Botox Economics

Naked Capitalism:"

Botox is commonly used to improve a person’s appearance by removing facial lines and other signs of aging. The effect is temporary and can have significant side effects. The world is currently taking the “botox” cure. A flood of money from central banks and governments — “financial botox” — has temporarily covered up unresolved and deep-seated problems.The surface is glossy and smooth, the interior decayed and rotten

The 2009 ‘recovery’ was based on low or zero interest rate policies (“ZIRP”) of major central banks. Massive government intervention also helped arrest the rate of decline of late 2008/ early 2009. Without government support, it is highly probable that most economies would have been in serious recession. Just as China practised capitalism with Chinese characteristics, developed economies discovered socialism with Western characteristics.

Capital injections, central bank purchases of “toxic” assets and explicit government support for deposits and debt issues helped stabilise the financial system. Changes in accounting rules deferred write-downs of potentially bad assets. Despite these actions, the global financial system remains fragile.

Further losses are likely from consumer loans, including mortgages. In the U.S. mortgage market, one-in-ten householders are at least one payment behind up from one-in-14 a year ago. If foreclosures (now around 5%) are included, then one-in-seven mortgagors are in some form of housing distress.

Recent stability in U.S. house prices may be misleading reflecting the effect of government incentives (the $8,000 first time homebuyer tax credit) and low mortgage rates driven in part by the Fed’s MBS purchases. The value of 20-30 % of properties is less than the loan outstanding. Home sales remain modest with around 25-30% of sales of existing homes being foreclosures. Housing inventories also remain high in historic terms. With more adjustable rate mortgages resetting in 2010 and 2011, the risk of further losses on mortgages cannot be discounted unless economic conditions improve.

Rising vacancy rates, falling rentals and declining values of commercial real estate (“CRE”), primarily office and retail properties, are apparent globally. In London, Nomura, the Japanese investment bank, secured a 20-year lease of a new office development on the River Thames – the 12-storey Watermark Place – for £40 per square foot. This was over 40% lower than the rents of nearly £70 per square foot demanded prior to the GFC. Nomura will also not pay any rent until 2015. Mark Lethbridge, partner at Drivers Jonas who advised Nomura, told the Financial Times: “… I’m unlikely to see [the terms] again in my career.”

Banks are likely to remain capital constrained in the near future reducing availability of credit. Commercial and consumer loan volumes have declined reflecting a lack of supply but also a lack of demand as companies and individuals reduce leverage.

The real economy remains fragile. Government actions, such as fiscal stimulus and special industry support schemes (cash for clunkers; investment incentives, trade credit subsidies), have boosted demand and industrial activity in the short term. The problem remains as government incentives encourage current consumption and investment but ultimately “steal” from future demand.

Employment, a key indicator given the importance of consumption in developed economies, continues to decline albeit at a slower pace. In the U.S., unemployment reached 10%.

In many countries enforced reduction in working hours and taking paid or unpaid leave reduced the rise in unemployment levels significantly. Working hours and personal income have fallen.

Changes in the structure of the labour force also distort the real picture. If workers working part time involuntarily and looking for full time employment are included, the U.S. underemployment figure is in the 16-18% range. Long term and youth employment also remains high.

European economies, especially countries such as Spain, are also experiencing significant unemployment. In some economies, unemployment is a new “export” as guest workers are shipped back to their country of origin or remittances home fell sharply.

In developed countries where an increasing part of the population is nearing retirement age, wealth effects affect consumption behaviours. Low interest rates and reduced dividend levels limit income and expenditure.

In 2009, global trade stabilised after precipitous earlier falls. According to the CPB Netherlands Bureau for Economic Policy Analysis, as of September 2009 world trade was 8.0% above the low of May 2009 but 14% below its peak of April 2008. Trade protectionism threatens recovery in global trade.

Major risks in the financial and real economy remain and may disrupt the hoped for resumption of business as usual.

From late 2008 onwards, Governments have spent aggressively, going into or increasing deficits, to increase demand within the economy to offset weak private sector consumption and investment.

Financing these initiatives presents significant challenges. In the five quarters ending 30 September, 2009, U.S. Treasury borrowing increased by $2.8 trillion, a rise of around three times from the level of previous years. The U.K. and European countries increased public debt by similar or higher amounts (in percentage terms).

In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings, especially for major countries despite deteriorating public finances.

Central bank purchases under ‘quantitative easing’(“QE”) (read printing money) programs helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed purchases of assets, QE programs and other liquidity support programs reduced private sector net purchases of new Treasury issues to $200 billion in 2009. In 2010, in the absence of continued Fed support, private buyers will have to absorb $2,000 billion.

If buyers of sovereign debt pull back, Ireland, Greece and Spain provide an insight into the actions necessary. In order to restore fiscal stability, the Irish government introduced a special 7% pension levy and implemented the toughest budget in the country’s history. Public sector salaries were cut between 5-15%. Unemployment and welfare benefits were also cut. More recently Greece and Spain proposed a program of similar budgetary austerity.

Focus in the short run will be on the ‘PIGS’ (Portugal, Ireland, Greece, Spain) but in the longer term it will shift to major economies with high levels of government debt – the ‘FIBS’ (France, Italy, Britain, States). At least, Japan has its very large pool of domestic savings.

The need to maintain the confidence of rating agencies and investors as well as access to markets may ultimately force the required disciplines. As James Carville famously observed: “I want to come back as the bond market. You can intimidate everybody.” Politicians everywhere will learn the reality in Thatcher’s terms: “You can’t buck the markets.”

The need to reduce the overall level of debt in certain economies has not been fully addressed. Public debt has been substituted for private debt. As his friend Dink tells author Joe Bageant in Deer Hunting with Jesus: Despatches from America’s Class War: “Sounds like a piss-poor solution to me, cause they’re just throwing money we ain’t got at the big dogs who already got plenty. But hell what do I know?”

The last few decades have seen an economic experiment where increasing levels of debt have been used to promote high growth. This policy had the unintended consequence of increasing risk in the global economy, which was not fully understood by the individual entities taking this risk or regulators and governments. This experiment is now coming to an end.

The real risk is of long-term economic stagnation. A period of low growth, high unemployment or underemployment and over capacity is possible while individuals, firms and governments repair balance sheets.

Governments and central banks continue to inject liberal amounts of botox to cover up problems, at least, while supplies exist. In absence of any definite solutions, policymakers are deferring dealing with the problems, rolling them forward. In the words of David Bowers of Absolute Strategy Research: “It’s the last game of pass the parcel. When the tech bubble burst, balance sheet problems were passed to the household sector [through mortgages]. This time they are being passed to the public sector [through governments’ assumption of banks’ debts]. There’s nobody left to pass it to in the future.”

The summary of 2009 and the outlook for 2010 may be the logo on a black T-shirt worn by Lisbeth Salander, the heroine of Steig Larsson’s Girl with the Dragon Tattoo: “Armageddon was yesterday – Today we have a serious problem.”

By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).

EMU break-up risks global deflation shock that would dwarf Lehman collapse, warns ING

Another great story from Telegraph by Ambrose Evans-Pritchard:

A full-fledged disintegration of the eurozone would trigger the worst economic crisis in modern history, devastate every country in Europe including Germany, and inflict a deflationary shock on the US. There would be no winners, warns the Dutch bank ING in a new report "Quantifying the Unthinkable".

"Complete break-up would have effects that dwarf the post Lehman Brothers collapse. Governments would find themselves having to bail out banks again, worsening already fragile government finances. The risk of at least a temporary break-down in payments systems would be enormous, " said the report by Mark Cliffe, Maarten Leen, and Peter Vanden Houte.

"Initial trauma is sufficiently grave to give pause for thought to those who blithely propose EMU exit as a policy option," it said, a rebuke to those German politicians and economists who have talked openly of shaking out weaker members.

The new Greek drachma would crash by 80pc against the new Deutschemark. The currencies of Spain, Portugal, and Ireland would fall by 50pc or more, causing inflation to soar into double-digits. "The impact is dramatic and traumatic," it said.

ING has attempted to unpick the complex consequences of break-up scenarios, concluding that even a surgical exit by Greece alone would hurt everybody, and be suicidal for Greece. Both weak and strong states would suffer violent downturns if EMU unravelled altogether, though each in very different ways. "In the first year, output falls by between 5pc and 9pc across the various former member states," it said.

The German sphere would face a "deflationary shock". The US dollar would rocket to 85 cents against the euro equivalent, with a "temporary overshoot" to near 75 cents. This would tip the US into acute deflation, threatening North America with a double-dip recession. East Europe would contract 5pc in 2011 alone.

Safe-haven flows to core debt markets would drive down yields on 10-year US, German, and Dutch bonds to near 0.5pc, by far the lowest ever. Club Med yields would decouple brutally, rising to between 7pc and 12pc, "capital controls, notwithstanding."

This is the picture of a world falling apart. It is an outcome that Angela Merkel, the German Chancellor, now seems determined to avoid, after dragging her feet over the Spring. The Bundestag has backed Germany's share of the €110bn rescue for Greece, and the €750bn EU-IMF bail-out for future casualties should they need it. The Bundesbank has lifted its de facto veto on purchases of Club Med bonds by the European Central Bank.

Yet markets have failed to stabilise. Spreads on 10-year Greek bonds are still 750 basis points over Bunds. Investors clearly doubt whether the Greek austerity policy of wage deflation can ever work, or whether EU states will back their words with money, or both. The spreads are 285 for Portgual, 272 for Ireland, and 213 for Spain.

The markets perhaps sense that the bail-out battles in Germany are not yet over. There are four complaints lodged at the German constitutional court arguing that the rescues breach EU treaty law and therefore German basic law. While the court has refused an immediate injunction to block aid, it has not yet ruled on the cases.

A group of five professors has just expanded its original complaint against the Greek rescue to cover the EU's €440bn Stability Facility, describing the methods used to ram through the measures as "putschist" and anti-democratic. "This course is leading Germany to ruin," they said.

Germany's Centre for European Politics in Freiburg has joined the fray with a report arguing that the use of €60bn of EU money under Article 122 of the Lisbon Treaty to support the rescue package is illegal. "It is a complete violation of our constitutional law and the judges at the court will have to say so if a case reaches them, even though they are afraid of the economic consequences," said the author, Dr Thiemo Jeck. Bavarian politician Peter Gauweiler aims to file a fresh case along these lines.

ING's global strategist Mark Cliffe said any Anglo-Saxon Schadenfreude at a euro break-up would be short-lived. The UK economy would shrink by 4.5pc from 2011-2012. "It would be a very unpleasant experience," he said.

Safe-haven flows pouring into Britain would drive sterling through the roof. Eurozone demand for UK exports would contract viciously. Pension funds would suffer fat losses on eurozone assets. UK lenders would face havoc again though a web of cross-border linkages.

The Dutch bank does not make any judgement on the merits of EMU, or on whether it is an 'optimal currency area', nor does it explore half-way options such as a split into a hard Teutonic euro and a weak Latin euro.

The report said break-up talk is "no longer just a figment of fevered Anglo-Saxon imaginations". It has spread into top policy-making circles in the eurozone and must now be analysed as a serious tail-risk. A survey of 440 heads of global banks and companies by RBC Capital Markets found that 50pc expect at least one country to leave EMU by 2013, and a quarter expect a complete collapse.

ING said heavily indebted states such as Greece would not gain relief by escaping EMU and devaluing since their debt burden would remain, even if government bonds are switched into the new currency. This is a controversial point. If Greece devalues and defaults as well, the calculus is different. Many big bust-ups entail both, such as the Argentine crisis in 2001. Some Argentines argue that their trauma proved cathartic, pulling the country out of a destructive downward spiral.

If Greek, Portuguese or Spanish leaders ever start to ask their own Argentine questions as austerity grinds on, and unemployment grinds higher, events will run their ineluctable political course regardless of the greater risks.

INGBank Global Economics 20100707

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

The Aleph Blog:

Aggregation of economic variables is required for macroeconomic modeling. One of the largest problems with macroeconomics is whether that aggregation makes sense, or conceals a more dynamic and diverse economy.

The paradox of thrift as proposed by Keynes assumes that all saving is similar. People invest excess monies in some simple depositary instrument that earns interest. As people panic over bad economic activity, they save more, driving interest rates lower. But wait. What if they don’t place their money in depositary instruments? What if they pay down debt, whether secured or unsecured? In that case, banks will find themselves more willing to lend, as the surplus/assets ratio rises. The liquidity crunch at the banks will lessen. Or, people may save in a different way, by:

• Buying gold, commodities, or non-perishable consumables
• Enhancing their homes, cars, etc., making them cheaper to operate, or giving them longer lifespans
• Investing in foreign debt instruments

Saving can take many forms, some of which may look like consumption or investment. The main idea is to direct your excess assets to the place that will give you the best long term benefit.

Even corporations will want to save during a tough environment. Building up cash balances gives flexibility for the future, and gives options to buy assets cheaply if competitors crater. Some firms even borrow long-term to have cash on hand. It’s a negative arb, but it gives the firm flexibility. But even firms may have alternative ways to save:

• Investing in labor-saving or waste reducing technology.
• Stockpiling needed nonperishable commodities, or locking in long-term supply agreements, at attractive prices.
• Retiring stock or debt through buybacks at attractive prices.

Saving need not be in money markets or banks. There are many ways to save, and there are always alternative uses for money. Each economic actor has to find the most fitting savings method for his needs.

Now, recently I ran across a paper called The Paradox of Toil. The abstract:

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

This paper does the same simplifications that Keynes did to produce his paradox of thrift. There is only one type of labor. Well, certainly if everyone does the same thing, there are diminishing marginal returns to scale. Big deal.

But labor is different. We have the ability to choose different firms to work at. Not all work is equal, and there are often better and worse opportunities available for labor. Recessions occur partially because capital and labor are misallocated. Look for the firms that are showing promise in the recession, and angle to work for them.

But beyond that, workers have one more option: work for yourself; start your own firm. Find a problem that irritates many, and solve it. Create a product or service that meets the needs of many. In a deflationary environment that might mean finding a cheaper way to do things. But it could be creating a new product that meets needs that people or businesses did not know they wanted. Go for a Blue Ocean Strategy.

The best businesses are often created in recessions. Flip the paradox of toil, and work many hours for yourself and your ideals.

Summary

I don’t believe in the paradox of thrift or the paradox of toil. They are bogus results of oversimplified models that do not reflect reality. As an investor and an economic historian, I know of many times where massive amounts of money were allocated to a single asset class or a single sector of the market. If everyone follows a mania strategy, whether due to greed or panic, I can guarantee that there will be a bad result.

• The dot-coms of the late ’90s
• The one decision stocks of the ’60s.
• Gold in the ’70s.
• Railroads in the late 1800s.
• Buying stocks in the 1920s.
• Selling stocks in the 1930s.
• Selling bonds in the early ’80s.
• The mercantilist era — exporting cheaply to get gold, then getting less in return when liquidating the gold.

I could go on to various manias in earlier eras, less well-known manias, or individual stocks, but that wouldn’t help make my case any more than I have already. The main point is the same. Anytime everyone does the same thing, it is foolish. It would be stupid for everyone to save using T-bills, or sell their excess labor to agricultural day labor.

I trust intelligent people to seek their best advantage in the markets. That does not mean that foolish people will not get hosed. That’s the nature of being foolish. But bright people see recessions as a time to reorient and look ahead, to see what the new economy will want, and ignore what the old economy wanted.

So, I don’t see any value in:

• Stimulus programs that don’t produce economic value. If it only pays a wage, that is destructive. For stimulus to be effective it must produce infrastructure that lowers the costs of the economy. Think of all the useless projects built in Japan.
• Paying extended unemployment benefits. Additional consumption today, plus debt tomorrow is a recipe for economic lethargy.
• Running large deficits. If the money is not being spent on something that will produce future growth, it is a loss.
• Bailouts of large financial institutions. We have too many of those.
• Housing tax credits. We have too many houses.
• Bailing out auto companies. Too many autos are made in our world today.
• Bailing out the GSEs. They are deadweight losses. Let them die, and let the senior bondholders feel the pain. Let the junior bondholders be wiped out.
• Monetary policy that steals from savers, thus depriving the private capital markets of a supply of private capital for productive investments, rather than the government absorbing most of the capital at low rates, and wasting the money on less productive projects.

Don’t listen to the fools that insist that we must run huge deficits and run a loose monetary policy. A “big bang” would be preferable to the “Chinese water torture” that we are now undergoing. Far better to take a short dose of sharp pain, where asset prices fall, some more banks fail, and bad debts are purged from the system, than to endure another lost decade, where the ability to employ capital productively is difficult.

As it is, we are pursuing the Japan solution to our overleverage. They have had two lost decades, and are starting on their third lost decade. Is that what we want?

Those low interest rate U-Zirpers at the BIS

FT Alphaville:

Those low interest rate U-Zirpers at the BIS

Posted by Tracy Alloway on Jun 29 08:15.

In the battle between Austerians and Stimulants, the Bank for International Settlements (BIS) knows where it stands. In its latest annual report the central banks’ bank takes aim at everything from delayed fiscal adjustments to the extended period of low interest rates in places like the UK and US.

The whole thing reads like a confirmation of every risk you might have suspected, to date, could accompany extended loose and unconventional monetary policy. It’s BIS’s job to identify risks, of course, but seldom are they so . . . forthright, or wide-ranging. Rage against the Zirp, dear BIS.

The summary:

. . . policymakers will need to consider the distortions caused by prolonged conditions of monetary ease. After all, sustained low interest rates have been identified by many as an important factor that contributed to the crisis (see BIS, 79th Annual Report, Chapter I). At the same time, policymakers should also closely monitor the distortions arising from unconventional monetary policy tools. These include price distortions in bond markets that can result from changes in central banks’ criteria for eligible repo collateral and from their asset purchases. Artificially high asset prices in certain markets might delay the necessary restructuring of private sector balance sheets. There are also distortions in market activity that arise from central banks’ increased intermediation during the crisis. Moreover, the asset purchases have exposed central banks to considerable credit risk, which together with the changed balance sheet composition may expose them to political pressures.

History offers little guidance on the economic significance of the side effects of unconventional monetary policy. By contrast, distortions arising from low interest rates have been observed in the past. In this chapter, we review these risks in the current context and argue that, if not addressed soon, they may contain the seeds of future problems at home and abroad. In doing so, we draw on lessons from the run-up to the financial crisis of 2007–09 and on Japanese experiences since the mid-1990s . . .

Uh oh — subprime and the Lost Decade? You know what’s coming — a rather stunning indictment of certain current central bank policies. Some choice bits recounted below, with our highlights.

For a start, the risks of that steep yield curve:

Low policy rates in combination with higher long-term rates increase the profits that banks can earn from maturity transformation, ie by borrowing short-term and lending long-term. Indeed, part of the motivation of central banks in lowering policy rates was to enable battered financial institutions to raise such profits and thereby build up capital. The heightened attractiveness of maturity transformation since the crisis was reflected in rising carry-to-risk ratios in 2009 and early 2010 (Graph II.1, bottom right-hand panel). Increasing government bond yields, caused by ballooning deficits and debt levels and a growing awareness of the associated risks, make the yield curve even steeper and reinforce the appeal of maturity transformation strategies.

However, financial institutions may underestimate the risk associated with this maturity exposure and overinvest in long-term assets. As already noted, interest rate exposures of banks as measured by VaRs remain high. If an unexpected rise in policy rates triggers a similar increase in bond yields, the resulting fall in bond prices would impose considerable losses on banks. As a consequence, they might face difficulties rolling over their short-term debt. These risks may have increased somewhat in the aftermath of the 2007–09 crisis, because the poor credit environment for banks and the greater availability of central bank funding have left many banks with funding structures skewed towards shorter maturities. A squeeze on banks’ wholesale funding might set off renewed asset sales and further price declines.

On extend and pretend, or the ‘evergreening,’ of loans:

One legacy of the financial crisis and the years preceding it is the need to clean up the balance sheets of financial institutions, households and the public sector, which finds itself in a poor fiscal position, partly as a result of the rescue measures adopted during the crisis. Low policy rates may slow down or even hinder such necessary balance sheet adjustments. In the financial sector, the currently steep yield curve provides financial institutions with a source of income that may diminish the sense of urgency for reducing leverage and selling or writing down bad assets (see also Chapter VI). Central banks’ commitment to keep policy rates low for extended periods, while useful in stabilising market expectations, may contribute to such complacency.

Past experience has shown that low policy rates allow “evergreening”, ie the rolling-over of non-viable loans. During the protracted run of low nominal interest rates in Japan in the 1990s, banks there permitted debtors to roll over loans on which they could afford the near zero interest payments but not repayments of principal. Banks evergreened loans instead of writing them off in order to preserve their own capital, which was already weak due to the earlier fall in asset prices. This delayed the necessary restructuring and shrinking of financial sector balance sheets. Moreover, the presence of non-viable (“zombie”) firms sustained by evergreened loans probably limited competition, reduced investment and prevented the entry of new enterprises.

And the international side effects of the search-for-yield:

Capital flows allow a better allocation of economic resources, and inflows are important contributors to growth, especially in emerging market economies. In the current situation, however, they may lead to further asset price increases and have an inflationary impact on the macroeconomy. They have also caused an appreciation of those target currencies that float, which corresponds to a tightening of monetary conditions in those countries. Nevertheless, further interest rate increases seem likely, and these may attract even more funds from abroad. This exposes the receiving economies to the risk of rapid and large capital outflows and the reversal of exchange rate pressures in the event of a change in global macroeconomic, monetary and financial conditions or in investors’ perception thereof. Chapter IV discusses the issues associated with capital flows to emerging markets in more detail.

The major worry then is what happens should these government efforts fail. All of their policies — Zirp, quantitative easing, debt forbearance, etc. — are predicated on the idea that markets just need time to start functioning again. That has so far not happened and, in the meantime, central banks are stuck.

As BIS puts it:

Unlike [in 2008], however, we have hardly any room for manoeuvre. Policy rates are already at zero and central bank balance sheets are bloated. Although private sector debt has started to decline, public debt has taken its place, with sovereign fiscal positions already on an unsustainable path in a number of countries. In short, macroeconomic policy is in a vastly worse position than it was three years ago, with little capacity to combat a new crisis – it will be difficult to find a source of further treatment should another emergency arise. Regaining the ability to react to economic and financial crises, by putting policies onto sustainable paths, is therefore a priority for macroeconomic policy.

Crikey. That’s quite a lot for so early in the morning.

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.