Research Watch

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

Some leopards never change their spots, it seems, and David Rosenberg is contesting Warren Buffett’s bullish line on stocks by clinging to the bond market, which appears to be saying the equity market is heading straight for the rocks. But as with any strategy, Rosenberg’s bet on bonds will only work if he gets the timing right. There are plenty though, who are seeing bargains in equities, and US hedge fund CEO Steve Tananbaum says the best buys are in particular sectors. But it won’t matter how cheap stocks are for many investors if the almighty China catches cold, and two warning flags suggest that all is not well. Reports are emerging that iron ore prices are slipping on reduced demand, leaving the mining giants with lower contract prices with steel makers. Gold, meanwhile, is shooting ever-upward, but find out its real value using the Keynes-backed Gibson Paradox. Or, alternatively, man-up and look to some survivalist stocks, which, reports say, will always carry their investors. Then a new study by asks us to believe that gullible people are the driving force behind bubbles. Then a critique of the story suggesting ETFs could collapse, personal trainers discovers a huge new market and on video, a tour of eccentric fund manager Hugh Hendry’s office.

Stocks versus bonds '¦ “Everything continues to rally. It is a true miracle. Perhaps the Bank of Japan’s willingness to buy just about everything in sight was the latest inflection point in this whopper of a risk trade '¦ It is now very clear after the economics department at Goldman Sachs (the other GS) released its dual scenario for the US macro outlook – “fairly bad” or “very bad”, that for the time being the stockmarket and the economy have become unglued. It’s now all about asset purchases by central banks – and it is global. Chuck Prince is likely looking for a dancing partner this very moment. But it does beg the question as to what the catalyst could be to prick the balloon – it will likely be earnings disappointment or negative guidance. Is Warren Buffet correct on this one? Hey, everyone is entitled to his or her opinions, especially oracles: 'They’re making a mistake, the ones that are buying the bonds '¦ It’s quite clear that stocks are cheaper than bonds. I can’t imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities. But people do because they lack of confidence '¦ If they had their confidence back, they wouldn’t be selling at these prices. And believe me, it will come back over time’ '¦ That’s quite a statement, considering what bonds, even at ultra-low yield levels, have managed to generate in terms of total returns this year compared to the equity market. It’s not even close, with all deference to the recent snapback in the stockmarket. More fundamentally, there is a critical difference between something that is government-guaranteed and comes due in 10 years versus something that has downside capital price risks and never comes due.” (David Rosenberg, of Gluskin Sheff, October 6)

Here’s where one US hedge fund chief shops for cheap equities '¦ “Steve Tananbaum, founder and CEO, of Golden Tree Asset Management: '¦ 'There is definitely different views in the credit market out there between what the corporate debt markets are saying and what the equity markets are saying, and it's beginning to narrow in the last month or six weeks '¦ If you look at where spreads are, even where yields are, they are at relatively normal levels. Where if you look statistically, equities are pretty cheap, if you believe the forward earnings. For corporate debt there is kind of a tug-of-war between what yields are and what spreads are. Spreads are still pretty wide, above average. Yields are pretty much as low as they've been in leveraged credit.’ For this reason, the hedge fund manager is positing portfolios in certain industries. 'Take hospital stocks, pretty much you can go across the board and the credit markets would finance 100% of the market cap of pretty much all the hospital stocks '¦ If you look over the past 25 years, only in 1987 did you have the S&P earnings yield be the same as the high yield. So right now the debt markets are much more expensive than the equity markets.” (Gennine Kelly, in CNBC, October 6)

Is China showing signs of illness? '¦ “Anthony Chan from Alliance Bernstein says Chinese orders of semi-manufactures from Taiwan have been in 'sharp decline’. This is usually a warning signal for the health of China’s economy. 'The indicator – which tends to anticipate China’s overall import growth quite accurately by about two months – has been decelerating for five consecutive months, from close to 60% (year on year) in March to just 8.8% in August. The product mix shows a sharp decline in China’s orders for electronics and IT products as well as other light manufacturing items such as precision instruments, clocks, and watches,’ he said. Separately, Melissa Kidd from Lombard Street Research has sent a note suggesting that world steel production over the three months to August has been falling at rates comparable to the onset of the Great Recession. The drops are 7% global, 9% in the US, and 13% in Germany and China. The fall in China is actually faster than it was in late 2008.The question from both these notes is whether China is just going through a breather after tapping on credit brakes in a well-calibrated slowdown, or whether something deeper is at work. It is probably best to watch and wait, without jumping to conclusions.” (Ambrose Evans Pritchard in Telegraph, September 28)

BHP, Rio, Vale take a price cut '¦ “Steel producers can breathe a little easy in the coming months with iron ore prices going down from their peak levels. After quarterly pricing norms came into effect, this is the first time that prices of iron ore, valid for the October-December period this year, will be lowered. The price cut is expected to benefit large domestic steel companies such as state-owned Steel Authority of India, JSW Steel and Essar Steel, which buy through contracts from the National Mineral Development Corporation (NMDC) '¦ The move is in line with global trends as the start of the third quarter has seen a cut in prices. Following the global trend for iron ore contracts, NMDC has also reduced prices of ore exported to countries like South Korea and Japan by 13.3% to $130–147 a tonne for the third quarter of the current fiscal year '¦ However, the lowering of input costs is not likely to be transferred to final steel prices immediately. Steel makers have already announced a price hike of anywhere between 1000 and 1,500 renminbi per tonne in the current month. The fall in ore prices is mainly led by lower demand from China, which is one of the biggest buyers of ore in global market. International miners like BHP Billiton, Rio Tinto and Vale are believed to have firmed up deals with Asian steel makers at prices lower by 10–11% than those prevailing in the July-September quarter. The situation is in contrast to the beginning of the year when large companies had sought up to 90–100% hike in prices in line with prevailing high ore prices.” (Rakhi Mazumdar in The Economic Times, October 4)

Gold’s value according to the Gibson Paradox '¦ “There’s an old joke that the price of gold is understood by exactly two people in the entire world. They both work for the Bank of England and they disagree '¦ I want to take a step back for a moment and discuss a strange paradox in economics known as Gibson’s Paradox '¦ this is the observation that interest rates tend to follow the general price level and not the rate of inflation. That’s very strange because it seems obvious that as inflation rises, interest rates ought to keep up. And as inflation falls back, rates should move back as well '¦ Yet it really does exist. John Maynard Keynes called it 'one of the most completely established empirical facts in the whole field of quantitative economics’ '¦ Summers and Barsky explain that the Gibson Paradox does indeed exist. They also say that it’s not connected with nominal interest rates but with real (meaning after-inflation) interest rates. The catch is that the paradox only works under a gold standard. Once the gold standard is gone, the Gibson Paradox fades away. It’s my hypothesis that Summers and Barsky are on to something and that we can use their insight to build a model for the price of gold. The key is that gold is tied to real interest rates. Where I differ from them is that I use real short-term interest rates whereas they focused on long-term rates. Here’s how it works. I’ve done some back-testing and found that the magic number is 2% (I’m dumbing this down for ease of explanation). Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualised rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate '¦ The relationship isn’t perfect but it’s held up fairly well over the past 15 years or so. The same dynamic seems at work in the 15 years before that, but I think the ratios are different.” (Eddy Elfenbein, Crossing Wall Street, October 6)

Real men don’t buy gold '¦ “There are those who will tell you that gold still has room to roam: that you ain't seen nothing yet '¦ But 'real men don't buy gold,’ argues writer Joe Eqcome, who dismisses gold as a 'pantywaist’ investment. The reason? If civilisation truly falls apart, the things of value will be the basics: food, potable water, clean air, energy, guns and ammunition. His Survivor Index compares gold's performance to a composite average of the stocks for seven companies making stuff survivalists will want to have – canned food (Ball Corp); air (Airgas); potable water (Dr. Pepper); guns (Smith & Wesson); and energy (Cummins). Since 2000 the Index has outperformed gold handsomely. (Alan Farnham, ABC News/money, October 4)

A test for the gullible '¦ “From the abstract to a new paper by Andrew Odlyzko, professor of maths at the University of Minnesota (HT Kedrosky): 'Gullibility is the principal cause of bubbles. Investors and the general public get snared by a 'beautiful illusion’ and throw caution to the wind. Attempts to identify and control bubbles are complicated by the fact that the authorities who might naturally be expected to take action have often (especially in recent years) been among the most gullible, and were cheerleaders for the exuberant behavior. Hence what is needed is an objective measure of gullibility '¦ Can one construct an objective measure of gullibility? Modern research offers hope. Asking financial regulators what is 2 2 is clearly not going to be productive, but more subtle approaches could bear fruit '¦ Some work on measuring the impact of electronic message board rumors on stock prices has already been done (cf, Bettman et al, 2010), and could be extended. We could try passing out tales of various degrees of credibility, combined with various degrees of material rewards, to see how people react (and how that changes, depending on the presence or absence of a boom mentality). The degree to which mutually contradictory gossips coexist in the network would also provide a measure of 'information viscosity.’ These are all just some simple preliminary ideas.” (Cardiff Garcia, ft.com/alphaville, October 1)

ETFs are solid-as-a-rock '¦ “Bogan Associates, an independent research shop based out of Boston '¦ has examined the case of the SPDR S&P Retail ETF, a small ETF that is popular with short-sellers. In fact, XRT is so popular with short-sellers that at one point there were 95 million shares sold short, despite the fact that there were only 17 million shares in existence. That sounds scary, as Bogan explains, because authorised participants can create or redeem large blocks of ETF shares on a daily basis. 'Redemptions occur when more owners wish to sell out of their holding in the ETF than there are new buyers for the existing shares,’ writes Bogan, 'so unwanted blocks of 50,000 ETF shares each are redeemed through the authorised participants with the ETF operator for cash, or more typically for in-kind shares in the ETF’s underlying index’s stocks.’ What would happen, the report asks, if authorised participants redeemed all 17 million shares of XRT, leaving the other 78 million people who thought they had bought XRT holding the bag. 'Presumably,’ the report states, 'the SPDR S&P Retail ETF might simply close and cease to exist once its remaining 12 million ETF shares outstanding had been redeemed and all its underlying equity holdings had been delivered to redeeming authorised participants.’ It’s easy to see Bogan’s concern. In fact, it’s so easy to see Bogan’s concern that almost everyone I’ve talked to in the ETF industry has thought about it before '¦ That’s why this concern is addressed in the prospectus and Statement of Additional Information (SAI) of every ETF I’ve ever looked at '¦ when redeeming shares of XRT, you have to say that the shares aren’t lent out. If there’s high short interest in the fund, you’ll have to prove it, or the redemption doesn’t go through.” (Matt Hougan, Yahoo Finance, September 24)

Two fat bankers '¦ “Are you a fat banker, and do you want to tone up and feel good about yourself again? If so, we know some folks who can help you - and it won't cost you a thing. The Matt Roberts company has Personal Training Clubs in some of London's most prestigious venues - Mayfair, the City, Hampstead and Chelsea, and on offer free to two fat bankers is a fitness package worth £1600 each to help them get back into shape. You will be given a full initial consultation with a fitness test, biomechanical analysis, dietary consultation and physiotherapy screening, followed by two personal training sessions each week for eight weeks starting from October 25. The bankers will be expected to follow a structured diet plan, and will also be advised on two additional workouts to be completed outside of the club (so they will train four times a week).If you are up for the challenge, and want to go up against a fellow banker to see who can achieve the best results over the two-month period, please contact news@hereisthecity.com, providing details of your age, height and weight. The successful bankers will also be asked to nominate a charity and obtain sponsorship for their endeavours from friends and work colleagues. (Here is the city, October 6)

What penalty for a little rogue trading? '¦ “Yesterday in France, a court sentenced everyone’s favorite rogue trader, Jerome Kerviel, to three years in prison and said he must also 'pay back’ the $6.8 billion that was lost. At his current salary as a technology consultant, it should only take Kerviel 170,000 years to do so. Attorney Olivier Metzner said his client is 'disgusted’ by the ruling and today JK compared it to being 'hit on the head with a club'¦I’m starting to digest it, but I’m nonetheless crushed by the weight of the sanction and the weight of responsibility the ruling places on me.’ Well his former employer has some news that might just turn that frown upside down. Yes, he’s still going to the big house, but! He doesn’t have to pay back the full $6.8 billion! According to bank spokeswoman Caroline Guillaumin, they were just messing with the kid. You know, try and scare him a little bit. 'There’s no question of asking one man to pay such a sum,’ she told a French radio show. Having said that, the bank still wants Kerviel to do something and it should be 'in the interests of the shareholders and employees, and that take into account his situation’,” – It seems Societe Generale are open to suggestions – “So, any ideas? Shall he serve as a butler for every shareholder for a few days?” (Bess Levin in Dealbreaker, October 6)

Video of the week: Office Tour – inside Hugh Hendry’s hedge fund, Eclectica '¦ How does a man managing $400 million spend his day?

(BusinessInsider)