By: Doug Noland
Friday, April 24, 2015

The lesson should have been learned by 1994. After a period of extraordinarily loose monetary policy, bloody market chaos was unleashed when the Fed bumped up rates 25 bps (to 3.25%) on February 4, 1994. Treasury and corporate bond markets were clobbered - and leveraged mortgage derivative strategies were obliterated.

At that point, the Federal Reserve should have become focused on the new reality that market-based Credit, leveraged speculation, derivatives and loose monetary policy made for a toxic mix. The Fed needed to have adopted financial stability as a primary objective, with a determination to minimize policy-induced market distortions and fledgling Bubbles. Instead, the lesson drawn from that experience was for the Fed to move even more cautiously and transparently when "tightening" policy.

All the justification and rationalization in the world does not change the harsh reality: The Fed had turned Pro-Bubble and there was, apparently, no turning back.

With Amazon this week up 18.5%, Microsoft 15.0%, Starbucks 8.9%, Lam Research 8.6% and Google 7.8% - and NASDAQ surpassing year-2000 highs (up 290% from 2009 lows!) - my thoughts returned to the forces underpinning the late-nineties Bubble period. The year 1998 was critical. It's worth recalling that NASDAQ was up 28% y-t-d through July 20, 1998. The Bank index had surged 27%, with the S&P500 gaining 22% through mid-July. Markets were Bubbling in spite of unfolding global turmoil. To be sure, there are important parallels to the current backdrop.

In the face of growth that had accelerated to 4.5% in 1997, the Fed maintained its tightening bias yet refrained from adjusting rates up from the 5.5% level set in March 1997. Financial sector Credit was expanding rapidly and general Credit conditions were loosening. Yet the "Asian Tiger" collapse and other global instabilities were weighing on the Fed. A fledgling "tech Bubble" took complete advantage.

After beginning 1995 at 752, the NASDAQ Composite traded at an intra-day high of 2,028 on July 21st 1998. Bubble Dynamics were on display throughout 1998 - including a show of how quickly air could escape. NASDAQ lost a third of its value in less than three months (July 21 to October 8), trading to a low of 1,357 at the height of the Russia/LTCM crisis. Demonstrating that the Fed was much more concerned with bursting Bubbles than inflating ones, rates were cut from 5.5% to 4.75% in a two-month period (Sept 29 to Nov. 17).

The Fed orchestrated an extraordinary bailout of the hedge fund Long Term Capital Management (LTCM), less than four years after global crisis fears spurred the Mexican bailout. NASDAQ then proceeded to rally 62% in less than three months to trade above 2,200 during 1998's final trading session. NASDAQ ended 1999 at 4,091 and then reached its cycle peak at 5,133 on March 10, 2000. Not until late-1999 did Fed funds even make it back to the pre-crisis 5.5% level.

Fed rate manipulations and market distortions remain integral to Bubble Dynamics. Global fragilities remain fundamental as well. Back in the late-nineties, an unsettled backdrop kept the Fed from tightening what was clearly dangerously loose U.S. monetary and Credit conditions. While few at the time appreciated the underlying finance inflating the Bubble, the sources were not difficult to discern at the time.

GSE balance sheets expanded an unprecedented $151bn in 1994, $305bn in 1998 and $317bn in 1999. During the six-year period 1994 through 1999, GSE assets surged $1.092 TN, or 173%, to $1.723 TN. Total GSE Securities (borrowings and MBS) over this period ballooned $2.009 TN, or 105%, to $3.916 TN. In a transformative market development, the GSEs assumed the role as reliable market liquidity backstops, willing and able to aggressively intervene in the markets during period of market stress.

The U.S. dollar index ended 1995 at 84.76. Between the Fed's Pro-Bubble "asymmetrical" policy approach, GSE market backstops and heightened global fragilities, few global markets could compete with the risk vs. reward profile enjoyed by U.S. securities markets. The dollar index ended 1999 at almost 102 and peaked in 2000 at about 119.

"King dollar" "hot money" and foreign investor buying were key sources of demand for booming U.S. securities markets. Corporate borrowing surged 8.6% in 1997, 10.8% in 1998, 9.6% in 1999 and 8.3% in 2000. Much of corporate borrowings were high-risk loans feeding the technology Bubble. With NASDAQ fueling historic wealth accumulations, a torrent of liquidity was inundating the market and technology industry.

At the time, the bullish American "New Era" and "New Paradigm" mottos were compelling (parallels to today). Yet it was clear to me at the time that the finance fueling the Bubble was unsound and unsustainable. Bubbles burst. And that was the fate awaiting NASDAQ, the corporate debt market and king dollar. Anyone discussing such a fate in 1999 was considered a hopeless lunatic.

While also pertinent to the current Bubble backdrop, I'll avoid rehashing the analysis of the unsound finance that fueled the mortgage finance Bubble. In short, mortgage debt doubled in less than seven years. There was huge growth in (to name a few) the broker/dealers and speculator leveraging. There was spectacular expansion in "repos," special purpose vehicles (SPVs), Eurodollar borrowings, the ABS marketplace and derivatives (subprime CDOs!).

Underpinning the historic expansion of Credit and mortgage risk was the market view that Washington would never allow a housing bust. Very few at the time saw serious issues. And it all appeared sustainable - that is so long as housing prices continued to inflate.

After failing to heed the lessons from 1994 and 2000 experiences, we shouldn't have been surprised by another failure. The number one lesson global policymakers gleaned from the 2008 debacle: Lehman Brothers should never have been allowed to fail. Somehow, Trillions of high-risk loans, Trillions of leverage, Trillions of fraud/corruption, Trillions of mispriced securities, and resulting unprecedented economic maladjustment could have been sustained had Lehman been bailed out (a modern version of "the Great Depression could have been avoided had the Fed recapitalized the banking system."). Given determination and some time, it's always possible to inflate out of debt troubles. Really Dangerous Thinking.

So global policymakers have come to believe that Bubbles can be accommodated - even used as a policy tool. Market perceptions can be readily manipulated - and the Fed has a role, a moral obligation to do so. Market risk aversion, liquidity and tumult can be expertly managed. Do whatever it takes to assure the markets that crisis will not be tolerated. Act with sufficient resolve to ensure the speculator community bets with policy and not against it. Above all, guarantee abundant, uninterrupted cheap marketplace liquidity. And this all goes directly counter to what I believe is the critically important analysis of our times: There is no alternative but to develop a systematic approach to suppressing Bubbles - and the earlier the better.

Here in the U.S., there's been zero effort to downsize the GSEs. Despite the Trillions that have flowed into "bond" funds, ETFs and risk assets more generally, the Fed has made no attempt to extricate itself from crisis-period market manipulations and move toward a more normalized risk market backdrop. Leveraged speculation has never been so popular. The marketplace for Credit and market derivative "insurance" poses as big a systemic risk as ever. Arguably, securities markets have never been so distorted.

Today's policy debate centers on when to commence transparent, slow-motion little baby step rate increases - and on the eventual pace of reducing the Fed's bloated balance sheet. It's all Pro-Bubble.

The critical issue is the market perception that the Fed will immediately reemploy QE at the first sign of market tumult. This is the fundamental Pro-Bubble Market Distortion that desperately needs to be addressed and rectified (reminiscent of the Pro-Bubble market perception that the Treasury and Fed would back GSE obligations that was at the heart of mortgage finance Bubble excesses). Why would market participant fret inflating Bubbles when they only increase the probabilities of additional QE?

Central to Credit Bubble Theory is the view that systemic risk rises exponentially during the "Terminal Phase" period of Bubble excess. Policymakers are on a fool's errand when they set a policy course to patiently and innocuously deflate a Bubble. After all, bailing out Lehman would have only led to a bigger Bubble. "Kicking the can" on an insolvent Greece has only worsened a really bad situation. Draghi's QE is Pro-securities Bubbles and is only worsening systemic fragility. Reckless BOJ QE is setting the stage for collapse. Meanwhile, no one is working more diligently to manage a runaway Bubble than the Chinese.

A Thursday evening Bloomberg headline resonated: "If China Sees Capital Outflows Now, What Happens in Crisis?" Considering the scope of Credit excess; an unprecedented Bubble in shoddy apartments; massive corruption and historic economic maladjustment, there's a stunning lack of concern for China's faltering Bubble. Another Bloomberg headline was direct and spot on: "China Has a Massive Debt Problem."

The aged global Bubble is in a precarious late-phase dynamic (that somehow passes for financial nirvana). Having survived previous scares, close calls, panics and even deep crises, the world has grown convinced that policymakers now have everything under control. "Money" printing works. Manipulating securities markets (for the greater good) has become adeptly refined. Moreover, when it comes to China and the Chinese Bubble, they have $3.7 Trillion of reserves - a horde easily capable of stimulating the economy, recapitalizing its banking system and accommodating financial outflows as necessary.

If my analytical framework is sound, Chinese policy is only exacerbating Bubble fragility. In the short-term, fiscal and monetary stimulus has sustained growth in incomes, spending and GDP. The bursting of the Chinese apartment Bubble has for the most part been held at bay.

Yet China will likely have another year of better than $2.0 Trillion of Credit expansion. They'll have another year of millions of new apartments and industrial capacity to add to already gross oversupply. This late-cycle Credit is of especially poor quality - much of it is financing inflated apartment markets, suspect local government borrowings and a whole host of enterprises and ventures that will prove uneconomic come the bursting of the Chinese and global Bubbles (if not sooner).

Importantly, much of this "Terminal Phase" Credit is being heavily intermediated through "wealth" and special-purpose vehicle, investment funds and other savings vehicles. As is typical during a Bubbles initial tottering phase, investors and speculators become captivated by what are perceived as attractive yields and returns. And the longer the "Terminal Phase" is extended, the more suspect debt that is created and the more of it that is accumulated by the unsophisticated and unsuspecting. And I would strongly argue that this deleterious dynamic is exacerbated by the policy-induced global yield collapse, including an estimated $3.0 Trillion of sovereign debt that now trades with negative yields.

It is this divergence between the expanding quantities of unsound Credit and the rising accumulation of perceived safe ("money-like") wealth that sets the stage for the inevitable crisis of confidence. Policymakers just have not learned: The Alchemists still believe they can inflate bad debt into good. Invariably, notions of cautiously reining in a Bubble meet the reality of the extraordinary impairment wrought upon system stability over relatively short periods of "Terminal" excess. The Shanghai Composite's nine-month, 90% moonshot is testament to the hazard of accommodating late-cycle Bubbles.

April 23 - Bloomberg (Ting Shi): "From "Lord Ringtone" to a banker accused of authorizing $1.6 billion in illegal loans, China's list of most-wanted fugitives offers an illustrated guide to the Communist Party's breathtaking variety of official graft. The online rogue's gallery of 100 top overseas corruption suspects was released by Chinese authorities to pressure the U.S. and other governments to help track down and return them... The list spans China's industries, from finance and property to oil and car manufacturing. There are former representatives of the state-controlled news media and one ex-history professor. The campaign to repatriate financial fugitives -- dubbed "Sky Net" -- is key to President Xi Jinping's nationwide corruption crackdown, with some 40 people on the list released Wednesday thought to be in the U.S."

Some estimates have over $1.0 Trillion of corrupt "money" having fled China. How much has made it to U.S. real estate and securities markets? For that matter, how much global finance Bubble "dirty money" has made its way to America? How much legitimate wealth has escaped local fragility for greener U.S. pastures - from China, Russia, Brazil, Venezuela, Latin America, Europe and the Middle East? And how much "hot money" has been unleashed by respective QE currency devaluations from the Bank of Japan and European Central Bank? How big are global leveraged "carry trades"? What have been the impacts and what are the ramifications from these historic flows that I view as unsound, unstable and unsustainable?

By this point, things have gone way beyond the late-nineties "king dollar" dynamic. Recent years have seen unprecedented global flow instability - literally Trillions flowing to and fro in an unremitting chase for returns. The closest parallel is the profoundly unstable global backdrop from the late-twenties. And like the "Roaring Twenties," few today appreciate how deeply systemic all the unsound finance has become - not with stocks at record highs, bond prices at record highs and household net worth at all-time highs.

"Tech" Bubble fragility was exposed when NASDAQ reversed course and plummeted back in 2000. Mortgage finance Bubble fragility was unmasked when housing prices declined. And I fully expect global government finance Bubble fragilities to emerge when the world's overheated risk markets inevitably come back to earth. And when it comes to market Bubbles, it's often the final parabolic move that sets the stage. The NASDAQ 100 gained 4.5% this week - playing a little catch up with Bubbles in China, Europe, Japan and even EM more generally.

Barron's Cover

U.S. Money Managers Turn Cautious

Money managers have reined in their optimism since the fall, but they see bargains in Europe, energy, tech.

By Jack Willoughby           

April 25, 2015

America’s money managers have developed a fear of heights. Doctors might call it acrophobia, but investors call it a logical response to a stock market that has more than doubled in the past six years, and now sits just below an all-time high. This widespread wariness is evident in Barron’s latest Big Money poll, in which a record 50% of respondents categorize themselves as neutral about the market’s prospects through year end. That’s the highest neutral reading since the spring of 2005, when 40% were sitting on the fence, and a sharp increase from last fall’s 31%.

A record 50% of Big Money managers say they are neutral about the prospects for stocks this year; 45% call themselves bullish, and 5% claim to be bears. Illustration: Scott Pollack for Barron’s

“We see more tentativeness than we did last year, and more withdrawal requests,” says Douglas MacKay, founder of Broadleaf Partners in Hudson, Ohio, with $170 million under management. “There’s just not that urgency to get in. Your average investor isn’t putting money into stocks.”
Our poll would seem to confirm as much, with 65% of managers saying that their clients are neutral on stocks, and 10% indicating they’re bearish. Chris Wang, director of research at Runnymede Capital Management in Morristown, N.J., which oversees $200 million, thinks he understands why. Wang considers himself bullish, and believes that expansionary monetary policies, corporate mergers, and share buybacks could propel stocks higher still. “But investors have reason to be cautious,” he says. “This is the sixth year of a bull market. Is the economy slowing? How soon will the Federal Reserve raise interest rates? These are questions that worry investors.”
The market’s valuation is also a concern. Seventy-one percent of Big Money managers say that stocks are fairly valued, while just 8% consider them undervalued. The Standard & Poor’s 500 is trading at 17.4 times this year’s expected earnings of $121.17, on the high side relative to its history.
While Wall Street analysts expect S&P profits to rise less than 1% this year, according to Thomson Reuters, the Big Money managers aren’t entirely pessimistic. Seventy-four percent expect earnings to increase by 1% to 5%, and 25% peg growth at 6% to 10%. Just 36% of poll respondents look for the market’s price/earnings ratio to expand in 2015, compared with 45% who see no change, and 19% who forecast multiple compression.
Robert Maynard, chief investment officer of the $15 billion Public Employee Retirement System of Idaho, or Persi, calls the market “fully valued to slightly overvalued, but not stunningly so.” He expects a combination of economic growth, stock buybacks, and dividends to produce a total return of 9% this year, or 7% on an inflation-adjusted basis.
THE BULLS’ CAMP is home to 45% of Big Money managers this spring, about on par with the spring of 2007, but down from 59% last fall. Based on their mean prediction, the bulls expect the Dow Jones industrials to rally about 4% through the middle of 2016, ending this year at 18,824, en route to 19,531. The S&P 500 similarly could tack on 8%, they estimate, hitting 2282 by June 30, 2016, while the Nasdaq Composite could add almost 7%, to 5382.


Most poll respondents are upbeat about the global economy, with 68% expecting the recovery to strengthen in the next 12 months. They look for continued growth in the U.S. economy, with 39% predicting a 2.5% increase in gross domestic product, and 42% putting GDP gains at an annualized 3% or 3.5% in the year ahead. Fourth-quarter GDP increased at an annualized rate of 2.2%; the Commerce Department will release first-quarter numbers on April 29.
Consistent with their rosier economic outlook, most Big Money managers expect an unemployment rate of 5.5% to 5%, just about half the level in 2009, in the aftermath of the financial crisis. Eighty-six percent expect the three-year-old housing recovery to continue. The housing market sent conflicting signals last week: The National Association of Realtors reported that existing-home sales rose 6.1% in March, to the highest level in 18 months, while the Commerce Department said that new-home sales fell 11.4% that month, the biggest drop in more than 18 months.
“We believe there is more juice left in the U.S. economy, and we expect it to push stock prices higher,” says Kaleialoha Cadinha-Pua’a, president and CEO of Honolulu-based Cadinha & Co., which oversees $1 billion. “The U.S. stands to deliver 3.5% GDP growth,” she adds, calling it a “safe haven” for investment assets in an increasingly risky world.
Company-specific developments, from mergers and spinoffs to buybacks and dividend hikes, also encourage the bulls. “A lot of things going on in the market give me comfort,” says David Marcus, co-founder of Evermore Global Advisors in Summit, N.J., which manages $400 million. “Big companies in the U.S. are transforming their operations, breaking up and spinning off new businesses, and focusing on their best businesses.”
Marcus, the survey’s most bullish respondent, puts the Dow at 24,700 by mid-2016, and the Nasdaq at 6,125. Lower fuel costs mean lower operating costs for companies—another plus, he says.
Robert Turner, chairman of Turner Investments in Berwyn, Pa., which manages $1 billion, has been bullish for several years and sees no reason to rein in his optimism. “To have a severe correction, you need severe excesses, and I just don’t see them,” he says. “Stocks trade at a reasonable multiple of expected earnings. Even the yield on the S&P 500 is on par with the yield on the 10-year Treasury, which doesn’t happen often.”
The S&P is yielding 1.96%, compared with the 10-year Treasury’s 1.99%.
Turner favors the work of Dan Wantrobski, a technical analyst at Janney Capital Markets in Philadelphia, who says “the expansion cycle” has much further to run. Demographics, he notes, point to a coming boom, as the 90 million members of the millennial generation approach family-formation age and start looking to buy and furnish homes. Moreover, the stock market typically has peaked at P/E multiples much higher than today’s, Wantrobski says.
THE BIG MONEY managers are most bullish about the prospects for European and U.S. stocks, and real estate. They are mostly bearish on U.S. Treasuries, U.S. corporate bonds, and commodities. More than 70% expect equities to be the best-performing asset class in the next 12 months, while 13% think that real estate will lead the pack.
The managers see the biggest investment opportunities in energy, European, and technology stocks, and the greatest risks in bonds, biotechs, and emerging-market stocks. They expect consumer cyclicals, health care, energy, financials, and technology to perform best among S&P 500 sectors, although, to be fair, a fourth of the managers look for energy stocks to bring up the rear.
The Big Money pros see little change in oil prices this year; their mean forecast for West Texas Intermediate crude, the U.S. benchmark, is $54.45 a barrel, compared with a recent spot price of $57.74. Gold, too, has relatively few fans in this crowd, with poll respondents looking for the metal to end the year around $1,170 an ounce, below last week’s $1,178.
Nearly half of the Big Money managers say Europe will be the best-performing stock market in the next 12 months—and that’s after European shares, as measured by the Stoxx Europe 600 index, have rallied 20% this year, in tandem with the European Central Bank’s $1 trillion bond-buying program.
Marcus, of Evermore, notes that the euro’s collapse in the past year, relative to the dollar, is bringing an export advantage to European multinationals.
The common currency slid from $1.39 in May 2014 to $1.07 last week, and 70% of Big Money managers expect the downward trend to persist. 
Jason Norris, executive vice president of research at Portland, Ore.–based Ferguson Wellman Capital Management, with $4.2 billion in assets, says he has been scouring European markets for bargains. “U.S. markets have outperformed global markets by 70% these past few years,” he says. “Investors expect some reversion to the mean. Easy money in Europe promises higher equity prices, [whereas] the U.S. is on the verge of tightening monetary policy.”
The valuation differential also is a draw, he says, noting that European equities trade for roughly 15 times expected earnings.
BARRON’S CONDUCTS the Big Money poll every spring and fall, with the help of Beta Research in Syosset, N.Y. The latest survey, e-mailed in late March, drew responses from 143 money managers across the country, representing some of the nation’s largest investment firms and pension funds, as well as many smaller investment boutiques.
What might send U.S. stocks sharply higher in the next 12 months? Nearly half of the managers cite rising corporate profits, while 22% point to a lack of action by the Federal Reserve. Most Big Money managers expect the central bank to begin raising short-term interest rates in the fourth quarter of 2015 or first-quarter 2016—a view that much of the rest of Wall Street also has adopted in the past month, based on recent, less-than-stellar economic reports. This will mark the first change in the Fed’s rate target since December 2008, and the first increase since June 2006.
Only 25% of respondents expect the stock market to slide in the six months following the Fed’s tightening, while 55% predict that stocks will rise. A majority of managers predict that the 10-year Treasury bond will yield 2.5% or 3% a year from now, although 27% see little change from today’s near-2%. Looking out five years, however, more than 40% expect the 10-year to yield 4% or more.

With interest rates at historic lows—and government bond yields negative in key European markets—the managers are split as to whether their fixed-income portfolios will generate positive returns this year. Fifty-six percent say that the U.S. bond market is exhibiting bubble characteristics, although that doesn’t mean a correction is near. “There is a bond bubble unless the Fed says otherwise,” one manager said in write-in comments. “If the Fed continues to suppress yields, there is no bubble. If the Fed does what it should, bond prices will fall as fast as the Fed will allow.”
Interest-rate suppression will end, “but the start date has been pushed out, and many now believe the process will take longer than originally expected,” wrote poll respondent John Boland, a principal with Maple Capital Management, a $650 million-in-assets firm in Montpelier, Vt., in a recent newsletter.
Boland describes a difficult backdrop filled with “troubling disconnects.” Corporate profits are going down, he notes, but people are calling for stock prices to go up. At the same time, the flow of earnings news could bring more stock-price volatility. Boland, who labels himself neutral, looks for the Dow Jones industrials to hit 18,750 by year end, but retreat to 17,000 in the first half of 2016.
A MERE 5% of the Big Money men and women are self-described bears today, down from 10% six months ago. The higher the market has climbed, it seems, the more ambivalent erstwhile bears have grown.
While more than 75% of the managers think stocks will correct by at least 10% in the next 12 months, most likely driven lower by a geopolitical crisis or earnings shock, the bears are a class apart:
They don’t see a rebound thereafter. To the contrary, they expect the Dow to slide 7% by the middle of next year, to 16,788. The S&P 500 could fall 8%, to 1935, in that span, they say, and the Nasdaq could give up 8%, to 4633.
“We look for negative returns in the coming months,” says David Villa, chief investment officer of the $105 billion State of Wisconsin Investment Board. “We’ve had a really strong run in the U.S. All the talk of rates going up at the end of the year will reverse momentum.” Villa asserts that U.S. equities are 10% overvalued, while European stocks are attractive. “For example, we really like European grocers, but find North American grocers’ shares unattractive,” he says. Villa expects the Dow to tumble to 17,250 by year end, but rebound to 18,630 in the first half of 2016.
Ralph Segall, a principal with Chicago-based Segall, Bryant & Hamill, with $9.7 billion under management, projects the Dow will fall as low as 16,800 by the end of this year, and climb back to 17,500 by June 2016. The selloff could be driven by earnings disappointments and the expectation of higher interest rates, he says. Segall sees particular risk in passive investment products, such as index funds and exchange-traded funds, which have garnered huge popularity in the bull market. They could quickly lose ground as the market grows more volatile.
“The public and institutions sound as convinced about the virtues of indexing as they did about the virtues of tech investing at the height of the bubble,” he comments. “It will all end badly, I fear.”
DESPITE THEIR concern about the market’s advance to rarified heights, the Big Money pros find plenty of stocks to like. Their top picks this spring include Apple (ticker: AAPL), Dow Chemical (DOW), American Airlines Group (AAL), Celgene (CELG), and General Motors (GM), among others.
Dow Chemical shares have been relatively flat for the past year, and recently closed at $51. But David Becker, president of Northern Oak Wealth Management in Milwaukee, which manages $630 million, has a $60 target price. He expects earnings per share to rise 20% in 2016 and 2017, and lauds management’s efforts to shift to higher-margin, noncyclical businesses from commodity chemicals.
Dow pays an annual dividend of $1.68, and yields 3.33%. The company also has a buyback program.

Technically, says Becker, the stock is breaking out of a consolidation phase that lasted more than a decade.

As much as investors like dividend payments—Dow Chemical’s have been on the rise for the past four years—they also see other compelling uses for corporate cash. For example, 35% of Big Money respondents think capital spending is the best use of corporate cash today, and 11% favor acquisitions. That compares with 34% who regard dividend payments as the best investment, and 20% who prefer buybacks.
The managers see a lot of froth in biotech stocks, but Celgene, a $95 billion-market-cap giant, could be a smart way to play the industry’s rapid growth. Spun out of chemical maker Celanese in 1986, Celgene is best known for cancer treatments, and has one of the broadest pipelines in the biotech business. The company bought a number of small biotech outfits, and shareholder-friendly management has actively repurchased shares.
At a recent $116, Celgene trades for 19 times next year’s expected earnings of $6.32 a share. Geoffrey Porges, an analyst at Sanford C. Bernstein, has a price target of $155 a share, and says the stock is “set up nicely to rally.”
GM is a favorite of William Harnisch, president of Peconic Partners, which oversees $533 million in assets. The auto maker’s shares are trading around $36, or for a well-below-market valuation of seven times estimated 2016 earnings of $5.17 a share. Harnisch thinks the stock is worth at least $50, and says the market has yet to see past the company’s recent recall problems.
Nor do investors understand just how well GM is doing in truck manufacturing, he adds. In many ways, Harnisch says, GM is a stealth technology company, and a leader in computer-enhanced “connected” vehicles designed for superior performance and safety.
Robert Medway, a principal in New York’s Royal Capital Management, which manages about $100 million, prefers lesser-known stocks, and says relatively high valuations have forced bargain hunters to move into “special situations and orphan stocks that trade down because of some basic misunderstanding or disagreement.”
McDermott International (MDR), an oil-infrastructure specialist, is one example, he says. The stock was hit most recently by the plunge in oil prices, but the company has stable long-term contracts with prime producers, Medway notes.
ASK ANY GROUP of people what they think of Apple, and opinions of its products and stock will be mixed. While 81% of Big Money respondents view the company favorably, and some call its stock a favorite, others label the shares among the market’s most overvalued.
The managers also consider Tesla Motors (TSLA), (AMZN), Facebook(FB), and the casual-dining chain Chipotle Mexican Grill(CMG) to be among the market’s most overvalued names, as they did last fall, even though Tesla and Chipotle have fallen 4% and 1% since late October, and Facebook is up 9%. Amazon is another story; it’s up 28% in the past six months, to $390, and fetches a cool 165 times next year’s expected earnings.
Chipotle trades for a comparatively reasonable 31 times estimated profits, but that is too rich by far for James Pappas, chief investment officer of James Pappas Investment Counsel, which manages $30 million in Longboat Key, Fla. “This is not a cure for cancer; it is a burrito chain whose growth is starting to slow,” he says.
Pappas notes that Chipotle’s $19.7 billion stock market capitalization values each of its 1,800 stores at a lofty $12 million. The restaurants produce an annual profit of $250,000 each. Viewed another way, that’s just a 2% return, akin to the 10-year Treasury yield, but with a lot more risk.
Pappas expects the Dow to hold steady for the rest of this year at about 18,000, before climbing to 19,200 by mid-2016—an implied gain of just under 7%.
POLITICS ARE HARD to escape these days, even if you try. What happens in the Capitol, and on the hustings, is of keen interest to the nation’s investment managers, especially given Washington’s growing influence on Wall Street. If the Big Money folks could write the script, 39% would like to see the White House and Congress focus most urgently on tax reform, and presumably on lowering the nation’s corporate tax rate.
Another 29% argue that reform of entitlement programs is the top priority, while 11% contend it is reductions in federal spending. Only 6% consider immigration reform the most pressing issue before Congress.
At this early juncture, 79% of Big Money managers expect Hillary Clinton to be the Democrats’ candidate for president in 2016. Just half of poll respondents think Jeb Bush will carry the banner for the Republicans, with another 20% putting high odds on Wisconsin Gov. Scott Walker. No matter who runs, 66% predict that the Republican candidate will win.
The markets could look a lot different—or not—by the time the next president reports for duty. In the meantime, the nation’s professional money managers have their work cut out, especially given stocks’ valuation and the uncertainty surrounding the Fed’s next rate move. Eighty-two percent of Big Money managers say they’re beating the market this year—a good batting average. We’ll let you know how they’re doing, and what they’re thinking, when we check back with them in the fall.


Default is not in the stars

Junk bonds have been remarkably good credits

Apr 25th 2015

THE world of bonds is usually thought of as one of rigid divisions. At one end of the scale, there is government debt: safe, reliable, suitable for widows and orphans. At the other end, there are junk bonds: speculative offerings issued by companies with poor credit ratings and suitable only for the young and reckless.

That picture looks a bit out of date. Speculation is rampant that Greece might be about to default on its government debt again. Meanwhile, the short-term bonds of many European countries are trading at negative yields. That means investors are guaranteed to lose money in nominal terms (ie, before accounting for inflation).

Junk debt also looks a lot less like garbage than it used to. Contrary to its reputation, issuers are proving to be reliable payers, as a new study by Deutsche Bank shows. Since 1983 (the period for which Deutsche has data), the default rate for junk bonds has averaged 4.9%. But that disguises a big change that occurred after 2002. The average default rate from 1983 to 2002 was 6.9%; since then, the average has been just 1.5%. In this later period, the only year in which the default rate was above the long-term average, at 15%, was 2009, when the world economy was slumping.

This is particularly surprising given that the creditworthiness of issuers has steadily declined over time, as judged by the rating agencies. A bigger proportion of them is in the “C” categories, the lowest tier for those that have not actually defaulted. This should, over time, have led to a greater number of deadbeats.

So what has driven the improvement? More than anything else, corporate debtors depend on confidence. They borrow not just from the bond markets, but also from the banks. When they get into trouble, it is usually because the banks will not extend their loans. And when that happens, they often struggle to keep up with their bond payments.

The result is that the corporate-bond markets can get into virtuous or vicious cycles. In the former, confidence is high and the spread (excess interest) paid by riskier borrowers is small. As a result, such borrowers find it easier to service their debts, bringing spreads further down, and so on. This has been the dynamic for much of the past 13 years.

The cycle has been reinforced by monetary policy. Short-term interest rates have been zero, or even negative in some countries, and central banks have also steered long-term government-bond yields to historic lows. That has prompted income-seeking investors to turn to junk bonds to add a bit of juice to their portfolios.

Ultra-low rates have allowed corporate borrowers to lock in cheap credit for the long term.

Moody’s, a rating agency, says that issuance of high-yield debt in America in the first quarter was $79 billion; in Europe it was $39 billion. Both figures are higher than in the same period of 2014. There was also a rise in the number of issuers borrowing for eight to ten years rather than the usual six or seven. The longer the maturity, the less vulnerable the borrower to a sudden decline in confidence.

So what might trigger a shift into a vicious cycle, in which a loss of confidence leads to higher spreads, making it more difficult for companies to finance themselves? Deutsche reckons that the willingness of banks to lend depends on the shape of the yield curve—the difference between the rates available on short- and long-term debt.

When rates on long-term debt are much higher, banks earn a good return lending to companies. But as the gap narrows, or even turns negative, they lose their enthusiasm for lending. As they turn off the taps, many of the companies denied bank loans also end up defaulting on their bonds.

Deutsche’s research shows that there is a lag of around 30 months between the yield curve becoming flat and a rise in defaults (see chart). Another important factor is the level of real rates (ie, after accounting for inflation). High real rates also lead to higher defaults with a 30-month lag. Based on these two factors, Deutsche predicts the next upcycle in American defaults will occur in the second half of 2017. In Europe, where there tends to be a shorter lead time, a rise may occur in the second half of next year.

Of course, investors in junk bonds can suffer losses without a sharp rise in defaults. If the general level of bond yields rises—perhaps because of an increase in inflation or a sudden change in monetary policy—the price of junk bonds will fall. But not many people are expecting that to happen. The enthusiasm for junk is not going away.

Glut of Capital and Labor Challenge Policy Makers

Global oversupply extends beyond commodities, elevating deflation risk

By Josh Zumbrun and Carolyn Cui

April 24, 2015 5:30 a.m. ET

        A coal shoot loads barges with coal outside Pittsburgh. Photo: Bloomberg News        

The global economy is awash as never before in commodities like oil, cotton and iron ore, but also with capital and labor—a glut that presents several challenges as policy makers struggle to stoke demand.

“What we’re looking at is a low-growth, low-inflation, low-rate environment,” said Megan Greene, chief economist of John Hancock Asset Management, who added that the global economy could spend the next decade “working this off.”

The current state of plenty is confounding on many fronts. The surfeit of commodities depresses prices and stokes concerns of deflation. Global wealth—estimated by Credit Suisse CS -1.80 % at around $263 trillion, more than double the $117 trillion in 2000—represents a vast supply of savings and capital, helping to hold down interest rates, undermining the power of monetary policy. And the surplus of workers depresses wages.

Meanwhile, public indebtedness in the U.S., Japan and Europe limits governments’ capacity to fuel growth through public expenditure. That leaves central banks to supply economies with as much liquidity as possible, even though recent rounds of easing haven’t returned these economies anywhere close to their previous growth paths.

“The classic notion is that you cannot have a condition of oversupply,” said Daniel Alpert, an investment banker and author of a book, “The Age of Oversupply,” on what all this abundance means. “The science of economics is all based on shortages.”

The fall of the Soviet Union and the rise of China added over one billion workers to the world’s labor force, meaning workers everywhere face global competition for jobs and wages. Many newly emerging countries run budget surpluses, and their citizens save more than in developed countries—contributing to what Mr. Alpert sees as an excess of capital.

Examples of oversupply abound.

At Cushing, Okla., one of the biggest oil-storage hubs in the U.S., crude oil is filling tanks to the brim. Last week, crude-oil inventories in the U.S. rose to 489 million barrels, an all-time high in records going back to 1982.

Around the world, about 110 million bales of cotton are estimated to be sitting idle at textile mills or state warehouses at the end of this season, a record high since 1973 when the U.S. began to publish data on cotton stockpiles.

Huge surpluses are also seen in many finished-goods markets as the glut moves down the supply chain. In February, total inventories of manufactured durable goods in the U.S. rose to $413 billion, the highest level since 1992 when the Census Bureau began to publish the data. In China, car dealers are sitting on their highest inventories of unsold cars in almost 2½ years.

Central to the problem is a cooling Chinese economy combined with tepid demand among many developed countries. As China moves away from its reliance on commodity-intensive industries such as steelmaking and textiles, its demand for many materials has slowed down and, in some cases, even contracted.

“This fall in commodity demand is counterintuitive, and we have only seen the tip of the iceberg,” said Cynthia Lim, an economist at Wood Mackenzie.

Not all commodities are in excess. China’s strong appetite for materials such as copper, gasoline and coffee will keep supplies tight in these markets.

For nearly a decade, producers struggled to keep up with the robust demand from China. But with Chinese output now slowing—its gross domestic product is expected to rise 7% this year, down from 10.4% five years ago—no economy has emerged to take up the slack.

The slowdown has caught many producers off guard as inventories continue to build.

The backlog is causing a scramble in many markets to find storage for excess supplies, clobbering commodity prices across the board, and foreshadowing painful output cuts down the road for many producers. Over the past 12 months, a broad measure of global commodity prices, the S&P GSCI, has plunged 34%, leaving prices at 2009 levels.

“These inventories have to be drawn down at least to some extent. At that point, prices will be back up again,” said Jeff Christian, managing director at CPM Group, a commodities consultancy.

Countries facing a demand shortfall often move to juice their economies through deficit spending, especially with interest rates so low. But many nations are queasy about adding to their debt burdens.

The world’s major economies have all continued to add debt in the years since the credit crisis, according to calculations from John Hancock’s Ms. Greene. Government, business and consumer debt has climbed to $25 trillion in the U.S. from $17 trillion since 2008, a jump to 181% of GDP from 167%. In Europe, debt has hit climbed to 204% of GDP from 180%, while in China debts have jumped to 241% of GDP from 134% by Ms. Greene’s measures.

Even if governments have the capacity for more fiscal stimulus, few have the political will to unleash it. That has left central banks to step into the void. The Federal Reserve and Bank of England have both expanded their balance sheets to nearly 25% of annual gross domestic product from around 6% in 2008. The European Central Bank’s has climbed to 23% from 14% and the Bank of Japan 8301 -6.85 % to nearly 66% from 22%.

In more normal times, this would have been sufficient to get economies rolling again, but Harvard University’s Lawrence Summers is among economists who say interest rates need to fall still lower to reconcile abundant savings with the more limited opportunities for investment, a scenario termed “secular stagnation,” which implies diminished potential for growth.

Not all agree. Former Fed Chairman Ben Bernanke wrote recently that the U.S. appears to be heading toward a state of full employment in which labor markets tighten and inflation will surely follow.

Just as a U.S. economy nearing full employment may help, new demand from emerging markets could help offset China’s waning influence. Enter India. Demand for energy and other commodities from the world’s second-most populous country has been growing rapidly.

But analysts are skeptical if the increased demand is enough to fill the void left by China.
The latest glut also underscores a challenging global trade environment as the dollar appreciates against almost all other currencies.

Exporters in countries such as Brazil and Russia are churning out sugar, coffee and crude oil at a faster pace, as they can fetch more in local-currency terms when it is converted from the dollar.

Producers have their own share of the blame. In a lower commodity price environment, producers typically are reluctant to cut production in an effort to maintain their market shares.

In some cases, producers even increase their output to make up for the revenue losses due to lower prices, exacerbating the problem of oversupply.

“Generally, this creates a feedback cycle where prices fall further because of the supply glut,” said Dane Davis, a commodity analyst with Barclays.