynamic at the abrupt point that the coin moves from an even spin to an irregular one, and again just before it stops. If you imagine a pen drawing out its movements, you would see it tracing out faster and faster circles as it moves from stability to instability.”

Broadening Instability, Hussman Weekly Market Comment, January 28, 2008

Over the years, I’ve frequently observed that the most favorable market return/risk profile we identify is associated with a material retreat in valuations, coupled with an early improvement in market action across a broad range of market internals. That combination does not require a retreat in valuations to historical norms, and whether that shift occurs at still-elevated valuations, depressed valuations, or in sporadic intervals, we fully anticipate such opportunities over the completion of the current market cycle and those ahead. It’s important to begin on that optimistic note; to recognize that there will be what we expect to be identifiable opportunities as conditions change, even though now is the precise antithesis of such an opportunity.

I’ve done all I can to clarify that my “permabear” reputation is an artifact related to my necessary but admittedly ill-timed 2009 insistence on stress-testing our methods against Depression-era data, as employment losses, economic contraction, credit strains, and market pressure became uncharacteristic and “out of sample” compared with the post-war data on which our methods were based. The ensemble methods that solved that “two data sets” problem improved on our pre-2009 methods, but they did lack various trend-sensitive overlays that we introduced in the late-1990’s in response to the tech bubble. Aggressive yield-seeking speculation provoked by the Federal Reserve’s zero interest rate policy led us to reintroduce variants of those overlays, in order to narrow our defensive response to persistent and uncorrected overvalued, overbought, overbullish extremes. All of that made for a terribly awkward transition from our pre-2009 methods of classifying market return/risk profiles to our present methods. Still, understanding that narrative (see Setting the Record Straight) is particularly important at present, in order to disabuse the belief that present conditions can be dismissed simply because we encountered those challenges in the first half of this wholly uncompleted market cycle.  

With regard to that 2009 stress-testing decision, I’ve frequently observed that our most historically reliable measures of valuation (which indicate that current valuations are about double their pre-bubble norms), were actually quite reasonable by late-2008 and early-2009 (see in particular my October 20, 2008 piece, Why Warren Buffett is Right and Why Nobody Cares). The problem is that the similar valuations, during the Depression, were followed by a further loss of two-thirds of the market’s value. It might be useful to recall that the legendary value investor Benjamin Graham was hedged going into the 1929 crash, but once valuations got down to what appeared to be reasonable valuation, he removed most of those hedges. Graham and his Graham-Newman partnership went on to suffer a 60% loss by 1932. One of the key lessons from our 2009-2010 “two data sets” challenge was that Depression-era data, as well as the credit crisis, imposed more demanding requirements on measures of market action (particularly measures of “early improvement”) than were typically needed in other post-war cycles.

Neither our stress-testing against Depression-era data, nor the adaptations we’ve made in response extreme yield-seeking speculation, do anything to diminish our conviction that historically reliable valuation measures are of immense importance to investors. Rather, the lessons to be drawn have to do with the criteria that distinguish periods where valuations have little near-term impact from periods where they suddenly matter with a vengeance.

The effect of valuations on subsequent market returns is conditional. While depressed valuations are a good indication of strong prospective long-term returns, depressed valuations don’t prevent further – sometimes massive – losses in the near-term. A retreat in valuation becomes reliably favorable mainly when it is joined with an early improvement in market internals. All of history (not just the Depression-era and the 2008-2009 collapse) imposes demanding requirements; not least that internals aren’t collapsing and credit spreads aren’t shooting higher, as they are today. Conversely, overvalued, overbought, overbullish extremes are associated with total market returns below risk-free interest rates, on average, but that average features an unpleasant skew: most of the week-to-week returns are actually positive, but the average is harmed by large, abrupt losses. Such extremes become reliably dangerous when they are joined by deterioration in market internals.

Present conditions create an urgency to examine all risk exposures. Once overvalued, overbought, overbullish extremes are joined by deterioration in market internals and trend-uniformity, one finds a narrow set comprising less than 5% of history that contains little but abrupt air-pockets, free-falls, and crashes.

In recent weeks, the market has transitioned to the most hostile return/risk profile we identify: the pairing of overvalued, overbought, overbullish conditions with deterioration in market internals and price cointegration – what we call “trend uniformity” – across a wide range of stocks, sectors, and security types (see my September 29, 2014 comment Ingredients of a Market Crash). As in 2007 and 2000, we’re observing characteristic features of that shift. One of those features is that early selling from overvalued bull market peaks tends to be indiscriminate, as deterioration in market internals and the “average stock” often precedes substantial losses in the major indices. As of Friday, only 28% of NYSE stocks are above their respective 200-day moving averages.

In the current cycle, both the Russell 2000 small-cap index, and the capitalization-weighted NYSE Composite set their recent highs on July 3, 2014, failing to confirm the later high in the S&P 500 on September 18, 2014. Through Friday, the NYSE Composite is down -7.3% from its July 3rd peak, and the Russell 2000 is down -12.8%, while the S&P 500 is down only -4.0% over the same period. What’s happening here is that selling is being partitioned in secondary stocks, and more recently high-beta stocks (those with greatest sensitivity to market fluctuations). Market action is narrowing in a classic pattern that reflects the effort of investors to reduce risk around the edges of their portfolios, in what typically proves an ill-founded belief that a falling tide will not lower all ships.

Abrupt market losses are typically not responses to obvious “catalysts” but instead reflect a shift in investor preferences toward risk aversion, at a point where risk premiums are quite thin and prone to an upward spike to normalize them. That’s essentially what’s captured by the combination of overvalued, overbought, overbullish coupled with deteriorating internals. Another characteristic of these shifts is increasing volatility at short intervals – what I described at the 2007 peak and in early-2008 by analogy to “phase transitions” in particle physics. The extreme daily and intra-day market volatility in recent sessions is typical of that dynamic.

Fed policy and risk premiums

Recall that very early into the 2000-2002 and 2007-2009 bear markets, the Federal Reserve began to aggressively ease monetary policy, but that did not prevent stock prices from going on to lose half or more of their value (see Following the Fed to 50% Flops). The short-term responses of the market were certainly positive, but those responses turned out in hindsight to be exit points. As I’ve noted before, if one is going to invest by aphorism, history teaches that “don’t fight the trend” strongly outperforms “don’t fight the Fed.” With respect to our own experience in the half-cycle since 2009, the primary lesson to be drawn is not that Fed policy trumps all other considerations. Rather, the lessons to be drawn relate to the criteria that distinguish periods where monetary easing is supportive to the markets from periods where policy shifts are irrelevant or even contribute to the loss of investor confidence.

Again, that distinction has a great deal to do with market internals and trend uniformity, because those measures of market action provide a signal about the tolerance or aversion of investors toward risk. In effect, Fed easing is effective provided that risk-free cash is considered an inferior holding. Fed easing is useless if investors actually prefer to hold risk-free cash as a safe haven.

There’s certainly a feedback circle to this: the purely psychological belief that Fed liquidity is a magical risk-removing fairy dust can certainly support increased risk tolerance, but that tolerance should still be read directly out of market internals and trend uniformity. When investor preferences shift toward risk aversion, more liquidity doesn’t support stock prices. Yield-seeking speculation fails to emerge because low or zero interest rates on cash are preferred to the prospect of steeply negative returns. As the market collapses of 2000-2002 and 2007-2009 demonstrate, aggressive Fed easing does not prevent extraordinary market losses once investors have the risk-aversion bit in their teeth.

The Fed certainly has a legitimate and often helpful role in crises when it is needed to act as a “lender of the last resort” by lending to solvent but liquidity-constrained financial institutions. Good public policy acts to responsibly relieve legitimate constraints on the economy that are actually binding. At present, however, the financial system is already drowning in trillions of dollars of idle cash reserves, which don’t need to “go” anywhere, because once a dollar of base money (currency or bank reserves) is created, it remains in existence, in the form of base money, until it is retired by the Federal Reserve. In other words, zero-interest sideline cash is zero-interest sideline cash and will remain zero-interest sideline cash until it is retired, and the only thing that $4 trillion of base money does for the economy is to change hands as a hot-potato that nobody wants to hold so long as risky assets appear to offer better returns than zero.

No doubt – this pile of zero-interest hot potatoes has helped to compress risk premiums across the entire range of risky assets toward zero (and we estimate, in some cases, below zero). But understand that the bulk of the advance in financial assets in recent years has not been a reasonable response to the level of interest rates, but instead reflects a dangerous compression of risk premiums.

The effect of zero-interest rates is measurable, and the arithmetic is straightforward. The expectation of another 3-4 years of zero interest rates (versus normal short-term interest rates of say, 4%) implies that risky long-term assets could reasonably be priced 12-16% above where they would be priced in a normal interest rate environment. That premium would reduce the prospective returns of those risky assets by that same 4% for 3-4 years, but would preserve normal risk premiums. But on valuation measures that are reliable across a century of history, including recent years, the valuation of the S&P 500 is now more than double its pre-bubble historical norms (and only looks more tolerable because investors do what they always do at cycle peaks, which is to capitalize peak cycle earnings as if they are fully representative of the entire stream of future long-term cash flows).

In short, every 3-month period of additional zero-interest rate policy promised by the Fed is worth about a 1% premium over historical valuation norms. Another year would be worth a premium about 4% over historical norms. But with the market more than double historical norms on reliable measures, the Fed would have to promise a quarter of a century of zero interest rate policy before current stock valuations would reflect a “reasonable” response to interest rates. No – stocks are not elevated because low interest rates “justify” these prices. They are elevated because the risk premium for holding stocks has been driven to zero. We presently estimate negative total returns for the S&P 500 on every horizon shorter than 8 years.

At present, prospective market return/risk should not be read from Fed policy. It should be read from valuations and the quality of market internals and trend uniformity, which we view as the best way to infer investor risk tolerances, the level of risk premiums, and the pressure on them. If these measures improve, a fresh easing of Fed policy would allow for further yield-seeking speculation. But in the context of extremely compressed risk premiums that are being pressed higher; in the context of an overvalued, overbought, overbullish market that has been joined by deteriorating market internals, broadening dispersion, and a loss of trend uniformity – all bets on the Fed are off, as they were in 2000-2002 and 2007-2009, until we observe a favorable shift in those measures of investor risk preferences.

Warning: Examine all risk exposures

All of that said, there’s no assurance that the present instance will match historical experience. As I noted at what in hindsight turned out to be the market peak in October 2007, in a piece that bears the same title as this section (see Warning: Examine All Risk Exposures):

“There is one particular syndrome of conditions after which stocks have reliably suffered major, generally abrupt losses, without any historical counter-examples. This syndrome features a combination of overvalued, overbought, overbullish conditions in an environment of upward pressure on yields or risk spreads. The negative outcomes are robust to alternative definitions, provided that they capture that general syndrome. We can't rule out the possibility that investors will adopt a fresh willingness to speculate (which we would observe through an improvement in market internals). Such speculation might prolong the current advance modestly, but even this would not substantially alter the risks that have ultimately been associated with overvalued, overbought, overbullish conditions.”

Though we should allow for a potential improvement in market conditions, I do believe that now is a particularly bad time to rely on the idea that “this time is different” with money you cannot afford to lose. This does not require forecasts about market direction – only proper consideration of market risk. Make sure that the portfolio of risks you do hold is the portfolio that you want to hold over the completion of the market cycle, understand the risk profile and actual losses that various asset classes have experienced over prior market cycles, take account of the prospective returns that are embedded into current valuations, and insist on historically reliable measures of valuation that demonstrate a strong association with actual subsequent returns over numerous market cycles across history.

My view is that even passive buy-and-hold investors should primarily focus on ensuring that the effective duration of their portfolio is not significantly longer than the horizon over which they expect to spend the funds. In other words, the duration of the assets should be matched with the anticipated horizon of spending needs (or liabilities). The estimated duration of the S&P 500 Index is roughly 50 years, 10-year Treasury bonds presently carry a duration of about 9 years, and cash has zero duration, so a passive investor expecting the average date of spending to be about 15 years in the future might match that with an asset portfolio of similar duration. Examples would include a 20%-55%-25% mix of stocks, bonds, and cash, respectively, or perhaps a 24%-33%-43% mix, but in any case not more than about 30% in equities.

The challenge here is that we associate each of those 15-year duration portfolio mixes with expected nominal total returns of less than 2% annually over the coming decade. Based on historically reliable valuation measures, we presently estimate prospective 10-year S&P 500 nominal total returns of just under 2% annually here, so increasing the equity portion does not improve the expected portfolio return. Investors should understand that “prices and valuations are high” is another way of saying “future returns have already been realized, leaving little to be gained for quite some time.”

Fortunately, as valuations retreat, durations shorten. For example, at the 1982 low, the dividend yield of the S&P 500 reached 6.7%, bringing the duration of the index down to 15 years, so from a duration-matching standpoint, even an investor with an expected spending horizon averaging 15 years could have been comfortable with 100% of assets in equities. At the 2009 low, the yield was a more moderate 3.8%, but that still implied a 26-year duration, making a 60% equity allocation quite reasonable even for a passive investor expecting to spend the assets, on average, 15 years hence.

Alternative investments are a bit trickier, as their exposure to market risk can vary. Since the potential for portfolio loss is a significant consideration, one approach might be to gauge relative risk by comparing maximum losses on a compound (log) basis. For example, if the worst historical drawdown of A has been 33% over several market cycles, and the worst drawdown of the market has been 55%, the relative risk of A might be estimated as log(1-.33)/log(1-.55) = 50% of that of the market. That odd-looking compounding arithmetic essentially captures the fact that it takes two back-to-back 33% losses to produce one 55% loss. Similarly, if worst historical drawdown of B has been 18%, the relative risk of B might be estimated as log(1-.18)/log(1-.55) = 25% of the market itself, as it takes four back-to-back 18% losses to produce one 55% loss like the S&P 500 experienced in 2007-2009.

An active investor would typically consider allocations not only from the standpoint of duration, but also broader conditions that affect returns over shorter portions of the market cycle. Presently, we don’t believe that active investors should expect a positive return from unhedged equities at all here, given the combination of rich valuations and deteriorating internals, which suggests skewing holdings toward cash or hedged alternatives until more favorable conditions emerge. Again, we view the strongest market return/risk profiles, and the best opportunities for unhedged investment, as coupling a material retreat in valuations with an early improvement in market internals. Now is the antithesis of those conditions.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

The Hussman Funds remain defensive toward equities, and modestly constructive toward Treasury bonds and precious metals shares. With market conditions in the same hostile configuration as we observed last week, the same considerations about day-to-day fluctuations apply. In Strategic Growth Fund, the recent decline has brought the major indices close to or below the strike prices of the long index put option side of our hedges. Though those put options currently represent a small percentage portfolio value (and could lose that amount if the market was to advance between now and their late-year expirations if we were to hold them throughout such an advance), they are also likely to change in value if the market declines significantly. In that event, we would expect good amount of “give-and-take” depending on whether the market advances or declines on a given day. So in the event of a significant market loss from here, these positions will tend to account a significant portion of day-to-day changes in net asset value in both directions.

We’ve long observed that deterioration in market internals and weakness in the “average stock” often precedes weakness in major indices (which are the most liquid vehicles for hedging). As a result, equity portfolios are likely to be somewhat more susceptible than usual to “tracking” differences between the stocks we hold long and the indices we use to hedge. With the broad NYSE Composite down 7.3% since its July 3rd peak, and the Russell 2000 down 12.8%, compared with a loss of only 4% in the S&P 500 over the same period, there is something of a headwind to the selection of individual stocks at the moment. Indiscriminate selling may produce further periodic day-to-day headwinds until investors begin picking the wheat from the chaff a bit more deliberately. Day-to-day changes in net asset value will also be affected to some extent as this process – common to the early declines following cyclical market peaks – takes its course.

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© Hussman Funds

www.hussman.net

 

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Falling to New Depths of Shallowness...

What happens in the corporate world often is a reflection of the values and trends in our society. Here are a couple of recent stories that, well, leave me scratching my head...

The world's leading soft drink company, Coca-Cola, has found a rather creative way to reverse the long slide in soft drink sales. They have developed a marketing campaign called "Share a Coke," whereby they imprint popular names like Chris, Jess, and Alex, on soda cans and bottles. Apparently, in response to this personalization, soft drink sales have rebounded sharply. A Wall Street Journal article tells the story of a couple searching all summer for bottles with their names on them, so they can keep them forever. Really? Meanwhile, another corporate icon, Apple, is battling complaints that their recently released and largest phone ever, the iPhone 6 Plus, bends when people sit on it.

I'm getting the disturbing picture of a poor soul named Jess who, after a relentless search, has found her personalized bottle of diet coke. Feeling true joy for the first time Jess holds the bottle, lifts it skyward, and sits down into a chair. Mesmerized by the experience she forgets that her new IPhone 6 Plus is in her back pocket...

And then, of course, the entire story goes viral on Facebook. What, if anything, does this nonsense say about our society?

For decades, Coca-Cola has been one of the most recognized global brands, and has had a long history of marketing success. I'd like to teach the world to sing, remains one of the iconic ads of all time. Perhaps Coca-Cola now understands that we have become the "Me Generation" and simply putting our names on products will motivate greater consumption. Would future marketing initiatives include our picture on the bottle or our voice recording when we unscrew the cap?

In a similar vein, should there be warning labels on iPhones? – Remove phone from back pocket before sitting down or jumping in to the pool... Wouldn't you rather have Apple spend its creative resources developing the next amazing product as they have done throughout its history? Perhaps they still can, but I fear there is a trade-off.

In essence the question to me is this - Will true innovation, driven by scientific research and discovery, be sacrificed by a focus on marketing to an increasingly superficial consumer, who moreover, seems less willing to take responsibility for their own actions?

Innovation, mind you, is the life blood of long-term earnings growth and ultimate business success. In a highly-competitive global economy, companies that can continually out-innovate their competition will be the winners over the long run. When Henry Ford introduced the Model T, he said "Any customer can have a car painted any colour that he wants, so long as it is black." How odd that seems today.

logisticsIn a society that values substance over style, patient, yet determined research and discovery naturally predominates. But when a society becomes too self-absorbed, it becomes impatient, demanding instant gratification. And when society puts too much of a burden on the corporate sector for irresponsible behaviour, innovation and growth suffer.

The United States economic system flows through cycles of prosperity and decline, affecting participants unevenly. While it is far from perfect, it is better than any other system, and has created more wealth than any economy in the history of the world. An amazing record in our relatively short history, but are our best days behind us or ahead of us? Stay tuned.

© Willingdon Wealth Management

http://www.willingdonwealth.com/

[description] => What happens in the corporate world often is a reflection of the values and trends in our society. Here are a couple of recent stories that, well, leave me scratching my head... [author] => Michael Kayes [legacyinterface_firm_id] => 457 [published_on] => 2014-10-13 [digest_date] => 2014-10-13 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-13 13:54:59 [created_by] => 945 [modified_on] => 2014-10-13 13:55:42 [modified_by] => 945 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1670 [hits] => 0 ) [18] => stdClass Object ( [legacyinterface_commentary_id] => 1605 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14846 [apv_conversation_id] => 2505 [content_type] => market-commentary [title] => The Age of Vulnerability [slug] => prosyn_101314 [fulltext] =>

NEW YORK – Two new studies show, once again, the magnitude of the inequality problem plaguing the United States. The first, the US Census Bureau’s annual income and poverty report, shows that, despite the economy’s supposed recovery from the Great Recession, ordinary Americans’ incomes continue to stagnate. Median household income, adjusted for inflation, remains below its level a quarter-century ago.

It used to be thought that America’s greatest strength was not its military power, but an economic system that was the envy of the world. But why would others seek to emulate an economic model by which a large proportion – even a majority – of the population has seen their income stagnate while incomes at the top have soared?

A second study, the United Nations Development Program’s Human Development Report 2014, corroborates these findings. Every year, the UNDP publishes a ranking of countries by their Human Development Index (HDI), which incorporates other dimensions of wellbeing besides income, including health and education.

America ranks fifth according to HDI, below Norway, Australia, Switzerland, and the Netherlands. But when its score is adjusted for inequality, it drops 23 spots – among the largest such declines for any highly developed country. Indeed, the US falls below Greece and Slovakia, countries that people do not typically regard as role models or as competitors with the US at the top of the league tables.

The UNDP report emphasizes another aspect of societal performance: vulnerability. It points out that while many countries succeeded in moving people out of poverty, the lives of many are still precarious. A small event – say, an illness in the family – can push them back into destitution. Downward mobility is a real threat, while upward mobility is limited.

In the US, upward mobility is more myth than reality, whereas downward mobility and vulnerability is a widely shared experience. This is partly because of America’s health-care system, which still leaves poor Americans in a precarious position, despite President Barack Obama’s reforms.

Those at the bottom are only a short step away from bankruptcy with all that that entails. Illness, divorce, or the loss of a job often is enough to push them over the brink.

 

To continue reading go here: http://www.project-syndicate.org/commentary/economic-failure-individual-insecurity-by-joseph-e--stiglitz-2014-10

[description] => While many countries succeeded in moving people out of poverty, the welfare of a growing number is precarious. An economic system that fails to deliver gains for most of its citizens, and in which a rising share of the population faces increasing insecurity, is, in a fundamental sense, a failed economic system. [author] => Joseph Stiglitz [legacyinterface_firm_id] => 345 [published_on] => 2014-10-13 [digest_date] => 2014-10-13 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-13 13:59:49 [created_by] => 945 [modified_on] => 2014-10-13 14:00:35 [modified_by] => 945 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1671 [hits] => 0 ) [19] => stdClass Object ( [legacyinterface_commentary_id] => 1606 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14847 [apv_conversation_id] => 2506 [content_type] => market-commentary [title] => Is the UK Getting Back to Business as Usual?​ [slug] => pimco_101314 [fulltext] =>
  • ​In light of the generally buoyant economy, we may start to see more normal conditions returning to the UK labour market and, importantly, upward movement in wage growth over the cyclical horizon. 
  • In turn, these developments are critical for the conduct and timing of monetary policy and the behaviour of the Bank of England’s (BOE) Monetary Policy Committee. 
  • We believe investors may want to treat the BOE’s interest rate cycle with caution​ in shorter-maturity bonds, while valuations offer more protection in intermediate bonds given PIMCO’s New Neutral thesis of secularly low real interest rates.
​​

Over recent months, a combination of geopolitics, weak inflation and most recently the Scottish referendum have all raised genuine questions over when, and by how much, UK interest rates will rise. In particular, very benign wage growth, below-target inflation and questions over the economic outlook for the eurozone have pushed expectations of the start of the UK hiking cycle to Q2 2015. In the knowledge that the UK will not be going through a challenging period of separation from Scotland, and while issues remain in the Middle East and Ukraine, this appears a good time to take stock and revisit the underlying performance of the economy and in turn the outlook for interest rates.

Before turning to the economic outlook for the UK, it is worth noting that one of the most interesting aspects of the market is the implied pricing of the Bank of England’s (BOE) first rate hike by Q2 2015, which to my mind is the least likely date for the start of any monetary cycle. This in large part relates to the cycle of meetings of the BOE’s Monetary Policy Committee (MPC), and their coincidence with the May 2015 general election. It seems highly likely that, when the MPC do get round to the first hike, BOE Governor Mark Carney will want to explain the MPC’s thinking in some detail. After all, the last UK rate hike was in July 2007, some seven years ago. Not a single current member of the MPC has raised interest rates in the UK. That suggests that the first rate hike will come alongside the quarterly forecasting round at the BOE, which results in the publication of the quarterly inflation report and accompanying press conference. The quarterly cycle runs in February, May, August and November each year. Thus the timing is such that the May decision and inflation report will be within days of the 2015 general election.

While we fully accept the MPC rhetoric that the political cycle will not weigh on its decisions, we think it is hard for the MPC to say anything else and equally hard to actually make the first move at such a politically charged moment. That brings us back to the question: Will the recovery be sufficiently well-entrenched to allow the MPC to start the hiking cycle ahead of the general election, or will we find that MPC guidance persistently indicates that rates are going up, but not yet?

Staying the course

A look at the underlying dynamics indicates the economy retains good momentum. GDP data has exhibited more volatility than the monthly purchasing manager index (PMI) over the last decade (see Figure 1), and there is a long-standing debate about which provides the higher-quality real-time information on the state of the economy. However, the striking aspect of these series is how they both have been strong for the last two years, and there is little in these series to suggest an imminent slowdown in activity. Most recently, some of the forward‒looking components, such as the new orders series, have come off their peak ‒ but levels remain strong. In short, the domestic tailwinds to growth appear to remain.

 

We can also see that the economy is holding up well by looking at a range of other business surveys, where investment intentions remain strong, as do the all-important surveys of employment intentions. Employment growth has been remarkably strong in this recovery (see Figure 2), currently running at levels not seen since the late 1980s.

 

While this all speaks to economic momentum being maintained, it does not answer the key question of why wage growth has remained so weak, and whether it will remain so. Given that inflation appears stable at 1.5%, as long as wages remain so weak, there will be little appetite for the MPC to raise interest rates (indeed, there would be no good reason to hike rates).

About that raise …

To answer the puzzle of low wage growth, we should look at not just the rate of improvement in the demand for labour, but also the level of demand relative to the level of supply. Indeed, if the level of supply still overwhelms the absolute amount of demand, it would be no great surprise that wage growth is so weak, particularly with the dark days of 2008 and 2009 so fresh in many people’s minds.

This indeed does appear to provide one potential answer to the puzzle of weak wage growth. Job centre vacancies in the UK have been rising strongly since mid-2012, rising from 450,000 to 650,000 at the most recent reading in July this year. These levels of vacancies are very similar to the average level of vacancies in the 10 years prior to the collapse of Lehman Brothers in 2008 (the average number of vacancies was 610,000). However, the number of unemployed is still materially higher than the decade prior to the collapse of Lehman Brothers, with a current number of 2.02 million compared with an average of 1.575 million in the decade prior to September 2008, according to the Office for National Statistics. So, putting the demand for labour in the context of the supply of labour, it should not be a big surprise that wage growth is weak. At present, average hourly earnings are growing at 0.6%, compared with the 4%–5% prior to September 2008.

That raises the obvious question: How long will it take the UK to use up that spare labour market capacity, and in turn see wages start to rise? While there are many caveats to any forecast, there are ways in which we can start to answer this question. One way is to look at the ratio of job centre vacancies to the total number of unemployed, and see how that compares to real wage growth (defined as average hourly earnings less CPI). Looking at Figure 3, the ratio of vacancies-to-unemployment remains below even the cyclical lows prior to the financial crisis, and in turn real wages are very weak. However, looking forward, if we were to assume that vacancies remain unchanged but that the unemployment rate continues to fall by 0.75% per annum, we could get an estimate as to how quickly the economy will reach the point of traction in wage growth.

Given current economic momentum, this is a pretty conservative set of assumptions for unemployment, which has fallen by 1.5% in the last 12 months. Under these assumptions, we should start to see upwards momentum in wage growth over the next six months.

Looking at market timing in a little more detail, the above projections suggest that the October 2014 data set will show vacancies as a percentage of the unemployed reaching the prior cycle lows, when we should start to see more normal conditions returning to the labour market. We believe that it is unlikely that real wage growth will return to 2% above inflation in the next 12 months, given the other factors pressing down on wages such as tighter controls on benefits, increasing numbers of over-65-year-olds remaining in the labour market and immigration.

However, we should be able to see real wages finally get back towards a positive number after six years of real wage contraction. This is critical for the conduct of monetary policy and the behaviour of the MPC. As the MPC members have been keen to make everyone aware, monetary policy works with a lag. Thus, they need not wait to see the actual rise in wages, but just to be confident that the rise in wages is coming, and that it will more than offset any productivity improvements. If that is the case, we should still expect to see the first rate hike this side of the general election, with the February 2015 MPC meeting and inflation report the most likely period.

Are we there yet?

If that is the case, then shorter-dated UK bonds will be vulnerable over the next six months, and are likely to be the focal point for any market weakness. Further out on the curve, PIMCO’s New Neutral base rate of 2%–2.5% implicit in the structure of the gilt curve suggests fairer valuations.

The UK remains a highly levered economy sensitive to changes in asset prices, especially housing. As such, treat the interest cycle with caution in shorter-maturity bonds, but remember the economic healing has a long way to go. That will temper this rate cycle (and probably the one after that). ​

© PIMCO

www.pimco.com

[description] => In light of the generally buoyant economy, we may start to see more normal conditions returning to the UK labour market and, importantly, upward movement in wage growth over the cyclical horizon. In turn, these developments are critical for the conduct and timing of monetary policy and the behaviour of the Bank of England's (BOE) Monetary Policy Committee. We believe investors may want to treat the BOE's interest rate cycle with caution in shorter-maturity bonds, while valuations offer more protection in intermediate bonds given PIMCO's New Neutral thesis of secularly low real interest rates. 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[attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) ) ) [env] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [request] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [start] => 820 [limitstart] => 820 [option] => com_legacyinterface [view] => commentaries [Itemid] => 616 ) [inputs:protected] => Array ( ) ) [server] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [HTTP_AUTHORIZATION] => [HTTP_HOST] => apdev.hubtech.tv [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/) [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8 [HTTP_IF_MODIFIED_SINCE] => Sun, 18 Mar 2018 23:21:17 GMT [PATH] => /sbin:/usr/sbin:/bin:/usr/bin [SERVER_SIGNATURE] => [SERVER_SOFTWARE] => Apache/2.4.16 (Amazon) PHP/5.5.31 [SERVER_NAME] => apdev.hubtech.tv [SERVER_ADDR] => 10.28.13.29 [SERVER_PORT] => 80 [REMOTE_ADDR] => 54.198.119.26 [DOCUMENT_ROOT] => /var/www/html/apcms [REQUEST_SCHEME] => http [CONTEXT_PREFIX] => [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms [SERVER_ADMIN] => ben@hubtech.tv [SCRIPT_FILENAME] => /var/www/html/apcms/index.php [REMOTE_PORT] => 44138 [GATEWAY_INTERFACE] => CGI/1.1 [SERVER_PROTOCOL] => HTTP/1.0 [REQUEST_METHOD] => GET [QUERY_STRING] => start=820 [REQUEST_URI] => /?start=820 [SCRIPT_NAME] => /index.php [PHP_SELF] => /index.php [REQUEST_TIME_FLOAT] => 1527336558.913 [REQUEST_TIME] => 1527336558 ) [inputs:protected] => Array ( ) ) [session] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [__default] => Array ( [session.counter] => 1 [session.timer.start] => 1527336559 [session.timer.last] => 1527336559 [session.timer.now] => 1527336559 [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/) [registry] => Joomla\Registry\Registry Object ( [data:protected] => stdClass Object ( [com_legacyinterface] => stdClass Object ( [commentaries] => stdClass Object ( [limitstart] => 820 [filter_order] => published_on [filter_order_Dir] => desc ) ) ) ) [user] => JUser Object ( [isRoot:protected] => [id] => 0 [name] => [username] => [email] => [password] => [password_clear] => [block] => [sendEmail] => 0 [registerDate] => [lastvisitDate] => [activation] => [params] => [groups] => Array ( [0] => 9 ) [guest] => 1 [lastResetTime] => [resetCount] => [requireReset] => [_params:protected] => Joomla\Registry\Registry Object ( [data:protected] => stdClass Object ( ) ) [_authGroups:protected] => Array ( [0] => 1 ) [_authLevels:protected] => Array ( [0] => 1 [1] => 1 ) [_authActions:protected] => [_errorMsg:protected] => [_errors:protected] => Array ( ) [aid] => 0 ) ) ) [inputs:protected] => Array ( ) ) [jrequest] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) ) ) [files] => JInputFiles Object ( [decodedData:protected] => Array ( ) [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [env] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [request] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [start] => 820 [limitstart] => 820 [option] => com_legacyinterface [view] => commentaries [Itemid] => 616 ) [inputs:protected] => Array ( ) ) [server] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [HTTP_AUTHORIZATION] => [HTTP_HOST] => apdev.hubtech.tv [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/) [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8 [HTTP_IF_MODIFIED_SINCE] => Sun, 18 Mar 2018 23:21:17 GMT [PATH] => /sbin:/usr/sbin:/bin:/usr/bin [SERVER_SIGNATURE] => [SERVER_SOFTWARE] => Apache/2.4.16 (Amazon) PHP/5.5.31 [SERVER_NAME] => apdev.hubtech.tv [SERVER_ADDR] => 10.28.13.29 [SERVER_PORT] => 80 [REMOTE_ADDR] => 54.198.119.26 [DOCUMENT_ROOT] => /var/www/html/apcms [REQUEST_SCHEME] => http [CONTEXT_PREFIX] => [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms [SERVER_ADMIN] => ben@hubtech.tv [SCRIPT_FILENAME] => /var/www/html/apcms/index.php [REMOTE_PORT] => 44138 [GATEWAY_INTERFACE] => CGI/1.1 [SERVER_PROTOCOL] => HTTP/1.0 [REQUEST_METHOD] => GET [QUERY_STRING] => start=820 [REQUEST_URI] => /?start=820 [SCRIPT_NAME] => /index.php [PHP_SELF] => /index.php [REQUEST_TIME_FLOAT] => 1527336558.913 [REQUEST_TIME] => 1527336558 ) [inputs:protected] => Array ( ) ) [session] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [__default] => Array ( [session.counter] => 1 [session.timer.start] => 1527336559 [session.timer.last] => 1527336559 [session.timer.now] => 1527336559 [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/) [registry] => Joomla\Registry\Registry Object ( [data:protected] => stdClass Object ( [com_legacyinterface] => stdClass Object ( [commentaries] => stdClass Object ( [limitstart] => 820 [filter_order] => published_on [filter_order_Dir] => desc ) ) ) ) [user] => JUser Object ( [isRoot:protected] => [id] => 0 [name] => [username] => [email] => [password] => [password_clear] => [block] => [sendEmail] => 0 [registerDate] => [lastvisitDate] => [activation] => [params] => [groups] => Array ( [0] => 9 ) [guest] => 1 [lastResetTime] => [resetCount] => [requireReset] => [_params:protected] => Joomla\Registry\Registry Object ( [data:protected] => stdClass Object ( ) ) [_authGroups:protected] => Array ( [0] => 1 ) [_authLevels:protected] => Array ( [0] => 1 [1] => 1 ) [_authActions:protected] => [_errorMsg:protected] => [_errors:protected] => Array ( ) [aid] => 0 ) ) ) [inputs:protected] => Array ( ) ) [jrequest] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) ) ) [post] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [cookie] => JInputCookie Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [files] => JInputFiles Object ( [decodedData:protected] => Array ( ) [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [env] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [request] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [start] => 820 [limitstart] => 820 [option] => com_legacyinterface [view] => commentaries [Itemid] => 616 ) [inputs:protected] => Array ( ) ) [server] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [HTTP_AUTHORIZATION] => [HTTP_HOST] => apdev.hubtech.tv [HTTP_ACCEPT_ENCODING] => x-gzip, gzip, deflate [HTTP_USER_AGENT] => CCBot/2.0 (http://commoncrawl.org/faq/) [HTTP_ACCEPT] => text/html,application/xhtml+xml,application/xml;q=0.9,*/*;q=0.8 [HTTP_IF_MODIFIED_SINCE] => Sun, 18 Mar 2018 23:21:17 GMT [PATH] => /sbin:/usr/sbin:/bin:/usr/bin [SERVER_SIGNATURE] => [SERVER_SOFTWARE] => Apache/2.4.16 (Amazon) PHP/5.5.31 [SERVER_NAME] => apdev.hubtech.tv [SERVER_ADDR] => 10.28.13.29 [SERVER_PORT] => 80 [REMOTE_ADDR] => 54.198.119.26 [DOCUMENT_ROOT] => /var/www/html/apcms [REQUEST_SCHEME] => http [CONTEXT_PREFIX] => [CONTEXT_DOCUMENT_ROOT] => /var/www/html/apcms [SERVER_ADMIN] => ben@hubtech.tv [SCRIPT_FILENAME] => /var/www/html/apcms/index.php [REMOTE_PORT] => 44138 [GATEWAY_INTERFACE] => CGI/1.1 [SERVER_PROTOCOL] => HTTP/1.0 [REQUEST_METHOD] => GET [QUERY_STRING] => start=820 [REQUEST_URI] => /?start=820 [SCRIPT_NAME] => /index.php [PHP_SELF] => /index.php [REQUEST_TIME_FLOAT] => 1527336558.913 [REQUEST_TIME] => 1527336558 ) [inputs:protected] => Array ( ) ) [session] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [__default] => Array ( [session.counter] => 1 [session.timer.start] => 1527336559 [session.timer.last] => 1527336559 [session.timer.now] => 1527336559 [session.client.browser] => CCBot/2.0 (http://commoncrawl.org/faq/) [registry] => Joomla\Registry\Registry Object ( [data:protected] => stdClass Object ( [com_legacyinterface] => stdClass Object ( [commentaries] => stdClass Object ( [limitstart] => 820 [filter_order] => published_on [filter_order_Dir] => desc ) ) ) ) [user] => JUser Object ( [isRoot:protected] => [id] => 0 [name] => [username] => [email] => [password] => [password_clear] => [block] => [sendEmail] => 0 [registerDate] => [lastvisitDate] => [activation] => [params] => [groups] => Array ( [0] => 9 ) [guest] => 1 [lastResetTime] => [resetCount] => [requireReset] => [_params:protected] => Joomla\Registry\Registry Object ( [data:protected] => stdClass Object ( ) ) [_authGroups:protected] => Array ( [0] => 1 ) [_authLevels:protected] => Array ( [0] => 1 [1] => 1 ) [_authActions:protected] => [_errorMsg:protected] => [_errors:protected] => Array ( ) [aid] => 0 ) ) ) [inputs:protected] => Array ( ) ) [jrequest] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) ) ) [list:protected] => Array ( [0] => stdClass Object ( [legacyinterface_commentary_id] => 1635 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14875 [apv_conversation_id] => [content_type] => market-commentary [title] => Dilma or No Dilma? [slug] => confluence_101514 [fulltext] =>

During the first round of Brazilian presidential elections on October 5, the incumbent Dilma Rousseff of the Workers’ Party received 42% of the votes while Aecio Neves of the Social Democracy Party received 34%.  Since none of the candidates received more than 50% of the vote, the second round of runoff elections will be held on October 26.  Currently, Rousseff leads the polls, signaling a likely continuation of state-centric policies.

The results from these elections are significant for the Brazilian domestic economy as well as foreign investors.  Whether Rousseff or Neves wins, the next president will inherit a low growth and high inflation environment.  Additionally, the incoming president will have to deal with high government spending while maintaining the high social spending that the ruling party has relied on for populist support.  The growing domestic middle class is demanding an end to corruption and better social services. 

Foreign investors are also closely watching these elections as a win for Neves could signal a more market-friendly political environment with better government fiscal responsibility and political transparency.

This week, we will look at the Brazilian presidential elections along with the current political and economic environment in the country.  We will briefly describe the recent political history of the country and look at the specifics of Brazil’s economic development.  As usual, we will conclude with market ramifications.

Recent History

Brazil’s population of 199 million makes it the fifth largest country in the world in terms of population.  Population growth has been rapid as the absolute number has doubled over the past 30 years.  Brazil is the seventh largest country in terms of total economic size. 

We need to remember that Brazil is still very new to the international markets as well as democracy.  The country was ruled by the military from 1964 to 1985.  During this time, civil rights were severely repressed while the military tried to implement economic reform.  In 1985, the military peacefully ceded power to civilian rulers, and the country held its first democratic election in 1989 with great enthusiasm.  The new government was able to get inflation under control through onerous reforms.  The constitution was ratified in 1988 and its new currency was introduced in 1994. 

Over the past decade, Brazil has benefited greatly from the surge in commodity prices.  The wealth effect was multiplied by capital inflows and credit expansion. Recently, discontent has grown as economic growth has slowed and inflation has risen.

Brazilian economic growth has mostly faltered due to weakening global commodity demand.  The Brazilian central bank forecasts that Brazilian GDP growth will be 0.7% in 2014.  The chart below shows the yearly GDP growth rates, which topped at

9.1% in 2010, when commodity demand from China boosted growth. 


Brazil’s recent growth has relied on commodity exports, especially soy beans, iron ore and oil.  With grain prices falling on increasing supplies and industrial metals prices falling on soft demand, Brazil’s main exports have been hit on both price and quantity.

At the same time, Brazilian manufacturing has become less competitive and its importance has been overshadowed by its reliance on commodities. Additionally, the country’s strong currency and structural inefficiencies have made Brazilian companies uncompetitive in the export markets.  Trade barriers, direct competition from China and inherent difficulties brought on by Brazil’s lack of infrastructure to accommodate for its size and difficult terrain have also hindered export growth.

Infrastructure has remained a constant bottleneck for the country as railway systems are in their infancy, the river system is not accessible enough for reliable transportation and the roadway systems remain in poor condition.  This is especially relevant since the country produces many low value-to-weight commodities. 

Mercosur, the South American trade bloc which includes Brazil, is likely to remain a drag on the economy due to its trade barriers.  Additionally, Mercosur’s charter has limited Brazil’s ability to sign trade agreements with other countries as a new agreement for any member country requires unanimous approval from all the member countries.

Commodity Addiction

Given the importance of commodity exports to the country, the political process is also shaped by the needs of commodity producers.  The crops that have historically done particularly well in the country are coffee and sugar, neither one of which is easily mechanized.  Therefore, both industries need large pools of low-skilled labor.  Due to this need there is a great disincentive to advance educational opportunities, resulting in a small pool of skilled workers and a large number of unskilled workers, in turn creating labor and infrastructure bottlenecks.  During periods of strong growth, the lack of skilled labor tends to cause capacity constraints, making it difficult to boost productivity.  Thus, Brazil faces persistent inflation pressures.

Historically, Brazil has been one of the highest inflation and lowest growth countries among emerging economies.  For example, inflation reached 2,000% per year in the 1980s.  The solution to this high inflation was an arduous path for the country, with capital controls, heavy bank regulation and deep cuts to the government’s budget.  In the early 2000s, investors dove into emerging markets; this, coupled with Brazil’s falling inflation as a result of deep-seated reforms, resulted in large inflows of capital into the Brazilian markets.  As a result, the Brazilian currency, the real, has appreciated and in turn made Brazilian manufacturing uncompetitive.  It is important to remember that the Brazilian economy is mostly commodity related and low skilled, so exports need to compete on pricing rather than the value-added sphere. 

Inequality

Brazil has successfully lifted about a quarter of its population into the middle class category in the past 10 years.  This is no small feat.  By comparison, China moved the same proportion of people out of poverty over the course of 30 years.  Brazil has been successful in alleviating poverty for the elderly as a result of comprehensive pension reform.  However, this has left little money for educational reform, and commodity dependence has created a need for a large, low-skilled labor pool.  However, in order to sustain the pace of improvements in living standards and support social mobility and equality, the availability and quality of education is crucial.  Additionally, Brazil has been undergoing slowing population growth rates since the 1960s, which will soon lead to a significant demographic transition.  The aging population and current low investment levels into human capital could hinder growth possibilities.

That being said, the country’s large middle class supports the growing domestic market demand and makes the economy more robust.  This is not the case for many emerging markets.  A study by the Brookings Institute indicates that about half of Brazil’s population is now considered middle class compared to 10% in China.

Even through the recent economic slowdown, the expanding middle class has maintained its expectations for uninterrupted economic growth.  Given the country’s commodity reliance and the slowdown in end market demand, it is unlikely that either candidate will be able to meet these enhanced expectations. 

Government

Brazil’s government spending is large, approximately 40% of GDP.  Government spending in comparable countries stands at about 25%.  At these levels, public funds crowd out private investments.  Since government investment is centrally controlled, it is generally less market efficient than its private counterpart.  Although the country needs huge infrastructure improvements, the government is spending only about 2% of its funds on infrastructure.  As a comparison, emerging markets in general are spending about 5%, with China as an outlier at 10%.  Additionally, Brazil spends 5% of GDP on pensions for civil servants, more than twice the amount of infrastructure spending.

The issues cited above are unlikely to improve quickly.  Reforms are implemented slowly in Brazil and oftentimes favoritism and vested interests keep the country from implementing the changes needed.

Infrastructure spending is technically difficult due to geography, and requires large amounts of investment and high levels of expertise.  However, linking the interior and the various coastal cities would sustain growth and encourage further foreign direct investments.  Many regulatory hindrances remain in place; as the World Bank reports, it takes an average of 119 days to set up a business in Brazil, the fifth longest period in the world.    

Another public grievance is widespread corruption.  Most recently, two people confessed to being part of a corruption ring involving the state oil company, Petrobras.  Allegedly, 3% of the company’s budget finances corruption.  Some observers claim that corruption has become institutionalized under the current government. 

Rousseff

Dilma Rousseff is the incumbent presidential candidate for the Workers’ Party.  She has been involved in left-wing politics for most of her political career.  She fought against the military dictatorship under the Marxist movement and was jailed under the regime.  She is one of the founders of the Democratic Labor Party, serving in several regional positions for the party.  In 2000, she left the party after an internal dispute to join the Workers’ Party.  She became the energy minister before running for president in 2010. 

She has gained popularity during her presidency for lowering energy and food tax rates.  In the beginning of her presidency, the country benefited from rising Chinese demand for Brazilian commodities and rising prices for those commodities.  This allowed the government to increase public spending without addressing economic inefficiencies.  The slower global growth environment has now surfaced these inefficiencies and discontent among her constituents.  Corruption, slow growth and inflation are only some of the concerns.  At the same time, unemployment has trended lower, maintaining support for Rousseff.

Neves

Aecio Neves is the presidential candidate for the Brazilian Social Democracy Party.  He is an economist by training, and was the governor of the Minas Gerais region for seven years before being elected to represent the region in the Brazilian Federal Senate.  His grandfather was elected president but died before taking office.  Rousseff’s campaign has used Neves’ family background to accuse him of favoring the political elite at the expense of the working class.  However, it does not appear that he has done so during his political career.

As governor, Neves introduced reforms to balance the local government’s budget, known as the “Management Shock” program, which was aimed at reducing government spending and improving the quality of services and productivity of state institutions. Neves also promoted private investment, especially in infrastructure.  On the education front, he initiated a program to boost high school graduation rates.

As president, Neves has promised to address corruption, introduce fiscal responsibility and design policies to control inflation.

Ramifications

None of the limitations that hamper Brazil’s economy can be removed in the near term, no matter which candidate is in office.  In the short run, however, the outcome of the presidential election will signal the country’s willingness to reform and become fiscally responsible and politically transparent, which will determine the direction and strength of capital flows.  If Neves wins, capital inflows would increase in anticipation of economic reform.  Brazilian markets rose after a poll showed that Rousseff and Neves are now tied in the runoff elections, whereas Neves had lagged in prior polls. 

Brazil faces economic difficulties that are related to its dependency on commodities and manufacturing weaknesses, especially in a slower global growth environment.  For foreign investors, Brazilian domestic economic indicators are just as important as the strength of the economies that import Brazilian commodities, especially China.  If the Chinese economy is slowing, we are likely to see a disproportionately larger deceleration in Brazilian economic growth.  For these reasons, Brazil is often referred to as the “end of the whip” in global economic growth.  On the other hand, if the Chinese government decides to pursue further investment growth, we could see limited strength in the Brazilian economy.  However, given the global inventory overhang of industrial metals and oil, the boost in growth could be delayed.  Lacking significantly stronger commodity demand from China, Brazilian commodity exports are likely to remain subdued.

Domestically, controlling inflation and continuing social welfare programs are key priorities in avoiding social unrest.  Rousseff has used social spending to placate dissatisfaction, but if the government is serious about getting its spending under control then these social programs may have to be reduced and thus cannot be used to pacify the masses.  If Neves wins, we could see increasing instability from the region if the country moves to limit its social programs.  Additionally, if government subsidies for fuel and electricity are cut, inflation could rise further.  If inflation picks up, a foreign investor should pay close attention to the central bank’s response.  Tightening monetary policy could constrain economic growth in the already weak manufacturing sector. 

Corruption has also soared under Rousseff, a practice which Neves has promised to tackle.  This could introduce further social instability.  Thus, we could see increased geopolitical risk from the region under Neves as the country moves to reform itself.

At the same time, under the incumbent Rousseff, reform and possible social unrest would likely be delayed as she would continue her social policies.  We would see further capital outflows from the country under Rousseff as foreign investors might fear that Brazil will follow in Argentina’s path.

Kaisa Stucke and Bill O’Grady

October 13, 2014

This report was prepared by Bill O’Grady and Kaisa Stucke of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Confluence Investment Management LLC

Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri.  The firm provides professional portfolio management and advisory services to institutional and individual clients.  Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach.  The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives.  The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication.  

© Confluence Investment Management

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You don’t need a weatherman
To know which way the wind blows.

– Bob Dylan, “Subterranean Homesick Blues,” 1965

Full fathom five thy father lies.
Of his bones are coral made.
Those are pearls that were his eyes.
Nothing of him that doth fade,
But doth suffer a sea-change
Into something rich and strange.

– William Shakespeare, The Tempest

Did you feel the economic weather change this week? The shift was subtle, like fall tippy-toeing in after a pleasant summer to surprise us, but I think we’ll look back and say this was the moment when that last grain of sand fell onto the sandpile, triggering many profound fingers of instability in a pile that has long been close to collapse. This is the grain of sand that sets off those long chains of volatility that have been gathering for the last five years, waiting to surprise us with the suddenness and violence of the avalanche they unleash.

I suppose the analogy sprang to mind as I stepped out onto my balcony this morning. Texas has been experiencing one of the most pleasant summers and incredibly wonderful falls in my memory. One of the conversations that seem to occur regularly among locals who have a few decades under their belts here, is just how truly remarkable the weather has been. So it was a bit of a surprise to step out and realize the air had turned brisk. In retrospect it shouldn’t have fazed me. The air has been turning brisk in Texas at some point in October for the six decades that my memory covers, and for quite a few additional millennia, I suspect.

But this week, as I worked through my ever-growing mountain of reading, I felt a similar awareness of a change in the economic climate. Like fall, I knew it was coming. In fact, I’ve been writing about it for years! But just as fall tells us that it’s time to get ready for winter, at least in more northerly climes, the portents of the moment suggest to me that it’s time to make sure our portfolios are ready for the change in season.

Sea Change

Shakespeare coined the marvelous term sea change in his play The Tempest. Modern-day pundits are liable to apply the word to the relatively minor ebb and flow of events, but Shakespeare meant sea change as a truly transformative event, a metamorphosis of the very nature and substance of a man, by the sea.

In this week’s letter we’ll talk about the imminent arrival of a true financial sea change, the harbinger of which was some minor commentary this week about the economic climate. This letter is arriving to you a little later this week, as I had quite some difficulty writing it, because, while the signal event is rather easy to discuss, the follow-on consequences are myriad and require more in-depth analysis than I’ve been able to bring to them on short notice. As I wrestled with what to write, I finally came to realize that this sea change is going to take multiple letters to properly describe. In fact, it might eventually take a book.

So, in a departure from my normal writing style, I am going to offer you a chapter-by-chapter outline for a book. As with all book outlines, it will be simply full of bones but without much meat on them, let alone dressed up with skin and clothing. I will probably even connect the bones in the wrong order and have to go back later and replace a leg bone with a rib, but that is what outlines are for. There is clearly enough content suggested by this outline to carry us through the next several months; and given the importance of the subject, I expect to explore it fully with you. Whether it actually becomes a book, I cannot yet say.

I should note that much of what follows has grown out of in-depth conversations with my associate Worth Wray and our mutual friends. We’ve become convinced that the imbalances in the global economic system are such that the risks are high that another period of economic volatility like the Great Recession is not only likely but is now in the process of developing. While this time will be different in terms of its causes and symptoms (as all such stressful periods differ from each other in many ways), there will be a rhyme and a rhythm that feels all too familiar. That should actually be good news to most readers, as the last 14 years have taught us a little bit about living through periods of economic volatility. You will get to use those skills you learned the hard way.

This will not be the end of the world if you prepare properly. In fact, there will be plenty of opportunities to take advantage of the coming volatility. If the weatherman tells you winter is coming, is he a prophet of doom? Or is it reasonable counsel that maybe we should get our winter clothes out?

Three caveats before we get started. One, I am often wrong but seldom in doubt. And while I will marshal facts and graphs aplenty to reinforce my arguments, I would encourage you to think through the counterfactuals presented by those who will aggressively disagree.

Two, while it goes without saying, you are responsible for your own decisions. It is easy for me to say that I think the bond market is going to go in a particular direction. I can even bet my personal portfolio on my beliefs. I can’t know your circumstances, but if you are similar to most investors, this is the time to make sure you have a truly balanced portfolio with serious risk management in the event of a sudden crisis.

Three, give me (and Worth, whom I am going to draft to write some letters) some time to develop the full range of our ideas. To follow on with my weather analogy, the air is just starting to get crisp, and winter is still a couple months away. Absent something extraordinary, we are not going to get snow and a blizzard in Dallas, Texas, tomorrow. We may still have some time to prepare, but at a minimum it is time to start your preparations. So with those caveats, let’s look at an outline for a potential book called Sea Change.

Prologue

I turned publicly bearish on gold in 1986. At the time (a former life in a galaxy far, far away), I was actually writing a newsletter on gold stocks and came to the conclusion that gold was going nowhere – and sold the letter. I was still bearish some 16 years later. Then, on March 1, 2002, I wrote in Thoughts from the Frontline that it was time to turn bullish on gold. Gold at that time was languishing around $300 an ounce, near its all-time bottom.

What drove that call? I thought that the future directions of gold and the dollar were joined at the hip. A bit over a year later I laid out the case for a much weaker dollar in a letter entitled “King Dollar Meets the Guillotine,” which later became the basis for a chapter in Bull’s Eye Investing. As the chart below shows, the dollar had risen relentlessly through the early Reagan years, doubling in value against the currencies of America’s global neighbors, causing exporters to grumble about US dollar policy. Then the bottom fell out, as the dollar made new lows in 1992. From 1992 through 2002 the dollar recovered about half of its value, getting back to roughly where it was in 1967. Elsewhere about that time, I predicted that the euro, which was then at $0.88, would rise to $1.50 before falling back to parity over a very long period of time. I believe we are still on that journey.

One of the biggest drivers of economic fortunes in the global economy is the currency markets. The value of your trading currency affects every aspect of your business and investments. It is fundamental in nature. While most Americans never even see a piece of foreign currency, every time we walk into Walmart, we are subject to the ebb and flow of global currency valuations, as are Europeans and indeed every person who participates in the movement of goods and services around the globe. In fact, globalization means that currency values are more important than ever. The world is more tightly interconnected now than it has ever been, which means that events which previously had no effect upon global affairs can trigger cascades of events that affect everyone.

I believe we are in the early stages of a profound currency-valuation sea change. I have lived through five major changes in the value of the dollar in the 45 years since Nixon closed the gold window. And while we are used to 40% to 50% moves in the stock market and other commodity prices happening in just a few years (or less), large movements in major trading currencies typically take many years, if not decades, to develop. I believe we are in the opening act of a multi-year US dollar bull market.

Chapter 1 – The Boys Who Cry Wolf

We all know the story of the boy who cried “Wolf!” once too often. I have been pounding the table about a dollar bull market for about three years now. I see eyes roll when I speak at conferences around the world and boldly forecast that the dollar is going to get stronger than anyone in the room can possibly fathom. All the signs have been pointing to it, and indeed we’ve seen the dollar move upward in a rather herky-jerky fashion off the lows of 2010, but not in a way that has been all that dramatic (except, arguably, against the Japanese yen). Indeed, the relative trading range of the dollar has been relatively constrained over the past six to seven years, pivoting around 80 on the DXY (symbol for the US dollar spot index).

This is in contrast to the true doom-and-gloomers, who are forecasting “the Demise of the Dollar.” At the same time, they are calling for an unseemly rise in interest rates, and many of them believe the Federal Reserve will push us over the brink into hyperinflation. Needless to say, then, you should buy massive amounts of gold and get your money out of the country.

I have had long conversations with many who believe in such a scenario. I call some of them close friends, even if we disagree on something as fundamental as the future of the dollar. I’ve come to the conclusion that their conviction is a lot like a religious belief.  I’m not going to change them, and so I make very little effort to try. So, fair and friendly warning: if you think the US dollar is headed to oblivion, you are not going to like this book outline or the next few months of my letter.

(Sidebar to those of you who, like me, own gold. You do not have to be a dollar bear to be constructive on gold and believe that it belongs in a diversified portfolio. But more on that front if we do a chapter on gold.)

Getting back to portents of winter, this week saw two side comments by Federal Reserve members that put a distinct chill in the air.

The first is from William Dudley, the president of the Federal Reserve Bank of New York and a permanent voting member on the FOMC. In a speech at Rensselaer Polytechnic Institute, he pushed back on the idea that it is time to raise rates. While acknowledging the relatively positive stance of the Federal Reserve in its forecast, he said:

While I believe that the risks around this consensus forecast are reasonably well balanced, I also believe that the likelihood that growth will be substantially stronger than the point forecast is probably relatively low. [my emphasis]

He went on to cite weaker than expected consumer spending and the expectation that consumer durable purchases will be weaker in the future (by which I assume he means automobiles, which have been on a blistering, back-to-the-all-time-high pace due to supereasy credit, much of it subprime and with durations beyond five years.) He faults mortgage lenders for the substandard housing recovery, as if the last massacre of lenders was not enough to scar their collective psyche for decades.

(Sadly, he might have a point. Somewhat humorously, Ben Bernanke tells us he was turned down for a mortgage because his income is somewhat unsteady. He did not fit the “check-the-box” protocol of his local mortgage lender. I sympathize. I was turned down multiple times earlier this year before finding willing lenders who actually competed for my business. My business life does not accord with a standard check-the-box mortgage. I read about another business owner who noted that any of his 300 employees could get a mortgage, but he could not because his income was not stable enough. Go figure.)

Each of Dudley’s points was covered in long paragraphs. And then he delivered a short, throwaway line that caught my attention. He cited the growth in the exchange value of the dollar over the last few months as a reason for downside risk. Really? Go back and look at the chart above and see the relatively minor dollar moves of the past few months. Why should dollar strength show up in a list of reasons for upcoming weakness in the US economy?

The next day saw the release of the minutes of the previous month’s FOMC meeting. In the part labeled “Staff Review of the Financial Situation,” the staff mentioned “… responding in part to disappointing economic data abroad, the US dollar appreciated against most currencies over the inter-meeting period, including large appreciations against the euro, the yen, and the pound sterling.”

While there are precedents for the staff review to mention the dollar, it doesn’t happen often. (In January 2002 the staff notes included concern about the strength of the dollar. That concern went away rather quickly. Coincidence? Hat tip, Joan McCullough.) The strengthening dollar is clearly on the minds of the members and staff of the Federal Reserve. Hmmm…

The key here is to note that the strength of the dollar (or lack of it) is not traditionally a Federal Reserve concern. The relative value of the dollar is the purview of the US Treasury, while the Federal Reserve is responsible for maintaining stable purchasing power (interest rates and money supply, etc.). Both organizations are careful not to tread on the other’s territory.

What if we are at the beginning of another 10-year bull market in the dollar? Is it unthinkable that the value of the dollar could rise back to 120 on the index over that time? Let’s look at that chart again:

From a very long-term perspective, 100 on that index is certainly a possibility, and 120 is not without precedent. But if the dollar rises to those levels, even in the very short-term, volatile patterns of the past, it changes everything it touches. And the value of the dollar touches everything. So let’s think about some of the consequences over the long term of a rising dollar.

Chapter 2 – A Monkey Wrench for the Fed

A rising dollar is almighty inconvenient for a Federal Reserve that would like to eventually raise interest rates. Multiple regional Fed presidents and Fed governors would really like to see inflation in the 2% range prior to raising rates.

A dollar that is rising against the currencies of our major trading partners is inherently disinflationary, if not outright deflationary. (Pay attention to how often that word deflation occurs in this outline.) The current inflation rate is 1.7%. The Dallas trimmed-mean PCE inflation rate was actually negative in August and has been falling for the last five months, more or less coinciding with the rising dollar.

The makeup of the Federal Reserve FOMC voting membership next year is going to be decidedly “dovish.” Dallas Fed President Richard Fisher will retire, and his voice will no longer be present. Yellen and the entire team (with two notable exceptions) have been out and about using the words data-dependent, with Minneapolis Fed President Kocherlakota arguing that raising rates anytime in 2015 would be a mistake.

Look at what Federal Reserve unemployment and inflation-rate predictions are as of September 17:

Fourteen of the 17 members of the Fed (including the 12 regional presidents) anticipate that rates will be raised in 2015.  Most observers think the first rate increase will happen at the June meeting.

What happens if unemployment continues to fall toward 5.5% and inflation drops below 1.5%? Can this Fed – not you or I, but the aggressively Keynesian members sitting on that board – justify raising rates if inflation is only 1.5% and falling? Which is the more important data number, unemployment or inflation? Or do they both need to click into place?

If the dollar were to continue to rise and thus allow Europe and Japan to export their deflation to the US, it is not clear that the Fed would raise rates in June.

A rise in the dollar from its current 85 on the DXY to 120 over the next six or seven years will throw a monkey wrench into the plans of the Federal Reserve.

Chapter 3 – Every Central Bank for Itself

A rising dollar presents all sorts of problems and opportunities for the central banks of the world. Japan has chosen the most aggressive monetary policy in the history of the world and will, I believe, work to see the value of the yen cut in half over time. Notice in the chart below that it was only 20 years ago that the yen was at 250. It touched 150 less than eight years ago. Forty years ago it was at 357. Is it so unthinkable that the yen could retrace half that move? Not to the Japanese. That would take it into the range of 200 to the dollar. I made the case for such a move in Endgame and doubled down on the prospects for Japan in Code Red. Japan is a bug in search of a windshield. The yen is embarked on a multi-year decline.

Europe would clearly like to see a weaker euro against the dollar and other major trading currencies. Ditto for almost every central bank in the world. But a rising dollar creates special problems for China and some emerging markets, problems we will look at in later chapters.

In an important speech on Saturday, October 11, Fed Vice-Chairman Stan Fischer outlined the mechanisms for the international transmission of monetary policy. Fischer says the international effects of monetary policy “spill back” onto the US, and the central bank cannot make “sensible” choices without taking them into account.

[T]he U.S. economy and the economies of the rest of the world have important feedback effects on each other. To make coherent policy choices, we have to take these feedback effects into account.

He ended with an assurance to all that the Federal Reserve would provide liquidity to the world in the event of another crisis. Because it is in our interest, he says. This will be the ultimate test of game theory, where it might take years to find the Nash equilibrium.

The bottom line? It’s every central bank for itself. No matter how much pleading there is from peripheral central banks, there will be no true coordination among the major central banks. (Hat tip to David Kotok for alerting me to Fischer’s speech as I was writing. He also pointed out that the unintended consequences of the feedback effect means that policymaking can be dangerous.)

Chapter 4 – The Man Behind the Euro Curtain

Was it only a few years ago that Mario Draghi uttered his famous line, “We will do whatever it takes”? Interest rates in Europe have collapsed since then, as the European bond markets believed that Mario had their back. He has not had to do anything of true significance to back up those words, and what he has done has been lackluster.

This week Mario was up on the stage in Washington DC, where he essentially said that the problems in Europe cannot be fixed by monetary policy but are fiscal and regulatory and require actions from governments, not from central banks. The Bundesbank has clearly held sway, at least so far as the prospects for European quantitative easing go. While Draghi hinted that he would like to do €1 trillion worth of QE, it is not clear exactly how he would go about that.

Mario is like the Wizard of Oz. He talks a good game and puts on a good show, but it is soon going to become apparent that he really doesn’t have any magic, at least not until the Germans allow him to open up his trunk of tricks. Right now they’re keeping it safely stowed away in Berlin.

German intransigence is going to precipitate a crisis in Europe. Italy has been in a recession. France is crossing into one. Spain is barely holding on. Even German exports are slowing. France and Italy are balking at meeting the 3% deficit targets mandated by the EU treaty. Germany has drawn a line in the sand; France and Italy fully intend to cross it. This should be interesting; but however it turns out, I don’t think it will be good for the euro.

How long can interest rates in Europe stay at the irrationally low levels where they are today? We touched on that question in past letters, so I won’t cover that ground again, other than to say negative interest rates in Ireland and France are as indicative of dysfunctional markets as anything one might postulate.

When Draghi loses the narrative, or his ability to simply jawbone the market to where he would like it to be, all hell is going to break loose in the European bond market. Exactly what will the safe-haven currency be? The Swiss can’t print enough francs. Even Norway doesn’t have that many kroner. It will be the US dollar. Implications in a later chapter.

Chapter 5 – The Wrong Side of the Trade

Close to 50% of sales and profits for the S&P 500 come from outside the US. A strong dollar will put a strain on those dollar-denominated profits. Not an insurmountable problem, as Japanese businesses have figured out how to thrive in a rising-yen environment for decades. But old US business dogs are going to have to learn new tricks in a rising-dollar world.

But a strong dollar is not just a problem for US exporters. It is particularly a problem for countries that are financed by the dollar carry trade. Multiple trillions of dollars have left the US courtesy of quantitative easing and have ended up financing all manner of trades and investments around the world. As long as the dollar is neutral or falling, that’s a good thing for dollar carry-trade investors.

If you are a Chinese businessman and you can borrow dollars (which you certainly can) and you believe that your government is going to make the yuan stronger over time, you will be able to pay back cheaper dollars and make the difference on the carry (the difference between what US bonds pay and returns that can be earned in China). But what happens if the yuan begins to fall? That trade unwinds swiftly and negatively. And it unwinds at a time that is particularly inconvenient for China. Flood the market with too much money, and inflation becomes a problem. (The Chinese are in a different phase of the monetary cycle than the US is, so the problems are not the same.)

It is not just China. Those dollars have filtered into every nook and cranny of the world; and now, if those trades are unwound, investors and most specifically hedge funds are going to have to buy dollars to unwind their trades. That will force the dollar ever higher against various currencies; and while any one currency is not significant enough to create a structural difference that can impact global trade, together they will have a significant effect.

There is a crisis brewing in emerging markets. Most of the world’s hedge funds and investors are on the wrong side of the dollar trade. Unwinding that trade is going to be a bitch (that is a technical economics term). Worth Wray will be writing about that very topic in a few weeks. You do not want to miss that letter.

Chapter 6 – The Texas Carry Trade

A rising dollar is going to put pressure on oil prices in particular and on energy prices in general. And falling oil prices have a strong secondary effect on Federal Reserve interest-rate policy. Pay attention, there will be a quiz.

Over at The National Interest, Sam Rines of Chilton Capital writes that Texas has been the engine of growth for the US for the past five years:

Job creation might be a good place to start. Texas has created jobs – there is little arguing that point. For instance, we know the U.S. economy only recently gained back the jobs lost in the Great Recession. This is not true of Texas. While the United States dropped about 6 percent of employment, Texas lost 4 percent and recovered them all by August 2011 – nearly three years before the United States as a whole.

Here is where the numbers get interesting. From its peak in January 2008 through today, the United States has created only 750,000 jobs. Texas created over a million jobs during that same period – meaning that the rest of the country (RotC) is still short 300,000 jobs. During the recovery, job creation has been all Texas or – at the very least – disproportionately Texas.

Choosing a different starting point – for example, in the trough of job losses – changes the extremity of the story. And there are all sorts of reasons for this disparity between Texas and the rest of the country, most of which miss the main point. In a conversation with Worth, Rines called the disparity the Texas Carry Trade. I like that.

The Texas story is by and large an oil story. We are far more diversified that we were in the ’80s, but oil is clearly the driver. Texas has been at the forefront of job creation because our borders happen to contain the mostly inhospitable scrubland known as the Permian Basin in West Texas, not to mention the coastal plays and those in East Texas. Much (not all) of the growth in oil has come from horizontal drilling and fracking. And while there are enormous amounts of energy in Texas, it is not necessarily cheap energy – not like it was in the “good old days.”

Seventy-dollar oil considerably restrains the enthusiasm of Texas oil companies, let alone the banks and individuals that finance them.

And it is not just Texas companies. The Marcellus play in the Northeast is responsible for hundreds of thousands of jobs. And it’s much the same story all over the US. Oil has been a significant portion of the growth of US GDP for the past five years. If you take the massive oil boom away, the US looks a lot like Europe in terms of growth and job creation. Which is to say, anemic.

Seventy-dollar oil starts to show up in the unemployment rate, which makes it more difficult for the Federal Reserve to raise rates.

I was talking with Joe Goyne, president of Pegasus Bank in Dallas. He is one of those entrepreneurial bankers who actually analyzes a loan personally rather than letting some computer determine whether it fits the criteria. (The country would be better off with a lot more Joes running the banking industry, but that’s another story.) Joe’s customers are a who’s who of Dallas. We were discussing my convictions about a strong dollar and what that would do to the price of oil. Joe offered, “You won’t believe the pain in Dallas if oil falls to $60.” We went on to discuss some details. Does $60 oil sound far-fetched? Joe and I both remember $15 oil. Texas has been through numerous oil busts. The running joke in the late ’80s was “Would the last person leaving Houston please turn out the lights?”

The late ’80s was an ugly time for Texas. Will the Saudis ever allow oil to dip below $60 again? Can they afford to cut their production that much? What will happen to Russia if Brent drops to $80, let alone $60? It’s not just Texas. And while the world might benefit from lower energy prices, they would create havoc in a few key regions. And throw another monkey wrench in Federal Reserve policy. And in terms of the oil price, gods forbid that peace breaks out in the Middle East. But, sadly, given current circumstances, it doesn’t look like we have to worry about that.

Chapter 7 – The Bond Bull Comes Stampeding Back

Many of us in the US look at Europe and wonder how interest rates can fall to such insane levels. And the answer is that bond markets have rationales all their own. The unwinding of carry trades means the demand for dollars will rise just as the Federal Reserve cuts off the spigot. Some people look at Japan’s flooding the market with yen as an antidote and hope that the ECB, too, will soon start printing; but that is not going to reduce the demand for dollars to unwind the carry trade.

Whatever Japan and Europe do, the growth of global liquidity is still likely to fall over the next few years; and that is an inherently deflationary event, especially in dollar terms.

In addition, when – not if – there is a renewed crisis in Europe, the flight to safety is going to put pressure on the dollar and further downward pressure on US interest rates. While it is not altogether certain that China will have a major crisis – although reasonable economic historians would suggest that is the probable case – if it happens it will put further upward pressure on the dollar as a safe-haven currency. God forbid those two events – crises in Europe and China – happen at the same time. Our necks would snap at the severity of the acceleration in the value of the dollar. The convergent crises would also trigger a global recession.

We’re going to see a return of the bond bull market with a vengeance. Almost the entire world has hedged its bets for a rising interest-rate environment and assumes a benign dollar market. Almost no one expects a falling interest-rate environment, yet that is precisely what we will get if the dollar continues to rise and we have a crisis or two.

Chapter 8 – The Third Leg of the Secular Bear Market

I was writing about secular bear markets in 1999. I was early to the party, as usual (although my friends will note that I’m often late to real-time, real-life parties). I noted in Bull’s Eye Investing that it typically takes three events to completely wash out a trend. We have had two significant corrections since April 2000, accompanied by two recessions. I think the next recession will give us that final third leg of the secular bear market, hard on the heels of another correction that tests (but maybe doesn’t quite touch) the lows of 2009.

At that point I will trade my secular bear beret for a snappy new secular bull Panama. And while we may see a significant correction out of the current volatility, I don’t think the final dénouement of the secular bear will come without a global recession.

Since most of you have been through this before, you can probably figure out what strategy you should choose; but I would suggest at least thinking about having some type of hedge/moving average/risk-dispersion strategy in your toolkit.

The point is to get through this next crucial phase with as much of your capital intact as possible, in order to be able to take advantage of the coming secular bull market, when it will be anchors aweigh. Remember, we always get through these things. It is almost never the end of the world, and betting on the end of the world is a losing proposition anyway. Specifics to come later (maddening, I know, but there are space limits).

Chapter 9 – Commodities in a Dollar Bull Market

This book outline is running a little long, but a quick word on commodities. In general, commodity prices are going to face downward pressure, at least in dollar terms. That includes copper, most of the base metals, oil, etc. Silver has clearly been in a very ugly bear market. I would continue to accumulate insurance gold, but I would invest in gold only in terms of yen or another depreciating currency. Bear in mind that precious metals – along with other commodities – can and will fall precipitously in the event of a deflationary shock… although the inflationary effects of an aggressive central bank response may ultimately drive the yellow metal far above its current price.

Chapter 10 – The Return of Volatility

The final chapter and conclusion pretty much end as you would expect: the demise of monetary policy’s ability to soothe the soul of the markets and the return of volatility. We hopefully get a full-fledged restructuring of the sovereign debt markets. The Fed and sister central banks will try the same tired tools they have been using. Except they have already been to the zero rate boundary and have wasted the opportunity they had to increase rates so that they could lower them later. Another round of quantitative easing? Quite possible if we get a true deflation scare or a global recession. But I don’t think it will have the same results. The unintended consequences and the unknown spillovers will only increase eventual volatility.

For new readers, I invite you to read my books (co-authored with Jonathan Tepper) Endgame and Code Red. They pretty much lay out the background you need in order to understand what will be happening in the future. We are seeing the end of the debt supercycle and the beginning of currency wars. We’ll experience the throes of hyper-indebted nation-states trying to survive what they will see as irrational attacks by a bond market. “How can you not have faith in the government? We are doing our best to try to make everything work out just fine. As long as you cooperate.” Which bond markets have a nasty habit of not doing. Oh, you can placate them in the short term, but ultimately they want to be paid back in risk-adjusted buying power. And that is the one currency that many nation-states will no longer have. Now without major reforms and a significant restructuring of the social order.

A final thought. Businesses will keep on doing what they do, in spite of the machinations of governments and monetary authorities. Entrepreneurs will adjust. New inventions will be made. Over the medium term, life on earth will get better. I honestly do see a return of the secular bull market and a pretty cool third decade, an updated version of the Roaring Twenties. Only this time there will be no need for speakeasies. I fully intend to be around to enjoy it and am looking forward to being relatively optimistic about the future. I really don’t get much personal pleasure from writing these Debbie Downer letters. But my role is to not think about the world as it should be or as I want it to be, but to be as right as I can about the direction we are going. The ride could just be a little bumpier in the short term of the next few years. Fasten your seatbelts.

And for those of you looking for specific advice, let me point you to Jared Dillian, the new editor of my own Bull’s Eye Investor service. He has been finding ways to trade and invest in this market. Last Friday he wrote:

Guys, the price action has been bad for a while. And it is getting worse. The market is demonstrating repeatedly that it can’t hold its gains. In my 15 years of doing this, I’ve only seen worse price action twice: 2000, and 2007.

You can read about Jared and appreciate his baleful glare of a photo right here. Want to sit on a trading desk across from him? I want him on MY side of the table. See if you might want him in your corner as well.

Chicago, Athens (Texas), Boston, Geneva, and Atlanta

I have one more week to enjoy Dallas, and then I’m back on the road. I will go to Chicago for a speech, fly back to a meeting with Kyle Bass and his friends at the Barefoot Ranch in Athens, Texas, and then fly out to Boston to spend the weekend with Niall Ferguson and some of his friends at his annual briefing. I am sure I will be happily surfing mental stimulus overload that week. I fly from Boston to Geneva for a few days and then more or less directly to Atlanta for a day (board meeting), before heading back to Dallas.

Next Saturday is wedding day. It has been years since I’ve been to a wedding, and next Saturday I will go to two. I fly to Houston to watch my young associate, Mr. Worth Wray, tie the knot with his lovely fiancée, Adrienne. You have to admire a young man for playing above his weight class. He gets married in the morning, and that afternoon we fly back to Dallas to attend the wedding of David Tice’s daughter Abigail.

Next Monday evening I get to spend some time with Woody Brock here in Dallas before I launch my travels. I’ll be back in time for Halloween.

It’s time to hit the send button. I smell stir-fry chicken and vegetables simmering on the stove and need to find a piece of mindless entertainment with which to relax with family and friends. Have a great week,

Your ready to find his sweaters analyst,

John Mauldin
subscribers@mauldineconomics.com

 

The article Thoughts from the Frontline: Sea Change was originally published at mauldineconomics.com.
[description] => The final chapter and conclusion pretty much end as you would expect: the demise of monetary policy’s ability to soothe the soul of the markets and the return of volatility. We hopefully get a full-fledged restructuring of the sovereign debt markets. The Fed and sister central banks will try the same tired tools they have been using. Except they have already been to the zero rate boundary and have wasted the opportunity they had to increase rates so that they could lower them later. Another round of quantitative easing? Quite possible if we get a true deflation scare or a global recession. [author] => John Mauldin [legacyinterface_firm_id] => 287 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 01:12:42 [created_by] => 945 [modified_on] => 2014-10-14 13:47:47 [modified_by] => 951 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1678 [hits] => 0 ) [2] => stdClass Object ( [legacyinterface_commentary_id] => 1613 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14854 [apv_conversation_id] => 2527 [content_type] => market-commentary [title] => The Eurozone Plots Its Long Road to Recovery [slug] => franklin_101414 [fulltext] =>

We at the Franklin Templeton Fixed Income Group believe Europe in general will be in a slow-growth, low-inflationary environment for a considerable time. With that backdrop, we think a long-term, accommodative approach is needed to help spur the economy.

While the European Central Bank (ECB) has a role to play in the eurozone’s economic recovery, we think the core economies should do a bit more to achieve necessary reform. We don’t think the authorities are doing nearly enough in France, for example. Their deficit is quite high, and, in the latest draft budget, the French government has effectively said it can’t meet the deficit target and will try to meet it at a later date. The country needs economic reform, in our view, and it doesn’t appear to be working hard enough on it.

Germany, we believe, is meeting its fiscal requirements very well. Still, when most other countries in Europe are in fiscal austerity, maybe Germany can afford not to be so austere.

I think some of the eurozone’s core countries could take a lesson from the so-called periphery economies. In many of the periphery countries, the authorities have enacted necessary reforms. They have put plans into place that successfully reduced their budget deficits. I’m not saying some of the periphery countries shouldn’t do more, but many reforms have been passed, and we’re starting to see them implemented.

Still in Europe, but outside the eurozone, the UK economy is moving in a positive direction, in my opinion. Growth is good, inflation appears to be under control, and the country’s central bank is in a very different place than the eurozone’s. The central bank—the Bank of England—is considering raising interest rates, and we believe it’s not a matter of if, but when it will raise rates. I think that’s a good sign for the UK economy and, as a result, we don’t believe UK Gilts offer a lot of value. For UK investors, there may be a case for looking at opportunities elsewhere in Europe because the economies appear to be moving in different directions.

DZahnBox_US ver

Common Bonds

Looking globally, I believe the eurozone has more in common with Japan than with the United States or the UK at this point, and I think that trend will likely continue. Inflation in the eurozone is running at 0.4%, which is a far cry from the ECB’s 2% target. My team and I expect inflation will likely rise a little next year, but it’s likely not going anywhere near 2%. I think that’s what ECB President Mario Draghi is primarily concerned about. He has said the ECB is fully behind undertaking whatever measures are necessary to combat low inflation.

I expect the Bank of Japan (BOJ) and the ECB should likely continue to be accommodative to combat deflation and low inflation in their respective countries. Much has been made about the amount of liquidity the US Federal Reserve Bank (Fed) has pumped into the US economy during its quantitative easing (QE) program. But, when you take into account what Japan and Europe combined are currently contributing to their QE programs, it probably more than matches what the United States was doing. So, on a global scale, we have probably just as much or more liquidity being created now than when the Fed was acting alone.

Divergent Paths

Meanwhile, the US economy has been performing relatively well. In the United States, the Fed has indicated it is going to stop its QE program this month, and its next focus will be on when to raise interest rates.

That’s a strong differential to make, and it has ramifications for the currencies. I think the euro should probably weaken against the US dollar and, to a lesser extent, the British pound—it has already weakened quite a bit against the pound—because the economies are on different trajectories.

That might suggest to investors that European bonds may be a good place to look for potential opportunities. In the fund, we have taken a long-duration posture in Europe.1

David Zahn’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

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Franklin Global Government Bond Fund

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[description] => Growth in much of Europe is slow—some observers even say the economy is moving sideways. Lately, the eurozone seems to have more in common with Japan, whose economy has been idling for years, than it does with the UK or the United States. The European Central Bank (ECB) has recently launched programs to inject capital into the economy, and David Zahn, head of European fixed income and portfolio manager, says they’re a good start. He urges a long-term approach driven by both the ECB and the governments of individual countries, which all have to do their part to get the European economic engine running on all cylinders. [author] => David Zahn [legacyinterface_firm_id] => 163 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 01:28:56 [created_by] => 945 [modified_on] => 2014-10-14 01:29:20 [modified_by] => 945 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1679 [hits] => 0 ) [3] => stdClass Object ( [legacyinterface_commentary_id] => 1614 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14855 [apv_conversation_id] => [content_type] => market-commentary [title] => Assessing the Economic Impact of Hong Kong’s Occupy Central Movement [slug] => invesco_101414 [fulltext] =>

The Occupy Central (OC) movement was officially launched on Sept. 28, starting with members from the Occupy Central with Love and Peace (OCLP), the HK Federation of Students and Scholarism groups staging a sit-in in Central and Admiralty that blocked traffic in key commercial and business districts in Hong Kong. The objective of this campaign is to display the organizers’ determination to have “real” universal suffrage for the chief executive (CE) election in 2017, and more importantly, to demonstrate their discontent over the National People’s Congress’ decision to require that CE candidates be screened by a nomination committee, which is expected to be composed of pro-China members, and therefore lacking broad-based representation.

Our assessment

Below, we attempt to provide an assessment of the outcome of the OC movement and its impact on the various aspects of the economy under three separate scenarios:

Scenario 1

The Hong Kong government performs a violent crackdown

We think this scenario is unlikely. After the tear gas incident, which was perceived as violent, we have observed a change in the attitude of the police. They have become more accommodative toward the protesters, and their response has been more restrained. We feel that the Hong Kong government is very conscious of the public disapproval over the police’s actions and does not want the press and international community to portray the police as using force against peaceful demonstrators fighting for democracy.

On the campaigners’ part, we believe the majority of them realize that this is a long-term pursuit and that hostility will not yield a turnaround in Beijing’s decision overnight. Reaching an opportunity for dialogue with the Hong Kong government will be a first step toward a constructive outcome. In the process of trying to achieve this, the movement may attempt to test the government’s tolerance.

As a result, when “sensible” demonstrators meet “restrained” police, a sharp deterioration of the current situation is unlikely, in our view.

Scenario 2

Dialogue between the campaigners and the Hong Kong government fails, no resolution is reached, and the demonstrators lose public support and sympathy. In turn, the police step in and restore order quickly. Status quo remains.

This seems quite possible at this stage in time. Though this is a less-than-perfect outcome for the protesters, at least public order would be restored and everything would go back to business as usual.

Scenario 3

A dialogue between the campaigners and the Hong Kong government yields some positive results, and both parties declare they have reached a “win-win” situation.

We assign a relatively high probability of this outcome. We have seen the Chief Secretary Carrie Lam’s tone soften, and she has offered to meet with student leaders to discuss electoral reform. Government officials have also reiterated that there is room for discussions over key issues, such as how the formation of the nomination committee can offer better public representation. We believe the government is willing to offer some sort of moderate compromise after all, and that they are working toward a deadline to get Beijing’s proposal passed by the Legislative Council and start the second phase of the consultation process by Oct. 8.

Having said that, the current situation is very fluid, and emotional eruptions have started in certain parts of the occupied areas among the demonstrators and some anti-OC protestors. Fighting has broken out and resulted in some people getting injured. This is sad, but at the same time we believe it was inevitable, as maintaining full control over a movement of this scale is realistically a difficult task. However, we are still hopeful that the overall situation will remain peaceful. We have also seen some blocked areas in Causeway Bay and Tsim Sha Tsui being cleared out without the use of force, which is positive.

Impact on the economy

The sectors that are most affected in the immediate term are retail, restaurants and hotels. The China National Tourism Administration has stopped signing off on package tours to Hong Kong from Oct. 1 to 7 (and up to Oct. 10 for some regions). As Chinese visitors traveling via package tours accounted for 30% of total Chinese visitations year-to-date (January to August), a loss in retail sales in the near term is certain.

On a longer-term basis, we believe the stoppage of package tours is only temporary and does not point to a structural change in the Chinese government’s policy toward Hong Kong. We also disagree with some suggestions that this may even end up with China cutting the Individual Visitors Scheme (IVS). Our opinion is that the IVS policy should not be viewed merely as a “gift” from the Chinese government, but part of China’s bigger scheme of integrating Hong Kong with the mainland. Over the years, we have witnessed aspects of trade, finance and people flows being opened up. Cutting off tourism does not fit in with the overall plan.

On a fundamental basis, with Hang Seng Index (HSI) constituent stocks that have pure Hong Kong exposure (i.e., excluding all Chinese and multi-national companies) accounting for only 20% of the total market cap, we do not think this will lead to a broad-based earnings downgrade of the HSI.

Impact on 2014 Hong Kong gross domestic product (GDP)

Despite retail sales being disrupted, we believe the other core GDP components, such as trade and fixed capital investment, will not be impacted. As such, we maintain our 2014 GDP growth forecast at 2.0%.

Background

Since early 2013, the pro-democracy camp has been petitioning the Chinese and Hong Kong governments to create an electoral system that satisfies the international standards of universal suffrage. These standards, they argue, include an equal number of votes, an equal weight for each vote and no unreasonable restrictions on the right to stand for election. It also stipulates that the final proposal for the electoral reform be decided by means of a democratic process. On the other hand, the Chinese government has repeatedly declared that the chief executive (CE) must conform to the standard of “loving China and loving Hong Kong” to ensure that the chosen CE will not be a candidate with an anti-Beijing stance.

To that end, the Hong Kong government, strongly backed by Beijing, reiterated that CE nominees have to be screened by a "broadly representative nominating committee," and there was no provision for civic nominations. The position was reaffirmed in a State Council decision announced on Aug. 31, 2014.

Sequence of events

At the time of this writing, the OC movement has continued for more than a week with the situation evolving on a daily basis. The following provides a recap of the major events:

Sept. 28 — The Occupy Central (OC) movement was officially launched. Large crowds of protesters took to the streets and occupied key financial areas in Admiralty and Central.

Sept. 29-30 — Police attempted to disperse the crowds by firing tear gas at the public. However, not only did they fail to regain control of the districts blocked by the campaigners, this action provoked public anger and criticism over the use of unnecessary violence, and earned the OC movement more supporters. A new crowd gathered in major shopping and commercial district Causeway Bay.

Oct. 1— Students demanded that Chief Executive C.Y. Leung step down and that Beijing retract its decision on the 2017 CE nomination process.

Oct. 2 — Chief Secretary Carrie Lam offered to meet with representatives of the Federation of Students to discuss political reform.

Oct. 3 — Street violence broke out among the demonstrators and anti-OC protesters in another shopping and commercial district called Mongkok.

Important Information

The Hang Seng Index includes the largest companies of the Hong Kong stock market and is considered the main indicator of the overall market performance in Hong Kong.

China remains a totalitarian country with the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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[description] => The Occupy Central (OC) movement was officially launched on Sept. 28, starting with members from the Occupy Central with Love and Peace (OCLP), the HK Federation of Students and Scholarism groups staging a sit-in in Central and Admiralty that blocked traffic in key commercial and business districts in Hong Kong. [author] => Paul Chan [legacyinterface_firm_id] => 225 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 13:11:09 [created_by] => 948 [modified_on] => 2014-10-14 13:29:18 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1680 [hits] => 0 ) [4] => stdClass Object ( [legacyinterface_commentary_id] => 1615 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14856 [apv_conversation_id] => [content_type] => market-commentary [title] => Finding Value in the Municipal Market Today [slug] => andres_101414 [fulltext] =>

With the Fed’s recent remarks regarding their near term plan or lack thereof for short term rates, investors continue to be surrounded by uncertainty as to the timing and velocity of future interest rate movements. This uncertainty creates the question of how one can protect one’s capital base, while earning decent returns.

One of the ways to answer this question lies in recalling some of that high school math we never thought we’d need in real life. Remember when x and y axes were introduced, and the concepts of points in two-dimensional space were a real challenge? Today, if you’re building roofs or making stairs, you’re intimately familiar with “run and rise”, the triangles that show how high you go vertically for every unit of horizontal movement. For us bond folks, it’s the slope of the yield curve we get when we plot the same parameters of how far and how high.

Unlike in carpentry, our slopes change. It’s in this change that we can find some solutions to the dilemma of uncovering value. Let’s take a look at the curves as they are now and see if we can come up with ways to both protect principal and earn decent returns.

The chart above illustrates that the front end of the municipal curve slopes sharply upward until just at year eight (2022). After year eight, the curve begins to flatten until it becomes virtually horizontal out in year 23 (2037). In absolute terms, for each year of extension out to 2022, you pick up 22 basis points for AAA, 28 for AA, and 31 for A rated municipal bonds. At 20 years ,the numbers drop to 14, 16, and 17 respectively until they become one or two a year.

So does any of this mean anything to investors? Well, if you want to protect yourself it certainly does. You’re not rewarded much for extending into the long end of the municipal yield curve, so why do it? You expose yourself to greater losses in dollar value for each basis point in higher yields, and time is less of an ally as well. If you stay inside the eight-year range, then you’ll earn at least 2%, while limiting your exposure to the possibility of rising interest rates.

The variables associated with all municipal bonds are: coupon, maturity, yield to maturity, and rating. Having argued that the best value and most defensive maturities in municipal bonds fall in the eight year and shorter range, we now turn our attention to the other factors.

Virtually all-individual investors and many of their advisors prefer those bonds referred to in the trade as “current coupons”. That is to say, they buy bonds priced at or near par, which is exactly the wrong thing to do. An aversion to and misunderstanding of the premium paid for the larger coupons prevents them from earning the much higher total returns available with those larger coupons.

Mutual fund managers and other large fund investors insist on those larger coupons because they understand the net total return is always larger with premium bonds, even after netting the amortization. In fact, the benchmark scales published daily by Municipal Market Data, a Thompson Reuters company, presume a 5% coupon. The reason for the preference expressed by the professionals is quite simple. The cash flows from the larger coupons more than offset the amortization paid in every case. So, total return is largely determined by cash flow, premium bonds act better in declining markets, and owners of premium bonds will never run afoul of the IRS de minimis rules for discounts, which is a whole other topic.

One of the professional money manager’s key tools to manage interest rate exposure is “Duration”, which may be defined as the weighted average maturity of a security’s cash flows, where the present value of the flows serve as the weights. The greater the Duration, the higher the percentage price volatility. Simply stated, duration gives you the change in dollar price for every one basis point change in yield. Inasmuch as higher coupons generate higher cash flows, they produce lower durations. Buy bigger coupons.

Briefly, yield to maturity is the offering yield, which produces a dollar price resultant from a present value calculation of that yield. It goes without saying that one should seek the highest yield one can, while taking into consideration that the dealer offering the bonds may or may not be willing to adjust the price to accommodate your interest. It never hurts to ask.

Finally, ratings. A plethora of books and articles have discussed the rating agencies and their role in the collapse of markets in 2008, and this is not a forum to go over old ground. Rather it is a place to discuss, in brief, their presence in the municipal market and how to use the ratings to your advantage.

There are three major agencies providing municipal bond ratings at present, Moody’s, Standard & Poor’s (S&P), and Fitch Ratings. These firms are all recognized as quite competent, have excellent research analysts, and usually issue ratings that are virtually identical. The four highest categories range from AAA to BBB, with gradations in each category below AAA. Examples are AA+, A-, BBB+, etc.

For the average investor, we do not recommend the purchase of BBB rated bonds. This is not to suggest that there may not be value in the category, but rather that the analysis of the risks associated with these bonds requires more sophistication and analytical tools than normally available to the average investor.

There are two major types of municipal bonds: 1) those secured by some tax pledge, either general obligation or by some specific tax, and 2) revenue bonds secured by a stream of cash flows from some governmental enterprise. Revenue bonds normally receive their income from water, sewer, and electric, and other local utilities. These are frequently referred to as “essential service” revenue bonds to differentiate them from other revenue issues, and they usually provide real value for investors.

In general, investors really don’t need the protection afforded them by AAA bonds, and there are better rewards found in dipping down to AA and A rated issues. The spread between AAA and A rated bonds in our 2022 maturity is 50 basis points, and if one looks hard for the right A rated essential services revenue bond, the rewards may even be better. So, that’s the conclusion: a 5% coupon A rated revenue bond inside 2022 for the time being. Let the Fed do its thing and earn all that nice tax tree income in the meanwhile.

And, finally, remember that not all bonds are created equal.

Good Fortune!

Bob Andres is editor of The Andres Review and founder of Andres Capital.  Bob’s career includes stops as: chief investment officer at Merion Wealth Partners, chief investment strategist at Envestnet (PMC division), co-founder at Martindale Andres & Co., a firm he grew to $2.4 billion before its sale, President at Merrill Lynch Mortgage Capital, etc.   He has been quoted and featured in various media: CNBC, Fox Business, Barron’s, Institutional Investor, etc.

© Andres Capital Management

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The Trade Followers Momentum indicators for the S&P 500 Index (SPX) continue to confirm lower prices with a series of lower highs. After trying to bounce, SPX broke through the 1955 support level that has been important on the Twitter stream for several weeks. It closed Friday near the next major support level of 1905 with 7 day momentum painting a small positive divergence with price. This divergence is a result of market participants tweeting that it’s time for a bounce. Many people are mentioning the 200 day moving average that hasn’t been touched in almost two years. Others are comparing this dip to previous declines during the long term rally. This suggests that a short term bottom is near. 

Once that low is in place it will be again time to watch the bounce. Since this bounce is coming from an obvious support level I’d like to see 7 day momentum paint a higher peak than the last two to indicate higher prices are ahead. A break of the current down trend line will provide hope, but not confirmation of a sustainable rally.

If the market continues to fall and 7 day momentum paints a lower low it will confirm the down trend and suggest that a larger correction is underway where rallies will likely fail.

Breadth from StockTwits and Twitter continue to deteriorate with fewer bullish stocks making the cut and at the same time more bearish stocks showing up in the lists. Last week I mentioned that finance, health care, and technology were holding up and that their performance gave some hope to the bulls. Unfortunately, those sectors experienced heaving selling on Friday with many of the stocks that had held up suffering declines of 5% or more. Without their support it will be difficult for the market to rally into the end of the year.

As mentioned above, 1905 on SPX is a strong support level. Below that there are scattered tweets, but nothing definitive. The lack of tweets below the market indicates hope and optimism from market participants. This can be dangerous near a strong support level because any break lower will turn hope into uncertainty and fear. 1905 on SPX is a must hold support level or we could see a cascade that carries price quickly to 1880 or 1850 where a small number of traders are tweeting support. Above the market 1955 and 2010 are the most tweeted levels with a small cluster near 1975. Watch those areas as likely resistance.

Sector strength shows positive readings in all of the defensive sectors and in financials, technology, and industrials as well. However, much of the strength in leading sectors came early last week. Friday saw a large decline in support for those sectors.

Overall social media is suggesting that traders are expecting a bounce near current levels. However, a break below 1905 on SPX would likely cause a swift drop before the market could catch. The nature of the next bounce should give us a direction for the rest of the year.

Blair Jensen is president of Trade Followers. The Trade Followers algorithm quantifies social media and creates stock market indicators that track the momentum of the crowd on Twitter and StockTwits.

© Downside Hedge

            

[description] => The Trade Followers Momentum indicators for the S&P 500 Index (SPX) continue to confirm lower prices with a series of lower highs. After trying to bounce, SPX broke through the 1955 support level that has been important on the Twitter stream for several weeks. It closed Friday near the next major support level of 1905 with 7 day momentum painting a small positive divergence with price. [author] => Blair Jensen [legacyinterface_firm_id] => 515 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:29:43 [created_by] => 948 [modified_on] => 2014-10-14 14:30:03 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1682 [hits] => 0 ) [6] => stdClass Object ( [legacyinterface_commentary_id] => 1617 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14858 [apv_conversation_id] => [content_type] => market-commentary [title] => How’s the Market Feeling These Days? [slug] => eaton_101414 [fulltext] =>

SUMMARY

  • Three of our preferred metrics for tracking investor sentiment and consensus portfolio positioning are the AAII BULL/BEAR ratio, BofA/Merrill Lynch’s Fund Manager Survey and attendance levels at investor conferences.
  • Recent investor sentiment readings suggest that lingering fear from the 2008 financial crisis has abated somewhat, and that sentiment has finally begun to catch up with market performance.
  • We see volatility potentially picking up in the fourth quarter of 2014, particularly with the midterm elections approaching in November.
  • Longer term, we continue to believe the market can deliver modest, middle-single-digit returns over a multiyear period.

It is almost tautological to say that investors seeking to earn excess returns must do something different from the general consensus of the market. Successful investors regularly find themselves lonely when attending the proverbial cocktail party where investment tips are being shared. The act of discussing one’s favorite controversial holdings or contrarian market views is frequently met with sideways looks and frowns. It is precisely this disgust or neglect on the part of the broad market that may allow security prices to reach an attractive enough valuation level where it becomes possible to achieve excess returns.

We use several metrics to track investor sentiment and consensus portfolio positioning. We do this not to reflexively position our portfolios against the consensus, but to understand where there might be hidden investment risks or opportunities. Three of our preferred sentiment indicators are:

  • The AAII BULL/BEAR ratio
  • BofA/Merrill Lynch’s Fund Manager Survey
  • Attendance levels at investor conferences
  1. AAII BULL/BEAR Ratio

Each week, the American Association of Individual Investors (AAII) surveys its members to ask if they are bullish, bearish or neutral on stocks over the next six months. By subtracting the percentage that is bearish from the percentage that is bullish, a net bullish score can be calculated. When this AAII BULL/BEAR figure rises to elevated levels, it can be a sign that there is too much enthusiasm for stocks and that the market may be due for a pullback. The reverse is often true as well, where excessive bearishness can signal a buying opportunity for investors.

This sentiment indicator had reached an exuberant level in late August 2014. Not surprisingly, stocks had a tough September, with the S&P 500 Index shedding 1.40% for the month on a total return basis (but still up 1.13% for the third quarter of 2014 and 8.34% year-to-date). Investor sentiment quickly reverted to more “normal” levels in September, as shown in Exhibit A below.

  1. BofA/Merrill Lynch’s Fund Manager Survey

Each month, Bank of America Merrill Lynch (BofA/ML) surveys professional fund managers to understand their preferences in terms of asset classes, geographic regions, economic sectors and industries. When professional investors have a strong consensus around their portfolio positioning, it is often the case that there are no incremental buyers/sellers to join them, and even a minor piece of disconfirming news about a given asset category can sometimes be enough to send security prices in the opposite direction.

Global fund managers’ latest preferences are shown in Exhibit B above. According to the September 2014 BofA/ML Global Fund Manager Survey (FMS), relative to history, equities in general were “overowned” by fund managers, whereas bonds were “underowned.” The most overowned economic sectors were the more cyclical consumer discretionary and technology groups, revealing many managers’ recent desire for some economic sensitivity in their portfolio exposure. Similarly, the less cyclical telecom and utilities sectors were both underowned.

  1. Attendance levels at investor conferences

Tracking attendance levels at investor conferences has long been a popular tool for gauging sentiment, and we have found it to be a useful indicator of both neglect and excessive enthusiasm, particularly at the industry and individual company levels.

September is typically the busiest month of the year for investor conferences, with many companies eager to get in front of shareholders before the books are closed on the quarter, and many investors keen on receiving an update post the summer lull in news flow. Our analysts and portfolio managers have attended numerous conferences over the past several weeks and came away with a few noteworthy observations regarding recent investor interest levels.

Consumer discretionary companies, particularly media names, have continued to attract heavy investor interest. At a recent media conference, one well-known company spoke to an audience of some 400 investors. The day before, one of the country’s largest real estate investment trusts (REITs) was able to garner an audience of only 20 investors in a room with 150 chairs.

Key takeaways

As of September 30, 2014, the stock market, as measured by the S&P 500 Index, was up more than 200% from its bear market low on March 9, 2009. For much of that five-and-a-half-year period, the market’s rise occurred despite lackluster investor sentiment and persistent retail outflows from domestic equity mutual funds. To a large extent, retail investors’ reluctance to embrace the bull market reflected their lingering fear in the wake of the 2008 financial crisis.

However, this fear has abated to some degree in 2014. Although domestic equity funds have continued to see net retail outflows, recent investor sentiment readings have been more normal or even somewhat elevated. This suggests that sentiment has finally begun to catch up with market performance.

Looking ahead

For many contrarian investors, the recent improvement in investor sentiment toward equities is cause for some concern, especially given how fickle retail sentiment can be. (Sentiment among institutional investors is less susceptible to the headlines of the day.) In this sense, the market’s slowdown and increased volatility in September 2014 was no surprise, as sentiment had started to become rather frothy leading up to that point.

So, what will the final months of 2014 bring? Was September just a brief hiccup in a sustainable market rally, or the beginning of a new trend of renewed market volatility and diminished equity returns?

Investors should bear in mind that prior to September, volatility for most of 2014 had been quite muted, and that could not be expected to last indefinitely. We see volatility potentially picking up in the fourth quarter, particularly with the midterm elections approaching. Historically, October has often been a volatile month for stocks.

That being said, our broad market outlook has not changed materially. Shorter term, we expect the U.S. market to finish 2014 firmly in positive territory. Longer term, we continue to believe the market can deliver middle-single-digit returns over a multiyear period – more modest than in recent years, but respectable. Bottom line: Investors should remain wary but not fearful and should try to maintain a long-term perspective with regard to their equity portfolios.

The S&P 500 Index is an unmanaged index commonly used to measure the performance of the broad U.S. stock market. It is not possible to invest directly in an index. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. Historical performance of the index illustrates market trends and does not represent the past or future performance of any fund.

About Risk

Investments in equity securities are sensitive to stock market volatility. Equity investing involves risk, including possible loss of principal. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant.

Past performance is no guarantee of future results.

About Eaton Vance

Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors.

The views expressed in this Insight are those of Edward J. Perkin and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.

This Insight may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.

©2014 Eaton Vance Distributors, Inc. | Member FINRA/SIPC | Two International Place, Boston, MA 02110 | 800.836.2414

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As of September 25, 2014 the NASDAQ Composite index is up 6.95% year-to-date, despite the recent downturn in the market. The darling tech stocks continue to come up with new and innovative ideas for products and services to drive their bottom lines. The NASDAQ is only down -2.86% from the high it made on September 2, 2014. One could conclude that the NASDAQ is indeed solid and that this is just another passing correction before it pushes on to higher levels.

What if I told you that 1,251 (48.9%) of the 2,558 stocks in the NASDAQ Composite index were down 20% or more from their 52-week high as of September 25? Would you still think that the NASDAQ seemed healthy? What if I told you that 852 (33.3%) of the stocks were down 30% or more from their 52-week high? You may be surprised.  These statistics are in the following table.

It would be natural to question this information because the two ideas don't seem to fit together. The NASDAQ just hit a recent high, yet here we find that 48.9% of the stocks are down 20% or more from their 52-week highs. The former suggests that the index is strong and ready to push higher. The latter sounds like an index in the midst of a bear market. You may wonder how this could be.

The answer is market capitalization, which is a total dollar market value of all of a company's outstanding shares and is commonly used to determine its size.  The NASDAQ is a market capitalization based index. This means that the larger the market capitalization of any given stock, the more the returns of that stock count for in the index's performance. The largest stock by market capitalization in the NASDAQ Composite index is Apple, with a 7.3% representation. That's a very large portion of return.

To further show the disparity between the larger capitalization and smaller capitalization stocks in the NASDAQ composite index, let's take the top 200 and bottom 200 stocks by market capitalization as of September 25, 2014. Each group of 200 represents approximately 7.8% of the 2,554 stocks in the NASDAQ composite index by number. The top 200 stocks in the NASDAQ Composite index by market capitalization, while being 7.8% by number, represent just shy of 75% of the entire market capitalization for the NASDAQ. This means the remaining 2,354 stocks, just a bit over 92% of the stocks in the index, represent only 25% of the index's market capitalization. That's heavily skewed.

If we look at the year-to-date returns from these two groups of stocks, we see something even more amazing. The top 200 market capitalization stocks have an average year-to-date return of 13.92%. Meanwhile the bottom 200 market capitalization stocks have an average year-to-date return of -10.49%. Yes, that is a negative. There is a pretty drastic difference between the two groups of stocks at the opposite ends of the market capitalization spectrum.

You may think that if we included more stocks from the lower market capitalization levels, the results will improve. Let's see. If we include all the other stocks with year-to-date returns, excluding the top 200 market capitalization stocks, we end up with a return of -1.97%. Yes, the return did improve, but -1.97% is still a far cry from the +13.92% of the top 200 market capitalization stocks.

What does this tell us? First, the larger capitalization stocks count for much more than the smaller stocks even though there are far more of the smaller stocks in number. In fact, the year-to-date returns for the top 8% of stocks by number are carrying the index for the remaining 92%. The market capitalization effect is making the index appear to be strong by hitting new highs when it is actually weak, based on an average numerical basis.

When a few large darling stocks carry the index higher while the rest lag, we refer to it as a narrow rally in stocks.  Narrow rallies are a sign of weakness and are an insight into the true health of the market at large.

We saw a similar narrowing of the stock participation in the NASDAQ Composite index in the time leading up to the market crash back in 2008. As of December 31, 2007, the NASDAQ was up 9.81% year-to-date. In the following table, we see that 75% of the stocks by number in the NASDAQ composite index were down 20% or more from their 52-week highs as of December 31, 2007. 58% of the stocks by number were down 30% or more from their 52-week highs. This is similar to the narrowing we are seeing today. It can be seen as an early indication that something is amiss and careful monitoring is called for.

Sincerely, 

Sean Hanlon, CFP®

Chairman, CEO and Chief Investment Officer

The NASDAQ Composite Index is an unmanaged, market-weighted index of equities traded on the National Association of Securities Dealers Automated Quotation System. Past performance is not a guarantee of future results. This Market Commentary is limited to the dissemination of general information pertaining to its investment advisory services and is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock and bond markets involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice. Hanlon has experienced periods of underperformance in the past and may also in the future. The returns represented herein are total return inclusive of reinvesting all interest and dividends. Hanlon Investment Management ("Hanlon") is an SEC registered investment adviser with its principal place of business in the State of New Jersey. Hanlon and its representatives are in compliance with the current registration and notice filing requirement imposed upon registered investment advisers by those states in which Hanlon maintains clients. Hanlon may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by Hanlon with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Hanlon, please contact Hanlon or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Hanlon, including fees and services, send for our disclosure statement as set forth on Form ADV from Hanlon using the contact information herein. Please read the disclosure statement carefully before you invest or send money. Not all Hanlon clients are in the strategies discussed herein.

© Hanlon Investment Management

[description] => As of September 25, 2014 the NASDAQ Composite index is up 6.95% year-to-date, despite the recent downturn in the market. The darling tech stocks continue to come up with new and innovative ideas for products and services to drive their bottom lines. The NASDAQ is only down -2.86% from the high it made on September 2, 2014. One could conclude that the NASDAQ is indeed solid and that this is just another passing correction before it pushes on to higher levels. [author] => Sean Hanlon [legacyinterface_firm_id] => 193 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:41:50 [created_by] => 948 [modified_on] => 2014-10-14 14:42:47 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1684 [hits] => 0 ) [8] => stdClass Object ( [legacyinterface_commentary_id] => 1619 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14860 [apv_conversation_id] => [content_type] => market-commentary [title] => What If We “Crash”? [slug] => charter_101414 [fulltext] =>

US equities are deeply oversold by many measures, and are likely to bottom here.  But what if we “crash”?  While market crashes are impossible to predict, it’s wise to be prepared for the occasional plunge from deeply oversold territory. 

From the perspective of implied volatility, there were ten occasions over the past sixteen years when volatility spikes were more than temporary.  These cases are illustrated in the chart below.

Here, a crash is defined as an event in which implied volatility (VXO) spikes above its 200-day moving average for five or more trading sessions.  This hasn’t happened yet, but if it does, the table below might come in handy.  The median crash generated greater-than-2-sigma volatility for 22 non-consecutive trading sessions.  The median price loss was 9%, counting from the first 2-sigma observation.

If the median crash were to repeat here, SPX would drop to 1760 before bottoming in early November.  Remember, this is not a prediction, but something to keep in mind if the unexpected should happen.  A move to 1760 would constitute a 13% correction from the September 2014 top and a re-test of the February 2014 bottom.  In other words, a fairly normal event by market standards.

Contemplating a hypothetical crash based on historic parameters is a useful exercise.  While a crash is unlikely, it’s wise to remember the old scout saying: “Be prepared.” 

© Charter Trust Company

[description] => US equities are deeply oversold by many measures, and are likely to bottom here. But what if we “crash”? While market crashes are impossible to predict, it’s wise to be prepared for the occasional plunge from deeply oversold territory. [author] => Mark Ungewitter [legacyinterface_firm_id] => 81 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:45:20 [created_by] => 948 [modified_on] => 2014-10-14 14:48:16 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1685 [hits] => 0 ) [9] => stdClass Object ( [legacyinterface_commentary_id] => 1620 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14861 [apv_conversation_id] => [content_type] => market-commentary [title] => You Ain't Seen Nothin Yet [slug] => smead_101414 [fulltext] =>

Someone recently asked a group of us which band we saw at our first rock concert. My answer was the Canadian band, The Guess Who, in 1975. With hits like “No Time,” “Undun” and “These Eyes,” The Guess Who hit the perfect balance between my 17-year old testosterone driven aggressiveness and my urge to romance the woman of my dreams. The key members of the band in the 1960’s and 1970’s were Burton Cummings and Randy Bachman.

Fortunately for this writer, Randy Bachman left the band in the early 1970's to form Bachman-Turner Overdrive (BTO). Their two biggest hits were “Takin' Care of Business” and “You Ain't Seen Nothin' Yet.” Today's equity market harkens back to the period 1983-1987 in the U.S. stock market which we alluded to in our 2014 outlook piece. As we look to the fourth quarter of 2014, we will quickly review what happened in the first nine months of the year, see how it compares with 1983-84 and consider what went on from 1984-1987. At Smead Capital Management, we believe “You Ain't Seen Nothin' Yet!”

By the middle of 1983, the U.S. economy was in the early stages of an elongated growth period. Small-cap stocks and fast-growing conceptual tech stocks were all the rage. Small-caps had a nine-year run of outperformance over large-caps under the idea that their earnings were more likely to grow faster than the persistently high double-digit inflation. From July 26, 1983 to June 30, 1984, the Russell 2000 small-cap index fell 20.21% from peak to trough and high-flying techs fell even further. The S&P 500 Index’s peak loss was around 10%, a significant outperformance.

As we write this letter in late September of 2014, the S&P 500 has gained close to 9% and the Russell 2000 has lost over 4% year to date, a spread almost identical to the rhyme we drew on from history. We think investors were overcommitted to small-caps in 1983 due to the "well known fact" surrounding persistently high inflation. At the beginning of 2014, a new "well known fact" seemed just as entrenched in investors’ minds: historically riskier small-cap indexes outperform the larger-cap indexes over long stretches of time.

At our firm, we believe valuation matters dearly and the historical advantage small-cap stocks normally have in the marketplace is very attractive. The advantage is that they are usually cheaper than their bigger and substantially more stable large brethren. By the end of 2013, we saw a 14-year run of small-cap domination come to an end. The great small-cap run was triggered by how much cheaper the Russell 2000 was in early 2000 than the S&P 500. Tech was all the rage and ridiculously expensive at the end of 1999. The Russell 2000’s tech exposure was higher than normal, but didn’t include the glamorous dot-com companies that traded at massive market capitalizations. Large traded at 27 P/E and small traded at closer to 15 P/E. A long period of success for small caps was bred.

As we entered 2014, the S&P 500 traded for around 17 P/E and the Russell 2000 was around 29 P/E. We aren’t the only ones looking at the severe over-pricing and over-capitalization of smaller cap companies. Market Historian, Hayes Martin said this in a September 23rd, 2014 Marketwatch.com interview:

Valuation: The area of the market whose valuation is most troubling, according to Martin’s work, is secondary stocks. His indicators, which focus on several valuation metrics such as the price-to-earnings and price-to-sales ratios, show the Russell 2000 index to be more overvalued today than at any time since it was created in 1984. In fact, Martin believes that, had the Russell 2000 index been around before 1984, you’d have to go back all the way to 1968 to find a time when secondary stocks were more overvalued than they are today. Martin adds, ominously, that 1968 was “the grandaddy of small-cap market peaks.”

Ironically, The Guess Who was making some of their best music in 1968. It is not just prices which tell the story of a "well known fact" and major over-capitalization. You need other evidence.

First, as we entered 2014, investments in hedge funds and private equity led to a massive over-capitalization in alternative investments led. We think hedge fund managers are much more likely to attempt to find an advantage in under-researched securities. The largest private equity investment is in leveraged buyouts, transactions which are mostly likely to occur in small and mid-cap companies. Since investors have drowned both of these alternatives with money (mostly coming from net liquidation of large-cap investments) it is easy to see how over-capitalization would occur. See the NACUBO study from the end of 2013 for the asset allocation of the nation’s foundations and endowments totaling over 1 trillion in investable dollars as representative of U.S. institutional investors as a whole:

Second, to top the whole thing off and truly lay the groundwork for seven to ten years of small-cap misery, you needed the equivalent of the Sports Illustrated curse. This came in the form of passive investing guru, Dr. Eugene Fama, receiving the Nobel Prize in Economics for emphasizing the historical outperformance of small-caps in indexing and asset allocation. He is a big believer in the idea that active management is for the birds compared to passive investments, especially the "smart beta" passive indexes which his company propagates. Bachman-Turner gave you all the asset allocation advice you need in this set of thoughts:

And now I'm feelin' better

'Cause I found out for sure

She took me to her doctor

And he told me of a cure

He said that any love is good love

So I took what I could get

Yes, I took what I could get

And then she looked at me with them big brown eyes

Returning to 1984 and You Ain't Seen Nothin' Yet, we all need a "cure". The S&P 500 went on to beat the Russell 2000 by 48% in the four-year stretch from June 30th, 1983 to June 30th, 1987. Each up market move saw large beat small and each down market especially punished small-cap stocks. Interest was also significantly diminished in glamour techs, a warning sign for owners of today's exciting and frothy darlings. In our opinion, when the wholesaler promoting alternatives shows up at your office, you better claim to be on vacation. When the doctor with those “big brown eyes" comes trumpeting small-caps and “smart indexes,” don’t make eye contact. Smead Capital believes only meritorious and undervalued securities are "good love".

We think investors should join CALPERS (who ditched hedge fund investments) in a pull back of capital (love) from hedge funds and reduce or eliminate commitments (love) to private equity while they wait for the big-time debacles to show. We believe this will lead to a mass exodus back to less expensive large-cap stocks, a process in the early stages. Some bear markets cure concentrated over-capitalization of asset classes like 2000-2003 and some clean out everything in total liquidation like 2007-09. We at Smead Capital believe the next cure will be centered in small-cap stocks, frothy conceptual tech stocks, hedge funds, private equity and high yield bonds/loans attached to them. Since we can't stutter in the process of writing, we'll share our last thought in BTO lyrics:

You ain't seen nothin' yet

B-b-b-baby, you just ain't seen n-n-nothin' yet

Here's something, here's something your never gonna forget

baby, you know, you know, you know you just ain't seen nothin' yet

© Smead Capital Management

[description] => Someone recently asked a group of us which band we saw at our first rock concert. My answer was the Canadian band, The Guess Who, in 1975. With hits like “No Time,” “Undun” and “These Eyes,” The Guess Who hit the perfect balance between my 17-year old testosterone driven aggressiveness and my urge to romance the woman of my dreams. The key members of the band in the 1960’s and 1970’s were Burton Cummings and Randy Bachman. [author] => William Smead [legacyinterface_firm_id] => 392 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:50:40 [created_by] => 948 [modified_on] => 2014-10-14 14:51:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1686 [hits] => 0 ) [10] => stdClass Object ( [legacyinterface_commentary_id] => 1621 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14862 [apv_conversation_id] => [content_type] => market-commentary [title] => Can The Market Make A Comeback? [slug] => fpi_101414 [fulltext] =>

Although I’m a Detroit Lions’ fan and thoroughly enjoyed my team’s rare, 19-to-7 triumph over Green Bay’s football team last month, I’ve always respected the Packers. (Maybe because as a Lions’ season ticket holder since the 80s, I probably have seen the Lions lose to them more than anyone else.) They epitomize what football is all about.

They always seem to be a contender (with thirteen league championships – the most in the NFL, four of which were Super Bowl victories), the team is a non-profit operation owned by its fans (to the point where it’s hard to tell where the stadium ends and the town begins), and its past stars are legends. The Lombardi teams of Starr, Tayor, Hornung, Kramer, Davis, Nitchke, and Aderley were a regular part of the season each fall during my childhood.

So I was delighted to see the Packer’s come-from-behind victory on Sunday, even though it meant they stayed in a tie for the North Division leadership with the Lions. Trailing 24-17 with just 4:09 to go, they scored a field goal to make it 24-20 and tighten things up. Then with just three seconds left in the game, the Packers’ perennial standout quarterback, Aaron Rodgers, reached back and tossed a perfect pass to tight end Andrew Quarless standing in the end zone. Game over, Packers’ victory! The few cheeseheads in the Florida stands exploded.

Last week’s stock market was a lot like Sunday’s game. Yesterday the lead changed hands three times. First Green Bay surged ahead, then the Dolphins, and back and forth again before Green Bay put on the final surge. In the stock market, 1.5%-plus up and down days occurred back and forth throughout the week. Overall, the Dow advanced and declined over 2000 points in the last week alone. But this time it was the bears (and not the Chicago variety) that came out ahead.

Stocks were down severely in September, and it’s been more of the same so far in the fourth quarter, so investors have to be asking: “Can the stock market make a comeback?”

With Ebola now spanning the Atlantic, recession worries shaking Europe, growth concerns in China, and earnings reports looming, most investors must feel like the punt returner who just caught the ball on the one-yard line and the entire opposing team is bearing down on him. Yet every weekend we see this occur, and every week some team marches 90-plus yards and scores a touchdown. I think this year is likely to end up in the same manner in the markets.

Like yesterday’s Packers’ game, though, I think we’ll take a field goal first before the touchdown. By that I mean, if we follow seasonal patterns, stocks should bounce this week, then regroup before moving higher around the end of the month until year’s end. Check out our Political Seasonal Index, which tracks over 100 years of the Dow Jones Industrial Average’s history. Some of the mid-month gains projected arise from this being an options expirations week. These weeks are usually positive and, with the market being so oversold, a bounce seems likely.

Longer term, interest rates may hold the key. Certainly the fact that rates are down so far this quarter (making bonds along with gold one of the few winning investments in the period) is a positive short term for stocks. But increasingly I am coming around to the view that rates may stay low longer than most on Wall Street believe is possible.

With the aforementioned economic weakness abroad, global investors have few havens for their funds other than the US, if they are seeking safety. And, of course, the rising Dollar is a plus here as well. In addition, the news on inflation is encouraging. While there have been signs of inflation creeping up, it is not soaring. If inflation is under control, what is the rationale for the Federal Reserve to raise interest rates? If this is the case next spring and the weakness abroad continues, it’s likely that the Fed might just wait a bit longer before it jacks up our interest rates. Notice how the Fed has reacted each time inflation prospects got this low:

Source: Bespoke Investment Group

As further evidence of inflation’s failure to heat up as yet in this recovery; check out the change in the price of gasoline. It’s been falling since July, and if seasonal tendencies exert themselves, gas prices could have much lower to go. I actually paid $2.97 per gallon today. Not only does that put less inflationary pressure into the markets, but it means consumers have more discretionary money to save or spend.

Source: Bespoke Investment Group

Economic reports have been generally underperforming expert predictions and have been one of the reasons why we have been forecasting the current set back in this newsletter for the last month, but last week we finally got a positive majority from the reports. While it was just a 4-2 split between the better-than-expected and less-than-expected economic missives, it was the first upturn in a while and could give some support to stocks, especially if the heavy number of reports on Wednesday and Thursday continue the positive trend.

Finally, earnings reports started off with a bang last week for the third quarter reporting season. Alcoa, always the first to report, outperformed analyst estimates. While there has been little predictive magic to Alcoa’s past performance vis-à-vis the rest of the market’s performance for the remainder of past earnings seasons, it is noteworthy that Alcoa is a multi-national corporation with overseas sales that seems not to have been hurt by the European or Chinese weakness – a big concern expressed by market bears.

Secondly, Alcoa’s performance may be reflecting what will perhaps become a trend this earnings season. Analysts have been unmerciful over the last month in downgrading the earnings expectations for stocks. As Bespoke Investment Group points out in its usual excellent investment analysis, when analysts are generally negative, they tend to lower the bar to the point that most stocks surprise to the upside with their earnings reports, i.e. they beat the lower expectations. And when most stocks beat their earnings expectations, stocks as a whole tend to rise.

As the chart below illustrates, since 2009, whenever analysts lowered expectations on more stocks than they raised them on, more often than not the S&P has completed the earnings season higher rather than lower. (And, conversely, when more raised expectations, stocks underperformed.) Going into this earnings season there were 12% more S&P 500 company earnings downgrades than upgrades.

Source:  Bespoke Investment Group

Stocks are oversold, seasonality is changing from negative to positive, yields are falling not rising, the economy here is humming, earnings reports (which won’t come in heavily for two more weeks) seem likely to provide pleasant surprises, and Green Bay rallied to a win. If you know a cheesehead (like Michiganders they’re everywhere), take him or her to lunch and say congratulations – comebacks are possible.

All the best,

Jerry

© Flexible Plan Investments

[description] => Although I’m a Detroit Lions’ fan and thoroughly enjoyed my team’s rare, 19-to-7 triumph over Green Bay’s football team last month, I’ve always respected the Packers. (Maybe because as a Lions’ season ticket holder since the 80s, I probably have seen the Lions lose to them more than anyone else.) They epitomize what football is all about. [author] => Jerry Wagner [legacyinterface_firm_id] => 156 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 14:59:50 [created_by] => 948 [modified_on] => 2014-10-14 15:00:05 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1687 [hits] => 0 ) [11] => stdClass Object ( [legacyinterface_commentary_id] => 1622 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14863 [apv_conversation_id] => [content_type] => market-commentary [title] => Rising Rate Strategy Performance in a Falling Rate Environment [slug] => wisdomtree_101414 [fulltext] =>

In financial markets, there is no free lunch. After a difficult market environment for bond investors in 2013, the prevailing consensus to start the year was that long-term bond yields would continue to rise in 2014. This view has yet to materialize in the markets. However, the market reprieve for assuming interest rate risk has provided us with valuable information about the performance of various bond strategies. In the following analysis, we attempt to explain the costs of hedging and their impact on total returns in a less-than-ideal market for rising rate strategies.
 
YieldDuration and Recent Performance for “Rising Rate” Indexes


For definitions of terms and Indexes in the chart, visit our glossary.

The table above highlights how hedged and negative duration variants of traditional fixed income indexes have performed in a falling interest rate environment compared to long-only strategies. In the case of zero duration strategies strategies, investors were primarily rewarded by assuming credit and prepayment risk but did not necessarily benefit from falling U.S. interest rates. Since these strategies seek to reduce or modify exposure to movements in nominal U.S. interest rates, it should stand to reason that returns will generally be lower than long-only strategies as rates fall. Interestingly, even though returns have lagged, both zero duration strategies generated positive total returns. In the case of the high-yield strategy, underperformance was less pronounced, given the lower costs of hedging. Even though it did not pay to hedge over this time period, we now have the ability to quantify the risk versus reward relationship in real time.

Shifting the focus to the negative duration strategies, we believe that these strategies make sense for investors who have a greater degree of conviction about rising rates. In the most recent period, as interest rates fell, these approaches underperformed due to losses on their short positions. In the case of the high-yield strategy, this approach lost value on both sides of the trade as credit spreads widen and interest rates fell. However, in both approaches, returns from income were able to help offset or finance a portion of these losses. Total returns from negative duration strategies didn’t lose as much as the strategies gained from the move in rates. This can largely be attributed to the fact that the long bond portion helps to defray some of the costs associated with maintaining these positions.

While examining these strategies independently can give some insight into the future drivers of total return, we believe that the real value of these strategies is how they can be incorporated into a broader portfolio of interest rate sensitive assets. As shown above, hedging interest rate risk during periods in which rates actually fall is likely to create a drag on investment returns. This is to be expected; hedging risk incurs a cost. However, with investors relatively complacent about rising rates, we believe that these strategies can offer valuable cover when the Fed starts to shift policy.

Important Risks Related to this Article

Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

© WisdomTree

[description] => In our view, exchange-traded funds (ETFs) can provide powerful tools for fixed income investors both big and small. Even some of the most sophisticated investment managers have used ETFs to gain broad-based exposure to certain subsets of the fixed income market. [author] => Rick Harper [legacyinterface_firm_id] => 494 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:02:08 [created_by] => 948 [modified_on] => 2014-10-14 15:02:25 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1688 [hits] => 0 ) [12] => stdClass Object ( [legacyinterface_commentary_id] => 1623 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14864 [apv_conversation_id] => [content_type] => market-commentary [title] => Forecasting the Market: A Thought Experiment Revisited [slug] => pieh_101414 [fulltext] =>

With Q3-14 reported earnings just beginning, here is the latest update of my ongoing "thought experiment" for forecasting the S&P 500 price based on earnings fundamentals. The chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor's website as of October 9th, 2014. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort's monthly valuation update for instructions on downloading the spreadsheet.

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Here are the key assumptions in the calculations:

  • The 10-year average of nominal TTM earnings is 65.52 as of September 2013, rising to 78.02 by the end of 2015, based on "as reported" earnings forecasts.
  • The average nominal cyclical P/E10 is currently 18.26.
  • The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
  • Standard & Poor's estimates of TTM earnings for Q4 2013 through Q4 2015 consist of the following:
  • The months between the quarterly earnings estimates are linear interpolations.

The blue line represents Standard & Poor's TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2014 year-end earnings of $111.71 and an average nominal P/E of 18.26, we would see the S&P 500 at 2040. At this level, the nominal P/E10 would be 28.58, and the index would be about 54% above a hypothetical price multiple of the extrapolated 10-year earnings average (1312).

The red line represents a hypothetical S&P 500 price that is a multiple of the average nominal P/E10 of 18.26 and the 10-year average earnings of 66.85 for December 2013. The monthly index price estimates thereafter are linear extrapolations based on average 10-year earnings growth and earnings estimates from Standard & Poor’s.

The optimistic view (blue line) would put us around 1997 in the S&P 500 at the end of October, the assumptions being that the Standard & Poor's earnings forecasts are correct the nominal P/E10 ratio is the multiple we see.

The pessimistic view (red line) is a reversion to the historic earnings and nominal P/E10 multiple.

But history shows us that, regardless of your preferred earnings divisor (nominal or real, TTM or the 10-year average TTM), the P/E ratio has never hovered around the average. The market swings above and below its long-term average valuation in erratic arcs that can last for many years. For a long-term perspective on valuation extremes, Four Market Valuation Indicators and the compelling research of Ed Easterling on the history of earnings per share.

Check back next month for a new progress report.


Note from dshort: For some interesting comparisons, here are Chris's charts from the last several months, based on the then current Standard & Poor's spreadsheets.

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[description] => With Q3-14 reported earnings just beginning, here is the latest update of my ongoing "thought experiment" for forecasting the S&P 500 price based on earnings fundamentals. The chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor's website as of October 9th, 2014. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort's monthly valuation update for instructions on downloading the spreadsheet. [author] => Colonel Chris Turner [legacyinterface_firm_id] => 516 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:05:48 [created_by] => 948 [modified_on] => 2014-10-14 19:41:23 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1689 [hits] => 0 ) [13] => stdClass Object ( [legacyinterface_commentary_id] => 1624 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14865 [apv_conversation_id] => [content_type] => market-commentary [title] => Finally, a Five Handle! [slug] => cleary_101414 [fulltext] =>

Last Friday’s jobs report was significant in that for the first time since July of 2008 the unemployment rate dipped below 6%. The September report indicated that the unemployment rate fell from 6.1% to 5.9%. While we have seen improvement in labor markets for some time now, the Fed still seems to want to take their time reducing stimulative policy.


Yellen Dashboard
We know that the Federal Reserve has been reducing their bond purchases all year. The program should come to an end by the end of 2014. The question now weighing on bond investors’ minds is when will they begin to raise short-term interest rates. The Fed Funds rate is pegged near zero and, based on Fed Funds futures, it doesn’t appear that the market believes it will rise much before the third quarter of 2015. The October 2015 Fed Fund futures are trading today near 0.55%.

In order to understand why the Fed feels the need to remain cautious about raising rates, we can look at the Yellen dashboard for some clues (dashboard hyperlink courtesy of Bloomberg). It provides a view of where each factor was before the recession, how it changed during and where it is today.  This is a set of labor market indicators used by Fed Chairwoman Janet Yellen to look beyond the unemployment rate to get a better characterization of what is really going on in the U.S. labor market.

The dashboard has a number of indicators that provide more clarity on who is finding jobs, how are people being paid and what is the quality of the labor improvement. It includes measures such as the number of people hired as well as laid off as a percentage of paid workers. It also includes the number of people that have quit and the number of job openings available.

The data in her dashboard also provides more color on the unemployment rate because it includes the number of people working part-time who would rather be working full time if they could find full time employment. It also provides information on the number of people that have been unemployed for more than 27 weeks and the number of people participating in the labor market as a percentage of those that are eligible.

This last piece of information seems to be the most troubling. The participation rate currently stands at 62.7%, up from its low but still nowhere near the better than 66% rate we had pre-recession. There are a number of reasons that appear to be at play here. Most of them have more to do with secular shifts in the economy than specifically related to the recession or the meagre recovery we’ve experienced since. Because they are secular in nature it is possible that the Fed may decide to either remain on hold longer with respect to policy, or they may begin to communicate that the dashboard features have changed so that they can begin raising rates sooner. It seems more likely that the latter will be the case.

Secular Trends
One of the biggest secular trends is the aging of the work force. As older baby boomers remain in the work force longer, both because they want to and in some cases because they have to, the underemployment rate among younger workers is intractably high. At the same time the unemployment rate among older workers in their late 50’s is particularly low, especially among college educated workers. Because the baby boom generation is very large, it is likely that this issue will take some time to work through and as a result we may see the numbers related to people feeling under employed remain high for some time. It is possible this is also why we see such a slack recovery in housing.

Employment Level – 55 years and over

Another secular trend in the labor force is the lower participation rate. Federal programs to provide assistance to those without work have remained in place much longer and in a manner that provides greater assistance than in periods before the recession. As a result, it may have been possible for those people to remain out of the labor force longer, thereby reducing the participation rate.

Price Stability
The Fed seems very focused on the labor market as a justification for their policies. However, their primary objective is price stability. So far, the economy has muddled along at a slow rate of real growth, less than 3% over the last five years, so that inflation hasn’t been a problem. There are also global deflationary forces at work that have provided the Fed a tail wind. Deflation in Japan and Europe and a big slow-down in Chinese economic growth have reduced the pressure on capacity utilization around the world. As a result, the Fed hasn’t had to really fight inflation with higher interest rates.

Germany just posted the lowest level of industrial production they’ve experienced since 2009. China is likely to see slower growth, in the mid-single digits, as a result of their transition to a consumer driven economy. Japan, even with the latest round of Abenomics, can’t seem to get their inflation rate moving in the right direction. With these headwinds, the rate of global growth may continue to be slower even though the U.S. is experiencing some improvement in our own growth rate.

This suggests that, for now, the Fed Funds futures market may have it right. The Fed doesn’t need to be in a hurry to raise rates and probably won’t be.

© Cleary Gull

[description] => Last Friday’s jobs report was significant in that for the first time since July of 2008 the unemployment rate dipped below 6%. The September report indicated that the unemployment rate fell from 6.1% to 5.9%. While we have seen improvement in labor markets for some time now, the Fed still seems to want to take their time reducing stimulative policy. [author] => Brian Andrew [legacyinterface_firm_id] => 491 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:20:19 [created_by] => 948 [modified_on] => 2014-10-14 15:20:43 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1690 [hits] => 0 ) [14] => stdClass Object ( [legacyinterface_commentary_id] => 1625 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14866 [apv_conversation_id] => [content_type] => market-commentary [title] => Oracle’s Present State Looks Great But Challenges Lie in Wait [slug] => ycharts_101414 [fulltext] =>

You may think of Oracle (ORCL) as a company that sells software. In fact, at its core, it is a company that sells software updates.

Oracle has four other segments-including "New Software"-but all of them are simply shovels used to feed business into the mighty furnace of Oracle's Updates & Supports segment.

The Updates & Support business-comprising nearly half of Oracle's revenue stream-is phenomenally profitable, with operating margins of close to 90%.

Because Oracle's traditional enterprise database software is such an integral part of highly-critical accounting and other business systems, and because millions of dollars is spent customizing Oracle's software to a given client's needs, once a client has committed to using an Oracle product, they are tied into an inexorable upgrade cycle.

Every time the cycle turns, Oracle generates huge profits. You can see this at a single glance at this chart, showing per-segment earnings before interest and taxes (EBIT) contribution.

Operational Leverage

You may notice that the "Hardware Products" piece of the EBIT pie is almost diminishingly small. Pundits attacked Ellison for structuring the 2010 acquisition of high-performance hardware firm, Sun Microsystems for this very reason. "What good could come," they asked "if high-margin Oracle buys a low margin hardware business?"

However, as this author pointed out in the first YCharts Focus Report on Oracle, we do not think it is mere chance that ever since Oracle bought Sun, Oracle's vitally important Updates & Supports business experienced an enormous uptick in operating leverage.[1]

Analyzing the most recent financial statements of Oracle in our most recent report, it is clear that the operating leverage boost we identified in our last report has continued, though to a somewhat less-pronounced degree.

This crooked smile ending with a value of 18% means in practice that while Software Updates' segment revenues increased by (a still robust) 6% in fiscal year 2014, the segment's profits grew even faster—at a rate of 7%.

The fact that operational leverage continues to be strong in comparison with prior years is, in this author's opinion, a positive sign that speaks to the continued success of the Sun acquisition for Oracle and its shareholders.

Future Challenges

Oracle is doing what it does best-generating huge amounts of profits using its dual pacemaker/disposable razor strategy.

Hardware sales look to have stabilized and, as explained above, Oracle's most important segment is converting revenues to profits increasingly efficiently. If Oracle were a machine, it would be humming along at peak performance.

However, this does not mean that an investment in Oracle is a fire-and-forget affair. In fact, the company is reaching a critical transition point, underscored by founder Larry Ellison turning the CEO reins over to Hurd and Catz.

As is obvious in the chart below, Oracle began an acquisition binge about 10 years ago, when its organic growth had begun to slow.

Over the past several years, it has spent an average of about half its Owners' Cash Profits (which we define as Cash Flow from Operations, less an estimate of the money required to maintain the firm as a going concern[2]) on investments designed to boost future profit growth.

While profits continue to grow, they are growing more slowly, and we think this means Oracle's investments are giving it less and less of a boost. When you're small, all you need is good ideas. When you're big, you need good big ideas, and those are rarer.

It is at this stage in a company's existence that it can either make a bold, transformative move to redefine itself [e.g., Apple (AAPL) turning from a manufacturer of niche computer systems into a designer and marketer of consumer products] or it must take its foot off the investment gas pedal and start to return more profits to shareholders.

The risk with the first course is that the bold, transformative move will fail [e.g., Ron Johnson's JC Penney (JCP)], permanently damaging the company. The risk with the second course is that it takes too long for management to realize that its investments are no longer creating value. In this case, the stock runs the risk of becoming "dead money" until management figures out the mistake and corrects it.

Oracle: Dead Money Candidate?

Of the two risks, this author is relatively more worried about the latter. Oracle's capital expenditure requirements are very low. With its present Owners' Cash Profit margin level in the mid-30% range, its present average investment spending implies a Free Cash Flow to Owners level in the sub-20% range (we define Free Cash Flow to Owners as Owners' Cash Profits less money spent on investments designed to boost future profit growth[3]).

If Oracle could gracefully cut its investment level to somewhere around one-fifth of its owners cash profits (i.e., cutting its present rate of expenditures by more than half), it could materially increase the amount of FCFO it is generating, even if revenues were slow growing and profit margins stabilized.

But if it were going to cut something, what would it cut?

Its acquisition strategy ties into its critical Software Updates business-acquired technology is incorporated into future rounds of updates to Oracle's products. So cutting back on these acquisitions would potentially hurt Oracle's most important business line.

However, we estimate that roughly 40% of its "investment" dollars are going to fund anti-dilutionary stock buybacks (i.e., back-door compensation to executives and other employees). Cutting into these expenditures will not be easy either.

This issue will most likely affect medium-term growth rates since the impact of today's corporate acquisitions are greatest a few years after they are made and integrated. Changing assumptions about these growth rates can have a large effect on valuations.

In our valuation analysis, a feasible worst-case scenario generates a valuation in the upper-$20 range. This scenario--in which Oracle continues to make increasingly hard-to-integrate acquisitions that make increasingly diminishing improvements to the company's profit growth without appreciably boosting revenue growth--is not dissimilar to the case of networking giant Cisco Systems (CSCO).

Cisco is the poster child of Old Tech Dead Money--a dubious title it won from Microsoft (MSFT) since the end of 2010.

Could the same fate befall Oracle? Without the new CEOs Catz and Hurd making hard decisions about future investments and growth strat



[1] Operating leverage means that as additional dollars of revenue flow in, the firm becomes increasingly efficient at converting those revenues into profits.

[2] For a full explanation of Owners’ Cash Profits (OCP), please see our Valuation Methodology webinar replay.

[3] For a full explanation of Free Cash Flow to Owners, again, please see our Valuation Methodology webinar replay.

© YCharts, Inc.

[description] => You may think of Oracle (ORCL) as a company that sells software. In fact, at its core, it is a company that sells software updates. [author] => Erik Kobayashi-Solomon [legacyinterface_firm_id] => 479 [published_on] => 2014-10-14 [digest_date] => 2014-10-14 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 0 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-14 15:30:49 [created_by] => 948 [modified_on] => 2014-10-14 15:31:35 [modified_by] => 948 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1691 [hits] => 0 ) [15] => stdClass Object ( [legacyinterface_commentary_id] => 1626 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 0 [apv_conversation_id] => [content_type] => market-commentary [title] => Rocking the Lifeboat - Comments on the Recent Stock Market Volatility [slug] => rocking-the-lifeboat-comments-on-the-recent-stock- [fulltext] =>

The cruise ship sank.  The passengers are gathered in the lifeboat.  The officer in charge knows how to reach safety, just over the horizon.  If the passengers trust him, sit in their seats, pull on the oars and bail when necessary, all will make it home.  The problem is one passenger, let’s call him Mr. CNBC-FOX-CNN-MSNBC, who is a hysteric.  If the waters are calm, he’ll focus on other issues (ISIL, Ebola, the mid-term elections, where is Kim Jong Un?)  But the moment some waves hit the boat, he panics and starts jumping from one side to the other of the lifeboat.  As he thrashes, other passengers panic with him.  Soon the whole lifeboat is rocking side to side (up 1.7% one day, down1.9% the next day.)  If the rocking becomes violent enough, some passengers may decide to jump out of the lifeboat and try to swim for shore by themselves (we don’t go back for those passengers.)

We’re surprised less by the recent volatility, surprised more that markets have been so calm over the last three years.  To help explain market volatility, we show this chart to prospective clients:

  • Housing Bubble inflates and bursts
  • Bear Stearns fails
  • Lehman Brothers fails
  • Great Recession of 2009, and March 2009 stock market collapse
  • Greece fails once
  • Greece fails a second time
  • Italy and Portugal nearly default

And then, most curiously, a three year stretch through August 2014 where the US Stock Market had almost no volatility at all.  Since no media outlet can remember events of more than 6 months ago, the recent return to NORMAL volatility is headlined as “The End of the World!”

We tell our prospects, “We’re reasonably confident MORE horrible events WILL happen over the next 15 years.  But we’re also reasonably confident your money will double, possibly triple in the same time frame – why wouldn’t you take that bet?”

The reason why investors DON’T take the bet is because our national media is dedicated to scaring you silly every day.  If it’s not stock market volatility, then you should fear Islamic terrorists, Russian hackers in your bank account, West African diseases coming through the airports, South American children swarming the borders of Texas and New Mexico.

Well, STOP!

Here’s the deal.  People who work for General Electric or McDonald’s or Pfizer watch the same bad news as you.  And then these employees go to work every morning to build better turbines, or better hamburgers or better Viagra, or they don’t get paid a salary.  And thus corporate revenues grow, thus earnings, thus stock prices, thus our clients’ portfolios.

The third of our clients who are retired and dependent on their portfolios for their lifestyle continue to receive their monthly draw without fail.  How?  Because we have a year’s worth of retirement income in “near cash” investments and four years of income in bonds.  We reload the cash and bond buckets a couple of times a year from the “risk bucket” which contains US, international stocks, and commodities.  If, as we saw in 2009, the “risk bucket” collapses in value, we simply suspend the transfer until risk asset prices recover.  We have NEVER reduced a clients’ monthly draw in the 20+ years we have run this firm.

The Short Term Explanation of Volatility

US stocks have come far and fast in recent years – 202% since the March 2009 low, 39% since January 2013.  Investors raised cash to purchase Alibaba stock last month by selling stocks that did very over the last 5 years.  The temporary downturn caused the “weak hand” investors to sell additional stock through the end of September, while other investors booked profits coming into quarter end.  The magnitude of the recent pullback of the same magnitude as NINE OTHER pullbacks over the last three years.  Each time, stocks moved to new highs within a month or two. 

We would totally EXPECT the market to “back and fill” for a few months given the age of the current bull market.  Fed policy STILL remains accommodative with interest rates STILL at multi-generational lows.  Inflation STILL remains contained at 1.5-2%.  The employment rate continues to drop, now 5.9% (yes, the labor participation rate is still too low, but the US economy will add 2.4 million jobs this year.)  2nd Quarter US GDP was a blistering 4.6%, reversing Q1’s decline of 2.1%.  On a year over year basis, the US economy is growing at about 2.2%, which is on the low side, but also means no risk of inflation.  More good news for inflation – energy prices are down sharply with oil at the lowest level in two years.  Gas station prices will fall in a month, throwing extra cash consumers as we head into holiday shopping.

Our biggest concern is that earnings growth is in a lull right now, with Q3 2014 numbers to show only 1.5% growth year over year.  For much of the year, the median stock price traded about 5% above Morningstar’s fair value estimate.  With the recent pullback, stocks are now at 2% discount.  We would need to see stocks trading 10% above fair value to cut back positions, or 10% below to buy aggressively.  At present, we are simply rebalancing accounts in line with our target allocations.

Portfolio-Level Performance Disclosure

The portfolio-level performance shown is hypothetical and for illustrative purposes only. Investor returns will differ from the results shown.

The benchmark is 80% S&P 500/20% Barclays Aggregate Bond index.  

© Heron Financial

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“Abrupt market weakness is generally the result of low risk premiums being pressed higher. There need not be any collapse in earnings for a deep market decline to occur. The stock market dropped by half in 1973-74 even while S&P 500 earnings grew  by over 50%. The 1987 crash was associated with no loss in earnings. Fundamentals don't have to change overnight. There is in fact zero correlation between year-over-year changes in earnings and year-over-year changes in the S&P 500. Rather, low and expanding risk premiums are at the root of nearly every abrupt market loss.

“One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals… I've noted over the years that substantial market declines are often preceded by a combination of internal dispersion, where the market simultaneously registers a relatively large number of new highs and new lows among individual stocks, and a leadership reversal, where the statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions.

“This is much like what happens when a substance goes through a ‘phase transition,’ for example, from a gas to a liquid or vice versa. Portions of the material begin to act distinctly, as if the particles are choosing between the two phases, and as the transition approaches its ‘critical point,’ you start to observe larger clusters as one phase takes precedence and the particles that have ‘made a choice’ affect their neighbors. You also observe fast oscillations between order and disorder in the remaining particles. So a phase transition features internal dispersion followed by leadership reversal. My impression is that this analogy also extends to the market's tendency to experience increasing volatility at 5-10 minute intervals prior to major declines.”

Market Internals Go Negative, Hussman Weekly Market Comment, July 30, 2007

“We've started to see the pattern of abrupt jumps and declines at 10-minute intervals that is often a hallmark of nervous markets. My continued concern is that numerous market plunges have been indifferent to both interest rate trends and even valuations, with the main warning flag being deterioration in the quality of market internals, as we observe at present. Both in the U.S. and internationally, ‘singular events’ tend to occur well after internal market action has turned unfavorable, and prices are well off their highs.

“Though I don't want to put too much emphasis on intra-day behavior, if you examine tick data or daily ranges before major declines both in the U.S. and elsewhere, you'll generally see price movements become chaotic at increasingly short intervals even before the event itself. One way to describe it without mathematics is to spin a quarter on the table and watch (and listen to it) closely - you'll observe a similar dynamic at the abrupt point that the coin moves from an even spin to an irregular one, and again just before it stops. If you imagine a pen drawing out its movements, you would see it tracing out faster and faster circles as it moves from stability to instability.”

Broadening Instability, Hussman Weekly Market Comment, January 28, 2008

Over the years, I’ve frequently observed that the most favorable market return/risk profile we identify is associated with a material retreat in valuations, coupled with an early improvement in market action across a broad range of market internals. That combination does not require a retreat in valuations to historical norms, and whether that shift occurs at still-elevated valuations, depressed valuations, or in sporadic intervals, we fully anticipate such opportunities over the completion of the current market cycle and those ahead. It’s important to begin on that optimistic note; to recognize that there will be what we expect to be identifiable opportunities as conditions change, even though now is the precise antithesis of such an opportunity.

I’ve done all I can to clarify that my “permabear” reputation is an artifact related to my necessary but admittedly ill-timed 2009 insistence on stress-testing our methods against Depression-era data, as employment losses, economic contraction, credit strains, and market pressure became uncharacteristic and “out of sample” compared with the post-war data on which our methods were based. The ensemble methods that solved that “two data sets” problem improved on our pre-2009 methods, but they did lack various trend-sensitive overlays that we introduced in the late-1990’s in response to the tech bubble. Aggressive yield-seeking speculation provoked by the Federal Reserve’s zero interest rate policy led us to reintroduce variants of those overlays, in order to narrow our defensive response to persistent and uncorrected overvalued, overbought, overbullish extremes. All of that made for a terribly awkward transition from our pre-2009 methods of classifying market return/risk profiles to our present methods. Still, understanding that narrative (see Setting the Record Straight) is particularly important at present, in order to disabuse the belief that present conditions can be dismissed simply because we encountered those challenges in the first half of this wholly uncompleted market cycle.  

With regard to that 2009 stress-testing decision, I’ve frequently observed that our most historically reliable measures of valuation (which indicate that current valuations are about double their pre-bubble norms), were actually quite reasonable by late-2008 and early-2009 (see in particular my October 20, 2008 piece, Why Warren Buffett is Right and Why Nobody Cares). The problem is that the similar valuations, during the Depression, were followed by a further loss of two-thirds of the market’s value. It might be useful to recall that the legendary value investor Benjamin Graham was hedged going into the 1929 crash, but once valuations got down to what appeared to be reasonable valuation, he removed most of those hedges. Graham and his Graham-Newman partnership went on to suffer a 60% loss by 1932. One of the key lessons from our 2009-2010 “two data sets” challenge was that Depression-era data, as well as the credit crisis, imposed more demanding requirements on measures of market action (particularly measures of “early improvement”) than were typically needed in other post-war cycles.

Neither our stress-testing against Depression-era data, nor the adaptations we’ve made in response extreme yield-seeking speculation, do anything to diminish our conviction that historically reliable valuation measures are of immense importance to investors. Rather, the lessons to be drawn have to do with the criteria that distinguish periods where valuations have little near-term impact from periods where they suddenly matter with a vengeance.

The effect of valuations on subsequent market returns is conditional. While depressed valuations are a good indication of strong prospective long-term returns, depressed valuations don’t prevent further – sometimes massive – losses in the near-term. A retreat in valuation becomes reliably favorable mainly when it is joined with an early improvement in market internals. All of history (not just the Depression-era and the 2008-2009 collapse) imposes demanding requirements; not least that internals aren’t collapsing and credit spreads aren’t shooting higher, as they are today. Conversely, overvalued, overbought, overbullish extremes are associated with total market returns below risk-free interest rates, on average, but that average features an unpleasant skew: most of the week-to-week returns are actually positive, but the average is harmed by large, abrupt losses. Such extremes become reliably dangerous when they are joined by deterioration in market internals.

Present conditions create an urgency to examine all risk exposures. Once overvalued, overbought, overbullish extremes are joined by deterioration in market internals and trend-uniformity, one finds a narrow set comprising less than 5% of history that contains little but abrupt air-pockets, free-falls, and crashes.

In recent weeks, the market has transitioned to the most hostile return/risk profile we identify: the pairing of overvalued, overbought, overbullish conditions with deterioration in market internals and price cointegration – what we call “trend uniformity” – across a wide range of stocks, sectors, and security types (see my September 29, 2014 comment Ingredients of a Market Crash). As in 2007 and 2000, we’re observing characteristic features of that shift. One of those features is that early selling from overvalued bull market peaks tends to be indiscriminate, as deterioration in market internals and the “average stock” often precedes substantial losses in the major indices. As of Friday, only 28% of NYSE stocks are above their respective 200-day moving averages.

In the current cycle, both the Russell 2000 small-cap index, and the capitalization-weighted NYSE Composite set their recent highs on July 3, 2014, failing to confirm the later high in the S&P 500 on September 18, 2014. Through Friday, the NYSE Composite is down -7.3% from its July 3rd peak, and the Russell 2000 is down -12.8%, while the S&P 500 is down only -4.0% over the same period. What’s happening here is that selling is being partitioned in secondary stocks, and more recently high-beta stocks (those with greatest sensitivity to market fluctuations). Market action is narrowing in a classic pattern that reflects the effort of investors to reduce risk around the edges of their portfolios, in what typically proves an ill-founded belief that a falling tide will not lower all ships.

Abrupt market losses are typically not responses to obvious “catalysts” but instead reflect a shift in investor preferences toward risk aversion, at a point where risk premiums are quite thin and prone to an upward spike to normalize them. That’s essentially what’s captured by the combination of overvalued, overbought, overbullish coupled with deteriorating internals. Another characteristic of these shifts is increasing volatility at short intervals – what I described at the 2007 peak and in early-2008 by analogy to “phase transitions” in particle physics. The extreme daily and intra-day market volatility in recent sessions is typical of that dynamic.

Fed policy and risk premiums

Recall that very early into the 2000-2002 and 2007-2009 bear markets, the Federal Reserve began to aggressively ease monetary policy, but that did not prevent stock prices from going on to lose half or more of their value (see Following the Fed to 50% Flops). The short-term responses of the market were certainly positive, but those responses turned out in hindsight to be exit points. As I’ve noted before, if one is going to invest by aphorism, history teaches that “don’t fight the trend” strongly outperforms “don’t fight the Fed.” With respect to our own experience in the half-cycle since 2009, the primary lesson to be drawn is not that Fed policy trumps all other considerations. Rather, the lessons to be drawn relate to the criteria that distinguish periods where monetary easing is supportive to the markets from periods where policy shifts are irrelevant or even contribute to the loss of investor confidence.

Again, that distinction has a great deal to do with market internals and trend uniformity, because those measures of market action provide a signal about the tolerance or aversion of investors toward risk. In effect, Fed easing is effective provided that risk-free cash is considered an inferior holding. Fed easing is useless if investors actually prefer to hold risk-free cash as a safe haven.

There’s certainly a feedback circle to this: the purely psychological belief that Fed liquidity is a magical risk-removing fairy dust can certainly support increased risk tolerance, but that tolerance should still be read directly out of market internals and trend uniformity. When investor preferences shift toward risk aversion, more liquidity doesn’t support stock prices. Yield-seeking speculation fails to emerge because low or zero interest rates on cash are preferred to the prospect of steeply negative returns. As the market collapses of 2000-2002 and 2007-2009 demonstrate, aggressive Fed easing does not prevent extraordinary market losses once investors have the risk-aversion bit in their teeth.

The Fed certainly has a legitimate and often helpful role in crises when it is needed to act as a “lender of the last resort” by lending to solvent but liquidity-constrained financial institutions. Good public policy acts to responsibly relieve legitimate constraints on the economy that are actually binding. At present, however, the financial system is already drowning in trillions of dollars of idle cash reserves, which don’t need to “go” anywhere, because once a dollar of base money (currency or bank reserves) is created, it remains in existence, in the form of base money, until it is retired by the Federal Reserve. In other words, zero-interest sideline cash is zero-interest sideline cash and will remain zero-interest sideline cash until it is retired, and the only thing that $4 trillion of base money does for the economy is to change hands as a hot-potato that nobody wants to hold so long as risky assets appear to offer better returns than zero.

No doubt – this pile of zero-interest hot potatoes has helped to compress risk premiums across the entire range of risky assets toward zero (and we estimate, in some cases, below zero). But understand that the bulk of the advance in financial assets in recent years has not been a reasonable response to the level of interest rates, but instead reflects a dangerous compression of risk premiums.

The effect of zero-interest rates is measurable, and the arithmetic is straightforward. The expectation of another 3-4 years of zero interest rates (versus normal short-term interest rates of say, 4%) implies that risky long-term assets could reasonably be priced 12-16% above where they would be priced in a normal interest rate environment. That premium would reduce the prospective returns of those risky assets by that same 4% for 3-4 years, but would preserve normal risk premiums. But on valuation measures that are reliable across a century of history, including recent years, the valuation of the S&P 500 is now more than double its pre-bubble historical norms (and only looks more tolerable because investors do what they always do at cycle peaks, which is to capitalize peak cycle earnings as if they are fully representative of the entire stream of future long-term cash flows).

In short, every 3-month period of additional zero-interest rate policy promised by the Fed is worth about a 1% premium over historical valuation norms. Another year would be worth a premium about 4% over historical norms. But with the market more than double historical norms on reliable measures, the Fed would have to promise a quarter of a century of zero interest rate policy before current stock valuations would reflect a “reasonable” response to interest rates. No – stocks are not elevated because low interest rates “justify” these prices. They are elevated because the risk premium for holding stocks has been driven to zero. We presently estimate negative total returns for the S&P 500 on every horizon shorter than 8 years.

At present, prospective market return/risk should not be read from Fed policy. It should be read from valuations and the quality of market internals and trend uniformity, which we view as the best way to infer investor risk tolerances, the level of risk premiums, and the pressure on them. If these measures improve, a fresh easing of Fed policy would allow for further yield-seeking speculation. But in the context of extremely compressed risk premiums that are being pressed higher; in the context of an overvalued, overbought, overbullish market that has been joined by deteriorating market internals, broadening dispersion, and a loss of trend uniformity – all bets on the Fed are off, as they were in 2000-2002 and 2007-2009, until we observe a favorable shift in those measures of investor risk preferences.

Warning: Examine all risk exposures

All of that said, there’s no assurance that the present instance will match historical experience. As I noted at what in hindsight turned out to be the market peak in October 2007, in a piece that bears the same title as this section (see Warning: Examine All Risk Exposures):

“There is one particular syndrome of conditions after which stocks have reliably suffered major, generally abrupt losses, without any historical counter-examples. This syndrome features a combination of overvalued, overbought, overbullish conditions in an environment of upward pressure on yields or risk spreads. The negative outcomes are robust to alternative definitions, provided that they capture that general syndrome. We can't rule out the possibility that investors will adopt a fresh willingness to speculate (which we would observe through an improvement in market internals). Such speculation might prolong the current advance modestly, but even this would not substantially alter the risks that have ultimately been associated with overvalued, overbought, overbullish conditions.”

Though we should allow for a potential improvement in market conditions, I do believe that now is a particularly bad time to rely on the idea that “this time is different” with money you cannot afford to lose. This does not require forecasts about market direction – only proper consideration of market risk. Make sure that the portfolio of risks you do hold is the portfolio that you want to hold over the completion of the market cycle, understand the risk profile and actual losses that various asset classes have experienced over prior market cycles, take account of the prospective returns that are embedded into current valuations, and insist on historically reliable measures of valuation that demonstrate a strong association with actual subsequent returns over numerous market cycles across history.

My view is that even passive buy-and-hold investors should primarily focus on ensuring that the effective duration of their portfolio is not significantly longer than the horizon over which they expect to spend the funds. In other words, the duration of the assets should be matched with the anticipated horizon of spending needs (or liabilities). The estimated duration of the S&P 500 Index is roughly 50 years, 10-year Treasury bonds presently carry a duration of about 9 years, and cash has zero duration, so a passive investor expecting the average date of spending to be about 15 years in the future might match that with an asset portfolio of similar duration. Examples would include a 20%-55%-25% mix of stocks, bonds, and cash, respectively, or perhaps a 24%-33%-43% mix, but in any case not more than about 30% in equities.

The challenge here is that we associate each of those 15-year duration portfolio mixes with expected nominal total returns of less than 2% annually over the coming decade. Based on historically reliable valuation measures, we presently estimate prospective 10-year S&P 500 nominal total returns of just under 2% annually here, so increasing the equity portion does not improve the expected portfolio return. Investors should understand that “prices and valuations are high” is another way of saying “future returns have already been realized, leaving little to be gained for quite some time.”

Fortunately, as valuations retreat, durations shorten. For example, at the 1982 low, the dividend yield of the S&P 500 reached 6.7%, bringing the duration of the index down to 15 years, so from a duration-matching standpoint, even an investor with an expected spending horizon averaging 15 years could have been comfortable with 100% of assets in equities. At the 2009 low, the yield was a more moderate 3.8%, but that still implied a 26-year duration, making a 60% equity allocation quite reasonable even for a passive investor expecting to spend the assets, on average, 15 years hence.

Alternative investments are a bit trickier, as their exposure to market risk can vary. Since the potential for portfolio loss is a significant consideration, one approach might be to gauge relative risk by comparing maximum losses on a compound (log) basis. For example, if the worst historical drawdown of A has been 33% over several market cycles, and the worst drawdown of the market has been 55%, the relative risk of A might be estimated as log(1-.33)/log(1-.55) = 50% of that of the market. That odd-looking compounding arithmetic essentially captures the fact that it takes two back-to-back 33% losses to produce one 55% loss. Similarly, if worst historical drawdown of B has been 18%, the relative risk of B might be estimated as log(1-.18)/log(1-.55) = 25% of the market itself, as it takes four back-to-back 18% losses to produce one 55% loss like the S&P 500 experienced in 2007-2009.

An active investor would typically consider allocations not only from the standpoint of duration, but also broader conditions that affect returns over shorter portions of the market cycle. Presently, we don’t believe that active investors should expect a positive return from unhedged equities at all here, given the combination of rich valuations and deteriorating internals, which suggests skewing holdings toward cash or hedged alternatives until more favorable conditions emerge. Again, we view the strongest market return/risk profiles, and the best opportunities for unhedged investment, as coupling a material retreat in valuations with an early improvement in market internals. Now is the antithesis of those conditions.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

The Hussman Funds remain defensive toward equities, and modestly constructive toward Treasury bonds and precious metals shares. With market conditions in the same hostile configuration as we observed last week, the same considerations about day-to-day fluctuations apply. In Strategic Growth Fund, the recent decline has brought the major indices close to or below the strike prices of the long index put option side of our hedges. Though those put options currently represent a small percentage portfolio value (and could lose that amount if the market was to advance between now and their late-year expirations if we were to hold them throughout such an advance), they are also likely to change in value if the market declines significantly. In that event, we would expect good amount of “give-and-take” depending on whether the market advances or declines on a given day. So in the event of a significant market loss from here, these positions will tend to account a significant portion of day-to-day changes in net asset value in both directions.

We’ve long observed that deterioration in market internals and weakness in the “average stock” often precedes weakness in major indices (which are the most liquid vehicles for hedging). As a result, equity portfolios are likely to be somewhat more susceptible than usual to “tracking” differences between the stocks we hold long and the indices we use to hedge. With the broad NYSE Composite down 7.3% since its July 3rd peak, and the Russell 2000 down 12.8%, compared with a loss of only 4% in the S&P 500 over the same period, there is something of a headwind to the selection of individual stocks at the moment. Indiscriminate selling may produce further periodic day-to-day headwinds until investors begin picking the wheat from the chaff a bit more deliberately. Day-to-day changes in net asset value will also be affected to some extent as this process – common to the early declines following cyclical market peaks – takes its course.

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© Hussman Funds

www.hussman.net

 

[description] => Once overvalued, overbought, overbullish extremes are joined by deterioration in market internals and trend-uniformity, one finds a narrow set comprising less than 5% of history that contains little but abrupt air-pockets, free-falls, and crashes. [author] => John Hussman [legacyinterface_firm_id] => 218 [published_on] => 2014-10-13 [digest_date] => 2014-10-13 [access] => 1 [ordering] => 0 [post_to_apviewpoint] => 1 [post_to_rss] => 1 [post_to_legacy_database] => 1 [enabled] => 1 [created_on] => 2014-10-13 03:20:15 [created_by] => 945 [modified_on] => 2014-10-13 03:21:15 [modified_by] => 945 [checked_out_time] => 0000-00-00 00:00:00 [checked_out] => 0 [asset_id] => 1669 [hits] => 0 ) [17] => stdClass Object ( [legacyinterface_commentary_id] => 1604 [legacyinterface_template_id] => 9 [legacyinterface_record_id] => 14845 [apv_conversation_id] => 2504 [content_type] => market-commentary [title] => New Depths of Shallowness [slug] => willingdon_101314 [fulltext] =>

Falling to New Depths of Shallowness...

What happens in the corporate world often is a reflection of the values and trends in our society. Here are a couple of recent stories that, well, leave me scratching my head...

The world's leading soft drink company, Coca-Cola, has found a rather creative way to reverse the long slide in soft drink sales. They have developed a marketing campaign called "Share a Coke," whereby they imprint popular names like Chris, Jess, and Alex, on soda cans and bottles. Apparently, in response to this personalization, soft drink sales have rebounded sharply. A Wall Street Journal article tells the story of a couple searching all summer for bottles with their names on them, so they can keep them forever. Really? Meanwhile, another corporate icon, Apple, is battling complaints that their recently released and largest phone ever, the iPhone 6 Plus, bends when people sit on it.

I'm getting the disturbing picture of a poor soul named Jess who, after a relentless search, has found her personalized bottle of diet coke. Feeling true joy for the first time Jess holds the bottle, lifts it skyward, and sits down into a chair. Mesmerized by the experience she forgets that her new IPhone 6 Plus is in her back pocket...

And then, of course, the entire story goes viral on Facebook. What, if anything, does this nonsense say about our society?

For decades, Coca-Cola has been one of the most recognized global brands, and has had a long history of marketing success. I'd like to teach the world to sing, remains one of the iconic ads of all time. Perhaps Coca-Cola now understands that we have become the "Me Generation" and simply putting our names on products will motivate greater consumption. Would future marketing initiatives include our picture on the bottle or our voice recording when we unscrew the cap?

In a similar vein, should there be warning labels on iPhones? – Remove phone from back pocket before sitting down or jumping in to the pool... Wouldn't you rather have Apple spend its creative resources developing the next amazing product as they have done throughout its history? Perhaps they still can, but I fear there is a trade-off.

In essence the question to me is this - Will true innovation, driven by scientific research and discovery, be sacrificed by a focus on marketing to an increasingly superficial consumer, who moreover, seems less willing to take responsibility for their own actions?

Innovation, mind you, is the life blood of long-term earnings growth and ultimate business success. In a highly-competitive global economy, companies that can continually out-innovate their competition will be the winners over the long run. When Henry Ford introduced the Model T, he said "Any customer can have a car painted any colour that he wants, so long as it is black." How odd that seems today.

logisticsIn a society that values substance over style, patient, yet determined research and discovery naturally predominates. But when a society becomes too self-absorbed, it becomes impatient, demanding instant gratification. And when society puts too much of a burden on the corporate sector for irresponsible behaviour, innovation and growth suffer.

The United States economic system flows through cycles of prosperity and decline, affecting participants unevenly. While it is far from perfect, it is better than any other system, and has created more wealth than any economy in the history of the world. An amazing record in our relatively short history, but are our best days behind us or ahead of us? Stay tuned.

© Willingdon Wealth Management

http://www.willingdonwealth.com/

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NEW YORK – Two new studies show, once again, the magnitude of the inequality problem plaguing the United States. The first, the US Census Bureau’s annual income and poverty report, shows that, despite the economy’s supposed recovery from the Great Recession, ordinary Americans’ incomes continue to stagnate. Median household income, adjusted for inflation, remains below its level a quarter-century ago.

It used to be thought that America’s greatest strength was not its military power, but an economic system that was the envy of the world. But why would others seek to emulate an economic model by which a large proportion – even a majority – of the population has seen their income stagnate while incomes at the top have soared?

A second study, the United Nations Development Program’s Human Development Report 2014, corroborates these findings. Every year, the UNDP publishes a ranking of countries by their Human Development Index (HDI), which incorporates other dimensions of wellbeing besides income, including health and education.

America ranks fifth according to HDI, below Norway, Australia, Switzerland, and the Netherlands. But when its score is adjusted for inequality, it drops 23 spots – among the largest such declines for any highly developed country. Indeed, the US falls below Greece and Slovakia, countries that people do not typically regard as role models or as competitors with the US at the top of the league tables.

The UNDP report emphasizes another aspect of societal performance: vulnerability. It points out that while many countries succeeded in moving people out of poverty, the lives of many are still precarious. A small event – say, an illness in the family – can push them back into destitution. Downward mobility is a real threat, while upward mobility is limited.

In the US, upward mobility is more myth than reality, whereas downward mobility and vulnerability is a widely shared experience. This is partly because of America’s health-care system, which still leaves poor Americans in a precarious position, despite President Barack Obama’s reforms.

Those at the bottom are only a short step away from bankruptcy with all that that entails. Illness, divorce, or the loss of a job often is enough to push them over the brink.

 

To continue reading go here: http://www.project-syndicate.org/commentary/economic-failure-individual-insecurity-by-joseph-e--stiglitz-2014-10

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  • ​In light of the generally buoyant economy, we may start to see more normal conditions returning to the UK labour market and, importantly, upward movement in wage growth over the cyclical horizon. 
  • In turn, these developments are critical for the conduct and timing of monetary policy and the behaviour of the Bank of England’s (BOE) Monetary Policy Committee. 
  • We believe investors may want to treat the BOE’s interest rate cycle with caution​ in shorter-maturity bonds, while valuations offer more protection in intermediate bonds given PIMCO’s New Neutral thesis of secularly low real interest rates.
​​

Over recent months, a combination of geopolitics, weak inflation and most recently the Scottish referendum have all raised genuine questions over when, and by how much, UK interest rates will rise. In particular, very benign wage growth, below-target inflation and questions over the economic outlook for the eurozone have pushed expectations of the start of the UK hiking cycle to Q2 2015. In the knowledge that the UK will not be going through a challenging period of separation from Scotland, and while issues remain in the Middle East and Ukraine, this appears a good time to take stock and revisit the underlying performance of the economy and in turn the outlook for interest rates.

Before turning to the economic outlook for the UK, it is worth noting that one of the most interesting aspects of the market is the implied pricing of the Bank of England’s (BOE) first rate hike by Q2 2015, which to my mind is the least likely date for the start of any monetary cycle. This in large part relates to the cycle of meetings of the BOE’s Monetary Policy Committee (MPC), and their coincidence with the May 2015 general election. It seems highly likely that, when the MPC do get round to the first hike, BOE Governor Mark Carney will want to explain the MPC’s thinking in some detail. After all, the last UK rate hike was in July 2007, some seven years ago. Not a single current member of the MPC has raised interest rates in the UK. That suggests that the first rate hike will come alongside the quarterly forecasting round at the BOE, which results in the publication of the quarterly inflation report and accompanying press conference. The quarterly cycle runs in February, May, August and November each year. Thus the timing is such that the May decision and inflation report will be within days of the 2015 general election.

While we fully accept the MPC rhetoric that the political cycle will not weigh on its decisions, we think it is hard for the MPC to say anything else and equally hard to actually make the first move at such a politically charged moment. That brings us back to the question: Will the recovery be sufficiently well-entrenched to allow the MPC to start the hiking cycle ahead of the general election, or will we find that MPC guidance persistently indicates that rates are going up, but not yet?

Staying the course

A look at the underlying dynamics indicates the economy retains good momentum. GDP data has exhibited more volatility than the monthly purchasing manager index (PMI) over the last decade (see Figure 1), and there is a long-standing debate about which provides the higher-quality real-time information on the state of the economy. However, the striking aspect of these series is how they both have been strong for the last two years, and there is little in these series to suggest an imminent slowdown in activity. Most recently, some of the forward‒looking components, such as the new orders series, have come off their peak ‒ but levels remain strong. In short, the domestic tailwinds to growth appear to remain.

 

We can also see that the economy is holding up well by looking at a range of other business surveys, where investment intentions remain strong, as do the all-important surveys of employment intentions. Employment growth has been remarkably strong in this recovery (see Figure 2), currently running at levels not seen since the late 1980s.

 

While this all speaks to economic momentum being maintained, it does not answer the key question of why wage growth has remained so weak, and whether it will remain so. Given that inflation appears stable at 1.5%, as long as wages remain so weak, there will be little appetite for the MPC to raise interest rates (indeed, there would be no good reason to hike rates).

About that raise …

To answer the puzzle of low wage growth, we should look at not just the rate of improvement in the demand for labour, but also the level of demand relative to the level of supply. Indeed, if the level of supply still overwhelms the absolute amount of demand, it would be no great surprise that wage growth is so weak, particularly with the dark days of 2008 and 2009 so fresh in many people’s minds.

This indeed does appear to provide one potential answer to the puzzle of weak wage growth. Job centre vacancies in the UK have been rising strongly since mid-2012, rising from 450,000 to 650,000 at the most recent reading in July this year. These levels of vacancies are very similar to the average level of vacancies in the 10 years prior to the collapse of Lehman Brothers in 2008 (the average number of vacancies was 610,000). However, the number of unemployed is still materially higher than the decade prior to the collapse of Lehman Brothers, with a current number of 2.02 million compared with an average of 1.575 million in the decade prior to September 2008, according to the Office for National Statistics. So, putting the demand for labour in the context of the supply of labour, it should not be a big surprise that wage growth is weak. At present, average hourly earnings are growing at 0.6%, compared with the 4%–5% prior to September 2008.

That raises the obvious question: How long will it take the UK to use up that spare labour market capacity, and in turn see wages start to rise? While there are many caveats to any forecast, there are ways in which we can start to answer this question. One way is to look at the ratio of job centre vacancies to the total number of unemployed, and see how that compares to real wage growth (defined as average hourly earnings less CPI). Looking at Figure 3, the ratio of vacancies-to-unemployment remains below even the cyclical lows prior to the financial crisis, and in turn real wages are very weak. However, looking forward, if we were to assume that vacancies remain unchanged but that the unemployment rate continues to fall by 0.75% per annum, we could get an estimate as to how quickly the economy will reach the point of traction in wage growth.

Given current economic momentum, this is a pretty conservative set of assumptions for unemployment, which has fallen by 1.5% in the last 12 months. Under these assumptions, we should start to see upwards momentum in wage growth over the next six months.

Looking at market timing in a little more detail, the above projections suggest that the October 2014 data set will show vacancies as a percentage of the unemployed reaching the prior cycle lows, when we should start to see more normal conditions returning to the labour market. We believe that it is unlikely that real wage growth will return to 2% above inflation in the next 12 months, given the other factors pressing down on wages such as tighter controls on benefits, increasing numbers of over-65-year-olds remaining in the labour market and immigration.

However, we should be able to see real wages finally get back towards a positive number after six years of real wage contraction. This is critical for the conduct of monetary policy and the behaviour of the MPC. As the MPC members have been keen to make everyone aware, monetary policy works with a lag. Thus, they need not wait to see the actual rise in wages, but just to be confident that the rise in wages is coming, and that it will more than offset any productivity improvements. If that is the case, we should still expect to see the first rate hike this side of the general election, with the February 2015 MPC meeting and inflation report the most likely period.

Are we there yet?

If that is the case, then shorter-dated UK bonds will be vulnerable over the next six months, and are likely to be the focal point for any market weakness. Further out on the curve, PIMCO’s New Neutral base rate of 2%–2.5% implicit in the structure of the gilt curve suggests fairer valuations.

The UK remains a highly levered economy sensitive to changes in asset prices, especially housing. As such, treat the interest cycle with caution in shorter-maturity bonds, but remember the economic healing has a long way to go. That will temper this rate cycle (and probably the one after that). ​

© PIMCO

www.pimco.com

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[options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( [start] => 820 ) [inputs:protected] => Array ( ) ) [post] => JInput Object ( [options:protected] => Array ( ) [filter:protected] => JFilterInput Object ( [tagsArray] => Array ( ) [attrArray] => Array ( ) [tagsMethod] => 0 [attrMethod] => 0 [xssAuto] => 1 [tagBlacklist] => Array ( [0] => applet [1] => body [2] => bgsound [3] => base [4] => basefont [5] => embed [6] => frame [7] => frameset [8] => head [9] => html [10] => id [11] => iframe [12] => ilayer [13] => layer [14] => link [15] => meta [16] => name [17] => object [18] => script [19] => style [20] => title [21] => xml ) [attrBlacklist] => Array ( [0] => action [1] => background [2] => codebase [3] => dynsrc [4] => lowsrc ) ) [data:protected] => Array ( ) [inputs:protected] => Array ( ) ) [cooki