Fed Monetizing and S&P 500 Index

Totalinvestor:
And now that the Fed is (mostly) done manipulating the stock market, traders are fleeing stocks. (Geesh, do we detect a trend?)

“There is a clear relationship,” writes James Turk of goldmoney.com, “between the rise in the S&P 500 Index from its March 2009 low and the Federal Reserve’s purchase of U.S. government debt instruments, which it calls ‘quantitative easing’ (QE). Another term for it is money ‘printing.’

“The Fed is simply turning U.S. government debt into more dollar currency, which of course debases the dollar. It also explains the correlation in the above chart.

“Note how the S&P Index started climbing with the commencement of QE. The S&P dropped early this year when the Fed announced QE would end. Interestingly, the stock market soon rallied thereafter, probably because few believed that the Fed would really take away the ‘punch bowl.’ But it did, and the S&P has been in a downtrend ever since...

“Now that the Fed has stopped printing, the S&P 500 Index not only stopped rising, but began falling to reflect the true state of underlying economic conditions. Consequently, I expect that there will be new calls in Congress for another stimulus package, but more immediately, it seems likely that the Federal Reserve will recommence its purchases of U.S. government paper. Quantitative easing, I expect, is about to get a second chance at reviving the moribund U.S. economy.”

Buy-and-Really-Hold Will Suck Your Portfolio Dry

Systematic Relative Strength:

It’s not often that a passive investor committed to Modern Portfolio Theory will help make our case for active management based on relative strength, but heck, we’ll take any help we can get.
In this guest article from Money Magazine, William Bernstein of Efficient Frontier Advisors discusses findings from a study by Dimensional Fund Advisors. The article gets to the thesis early:

It’s a little-known and depressing fact, but the majority of individual securities tend to post negative returns over the long run.

This, I think, is a ringing indictment of buy-and-really-hold investing. Often individuals assume that they can purchase shares of leading companies, shower them with benign neglect, and have the portfolio perform well. But, of course, today’s leader always turns into tomorrow’s laggard. The majority of stocks, given enough time, collectively lose money. Mr. Bernstein goes on to say,

In fact, researchers at the investment management firm Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago’s CRSP total equity market database.
As for the bottom 75% of stocks in the U.S. market, they collectively generated annual losses … over the past 29 years.

The following chart shows that if you miss the best 25% of stocks, you will end up losing more than 2% per year.

Source: Money Magazine and Dimensional Fund Advisors

The chart is offered as evidence of the futility of stock picking and the triumph of index investing. What it really reveals is this: index investing would be an abject failure if it weren’t for two things: 1) active management and/or 2) relative strength weighting. First, if indexes didn’t replace companies that went out of business or were no longer “representative,” they’d have a buy-and-hold portfolio that, by their own calculations, would lose money. Replacing losers (dead companies) with winners (live companies) is, in fact, an efficient casting out process used for active portfolio management. Second, index returns are helped immensely by increasing the weighting of the stocks that go up the most. This is actually a form of relative strength weighting, more commonly referred to by index providers as “capitalization weighting.” Emphasizing the winners at the expense of the losers also tends to help returns over time.
The alert reader will quickly discern that ”missing the best 25% of stocks” is another version of the “if you miss the 10 best days” argument. There’s one problem: while it may be impossible to pick out the 10 best days, there’s a ton of evidence to suggest that it is possible to select the strongest stocks using relative strength. Even efficient market theorists like Eugene Fama and Kenneth French have admitted that relative strength works.
Bernstein writes:

This may get you thinking: If a small list of securities accounts for the market’s long-term returns, why not avoid all the headaches and losses you’ve suffered recently by carefully choosing these superstocks?

That’s exactly what I’m thinking! Why not, indeed! I’d rather own the superstocks. And I will even let Ken French pick the stocks. Instead of buying an index fund, I’m going to let Ken French buy the best recent performers and cast out the stocks that weaken each month. This chart comes from Dr. French’s own website and shows the equity curve for large-cap, high relative strength stocks since 1927.

As an investor, you have three basic options. You can buy-and-really-hold which will insure that most of the companies you buy will lose money over a long time frame. You can buy an index fund, which will tend to perform better than buy-and-really-hold due to the hidden active management process of casting out and/or through capitalization weighting. Or you can identify the strongest stocks and use both casting out and relative strength weighting to manage the portfolio. Option 3 has historically provided the best returns, but it will be volatile and will go through periods of drawdown. (Of course, Options 1 and 2 will also be volatile and will go through periods of drawdown!)
As a result, I see no reason not to prefer active management using a systematic relative strength process. It’s always interesting to me how investors with a passive approach can selectively pull out data that they then claim supports an indexing approach. [Note: a major part of the reason for the cognitive dissonance in Dimensional Fund Advisors' data has to do with the original research source. The finding that 25% of all stocks account for all of the market's gains came from a Blackstar Funds research paper, The Capitalism Distribution. Blackstar's own interpretation of the findings was that such a skewed distribution of returns supported a trend-following method focused on strong stocks--exactly opposite of what DFA suggests! We happen to agree with Blackstar.]

Does Japan really have a public debt problem?

UK economist Martin Wolf has an article on his blog about Japan. What is proposing, is basically a robbing of the savers. Thats not a solution a normal economist should agree with. But situation in Japan's public finance is really bad and this should be the way to avoid default. Btw, read the comments section. Lot of interesting opinions.

Martin Wolf's Exchange | FT.com:

The conventional wisdom in both Japan itself and the west is that the country has an unmanageable public debt problem. I find this quite unpersuasive. All the country needs to do is generate, say, expectations of 3 per cent inflation and the public debt problem should melt away like snow. But the longer it waits the bigger the ultimate adjustment will need to be.

In 2010, according to the Organisation for Economic Co-operation and Development, Japan will pay net interest of 1.1 per cent of gross domestic product on net financial liabilities of 105 per cent of GDP. Since 2000, Japan’s average rate of deflation (on the GDP deflator, the widest measure of inflation) was 1.2 per cent. So let’s treat the expected real rate of interest on Japanese government borrowing at 2 per cent.

So here is the plan.

First, extend the maturity of debt to at least 15 years from the today’s average of 5.2 years. (Whoever was responsible for allowing Japanese debt to be so short term when the government can borrow at incredibly low long-term interest rates seems utterly incompetent.) That would bring average Japanese maturities above the far more sensible UK level of 13 years.

Second, hire a central bank governor who knows how to create inflation - an Argentine, for example. I am quite sure that any moderately determined central banker could do this, if he wanted to do so, by direct purchase of public and private sector assets on a sufficiently large scale. The government should prod this along by giving the Bank of Japan an inflation target of 3 per cent, after maturities have been extended, while informing the policy committee that all its members will be sacked, ignominiously, if they fail to hit the target within two years.

Third, let us suppose inflation indeed goes to 3 per cent. That should raise the interest rate on JGBs to 5 per cent. Other things equal, the market value of the outstanding net government debt would fall by 40 per cent. So now the Japanese government buys back the outstanding debt at its new market price, reducing the face value by 40 per cent of GDP. In the new inflationary environment, the Japanese find the real value of their huge holdings of cash falling sharply. So they buy real assets and consumer goods, instead, and, at last, the economy expands vigorously.

Fourth, now the government raises taxes and cuts spending, moving into a small primary surplus. Assume that the government only needs to borrow to roll over its debt and the debt ratio stabilises. How big a primary surplus is needed depends only on the relation between the real rate of interest and the rate of growth of the economy.

So there we have it. By extending maturities of debt, moving from deflation to modest inflation, Japan eliminates almost half of its outstanding debt, relative to GDP, and normalises the economy, in the process.

It is simple, really. The government has baited the trap. Now all it needs to do is spring it.

Countries with their own central banks do not need to default; they can inflate, instead. Provided they can borrow at long enough maturities and on favourable terms, the amount of inflation needed to eliminate huge debt overhangs is not enormous, provided it is unexpected. In Japan, any inflation would now be unexpected, given current long-term interest rates. So the solution there seems to be perfectly straightforward. What do you think? Leave your responses below.