July 5, 2013 2:01 pm

 
The Long View: ECB comes to the market’s rescue again
 
 
Reasons for eurozone worries have not gone away
 
 
The Fourth of July, the most joyous date in the American calendar, is usually a time for the US to celebrates its independence from Britain. This year, there was a twist. As Americans took a day off, the central banks of the UK and the eurozone declared their independence from the US.

Both the European Central Bank and the Bank of England used their monthly monetary policy meetings to change their practices of many years, and announce their long-term intentions for monetary policy. Both suggested that rates would be lower for longer than investors expected. As a result, the pound and the euro tanked, while British and eurozone shares leapt.
 
This might not sound revolutionary. But it was. Central bankers like to keep markets guessing, and hate to commit themselves in advance.

The ECB and BoE felt compelled to respond to events two weeks earlier. Then, the Federal Reserve’s Ben Bernanke announced a timetable for removing, or “tapering”, the stimulus he is injecting into the US economy. The market was amazed that he suggested that the stimulus could be ended altogether as soon as the middle of next year.

Friday’s US jobs report, revealing the US labour market continued to show slightly greater strength than many expected, forced the message home. Despite much ongoing weakness in the US economy, if its labour market keeps improving like this, the chances are that the Fed stimulus will end next summer. In response, bond yields moved sharply upwards across the world. This may well have been what Mr Bernanke wanted, even if Fed colleagues later downplayed his remarks.
 
What is now beyond doubt is that the market went very far beyond anything the BoE or ECB could tolerate.

To counter rising rates, the ECB said it “expects the key rates to remain at present or lower levels for an extended period of time”, while the BoE’s new governor, Mark Carney, said “the implied rise” in future rates was “not warranted by the recent developments in the domestic economy”. In other words, the market had set gilt yields too high.


As a result, although the Fed is still buying bonds, while the ECB’s balance sheet is contracting, the extra yield on German Bunds compared to US Treasury bonds reached its highest since the crisis.

There is irony here. When the Fed launched its programme of bond purchases in early 2009arguably a form of printing money – the rest of the world complained that it was fightingcurrency wars”.

Low US rates made for a weak dollar, and cheaper US exports. The response was for other countries to cut their rates. In effect, the Fed exported its low interest rates. Now the problem has reversed. The Fed is exporting higher rates, and the ECB and BoE have been forced to be more lenient.

There is one safe bet out of this, which is prolonged weakness for sterling and the euro, already near their lows for the year. When their central banks appear so much more dovish than the Fed, this can only weaken them against the dollar.
 
A second, slightly less safe bet is on European equities. Easy money is good for stocks, and these announcements will prop up stock markets which in Europe have been anaemic.

But there are provisos. In the UK, the great concern is the country’s bubble-prone housing market.

Adding stimulus when house prices are already high – and they are at extreme levels in London, if not the rest of the country – is a really bad idea. A weak economy and a housing bubble do not go well together.

In the eurozone, the issue is the resolution of the sovereign debt crisis, which has been in abeyance since the ECB’s promise last July to dowhatever it takes” to save the euro. But this promise does not resolve two critical issues. First, banks hold huge amounts of their own governments’ debt.

This link has to be severed, by agreeing ways to rescue banks that do not put pressure on public finances. That presumably means losses for banks’ creditors. Negotiations towards a “banking union” are tasked with resolving this, and they are tortuous.

Second, markets must be convinced that the credit of one eurozone country is as good as that of another. That means that countries must be prepared to stand behind each other, opening the prospect of expense for countries like Germany and of loss of sovereignty for those that might need help, like Portugal. It is an acute political problem.

This week proved that the ECB can still quash such concerns. A political crisis in Portugal called into question the survival of its coalition government, and of its economic austerity programme. But the stock market’s losses on this were reversed after the ECB had spoken.
 
While European stocks enjoy support from their central banks, it is a bad idea to bet against them. But in the longer term, the reasons for concern about the eurozone and UK are not going away. That they share the world with a Fed that is talking up rates only adds to the hazards.

 
Copyright The Financial Times Limited 2013.



July 5, 2013 5:35 pm
 
Stocks feel heat of central bank battle
 
 
Jawboning is one of the more subtle tools in a central bank’s armoury. But the European Central Bank and the Bank of England deployed it to effect this week.
 
On Thursday the two central banks for the first time explicitly promised that interest rates would stay low for a long time, so-calledforward guidance”.
 

Share markets' response to the Fed and ECB



    Their unusual and apparently uncoordinated verbal intervention was aimed at countering the recent rise in bond yields. That was triggered by the US Federal Reserve’s plans to reduce and then end its ownquantitative easingprogrammeseen as posing a risk to fragile recoveries in the UK and Europe.
 
Analysts hailed it as a “historic event” in central banking and the initial investor reaction was unambiguously positive. Equities and bond markets rallied, and the euro and sterling tumbled against the dollar. In effect, the ECB and BoE got some of the pop of QE, without buying a single security.
 
“The market’s reaction clearly showed that investors did not expect European central bankers to be so bold, so soon,” says Myles Bradshaw, a portfolio manager at Pimco.
 
But the rally in stocks ended abruptly on Friday, when robust employment numbers in the US bolstered expectations that the Fed will scale back QE. This once more roiled bond markets, and erased some of the gains made by European and UK equities.
 
The swift reversal underscores how tricky it will be for the ECB and the BoE to shield the European recovery from the effect of changing monetary policy in the US. For all the tools at their disposal, the Fed remains in effect the world’s most powerful central bank, and few countries will be able to escape the effect of rising Treasury yields.
 
Strategists and investors predict that the push and pull of disparate central bank policy will be a defining feature for markets in the coming year. “This highlights the new battle ground for central banks in Europe, namely to fight the market’s reaction to QE tapering,” Citigroup analysts said.
 
Many remain optimistic that the ECB and the BoE will succeed in at least partlydecoupling” their monetary conditions from the US. The forward guidance was robust and clear, and could be followed up with more concrete steps, such as restarting QE in the UK or moving to a negative deposit rate in the eurozone.
 
“It reinforces that the UK, Europe and the US are in very different stages of their cycles,” argues Nick Nelson, head of global equity strategy at UBS. “We’re not immune [from the rise in US rates], but we can have some nuances.”
 
The positive impact may be greatest through weaker currencies. While European and UK shares and bonds lost ground after the strong US employment data on Friday, the declines in the euro and sterling deepened further.
 
Many strategists and investors expect this trend to continue. Buying the dollar has been one of the most popular trades in the global currency market this year as investors have bet the US economy will pull away from its developed market counterparts.

Investors say that this week’s action by the ECB and BoE could make shorting the pound and euro against the dollar an easier trade.
 
Currency investors are also pleased to see some firm differentiation between central banks on future interest rates. Trading currencies on diverging interest rates has traditionally been a key way of making money – but that has been harder in recent years as most major central banks have moved in the same direction, to lower interest rates.
 
“We’re setting ourselves up for a world that has a lot more divergence in it,” says Matthew Cobon, a fixed income and currency investor at Threadneedle. “For someone who’s strategically dollar bullish that’s a welcome sign.”
 
Equities should also benefit from weaker currencies. A strong dollar is particularly good news for companies with US revenues, it helped the FTSE 100 keep most of its gains on Friday. But a weaker euro and sterling “will help all exporters”, Mr Nelson points out. “This is clearly good for equities.”
 
Nonetheless, some fund managers remain cautious. They point out that European central banks are more dovish due to the diverging economic outlook: the US is recovering but the UK and European economic outlooks remain gloomyhardly a fillip for stocks.
 
“A relaxed monetary policy is a positive for equities but at the same time you have to be careful because this is a confirmation that economic growth isn’t there,” notes William Davies, head of global equities at Threadneedle. “The worst is if you have an economy which isn’t recovering strongly and rising rates.”
 
Underlining the challenges facing the eurozone in particular, German new orders fell for a second month in May, revealing weaknesses even in the continent’s strongest economy. If bond yields also continue to climb, the ECB’s Mario Draghi and the BoE’s Mark Carney may well need to go beyond mere jawboning.

 
Copyright The Financial Times Limited 2013


A Venture Investor from Bell Labs Channels the Noise and the Knowledge

By John Mauldin

Jul 05, 2013


Recovery and Home


Investors seek that elusive substance called alpha. It is too often remains hidden from them, and instead they find some form of beta, or simply what the market gives everyone. Sometimes, in secular bull markets, that can be plenty and investors feel secure. But in the secular bear cycles investing is a difficult task and one that at the end of the day may find you distressingly close to where you started.

Beta, alternative beta (often trying to pass as alpha), and true alpha are the only real sources of returns. Today I am somewhat under the weather and unable to produce an issue of Thoughts from the Frontline, but I will offer you the following fascinating essay, sent to me by my good friend Andy Kessler. Our mutual friend George Gilder has written a powerful new book called Knowledge and Power, and he asked Andy to hammer out in his wordsmithy a foreword, which he has done to perfection.

Alpha is found on the edges, away from common knowledge. Andy sees it in new technologies, and it can surely be found there, although there are different risks at the edge. But there are other sources of alpha, which can be found not by looking at what has happened but at what is likely to happen, not just in technology but in markets and the actions and reactions of those who would try to move markets.

But for today, let's just look at Andy's essay and enjoy our weekends.


Foreword to Knowledge and Power

A Venture Investor from Bell Labs Channels the Noise and the Knowledge

By Andy Kessler


I get off the green Number 5 train at the Wall Street stop as I've done a million times before. It could be this year or years ago. It doesn't matter. I carefully shuffle out with the pack of humanity, half in suits, the other half wearing bike messenger bags, and make my way out through the turnstiles, and shoulder to shoulder with people in a hurry, slip and slide up the litter-strewn stairs onto the Street.

The sun is bright, piercing. You can see everything, but none of it comes into focus. I'm instead distracted by the racket. Car horns honking, jack hammers rattling away, a guy selling the New York Post going on about the latest sensational Twittered sex crime. Trucks roar by me. Subways screech beneath me. An ambulance with sirens blaring goes up on the sidewalk to get around some construction. Bad musicsomeone rapping "Turn it up! Bring the Noise" – is blaring from a Starbucks that turns out to have no restroom. My head is spinning. I can hardly hear myself think.

But underneath all that noise, I hear a sound, sort of a thub-dub, thub-dub, a relentless reggae beat, sometimes loud, sometimes soft, faster, slower, but the pulse is always there. Is it a heartbeat, the predictable rhythm of life? Or does it bear a signal, a difference, a delta of news? The precious modulation of a wave of new creativity in the channels of the economy?

I've got $500 large of other people's money to invest. "I won't lose any of your capital and I'll find the next Microsoft," I told them in 1995. What the hell was I thinking? It's so loud down here it's hard to make sense of anything. Every story sounds good, every stock looks like a bargain, but there are so many stories, they drown each other out. Too many stories essentially merge into one endless market oscillation, a random motion through time that will deceive most technical analysts who take it for a signal and be left gasping and grasping for handfuls of noise.

I think I'm different. I've got alpha, babywhich in Wall Street-speak means I think I can generate excess returns over the market. I think I can find the profits of surprise, the yield of real knowledge. Everyone says that, of course, but most investors are all beta, just volatility, just the random motion of the surf. When markets go up the beta warriors outperform and when markets go down, they get killed.

To generate alpha, I need help, direction, signposts, analysts, sometimes even brandy-toting salesmen. But about the only pointer in view is George Washington's outstretched arm on Wall and Broad aiming across the street to the New York Stock Exchange, almost as a warning to watch out for those guys in funny colored blazers. On the other corner is 23 Wall Street, the JP Morgan headquarters bombed by anarchists in 1920. Now they blow these banks up from the inside – with combustible illusions of alpha.

I've got to put that money to work, buy stocks that go up 5-10 times and prove the my alpha is real. In this book, and in Claude Shannon's classic model it describes, alpha goes under the name of entropy. But it's essentially the same thing. It is the unanticipated signal, the upside surprise, the unexpected return, the messages amongst the noise on the Street. The predictable returns are already in prices, in interest rates. I have to achieve upside surprises that are not implicit in current prices and I have to get them not merely today or tomorrow, but month by month, year by year. And I have to hedge them with shorts of stocks that are overblown and going down faster than the Titanic. Simple enough, right? I wish.

While subway surfing on that 5 train, I was channeled by history, in the form of Larry, a guy in a leisure suit, who ran Go-Go money, as we used to call it, back in 1973. "Ah," he tells me, "those were the days and daze. A White Weld institutional salesman would call me every morning at 9 AM, with the early word on what his analysts were saying on Polaroid or Xerox or Phillip Morris

Trading cost 75 cents a share, but who cares, there were only 50 stocks that mattered, the Nifty Fifty, and you just bought 'em, never sold. Maybe I'd get some ideas from the Heard on the Street in the Journal, or maybe Inside Wall Street from Business Week."

Unfortunately, the Nifty Fifty melted into a worthless heap, and Vanguard, John Bogle's pioneering new fund, rose from the ashes. Egged on by a Big Bang of market deregulation, negotiated commissions and lower transaction costs, Vanguard back in 1975 figured that alpha was a myth, that no mere mortals could beat the market, so they indexed the whole damn thing. Buying a Vanguard fund, you merely bought a statistical sample of the market.

It was like driving all the knowledge out of prices. Danny Noonan in Caddy Shack was told to "be the ball," Vanguard told us to "be the market." But if we are the market, we do not shape it; we are just bounced and dribbled around.

Shannon, the ultimate alpha man of investing, as we learn in this book, would not have been amused.
25 years later, much of the market is mindlessly indexed. That means it is all beta. The knowledge is leaching away in the surf of noise and rapid trading. Computers in, humans out, this is classic 1970's sci-fi all too real. A scream from a homeless man playing Angry Bird on his iPhone ends my subway séance with the wisdom of the 1970s.

An index is the market. It's a carrier, a channel, as defined mathematically by Shannon at Bell Labs in his seminal work on Information Theory. An index can only yield the predictable market return, mostly devoid of the profits of creativity and innovation, which largely come from new companies outside the index. I had to beat the indexes – by a lot. That means I needed knowledge. Riding on the channel, knowledge portends deformation of the mean. It is signaled by surprise, upside and downside, but it is not realized until the surprise – the information – is understood.
 
In that way, at that time, as the information revolution described in this book began to take off, I had an advantage. I started my career at Bell Labs, 35 years after Shannon. On your first day at Bell Labs, you are issued a 9x12 inch brown leatherette bag with a Bell logo in the lower corner. There were guards at every entrance and exit making sure employees didn't, uh, liberate equipment from the Labs. But the rule was that the guards would not search your Bell Bag.

In the days before personal computers, Bell Labs employeesOK, with that I mean me! – tried to take home a Digital Equipment PDP-11 minicomputer by taking it apart and fitting it into their Bag, much as MASH's Radar O'Reilly shipped home a Jeep. Rumor has it that the Bag was the reason Shockley and others invented the transistor, machines made out of vacuum tubes didn't fittoo much material, not enough information.

At Bell Labs we were reducing everything to information. Today it is almost all information and you could steal its crown jewels of software in a thumb drive.

Anyway, in a few years I left Bell Labs and moved to Wall Street.
As I strolled down Wall Street, the thub-dub was getting louder. It was the market, the pulse of the street. It's what everyone thinks. Every day, you're hit with a fire hose of information, in the Wall Street Journal, on Yahoo Finance, via real time stock quotes, in press releases, on Stocktwits.

But I still don't have knowledge, interpreting the surprises that others don't know about, that will drive a new narrative. You have to work and think and stress and fret to surmise the surprises by first fathoming the pulse.

The battle is just filtering out the few tiny gems, the insights that make up the new knowledge. If not, my $500 large gets returned to the index cesspool. Thub-dub this.

Except for a few exceptional periods of a bubble market, if there is no noise, there is no return. If it's so painfully obvious, like the "nifty fifty" of the '70s, if retired couples are talking about buying more Apple shares in the quiet of an airport Admiral's Club, run away until the noise returns.
 
As an investor, I need to feel the pulse every day, and wade through the drivel in order to pan the gold. The pulse has to reverberate in my veins, but only so I understand what the market is saying today. Then I have to resist the calming effect of that thub-dub of conventional thinking and venture out into the noise, out on the edge, to find new information, what's next, which can lead to knowledge. It's as elusive as humpback whales but it's there.

Amid the clutter of trends running around the Street, though, it is hard to tell what is real and what is just Synsonic synthesized sound. Reg FD or Regulation Full Disclosure means companies only give "guidance" on how they see business tracking once a quarter, on an earnings release conference call with questions like "Congratulations on the great quarter, uh, what's your tax rate going forward?" That is what Shannon might call zero-entropy communication. It removes information from the market, when I need more and more.

With a beta of 1.0, any sample of the market exactly recapitulates the market averages. It's the insight extracted from the information, that alpha, which separates the winners from the snoozers on Wall Street. Indexing is a waste heapall info so merged and muffled that it hides knowledge rather than reveals it. All beta, no alpha.

So what do the best modern money managers do? They live for the pulse, in the pulse, but then work out, often by an educated gut, what is different, what is going to changewhere the surprises will comewhere Shannon hid the entropy. That's valuable knowledge. No more leisure suit Nifty Fifty, no more indexing, no more day traders, no momentum investing, no more fooling around.

So I went to Palo Alto in the midst of Silicon Valley. Why Silicon Valley, where a 1500 square foot house runs $2.5 million? Because it's where the surprises are. Beating the market turned out to have nothing to do with trading or the plumbing of Wall Street, it had to do with understanding and predicting the surprises, the changes, the productivity fabric of the economy. The rest is noise.

Every day in Silicon Valley, someone writes a clever piece of code that changes retail, or uses Information Theory to write a security algorithm or invents a new way to shape Wi-Fi beams. These are all surprises. Getting away from the scopes of stock market trading and into the microscopic detail of how technology is changing and what is its affect on human-machine interfaces and why many existing industries will collapse is the only way to gain real actionable knowledge.

A day doesn't pass that I'm not surprised. Many years ago I met with a team that could very cheaply jam 5 gigabits per second of information down a couple of meters of cable, unheard of at the time. I didn't know you could do that and, voila, HDMI (High Definition Multimedia Interface) was born. I can almost guarantee it is how you get high def video to your flat screen TV. A game changer, not overnight, but over years. It might not have been the next Microsoft but it was good enough. It went from noise to become the narrative, the pulse, and huge amounts of wealth were created.

No index can capture it. The index is retrospective. The crucial alpha, the entropy, the signal modulating that linear advanceinformation light enough to stash away in your Bell Bag or thumb drive and shape the futurecomes from knowledge of the entrepreneurial surprises harbored on the edge of the noise.

The big narrative of the economy changes daily. That's productivity and progress. It is that high-energy message that the market as medium carries into the future.

Recovery and Home


I picked up some nasty bit of grunge in Europe and find myself quite under the weather. I rarely get sick and am not used to the feeling. For the first time in my life, I have had to cancel a speaking engagement, as I just don't have the strength to get on another airplane. Serendipitously, I now have two weeks at home to recover and expect to do so soon. Rest and liquids are the order of the day. I shall wish you a good week and return next week with final thoughts on the meaning of Cyprus.

Your ready for a new day analyst,

John Mauldin

Copyright 2013 John Mauldin. All Rights Reserved.