Friday, December 27, 2013

Hot Stocks of 2013 and 2014?

Mary Kristof of Kiplinger reports, Best S&P 500 Stocks of 2013:
Comebacks and momentum stories dominate the list of the hottest companies in Standard & Poor’s 500-stock index this year. Meanwhile, the names that did the worst in 2013 were once-hot shares that have turned suddenly cold, either because of industry woes or corporate stumbles. It’s a familiar theme. On Wall Street, one of the best ways to be this year’s darling is to be last year’s dog, and vice versa. “The market exaggerates,” says R.J. Hottovy, an analyst with Morningstar Investments in Chicago. “In some cases, companies get oversold…and then they get overbought.”

Netflix (symbol NFLX) is a prime example. The subscription movie company saw its shares slammed in 2011, thanks to a price hike and shift in its business model that alienated a huge number of subscribers. The company’s stock, which sold for $295 in July 2011, dropped to $54 in July 2012 as Netflix pressed forward with an expensive technology upgrade that allowed subscribers to receive movies and shows via the Internet rather than through the mail. But that gamble paid off, reviving the company’s subscriber base. Wall Street is so in love with Netflix that the stock soared 303% in 2013 and now sells for about 92 times projected 2014 earnings, which is nearly four times the Los Gatos, Cal., company’s projected long-term profit growth rate. (All stock returns as of December 12, 2013.)

Best Buy (BBY) has a similar story. Left for dead at the end of 2012, largely because of concerns that the chain couldn’t compete with the likes of (AMZN) and Costco Wholesale (COST), the Richfield, Minn., retailer brought in new management, cut costs and revived its online presence. The company is still not out of the woods, by the CEO’s own admission, but you’d never know that by the stock price. Best Buy’s shares shot up 245% in 2013 and, at $40, now sell for 14 times projected earnings for the fiscal year that ends in January 2015. While profitability is improving, “the market has probably overshot the intrinsic value,” says Hottovy. “Price competition is going to get a lot more attention in 2014 than it did this year.” (click on image below to view the top ten S&P 500 stocks of 2013. All stock returns as of December 12, 2013)

Other rags-to-riches stock stories in 2013 include Hewlett-Packard (HPQ), up 91%; Yahoo (YHOO), up 98%; First Solar (FSLR), up 76%; and Western Digital (WDC), up 87%. Both HP and Yahoo have new CEOs, who are attempting to return the companies to growth and profitability. Western Digital, like Seagate Technology (STX)—which rose 66%—languished in 2012 because the market had decided computer storage was as passé as mainframes. But both companies are helping store data in the “cloud,” and that’s made them hot again. First Solar, meanwhile, was one of the hot stocks of the initial solar-energy boom. But its shares were battered when Chinese solar companies entered the market and started slashing prices. The resulting shakeout reduced competition and left the survivors stronger, says John Blank, chief equity strategist at Zacks Investment Research.

However, 2013’s top performers also include some unqualified success stories. TripAdvisor (TRIP), the travel-planning Web site, took off immediately after it was spun off from Expedia (EXPE) two years ago. It now sells for $83, about three times more than its spinoff price and some 38 times its estimated 2014 earnings. The key to its success is that this Newton, Mass., travel concern was one of the nation’s first social networks, says Scott Kessler, an analyst with S&P Capital IQ. By persuading travelers to rate the hotels where they’ve stayed and the tours that they’ve taken, TripAdvisor created consumer rankings that make it easier for similarly inclined travelers to plan a trip. Kessler adds that the social media theme played well in 2013, fueling a 97% rise in the stock.

But he thinks TripAdvisor is not likely to produce the same sort of market-beating returns in 2014. “There’s a fair amount of uncertainty with this stock given all the appreciation we’ve seen so far,” he says. “It just doesn’t seem like a great opportunity at this time.”

Kessler is equally tepid about the prospects for Priceline (PCLN), a now four-figure stock that was up 89% in 2013. Although Priceline has been brilliant at growing sales and revenues by double digits annually, the online travel market is getting increasingly crowded, and Kessler thinks it will be tough to keep up the blistering growth rate. “The company has a strong management team and a proven track record of success, but it’s hard to see what catalysts have not already been priced into the stock.”

The S&P 500’s worst performers

On the opposite end of the performance spectrum are some once-hot stocks that went stone cold in 2013.

Consider Newmont Mining (NEM). Shares in the Greenwood, Colo., gold-mining company were selling for just $26 in October 2008, but the world financial crisis sent precious metal prices soaring, and Newmont’s stock hit $69 by the end of 2011. As world economies have edged away from the cliff, gold prices have plunged and so, too, has Newmont. The company’s shares now sell for a mere $23, down a whopping 47% in 2013 alone.

Big coal was all the rage during the 2012 presidential campaign, but in 2013 it accounted for some of the worst stock performance in the S&P 500 index. Cliffs Natural Resources (CLF) was down 37% during the year; Peabody Energy (BTU) dropped 30%. Blame fracking, says Blank, of Zacks Investment Research. Hydraulic fracturing procedures are allowing U.S. companies to produce more oil and natural gas than they ever have. Add that to the fact that solar has finally come out of the “1970s hippie thing” to become a viable business, and you see why coal companies have been left in the dust, he says. He doesn’t see that changing anytime soon, either.

You can’t blame the retail industry for what has happened to shares in Abercrombie & Fitch (ANF). Other S&P 500 retailers—from Michael Kors Holdings (KORS), which is up 57%, to T.J. Maxx parent TJX Companies (TJX), up 46%—are having a stellar year. But Abercrombie, known for advertising its clothing with sparsely clad youths, watched its stock price tumble 30% in 2013 as sales and profits plunged. The prospects remain bleak, says Blank: “It is your classic poorly run business.”
2013 was a great year for stocks. Reuters reports the S&P 500 has soared 29.2 percent this year, largely due to stimulus from the U.S. Federal Reserve. The index is on track for its best year since 1997. The Dow has gained 25.8 percent in 2013 while the Nasdaq has jumped 38 percent.

Bruce Upbin of Forbes reports, The Best Performing Big Tech Stocks Of 2013: Did You Own Any Of Them?:
Idaho, China, Menlo Park. That would have been your itinerary this year to find the tech stocks that make up the list of the best-performing names of 2013. These are stocks that have doubled or even tripled their investors’ money and, while some have likely exhausted the easy gains, others are expected by Wall Street analysts to continue soaring. And can you believe good old Yahoo! came in at number 10? It’s not growing that much but investors have realized the rising value of its approximately 24% stake in the Chinese e-commerce firm that is heading toward a huge IPO in 2014.

Forbes stats editor Scott DeCarlo and I screened close to 400 publicly traded technology stocks, cutting off the list for this ranking’s purposes at stocks that ended the year with a market cap under $5 billion. That excluded a bunch of well-known names that did extremely well in 2013 including Yelp (up 261%), Shutterstock (up 223% post-IPO), and WebMD (up 168%), as well as much of the solar sector, which had a terrific comeback this year with SunEdison up 298%.

But cutting off at $5 billion also excludes a lot of small-cap fliers and tiny Chinese ADRs. Nothing against Chinese ADRs except that they are, well, Chinese ADRs. We than re-ranked the big-cap list by total return through December 20. That’s the not the end of the year, I know, but stocks tend to meander in late December so I doubt the picture will look different by New Year’s Day. If it does, sue me. I’ll have another post to write.

The Nasdaq composite index, the annual performance bogey for most tech stocks, delivered a 36% return this year. Seventy out of the 105 stocks over $5 billion in market cap beat the Nasdaq, but you’d have done better in absolute terms (but not in percentage terms) throwing darts at the smaller-cap names, where 165 stocks beat the Nasdaq out of 261 that we tracked.

The best-performing large-cap tech stock of the year? Micron Technology, the Boise, Idaho maker of random access memory and microprocessors. Forbes contributor and stockpicker David Steinberg liked Micron at the beginning of the year and reiterated that call in September, saying that consolidation has finally brought a modicum of pricing power to the memory chip industry, and Micron is one of the few survivors. Demand is on the upswing and Micron has also put behind it the drag of an ongoing patent lawsuit with Rambus.

Here’s the top 10 and giant spreadsheet you can download with close to 400 tech stocks (above and below $5 billion market cap) ranked by 2013 performance:
  1. Micron Technology (MU), up 250%
  2. SouFun Holdings (SFUN) , up 218%
  3. Pandora Media (P), up 205%
  4. Qihoo 360 Technology (QIHU), up 165%
  5. 3D Systems (DDD), up 119%
  6. Splunk (SPLK), up 139%
  7. T-Mobile (TMUS), up 137%
  8. Facebook (FB), up 107%
  9. CoStar Group (CSGP), up 105%
  10. Yahoo! (YHOO), up 101%
At number two is SouFun, China’s biggest real estate Web portal. It makes money from property listing fees, ads and operating home improvement websites. The company has coverage in more than 320 cities in China with a big, active community of home buyers and sellers, as well as investors and property developers. Revenue in the most recent quarter was up 45% and operating earnings per share was up 66%. The stockpickers at Zacks likes next year’s growth prospects, recently raised to 35% growth from this year.

At number three is Pandora, whose shares nearly tripled in 2013. Few might have guessed they would perform that well, given how tough it is to make money in digital music streaming. But investors woke up to Pandora’s mighty position with 70% share of Internet radio and 71 million monthly active users. Advertising, which accounts for 80% of revenue, will hit $643 million this year. Mobile ad sales topped $100 million for the first time in the third quarter of 2013, making Pandora third in mobile ad revenue behind only Google and Facebook. Musicians aren’t happy about it, but Pandora is renegotiating (likely downward) its royalty rates with artists, labels and music publishers sometime early next year.

One of the big takeaways this year was the underperformance of most of the biggest names in tech. Apple came in dead last among the big-cap stocks, up a mere 5.7%. Also bringing up the rear were Cisco (up 10%), AT&T (up 7%), Verizon (16%), Oracle (10%) and Qualcomm (20%).

You might be wondering, “Where’s Netflix?”. Some consider it a tech stock, and it quadrupled in price in 2013, making it the best overall performer in the S&P 500, but in our industry categorization it falls under media stocks.
No but I'm wondering where is Twitter (TWTR)? Its shares have nearly tripled since their initial public offering last month, including an almost 5% gain on Thursday, making the microblogging site's IPO one of the best performing this year (shares are getting hit on an analyst's call but get ready to buy that dip!).

And if you think that's impressive, Kapital reports that small caps have been among the top performers in 2013:
It's almost 2014, and while there are many who are still concerned about flighty valuations in the stock market, the three major indices have seen a relatively strong December so far. Most analysts say that the rebound indicates the market is calming down at the prospect of tapering, and beginning to accept the implications that the economy is recovering.

Overall the stock market has performed exceptionally well in 2013, as gold and bond yields have plummeted. The optimistic climate has been good for growth stocks, so we decided to find the top five highest performing small cap stocks in the year to date, so see which companies may be poised for further growth in 2014.

With market capitalizations under $2 billion, these top performing small cap stocks are finishing the year outperforming their peers by over 400%. In addition, most have strong EPS growth projections for the next five years.

The top performer on any American index for the year was Zhone Technologies (ZHNE), an Israeli software company which is up nearly 1000% for the year. Part of the stock's performance has been attributed to a number of its technologies gaining approval for use in military and government contracts.

The second highest performing small cap on our list in 2013 was Canadian Solar (CSIQ), Canada's largest manufacturer of solar panels. Solar stocks have all performed well in 2013, even as sales at some of the firms declined.

So do you think these small cap stocks will continue to outperform in the next year? Check back for more lists of the top performing stocks of 2013.

1. Zhone Technologies (ZHNE): Designs, develops, manufactures, and sells communications network equipment for telecommunications, wireless, and cable operators worldwide. Market cap at $155.50M, most recent closing price at $5.21.

2. Canadian Solar Inc. (CSIQ): Engages in the design, development, manufacture, and sale of solar power products in Canada and internationally. Market cap at $1.28B, most recent closing price at $27.57.

3. SuperCom Ltd. (SPCB): Provides electronic monitoring, identification, and security products and solutions to governments, and private and public organizations in Europe, the United States, and Israel. Market cap at $41.03M, most recent closing price at $4.70.

4. Lannett Company, Inc. (LCI): Develops, manufactures, packages, markets, and distributes generic pharmaceutical products sold under generic chemical names in the United States. Market cap at $1.08B, most recent closing price at $32.22.

5. Gray Television Inc. (GTN): Operates as a television broadcast company in the United States. Market cap at $709.37M, most recent closing price at $12.75.
And here's a chart of a company most of you have never heard of, VisionChina Media Inc. (VISN). Its shares have skyrocketed from $1.77 to $31.63 in the last three months (click on image, short this pig but be careful!):

While these eye-popping returns caught most hedge funds and active fund managers off guard, I've been warning my readers for the longest time that the risks of a melt-up in stocks are a lot higher than the risks of a meltdown. Why? Because despite the recent Dectaper surprise, the Fed and other central banks continue to pump an inordinate amount of liquidity into the global financial system, and this will propel risk assets much higher.

But I also warned you that as the Fed tapers in 2014, the risks of deflation will rise significantly. Luckily, we don't have to worry about deflation for now because we'll first get the mother of all liquidity rallies and then suffer the consequences of the mother of all liquidity hangovers.

When I covered the activity of top funds during Q3 2013, I shared with you that I love tracking and trading stocks. I now track over 2000 stocks in over 80 industries (focus mostly on U.S.). At the end of each trading day, I look at the most active, top gainers and losers and add to my list of stocks to track. I also like to know which stocks are making new 52-week highs and lows, which stocks are being heavily shorted, and which ones offer the highest dividends.

I had a great year in 2013, now up close to 140 percent, but I've taken my beatings with stocks in the past. Nortel cost me a pretty penny and so did Patriot Coal when it restructured to shed their pension liabilities of all things. The company is now set to reemerge from bankruptcy as a well capitalized private company, effectively wiping out shareholders (PCXCQ).

Last year, I wrote on a lump of coal for Christmas, recommending coal, copper and steel stocks. I also mentioned a bunch of other stocks in other sectors, many of  which are part of the top performers in the S&P 500 in 2013. Coal stocks seem to have bottomed but copper and steel stocks have broken to the upside recently as the U.S. and global recovery gains momentum.

Coal, copper, steel and shipping shares which are starting to show signs of life lately, are all part of a mega trade centered around emerging markets. The Caisse is betting big on emerging markets but as I stated in a recent comment on why it's time short Canada, this trade might pan out or flop spectacularly in 2014. We shall see but it's interesting to note that steel stocks have recently decoupled from Chinese and other emerging market shares.

The two sectors that impressed me the most in 2013 were solar (TAN) and biotech (XBI). No doubt, there are a lot of high beta momentum chasers in these sectors but it's nice to see my 2008 call on the age of biotech and my 2011 prediction on the solar melt-up are finally kicking in (the turd wannabe traders on Zero Hedge couldn't see that one coming, they're still long gold. DOH!).

I'm particularly bullish on biotech because I think if deflation does take hold, you want to be in sectors with pricing power. But biotech shares are very risky which is why I track the activity of top biotech investors, like the Baker Brothers, very closely to gain insights on individual companies. Shares of Pharmacyclics Inc. (PCYC) and ACADIA Pharmaceuticals Inc. (ACAD) have soared and I like some of their smaller holdings, like Idera Pharmaceuticals, Inc. (IDRA), BioCryst Pharmaceuticals, Inc. (BCRX), Progenics Pharmaceuticals, Inc. (PGNX) and XOMA Corporation (XOMA) where they hold a significant percentage of the float.

And last Wednesday, I told my readers to buy the dip Galena Biopharma, Inc. (GALE) Inovio Pharmaceuticals, Inc. (INO), noting Louis Bacon's Moore Capital Management took a position in the latter company (but it's a global macro fund not a biotech fund).

Boston Scientific Corporation (BSX) as part of the top performing stocks in the S&P 500 in 2013 or to see the strong performance in Rite Aid Corporation (RAD). There are many more stocks in these sectors that I think are going to rip higher in 2014.

Another sector with pricing power that performed exceptionally well in 2013 was education. Shares of Apollo Education Group, Inc. (APOL), DeVry Education Group Inc. (DV) and Grand Canyon Education, Inc. (LOPE) all recorded great gains.

Finally, a little note on gold shares. I've been bearish on gold for a long time, warning my readers that the U.S. recovery would be stronger than expected and gold would plummet. Moreover, in the absence of inflation, there isn't really a strong case to invest in gold but I do think gold shares (GLD) are way oversold and it's a good time to start accumulating at these levels. Also, as I stated in my comment from tapering to deflation, the ECB will have to crank up its quantitative easing, and when it does, gold shares will rally hard (but they could go lower first so be careful).

There is a lot more to cover but I have been eating delicious food and drinking great wine over the last three days and I'm totally wiped. Once more, please remember to contribute to this blog by going to the top right-hand side and clicking on the PayPal options. Alternatively, you can email me and I will tell you where to send the cheque after I've verified who you are (email is

Those of you who want a more in-depth analysis on how to trounce the S&P 500 in 2014 can contact me and we'll arrange a consulting fee. I'm not cheap and have no time to waste with petty projects but I guarantee you that you will make more money following my advice than wasting 2 & 20 praying for an alternatives miracle. I should contact Natalia over at MCM and start a hedge fund in Montreal but think the industry is a frigging joke.

Lastly, Helen Solinski, Manager, Donor Relations at Myelin Repair Foundation, contacted me to tell me they are always looking for funds. I ask all you to please donate generously to this non-profit organization looking to repair myelin (the underlying abnormality in MS and other neurological diseases) by clicking here. Thank you and have a Happy and Healthy New Year!

Below, CNBC's "Fast Money" traders share their strategies to playing shipping stocks right now, including DryShips (DRYS) and Navios Maritime (NM). Be careful with shippers and anything related to China and global growth. There are a lot of momos (momentum chasers) chasing these high beta stocks but so far, there hasn't been any significant and sustained breakout.

And Scott Johnson, founder and CEO of the Myelin Repair Foundation, discusses how their foundation's Accelerated Research Collaboration™ (ARC™) model is designed to optimize the entire therapeutics development continuum through collaboration, for multiple sclerosis and all diseases.

Tuesday, December 24, 2013

The IRS Grinch That Stole Christmas?

David Cay Johnston, contributing editor at Newsweek and columnist for Al Jazeera, National Memo and Tax Analysts, sent me his latest article, District Court Rebukes IRS Church Plan Rulings:
The IRS Office of Chief Counsel came in for sharp criticism from a federal judge in the first significant decision in five lawsuits by workers who complain that the IRS is helping employers quietly strip away their pension rights.

Hundreds of thousands of workers at hospitals and other nonprofit organizations have been moved into so-called church pension plans, which are exempt from ERISA. IRS private letter rulings enabled each of these moves.

Most of the nonprofits that were granted IRS approval to operate as church plans exempt from ERISA were seriously under funded, the trustees having failed to set aside enough money to pay the old-age benefits workers had earned. The federal government guarantees the pensions of workers in ERISA plans, although when a plan fails, workers typically get less than they had been promised. Workers moved into church plans, however, lose the federal guarantee.

The five cases don't involve plans run by churches, but those operated by groups that claim a religious affiliation of some kind even though they may have for-profit partners, operate commercial businesses, and engage in activities that violate the doctrine of the affiliated religion. If the workers lose the five cases, there will be a swift expansion of church plans.

In some cases the plans always operated outside ERISA. In most cases, however, workers in ERISA plans were absorbed into church plans following approval from the IRS chief counsel.

Workers generally were not told about the valuable government guarantee they lost, although current IRS policy requires notifying workers. Many of these plans asked for, and got, refunds of insurance premiums paid to the Pension Benefit Guaranty Corporation when they operated subject to ERISA.

Rollins v. Dignity Health

The action in the first case came after a motion to dismiss by lawyers for Dignity Health, which covers 60,000 workers in Arizona, California, and Nevada. Dignity sought to dismiss a putative class action lawsuit brought by Starla Rollins, a longtime billing office employee.

District Judge Thelton E. Henderson denied the motion. His ruling amounts to a public thrashing of IRS chief counsel.

The chief counsel's private letter rulings are shocking because ERISA makes pension administrators fiduciaries, a necessity because the administrators are typically employees of the sponsoring nonprofit or company and have divided loyalties. Section 404(a)(1) requires plan administrators to act "solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and beneficiaries and defraying reasonable expenses."

Taking away a guaranteed income in old age cannot possibly meet the "solely and exclusively" test, indicating IRS chief counsel turned a blind eye to this standard in these private letter rulings.

The complaint filed by Bruce F. Rinaldi and Karen L. Handorf of Cohen Milstein Sellers & Toll PLLC and by Lynn Sarko of Keller Rohrback LLP argues that "Dignity plainly is not a church or a convention or association of churches" and that the pension was "not established by a church or a convention or association of churches," as the law requires of church plans. "Dignity is not owned by the Catholic Church" and "does not receive funding from the Catholic Church or other religious organizations," according to the plaintiffs.

The plaintiffs argue that Dignity:
is long since removed from the days when nuns once ran the hospitals, spread the gospel, and faithfully stewarded retirement assets for their employees. Dignity deliberately chooses to distance itself from, or even abrogate, many religious convictions of the Catholic Church, when it is in its economic interest to do so, such as when it hires employees, performs or authorizes medical procedures forbidden by the Catholic Church, and encourages divergent and contrary spiritual support to its clients.
Only two of nine Dignity directors are nuns. The executive ranks are composed entirely of lay people. CEO Lloyd H. Dean was paid more than $6 million in 2011, including more than $1 million to his retirement plan. A dozen other employees made between $1.1 million and $2.9 million. Last year Dignity paid more than $2.7 million just to persuade four executives to go away, its Form 990 shows.

In 2012 Dignity bought U.S. HealthWorks, a for-profit operator with 2,700 employees, which has "no claimed ties to religion." "Dignity's current growth model specifically targets the acquisition of additional healthcare facilities that have no claimed ties to religion," according to the complaint. "These facilities do not purport, and have never purported, to adhere to the moral and doctrinal teachings of the Catholic Church."

That point is significant because if Dignity prevails, it would open the door to organizations claiming religious affiliation to get exempted from ERISA and then take over for-profit enterprises and operate for-profit affiliates, just as Dignity does. That could strip multitudes of their government-guaranteed pensions.

The plaintiffs say that allowing Dignity a church plan exemption "violates the establishment clause [of the First Amendment] because it harms Dignity employees, puts Dignity competitors at economic disadvantage and relieves Dignity of no genuine religious burden created by ERISA."

Dignity operates ERISA-governed health and welfare benefit plans, dependent life insurance plans, and short-term disability plans, filing the necessary Forms 5500 each year with the IRS and the Labor Department. So Dignity runs ERISA plans, fully complying with the law, when it chooses, but claims a church plan exemption for its pension plan. How could the IRS chief counsel fail to have noticed this discrepancy?

Significantly, Dignity's lawyers do not assert that it is owned and operated by the Catholic Church. Instead, they write about how a "healing ministry is a central component" of the church's mission and note that Dignity "operates 24 Catholic and 15 non-Catholic hospitals."
I thank David Cay Johnston for sending me this and will let you read the rest of his lengthy analysis here. He also shared this with me:
This column was my first piece on this. I am especially proud of the legal analysis, which focuses on the fact that not only are workers ripped off, but the trustees get a get-out-of-litigation (and perhaps indictment) free card from the IRS.
David is an outstanding investigative reporter and his column exposes how the IRS chief counsel truly bungled this case up and opened the door to more pension abuse at a time when American workers are getting squeezed from all sides and are facing pension poverty.

Once again, I invite you to read my New York Times article on the U.S. public pension problem as well as my follow-up blog post answering some comments.  I also invite you to read my recent comment on solving the global pension crisis.

Importantly, if policymakers truly want American workers to retire in "dignity," they have to drop the 401(k) charade and move forward on bolstering defined-benefit plans for public and private sector workers and implement a shared risk model and top notch governance standards. That is the only solution to solving the pension crisis.

President Obama should be ashamed of himself. He squandered a golden opportunity to tackle the pension problem, but as we all know, his administration is having a tough time handling healthcare reforms. Unfortunately, Obama isn't concerned about pensions. In fact, his administration has done everything in its power to derail U.S. pension reforms.

Now, that's hope and change you can believe in! This is all part of money, power, Wall Street and disability. You see while Main Street is still hurting, the sharks on Wall Street have a license to steal, charging pension funds huge fees while their algos keep refining the Wall Street code.

But don't fret dear readers, I will be back after Boxing Day and throughout this holiday season, providing you with timely and wise insights on how you can beat the algos and their dumb code as well as big hedge funds that have become large and lazy asset gatherers.

We will use Warren Buffett's pension wisdom and piggyback on what top funds are buying and selling. But most of all we will use common sense knowing full well that while market timing is a loser's proposition, there are always investment opportunities in any market, even one where bubble anxiety is on the rise.

I wish you all a Merry Christmas and Happy Holidays but before you stuff your faces tonight, please remember to donate to those less fortunate.

Below, a brief history of The Montreal Gazette's Christmas Fund came to be, narrated by Gazette reporters Marian Scott and James Mennie. You can donate to the Montreal Gazette's Christmas Fund by clicking  here and remember the true spirit of Christmas is giving, not shopping.

I also embedded a Christmas Special with Luciano Pavarotti (1978) at Notre Dame Cathedral in Montreal, joined by a boys choir, Les Petits Chanteurs du Mont-Royal, and an adult choir, Les Disciples de Massenet (conductor: Franz-Paul Decker).

Monday, December 23, 2013

Time to Short Canada?

Camilla Hall of the Financial Times reports, Short-focused fund to launch in Canada:
Investors in Canada are to get the chance to bet against their own real estate market as one of the first short-focused funds is set to launch in the country, where concerns have grown that there is a housing bubble ready to burst.

The Spartan/Libertas Real Asset Opportunities Fund, set to launch in Toronto in the first quarter of next year, will allow Canadian brokers, developers or pension funds to mitigate their exposure towards a possible downturn in the real estate market, Michael Brown, manager of the fund told the Financial Times.

The new fund reflects broader investor interest in shorting or hedging risk to Canada after high-profile names from Steve Eisman, featured in Michael Lewis’s The Big Short, to Robert Shiller, the Nobel-prize winning economist, have raised questions over the challenges facing the Canadian real estate market.

Under the watch of Mark Carney, the former Bank of Canada governor who now holds the same job at the Bank of England, the country weathered the global financial crisis better than many industrialised peers. But low interest rates have encouraged soaring property prices and household debt levels which many economists say are unsustainable.

“The thesis behind the fund is that the Canadian housing market is one of the most overvalued in the world,” said Mr Brown. “A lot of things people observed in the US in the run-up to 2007-8 crisis are happening here.”

The OECD has ranked Canada as one of the countries most at risk of a price correction, especially if borrowing costs increase or income growth slows. Deutsche Bank recently said Canada is the most overvalued market in the world, with a 60 per cent overvaluation, above Belgium and Norway.

Canada’s average home price index has increased 20.2 per cent in the past 36 months, according to the Canadian Real Estate Association. Average existing home prices in Canada were at C$391,997 in November, 50 per cent higher than in the US, according to analysis by BMO Capital Markets.

Canada bears point to how low interest rates and the government’s backing of the mortgage market – by insuring home loans – have fuelled a real estate bubble and worse, stoked a consumer borrowing binge.

The ratio of household debt to disposable income has grown to 152 per cent in Canada, near to the US peak of 165 per cent, according to a December report from Canada’s central bank.

The level of the government’s involvement in the mortgage boom has drawn the attention of the International Monetary Fund, analysts and regulators as the portfolio of home loans insured by the Canada Mortgage and Housing Corporation has swelled to $560bn.

“When something gets that big, even governments get nervous,” Mr Eisman, founder of Emrys Partners told a conference in New York in May, attracting the attention of global investors.

But, since May, shares in mortgage company Home Capital Group – singled out by Mr Eisman – have increased more than 40 per cent and stocks of Genworth MI Canada have risen more than 30 per cent.

The new fund is being launched through Toronto-based Spartan, a multi-fund investment platform for individual hedge fund managers. Mr Brown was a managing director and partner of Enterprise Capital Management, a small, privately owned hedge fund sponsor.

While Mr Brown would not give specifics of the trades, the fund could look at strategies such as shorting equities or buying put options to bet on asset price declines, an alternative method of hedging.

It will bet on price declines across asset classes from equities, to fixed income and target sectors such as financial companies and real estate-linked companies, as well as the currency, said Mr Brown.

Goldman Sachs has recommended shorting the loonie, as the Canadian currency is known, as one of its top 2014 trades. In a separate report, Goldman also warned of the risks of overbuilding in Canada and said price declines could be “quite significant” in the event of a housing bust.

However, Canadian companies and banks are quite resolute in their rejection of the hedge fund bears and in particular, the comparisons they make with the US subprime mortgage crisis.

“[Canadian] Banks don’t lend money to people who can’t afford to buy houses and can’t afford to service the mortgages,” Gordon Nixon, chief executive of the Royal Bank of Canada told the Financial Times.
Damn those Goldman boys, they keep recommending my trades! For those of you who don't read this blog regularly, I've been warning my readers to short the loonie because the tailwinds that propelled it higher are no longer there (ie. massive Chinese investment in infrastructure bolstering commodities and commodity currencies) and the fundamentals in Canada are deteriorating quickly.

In a recent comment looking at whether Canada is on the right path, I noted the following:
As far as Canada's housing bubble, it keeps defying gravity but this too will come to an abrupt end. I know, there are millions of rich Chinese, Russian and Middle Eastern immigrants that will keep buying luxury condos for their kids to study in Canada and second homes for an insurance policy, but they will get clobbered along with everyone else investing in Canadian real estate at these prices.
Last night, I had dinner with my brother and friends and we talked about Montreal real estate. One of my friends who invests in affordable multi-family rental units noted: "Montreal's condo market is outrageously overpriced and high end condos, houses and cottages will be the first to get pummeled."

He also noted "Montreal is a poor city but people still need to live somewhere," which is why he prefers attractively priced apartment buildings. The problem is that there aren't many apartment buildings that offer an attractive yield, a point he underscored: "cap rates are ridiculously low."

I must admit, I've been bearish on Canadian real estate forever, fearing the worst from Canada's mortgage monster. Think it's grossly overvalued and a lot of young couples buying expensive homes or condos, taking out huge mortgages, will get slammed hard in the next few years. They are literally one job loss away from losing their home.

And the problem in Canada isn't just housing. Oil prices have fallen a lot over the past year (but have firmed up recently on good U.S. economic news). AIMCo recently invested $100 million in efficient oilsands technology but Leo de Bever, its President and CEO, isn't bullish on oil:
Alberta’s energy sector must learn to prosper in a world of much lower oil prices, warns Leo de Bever, CEO of Alberta Investment Management Corp., the province’s $70 billion public sector pension and endowment fund manager.

He believes the risks are high that oil prices will sink to the $70 US per barrel range or lower over the next five years, as North American output grows and demand wanes in the face of improved energy efficiencies. With West Texas Intermediate (WTI), the benchmark U.S. grade, now trading at more than $95 per barrel in New York, such a decline would represent a drop of 26 per cent from current levels. Western Canada Select, Alberta’s benchmark grade, is currently selling at just $66 per barrel.

As a result, AIMCo is looking to invest about $100 million in new, development-stage technologies that could help oilsands producers cut costs while addressing key environmental issues.

“If (WTI prices) go to $70 (US) a barrel, that’s a problem for Alberta, and the risks (of that happening) are pretty high,” de Bever said. “If this province is going to advance it has to deal with some of this. If we can bring the cost of refining down so we’re no longer the high-cost producer, we might give ourselves some options of not just shipping it to the Gulf but maybe refining more up here and shipping the high value-added stuff.”

In particular, AIMCo is trying to identify technologies that would use less energy to convert raw bitumen into synthetic crude.

“That usually means doing things at a lower temperature and lower pressure. That’s where all the costs are. I’m aware of four or five technologies that do that, and we’ve invested a little bit in two of them,” he said. “Maybe those two aren’t going to be the ones that carry the day, but there’s so many efforts being made in this regard that at some point somebody is going to punch through that wall, and the cost structure will come down quite dramatically.”

Since AIMCo’s primary goal is to generate solid returns for taxpayers, as opposed to funding development of new technologies that often don’t pay off, de Bever said he is “struggling with both how I can make money at it and do the right thing” for the Alberta economy.

That said, he emphasized that $100 million would equate to just a small fraction of AIMCo’s overall assets, which include the $16.6 billion Alberta Heritage Savings Trust Fund. AIMCo is currently on track to generate gains of more than 10 per cent for the full year, de Bever said.

“The overall numbers in terms of absolute return look pretty good, at over 10 per cent so far, with a 26 per cent increase in equities and zero or slightly negative (real) returns on bonds. The basic direction we took is we de-emphasized bonds and emphasized equities, and that has worked out for us. The only thing that’s a bit problematic is if you have unlisted assets as we do they tend to lag a big run-up like this, but eventually that will even out,” he said.

Asked whether he is worried about a sharp pullback in equity markets in view of the huge gains racked up by the major U.S. indexes this year, de Bever said he sees such corrections as longer-term buying opportunities.

“I have no doubt we’ll have stock market pullbacks as we’ve always had. But like Rip Van Winkle, if I were to wake up 10 years from now, I would rather have started out with a portfolio that’s more equities than bonds,” he said.

“There is tremendous opportunity in the long run in equities, and the dangers of being stuck in a holding pattern or worse for bonds is high. There’s only two scenarios for bonds: terrible and really terrible. I can’t conceive of a bond scenario that really generates a lot of capital gains going forward.”
There are tons of opportunities in equities and as I stated in my comment on Fed tapering and deflation, you better buy any dip in the stock market hard because the risks of a significant melt-up in stocks is high, fueling more bubble anxiety.

Nonetheless, I'm not as bearish on bonds as Leo de Bever and other pension funds betting massively on a rise in interest rates. I still fear deflation is the end game and after we get the mother of all liquidity rallies in risk assets, the next cycle will be prolonged debt deflation.

AIMCo's investment in this new technology is interesting but it's a pittance for their overall portfolio. I found it more interesting that they recently bailed out of Precision Drilling (PD.TO), prompting one analyst, Andrew Bradford of Raymond James, to upgrade their shares (update: AIMCo took profits and stock kept going higher. As of June 2014, it's at $16).

As far as Canada's energy sector, I warned my readers in early January about Canada's perfect storm, noting the following:
As for the great Canadian oil glut, it couldn't have come at a worse time. Coupled with the great Canadian condo glut, there is a perfect storm brewing up here which will seriously impact our economy for a long time (start shorting the loonie!). It's déjà vu all over again for Alberta as they haven't learned anything from the last oil boom & bust episode.
If you took my advice and shorted the loonie at the beginning of the year, you would have made a killing, just like if you took my advice and shorted the yen when I wrote about Japan's seismic shift in November 2012, you would made off like a bandit (I should run the research at a top global macro fund).

So what is the best way to short Canada? I still think it's better to short the loonie and selective commodity and energy companies rather than shorting Canadian banks, but if you're long Canadian banks, book your profits and go neutral or underweight after the record run-up. Looking ahead, I prefer U.S. banks over Canadian banks but think the latter are still well managed (some better than others).

Finally, it is worth noting the Caisse's CIO, Roland Lescure, doesn't think investors should bet against boring Canada. I respectfully disagree and note the Caisse hasn't made serious money trading currencies in all but one year in the last 20 years (their currency strategists have been extremely poor performers). The Caisse is also betting big on emerging markets, which might pan out or flop spectacularly (tough call).

Below, Mike Babad, the Globe and Mail's Report on Business News Editor, reports on why analysts can't agree on a Canadian housing bubble. I fear the worst for Canada and think economists expecting a "soft landing" in the Canadian real estate market are delusional fools. You've been warned.

Friday, December 20, 2013

Solving the Global Pension Crisis?

Mark Cobley of Dow Jones Financial News reports, Solving the pensions crisis across the globe:
In 2014, it will be the 125th anniversary of the pension scheme. Otto von Bismarck, the Chancellor who unified Germany, introduced the world’s first state pension in 1889 – but the concept has not aged well.

The basic design of the Bismarckian contributory pension – you pay into a fund throughout your working life, which entitles you to a guaranteed income from the age of 65 onward that is closely related to your previous salary – has been undermined by radically shifting demographics.

Ageing societies in the west can no longer afford these pensions, and most people in the world’s poorer countries have never had one anyway.

Yet something must be done to finance the world’s old age. Global policymakers, together with private-sector leaders, have finally accepted that they can no longer delay.

Larry Fink, the chief executive of BlackRock, the world’s largest asset manager, has been among those urging action. He told Financial News: “The fact is, a lot of national pension plans often don’t pay enough to fund a satisfactory retirement, and the problem is compounded by many of them being underfunded.

“Just as individuals have to be more proactive, so do governments. The current structures in place in most countries are simply insufficient to address retirement needs, especially in light of increased longevity.”

The demographic challenge is, in the words of Indian pensions expert Kavim Bhatnagar, “awe-inspiring”. He points out that population ageing is not just a western problem. About 100 countries, including India, Bangladesh and Venezuela, are set to double their populations of older people in the next couple of decades, he said. European nations such as France or the UK took more than a century to make the same transition.

He added: “These are also the countries where the coverage of old-age social security is almost missing, with 80% to 90% of the current working populations with no social security or pensions. The majority of older women are either widowed or deserted.”

Michael Herrmann, economic adviser to the UN Population Fund, said: “In countries like these, ageing is typically financed through informal family transfers. But people are moving into cities and those traditional family structures are breaking apart. That system won’t be sustainable.”

Hundreds of millions – if not billions – in rural areas and the informal economy in much of southern Asia and Africa are outside western-style financial systems. Many do not even have bank accounts, let alone pension schemes.

Economies in east Asia are often more developed, but the demographic challenge there is even more pressing. Robert Palacios, senior pensions economist at the World Bank, said: “Much of east Asia is in a race against time; a race to expand coverage of pension systems as the population ages. Japan has obviously a very high pensions coverage. But if you look at China, Thailand, Vietnam… when they converge on the demographic profile of Japan, and you look at how fast they have to expand coverage, it’s a monumental task.”

In China, the world’s most populous nation, a looming demographic crunch is unlikely to be alleviated by the government’s recent “rather mild” relaxation of its one-child policy, according to Stuart Leckie, chairman of Hong Kong-based consultancy Stirling Finance and an expert on the Chinese system.

He explained: “Previously, if two only-children married, they could apply to have a second child. Now what they are saying is that if only one of the parents is an only-child, they can apply. Over the last few years, about 16 million children have been born in China every year. People say that this new policy might encourage an extra one million births a year.

“Going from 16 million births to 17 million, in a country of 1.35 billion, is not going to solve the problem.”

In many developed economies, meanwhile, the guaranteed pension payable after 65 – the contributory defined-benefit scheme – is under severe pressure, if not already abandoned.

A contributing factor to DB’s demise has been that many nations have operated state DB systems on a pay-as-you-go basis: contributions into the system from current workers are paid directly to current pensioners. The workers build up a paper entitlement instead of an actual fund, and their pensions are then paid out of the contributions of tomorrow’s workforce.

Nick Sherry, a former Australian pensions minister now working as a consultant to other governments on pensions reform, said: “There is nothing wrong with pay-as-you-go in principle, if you are able to keep the cost manageable.

“Most countries have failed to do this. When retirement ages were set 100 years ago, they were set at the early to mid 60s, and most people did not live far beyond this. Countries like Greece, Spain and Portugal have got into trouble because the level of promise was much too generous and applies to most people.

“Clearly, Italy and France and ultimately Germany and Japan have similar promises that have been made. Demographics is creating enormous cost pressures on government.”

In the UK and US, he said, these same pressures apply to schemes in the public sector. In the private sector, DB promises tend to be funded, and have now been withdrawn because the funds were insufficient to pay for rising longevity. Sherry added: “I predict that public-sector DB in the US and UK will be gone in five to 10 years.”

Radical pensions reforms have a political cost and can lead to strikes and demonstrations.

Nevertheless, the demographics are inexorable. Last week, the UK set out new plans to raise the retirement age to 70 in the long term – putting it at the vanguard of international efforts to tackle rising life expectancy. Denmark and Italy have raised it to 69 in recent years; Ireland, the Czech Republic and Greece (see boxout) to 68.

Reforms can have immediate benefits. Last week the ratings agency Moody’s said Spain’s plan to decouple state pensions from inflation – announced in September – was “positive” for its outlook on the country’s debt, which it rates one notch above junk. The agency did not upgrade Spain, but it did shift its outlook from “negative” to “stable”.

The response to these twin challenges – reforming systems in the rich world, and extending them to the global poor – is taking a variety of forms, but a couple of outline trends are increasingly discernible.

The first and clearest is that most pension systems, whether public or private, will be based upon the principle of defined contributions. Unlike DB, DC schemes do not promise a guaranteed pension income.

Instead, contributions are saved up in a personal account for each worker, which is swapped for a pension upon retirement.

From its beginnings in Chile, Sweden, Australia and the US in the 1980s, DC has spread around the world in the past couple of decades. Latin American nations such as Mexico, Peru and Colombia followed Chile’s lead in the 1990s and early 2000s, shifting from public social security systems towards private DC funds. Following the collapse of Communism, many eastern European states followed this model as well. Meanwhile, the Anglo-Saxon nations have replaced private DB systems with private DC systems.

Today, both India and China are in the process of developing DC-based public systems and extending them to broad swathes of the population. Brazil is planning to introduce a DC top-up for its federal employees.

A shift toward investing pension contributions in the financial markets is often – but not always – coupled with the move from DB to DC (see accompanying article: “Private sector eyes increased role”).

However, some observers now detect a new trend emerging, especially in the global south. Chile, the test-bed for privatisation in 1981, embarked on a fresh reform in 2008, introducing a new public “safety net” pension, funded out of general taxation.

Palacios believes that such non-contributory systems, or contributory systems where the state matches payments-in from people without formal employment, will play a large role in extending pensions to the world’s poor.

He said: “In Mexico this year, the government has declared that it’s going to have a universal, non-contributory pension. In China, you have this expansion of the rural pension system, which is probably the most ambitious and rapid expansion of pensions coverage in history. It will be partly financed by matching contributions from federal and local government, and contributions from the individual.

“Globally, there is an increasing shift away from dependence on the old Bismarckian system; on payroll taxation and contributions, and the link to formal-sector employment.”

Greek woes lead to ‘drastic’ remedy

During the past few years of crisis, bailout and political upheaval, at the behest of its international lenders Greece has implemented probably the most radical pensions reforms undertaken by a developed country. And there may be more to come, writes Mark Cobley.

Georgios Symeonidis, a board member at the Hellenic Actuarial Authority and adviser to the Greek Labour Ministry, describes the redesign of Greece’s state system – which accounts for about 99% of all pensions paid – as “drastic”.

In 2010, payouts were cut, with the earnings-related portion of the state pension linked to career-average salaries instead of final salaries, which tend to be higher. A cap on increases in public pensions spending: 2.5 percentage points of GDP between 2009 and 2060 was also introduced that year. The Hellenic Actuarial Authority is to run projections every two years and if it estimates that the increase is exceeding that limit, pensions will be adjusted.

Symeonidis said: “This clause makes the system a self-correcting one.”

In 2012, the system of additional public occupational schemes, which overlies the state system, was converted to “notional defined contribution” – meaning that its payouts can be reduced if life expectancy climbs. The state pension age was lifted from 65 to 67, with further increases in this also tied to longevity. The OECD predicts 68 by 2050.

Launching the OECD’s global pensions report in London last month, Stefano Scarpetta, director of the organisation’s employment, labour and social affairs directorate, said: “In our last publication [in 2011] we were forecasting that public pension expenditure in Greece would rise to 24% of GDP by 2050. Following the troika reforms, we now think this will be 15.4%.”

The current OECD average is 9.3%, predicted to rise to 11.7% by 2050.

This year Greece has overhauled its pensions administration and data systems, and there has been a crackdown on contribution evasion – commonplace in previous years. The government has also convened a “special committee” of pensions experts to recommend further reforms, with a possible implementation date of 2015.

Nick Sherry, a former Australian pensions minister, is preparing a survey of 15 pension systems worldwide for the Bank of Greece.

Symeonidis said there were discussions between policymakers, politicians and pensions experts over a defined-contribution reform of some elements of the Greek system. He said: “One part of the system will have to change to DC, because we are all living longer.”
Unfortunately, the Greek government didn't invite me to recommend changes to their grossly antiquated and completely corrupt and inefficient pension system. Despite the reforms brought on by the crisis, Greece is still living in the dark ages when it comes to pensions (there is no governance, transparency and accountability whatsoever).

Importantly, Greece and any other country which wants to get serious about bolstering its pension system for the better, needs to incorporate many of the recommendations that I and other pension experts have put forth. Mr. Symeonidis should get in touch with Bernard Dussault, Canada's former Chief Actuary, and get valuable insights from the world's foremost expert on pension policy (email him at

The last thing countries should do is follow Australia's shift into state sponsored defined-contribution plans. As I've cogently argued in my blog, there are no pension lessons to be drawn from Down Under, and Australia doesn't deserve to be among the world's best pension spots.

And what about Canada? Well, our top ten defined-benefit plans are global trendsetters but our federal government foolishly ignores the benefits of DB plans, and instead continues to shamelessly pander to Canada's financial services industry. Fortunately, there are smart politicians that recognize Canada's huge pension crisis and I think it's high time Ontario goes it alone on pension reform.

People love complicating pensions and politicians are petrified to touch the third rail, but take it from Bernard Dussault, pensions aren't complicated. They're not a Ponzi scheme and an ageing demographics doesn't mean we can't afford defined-benefit plans. In fact, now more than ever, we need to bolster DB plans for everyone and reform global pension systems by implementing shared risk model that has worked well in the Netherlands.

But shared risk doesn't mean "risk dumping" like they did in New Brunswick. I had to revisit New Brunswick's pension reforms following comments from Bernard Dussault regarding cost-of-living adjustments. Bernard shared more insights with me and George Luste, Professor Emeritus of Physics at the University of Toronto, on why he opposes the conditional indexation provision in New Brunswick's Shared Risk Plan (SRP):
Here is why I am totally opposed to, and find perverse, unfair and inappropriate, the conditional indexation provision enshrined in the New Brunswick Shared Risk Plan:
  • Indexation is one on the key features of a Defined Benefit (DB) plan, as it protects the pension's purchasing power It shall remain unaltered.It is not a collateral benefit but rather a way of paying the pension.
  • Under the SRP:
    • Contributions are determined accounting fully (100%) for the value of indexation.
    • Indexation is paid only if the fund /benefit ratio is at least 105%: therefore, although indexation is paid for in full, 1/4 of it will never be paid because it represents about 20% of the contributions actually paid. NB Finance Minister Higgs accordingly and somewhat rightly said that indexation will be paid in only 75% of the cases. It is unfair to pay only 75% of a feature that you have paid in full.
    • It is anapropriate to use indexation to address a pension issue that is not caused by the inflation rate but rather the fluctuations in, and volatility of, the rate of return on investments. Volatility shall be attenuated by prohibiting contribution holidays and by amortizing both emerging surpluses and deficits over 15 years through yearly + and - adjustments to the normal cost of the plan (contribution rate).
    • Because indexation is conditional, no liability is held whatsoever in its respect, i.e. the liability side of the pension balance sheet is artificially reduced by about 20%. This is a perverse accounting gimmick that opens the door to actually generate further deficits as the resulting artificial surplus invites to overspend.
The SRP conditional indexation provision can be compared to a parent having enough money to by a larger pair of shoes (shoe size indexation) to his/her growing kid but does it only 75% of the time it is required because the kid suffers from heart arrhythmia (heart beat volatility) that requires huge medical fees that are not currently available. In other words, two problems, nothing done. Solution: buy the shoes now and use any extra income (emerging surplus) along with a loan (amorization of deficit) to provide the medical treatment for the heart arrhythmia.
As I stated above, Bernard is the foremost pension policy expert in Canada and the world. I was glad I finally met up with him recently at a conference in Ottawa looking into whether Canada is on the right path. He's a gentleman and someone who never waivers on his principles.

Below, PBS travels to one country -- The Netherlands -- that seems to have its pension problem solved. Ninety percent of Dutch workers get pensions, and retirees can expect roughly 70% of their working income paid to them for the rest of their lives.

Thursday, December 19, 2013

From Tapering to Deflation?

Daniel Worku wrote a comment for Liberty Voice, Federal Reserve System’s Mythical Taper has Finally Arrived:
The Federal Reserve System’s long dreaded taper fade has finally been announced. After leading on the markets for some time now, the fed-heads in charge of printing and minting currency, along with confidence, have decide that the time has come for a multi-billion dollar taper fade to be implemented.

Stocks have shot up on the news that fed-heads in charge of the Federal Reserve System have actually decided to take on the taper that they’ve been hinting would eventually happen. The reasons cited by the money wizards behind the curtain were that we now have a stronger economy, which among other things signals an appropriate time to begin scaling back the $85 billion a month bond purchase stimulus to something more conservative. The more conservative figure that has been agreed upon is a taper fade special of $10 billion a month, leaving the new monthly bond purchases at $75 billion.

Investors had for quite some time been frustrated at the wishy-washy position taken by the fed-heads, namely Bernanke, regarding whether or not the time was right to implement the taper they had talked about for so long. Now, as news of the decision to finally taper begins to circulate, the markets reaction shows how investors feel about the Federal Reserve System’s decision. The stock surge can be interpreted as a sort of digital smile, wink, and hair-toss from investors back in the direction of the fed-heads who have been leading them on for so long.

The Dow jumped more than 200 points in less than one hour after the announced taper, whereas just prior to the taper announcement the Dow was only up a mere 47 points. The S&P 500 along with Nasdaq followed suit, rising 1.0 percent and .05 percent respectively.

The $10 billion taper fade is set to begin in January, but already has shown itself to be a welcome bit of news to investors. The Federal Reserve System’s financial wizards seem to be making a statement with the recent decision. The announcement may seem to imply that the recent actions are a sign of good faith tossed across the bow to investors who had been getting tired of having their expectations and feelings disregarding by all the unexpected pivots by fed-heads regarding the implementation of the mythical taper.

The decision to taper now comes as somewhat of a surprise to investors, though not totally unexpected as Bernanke had clearly been tossing the decision around for some time. What appears to have taken some by surprise is the timing of the decision, which most expected to be made after the first quarter of 2014.

It appears as though the decision to taper will be supported by the incoming fed-head Janet Yellen. Ben Bernanke, in a recent statement made to the press, made it clear that he had consulted with the incoming leading lady of banking, and that Yellen “fully supports” the decision to taper.

The timing of the decision has translated into a nice boost to the markets as the fiscal years draws to a close, and with the response, it is clear that investors view the decision in a somewhat positive light.

As the statutory stitching that holds together the precarious global economic system gets pressed, every bit of confidence is sure to go a long way for the fed-heads and financial engineers in charge of maintaining the domestic and international money-go-round. This latest action will presumably buy the necessary confidence to keep the engine running until further notice.

The future remains unknown, but today’s news is that the Federal Reserve System’s mythical taper has finally arrived to the tune of $10 billion a month.
My friend Brian Romanchuk, author of the Bond Economics blog, had this to say on Taper! Taper! Taper!:
Well that was exciting. So far my forecast that this would be viewed as a policy error was wrong, but in my defense, it's too early to say...

The key points to note:
  • Fed monthly purchases drop by $10 billion to $75 billion per month; $5 billion each from Treasury and mortgage paper;
  • ignore that 6.5% unemployment rate triggering rate hikes thing; rates can remain at zero as long as inflation is well behaved.
My reading is that the baseline scenario should be:
  • Purchases reduced by $10 billion at each Fed meeting in 2014. This means that the end of 2014 is the end of QE (there are 8 Fed meetings per year).
  • Fed rate hikes commence shortly thereafter (early 2015).
This appears slightly more hawkish than what is priced into the forwards, but not by much. However, it seems consistent with the published consensus FOMC forecasts. The Fed wants bond market participants to believe that there will be a lengthy pause in between the end of QE and rate hikes, but we do yet not have enough information to believe them. However, it appears that risks may be skewed towards the Fed being less hawkish than this baseline, explaining why forward rates are below what the path of Fed funds it implies.

The initial financial market reaction was entertaining. So far, equities are up on the news. There goes the forecasts that "the Fed can never Taper because of stocks". However, it may be possible that the initial reaction is an incorrect read on future trends. However, it is nice to see the Fed having the will to act in December, despite the worries about the reaction of illiquid markets. The Fed needs to break its reputation of kowtowing to the needs of the equity markets.
There were a lot of "howevers" in the last paragraph but I too was a bit surprised by the Fed's decision to begin tapering at the end of the year. As I stated in my last comment on the Dectaper surprise, the threat of global deflation is huge, which is why I thought the Fed would not start tapering at this time.

I was less surprised, however, at the initial knee-jerk reaction of the stock market. As I predicted, stocks melted up. We are still in the early innings of a major liquidity melt-up and even if the Fed tapers by $10 billion at each of its meetings in 2014, stocks and other risk assets are headed much higher, fueling more bubble anxiety among jittery investors.

But the key question is why did the Fed start tapering? Sure, the U.S. economy has recovered but it's a long way from where it was before the crisis hit. Moreover, the gains have been very uneven, with the rich getting richer while most people struggle to make ends meet.

Over in Europe, Draghi is trying to calm fears of deflation, but he better heed the advice of Barry Eichengreen and start cranking up quantitative easing. In Japan, the government is prematurely dropping the word "deflation" from their monthly economic report, foolishly believing they've escaped years of price declines.

Last month, the OECD's chief economist said current European policies are pushing a string of countries into deflation and onto a much lower growth path and warned the global economy remains extremely fragile, highlighting the danger of "virulent episodes" in emerging markets as the US Federal Reserve starts to withdraw global dollar liquidity.

So what gives? Why did the Fed begin tapering? Is this going to be another major policy blunder? To answer this question, let me once again refer to Mike Whitley's excellent comment in counterpunch, The Truth About Deflation, where he notes:
The Fed is stuck in an ideological cul de sac mainly because its members ascribe to Bernanke’s monetary theories which simply don’t work. Here’s a clip from a speech the Fed chairman gave to the National Economists Club in 2002 that gives us a glimpse into his thinking:

“Under a fiat money system, a government… should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.” Ben S. Bernanke, “Deflation: Making Sure It Doesn’t Happen Here”, Federal Reserve, November, 2002

Okay, so where’s the inflation, Ben? The Fed’s 2 percent inflation target continues to move farther away the longer the Fed’s programs stay in place. Even more shocking is the fact that “The Fed’s preferred measure of U.S. inflation, the personal consumption expenditures deflator (PCE), showed last week that prices rose 0.7 percent in October, the least since 2009.” (Bloomberg) So even by the Fed’s own standards, QE and zirp have been a bust.

The reason for this is simple: QE does not raise inflation because QE does not increase incomes, wages or credit. The reserves that are created via QE remain in the banking system where they buoy asset prices by reducing the supply of stocks and bonds available for sale. But there is no transmission mechanism for delivering money to the real economy where it can increase activity, inflation and growth. The fact is, QE may actually be deflationary since it reduces the interest on bonds (US Treasuries) that provide income for savers and other fixed-income investors. Some analysts put the amount of potential savings lost due to QE in the neighborhood of $400 billion, which represents about half of all the money spent on Obama’s fiscal stimulus called the American Recovery and Reinvestment Act of 2009. Naturally, the loss of this revenue has only added to the sluggishness and stagnation of the US economy.

Economist Frances Coppola believes that QE is “deflationary rather than inflationary”, and makes the case in a recent post on her blog titled “Inflation, Deflation and QE”:
“Both UK and US governments believe that monetary tools such as QE can offset the contractionary impact of fiscal tightening. But this is wrong. Fiscal tightening principally affects those who live on earned income. QE supports asset prices, but it does nothing to support incomes. So QE cannot possibly offset the effects of fiscal tightening in the lives of ordinary working people – the largest part of the population. In fact because it seems to discourage productive corporate investment, it may even reinforce downwards pressure on real incomes. And when the real incomes of most people fall, so does demand for goods and services, which puts downward pressure on prices, driving companies to reduce costs by cutting hours, wages and jobs. This form of deflation is a vicious feedback loop between incomes, sales and consumer prices, which in my view propping up asset prices can do little to prevent.” (“Inflation, Deflation and QE”, Frances Coppola, Coppola Comment)
Coppola, who calls QE “one of the biggest policy mistakes in history,” backs up her claim with a number of charts and graphs which show how inflation fell during periods when central banks were buying sovereign bonds and boosting reserves at the banks. (Remember, the point of QE is to raise inflation expectations, not lower them.) Her repudiation of QE is further underscored by the fact that the so called “velocity of money” has dropped to a six decade low. Get a load of this graph from the St Louis Fed (click on image):

According to Investopedia the “velocity of money” means: “The rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time…Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services. This helps investors gauge how robust the economy is, and is a key input in the determination of an economy’s inflation calculation.”

Bernanke knows that velocity is in the doldrums and that QE has had no meaningful impact on activity. Keep in mind, these are the Fed’s own charts. All the members of the FOMC are familiar with them and know what they mean. And what they mean is that the money is going no where; it’s stuck in the financial system goosing asset prices and providing needed balm for bloody bank balance sheets which are still deep in the red five years after Lehman Brothers collapsed. In other words, QE is working largely as it was designed to work. It is boosting profits for the financial sector while keeping the real economy in a permanent slump. As long as the economy underperforms, the Fed will have a reason to continue the existing policy. If, however, the economy gains momentum and inflation rises, the Fed will be forced to wind down its asset purchases and raise rates cutting off the flow of interest-free money to the banks. Thus, the Fed’s strategy requires that the US Congress and the White House continue to shave the deficits, curtail public spending and implement other belt-tightening measures to make sure the economy does not rebound and upset the Fed’s plan to continue its wealth transfer to Wall Street.

This sounds easier than it is, in fact, the droopy rate of inflation suggests that Bernanke may already be too close to the cliff-edge to pull back in time. Credit growth, personal consumption, wages and incomes remain either flat or trending lower. The recent bump in Third Quarter (3Q) GDP was largely due to one-time inventory buildup that will undoubtedly weigh heavily on future readings. The same rule applies to unemployment where the uptick in payrolls is overshadowed the bleak participation rate which continues to reflect the abysmal state of the labor market. Also, the New York Fed just released a report (FRBNY Survey of Consumer Expectations: Household Finance Expectations) showing that “both household income growth and spending expectations are basically flat-lined (and) that there is no expectation of things getting any better or any worse.” (Housingwire) Needless to say, when consumers are as pessimistic as they are today, it greatly impacts their spending habits. (which the survey confirms)

Finally, the US economy is bound to be wacked by Japan’s accelerated QE program which has slashed the value of the yen weakening US exports while pushing up the value of the dollar. Like the Fed, the Bank of Japan is following a beggar-thy-neighbor policy which exports deflation to its trading partners in the relentless pursuit of aggregate demand. This is how currency wars start.

All of these are adding tinder to a woodpile that could burst into flames in 2014. CLSA’s prescient analyst, Russell Napier, believes the world is about to experience a “deflationary shock” that will send raw materials, manufactured goods, and stocks plunging. Here’s a short excerpt from his article titled “An Ill Wind” via Zero Hedge:
Three times since 1997 inflation has fallen below 1% with very negative impacts for equity investors. On all three occasions an existing low level of inflation was forced lower by dramatic events: the bankruptcy of Russia and collapse of LTCM in 1998; the terrorist attacks of 11 September 2001; and the bankruptcy of Lehman Brothers in September 2008. While nobody would attribute the 11 September atrocity with extant global deflationary forces, the other two episodes can clearly be associated with such forces. So perhaps it is global deflationary forces creating a bankruptcy event, somewhere in the world, that is the catalyst for a sudden change in inflationary expectations in the developed world. It can all happen very quickly; and it is dangerous to stay at an equity party driven by disinflation when it can spill so rapidly into deflation.

In 1998 falling export prices triggered a Russian default, and in 2008 falling US house prices triggered the Lehman bankruptcy. Going back further, deflation in the oil price in 1982 produced a Mexican default and a credit event which threatened to bring down the US banking system. Deflation in these key prices produced a credit event which rapidly produced a major reassessment of the outlook for the general price level. Across the world today we see falling commodity prices and, primarily due to the weak yen, falling manufactured-goods prices. When there is plenty of leverage in the system and any key price starts to decline then a credit event and a sudden change in inflationary expectations are much more possible than the consensus believes.” ( “An Ill Wind”, Russell Napier, CLSA, selected excerpts, zero hedge)

The threat of deflation is quite real, in fact, it’s probably just one bank failure away.
I agree, deflation is coming but it doesn't have to be a bad thing. As far as tapering, maybe the Fed took a look at the work of Frances Coppola and decided that QE wasn't stoking inflation expectations, it was actually pushing them down. So they decided to begin tapering hoping inflation expectations will rise. But if rates begin rising too fast, debt-laden consumers will be crushed, virtually ensuring a viral bout of debt deflation.

Below, Steve Schwarzman, Blackstone Group chairman, CEO & co-founder, shares his thoughts on the Fed's taper decision and provides and shares his outlook on the 10 -year Treasury yield and housing. "We are the largest owners of homes in the U.S.," Schwarzman reveals.

He better pray deflation doesn't rear its ugly head before they unload all those homes. I'll tell you who else is screwed if deflation is in the offing, pensions praying for an alternatives miracle.