Links to interesting articles I have read over the past few days that you might also enjoy…

Remember: In 1930, They Didn’t Know It Was “The Great Depression” Yet

China in Africa – Beijing Does Deals, Not Gifts

The Fallacy of a Drilling Moratorium

All You Need to Know About Public Sector Work (A whistleblower’s shocking account)

The Complete History Of European Sovereign Defaults From 1340-1939

Could Super Solar Flares Take Us Back to 5,000 BC?

Here’s Why You Shouldn’t Listen to Equity Analysts

… and here (if you need further evidence)

What’s The Point of Macro?

China’s Death Grip on Rare Earth Metals

Obama – The Caudillo President

The Green Jobs Myth

Welcome to the Insane Asylum or: How We Learned to Stop Worrying and Love the Big Lie

After having suffered the worst May since 1940 (Dow), equities have continued their sell-off into early June, amidst concerns about spreading European debt crisis, Chinese tightening and fading US recovery. The rally off the March 2009 lows was driven by liquidity, stimulus and improving economic and earnings data, particularly in the US. Now that government stimulus starts to taper off the question is whether economic growth has become self sustaining or not.

A natural slowing in the second half of the year has been expected. However, concerns about a double dip recession now appear to be growing, given the sovereign debt crisis and contagion risks in the eurozone and Europe’s impact on the global economy as countries start implementing austerity measures. Add concerns about Chinese tightening to cool an overheating economy and rampant real estate speculation, plus a weakening recovery in the US… the picture is not pretty.

In the US leading economic indicators have started turning over. The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index has gone negative for the first time in over a year, falling to 123.2 from 124 the week before – the lowest level since July 2009. The ECRI WLI has historically been a good predictor of US economic activity, so its downturn is pointing toward a significant slowing in economic growth in the coming months. The Conference Board’s LEI for the US peaked in March.

China has taken steps to cool growth. China’s LEI (leading economic index) peaked last fall, Chinese PMIs are weakening and property market activity has been declining in response to the authorities’ measures to curb speculation. The worry is how much the world’s growth engine will now slow down; so far the economy remains very resilient (exports jumped 48.5% in May). However, the Shanghai Composite index is off nearly 30%, indicating weaker global growth prospects.

May saw the largest slump in commodity prices since Lehman’s collapse, pointing to potentially disappointing global economic growth. The Journal of Commerce Industrial Price Commodity Smoothed Price Index plunged 57% last month, the most since October 2008. Copper price broke down to a new 7-month low, before a bounce this week.

For now the global business cycle expansion appears intact but growth is starting to soften. A mid-cycle slowdown is not so unusual; however, it’s not immediately clear whether we should expect a normal moderation or indeed a double dip recession.

According to the yield curve a recession is not likely. Having correctly called past recessions when it inverted (short rates higher than long rates), the yield curve presently sees the risk of a recession in the next 12 months or so as near zero.

Buy on dips? Maybe not this time …

So, has the recent panic in the financial markets been overdone? The global economy and financial system are still fragile and vulnerable to further shocks, and confidence is fast evaporating. This is no time for complacency – things could get very ugly very fast.

On top of everything else, policy shock (including US financial regulatory reform outcome) is an additional risk investors have to consider. As is often the case, the authorities have been adding to the uncertainty by increasingly erratic moves (chaotic ECB actions, Germany’s ban of naked short selling of some financial stocks and eurozone sovereign bonds and CDS – likely to be further extended, etc). Such actions are counterproductive; they only heighten volatility, increasing the cost of capital and reducing liquidity.

May proved catastrophic for most assets, including equities, commodities (except gold), the euro. The winners have been the US dollar and Treasuries, reflecting a flight to safety as well as a symptom of a deflationary trend. (Money supply is falling at a pace not seen since the early 1930s!)

Markets went into June very oversold, so the relief rally currently underway was expected, and indeed could last a little longer. However it is unlikely to be more than a short term bounce. The S&P has now closed below its 200 day moving average for 16 consecutive sessions – a clear sign of trend change. Although we can’t yet be 100% certain that this is indeed something far more worrisome than a standard correction, there are signs that the trend has turned negative. Until there is more clarity it may be wise not to buy this market – you will likely be able to pick up most assets at much lower valuations late in the year.

It is true that the market has already priced in plenty of bad news – assuming the global recovery remains intact and there is no contagion from Europe; however, that scenario is increasingly looking too optimistic. Considered there is still a great deal of complacency, the bulls could be in for a nasty shock in the coming weeks and months.

Credit crunch is back!

Furthermore, there is good reason to believe this sell-off is different from the previous ones we have seen since March 2009 – the action in the credit markets. We have not witnessed significant deterioration and widening of credit spreads since the start of the rally – until several weeks ago. This is a fundamental change and a sign that the credit crisis is returning.

Credit is the early warning sign; equities lag deterioration in credit conditions. Decline in commodity and equity prices, and ultimately in economic growth, are a result of weakness in the credit markets. It would be foolish to overlook that the current correction has indeed a differentiating characteristics to it; do pay attention to the funding markets.

The European sovereign debt crisis is not going anywhere, and global credit conditions have been worsening. Cost of credit is rising and credit availability declining, which is affecting the funding needs of corporations worldwide. The economic fallout is only just starting to become apparent.

And it’s not only Europe. Higher cost of capital is also noticeable in the US and emerging markets where corporate debt spreads have been rising and debt issuance slowing. Funding markets are seizing up and capital is becoming more expensive, a consequence of which will be a squeeze in profits and slowdown in global growth.

Credit clearly continues to point to further stress ahead. Some disturbing signs that we may be witnessing the beginning of credit crisis 2.0:

Widening eurozone government bond spreads: yield spreads between German bunds and Club Med bonds have resumed their widening trend in recent weeks and in some cases became wider than before Europe’s mega bailout package was announced (although they tightened somewhat this week). And it’s not just the PIGS’s creditworthiness that has been deteriorating; we have seen huge spikes in CDS spreads on Eastern European sovereign debt and even that of France, Austria, UK and Germany over the last month.

European bank CDS have surged, indicating rising stress in the banking system, loss of confidence and growing risk aversion. It means sharply higher borrowing costs for banks. (European banks have raised less from the capital markets in the past six weeks than in any year since 1995.) Some smaller banks have been reported to be completely shut out of the credit markets. Even more troubling is that some of the world’s largest banks in Spain, Germany and France are now becoming infected. The Markit iTraxx Financial Index of CDS on 25 European banks and insurers soared to the highest level since March 2009 (before improving somewhat this week).

The LIBOR-OIS spread has widened significantly in recent weeks (now standing at 32.4bps). Equally, the TED spread has been deteriorating and is now at 47, up more than 300% in the last three months.

LIBOR-OIS and TED reflect the health of (and perceived credit risk in) the interbank lending markets. They are gauges of financial strength or weakness of banks. A rising spread shows that banks are unsure of the creditworthiness of other banks, hence charging higher interest rates to compensate for greater risk. Due to the European debt crisis counterparty risk is increasing and banks are reluctant to lend to each other once again.

Eurozone banks have been parking record sums in the European Central Bank’s deposit facility. Use of the facility, which pays an interest rate of just 0.25%, reached a new high of 364.6 billion euros (higher level than after the Lehman collapse) – a further sign that banks don’t trust each other’s creditworthiness, opting to instead deposit funds with the ECB.

The uncertainty is also rocking the corporate debt markets. May was the worst month for corporate bond sales for over a decade. Issuance of high-yield company debt nearly halted amid new signs that Europe’s sovereign debt crisis may be spreading; investment grade companies are also finding it more difficult to issue bonds. Both High Yield and Investment Grade spreads have soared in recent weeks.

There has also been substantial deterioration in the US Commercial Paper market (short-term IOUs), which contracted to its lowest level since 1999. Debt outstanding dropped, after six straight weeks of decline, to the lowest level on record as companies pared back on tapping short-term funding.

The European contagion impact and lack of liquidity is being felt in the emerging markets as well. New bond issuance of Brazilian companies halted for a sixth straight week, the longest stretch in 14 months, as Europe’s debt crisis drove up borrowing costs and caused a surge in volatility.

This worrying credit contraction is eerily reminiscent of the situation in summer 2007. Investors are fleeing all but the safest government securities. Poor liquidity and vanishing risk tolerance could see consumers contract, businesses stop hiring and investing and economic activity coming to a halt.

The prospects aren’t so good. A recent ECB forecast (Financial Stability Review, May 2010) that eurozone’s financial institutions may have to write off 195 billion euros of bad debts by 2011 – on top of the 238 billion already accounted for – confirmed fears about the fragility of the financial system.

Deflation and double-dip recession?

Meanwhile, the economic picture in Europe is not encouraging.

On the positive side, European core has been surprising with strong economic data; German manufacturing and exports are booming – exports to non-euro area have now surpassed the pre-Lehman bankruptcy peak (a weaker euro will only supercharge this growth), Germany’s PMIs are at a four year high; IFO Expectations Index is at its highest level since mid 2007.

On the other hand, Greece is insolvent and will unlikely avoid debt restructuring/default, which poses a massive risk for the European banking system. (Could Spain and Portugal also turn out to be insolvent in the end?) The hope is that Europe has bought sufficient time to stabilize the rest of the eurozone before a Greek debt restructuring.

The question is whether the European sovereign debt crisis could bring down Europe’s banking system, causing a collapse in confidence and economic activity similar to the fallout of Lehman in September 2008. It’s too early to tell, but a bank run (and a capital strike against eurozone investments) is looking increasingly more plausible.

(Of course European banks are already in a precarious shape, having made much less progress on writedowns and rebuilding of equity than US banks. They will also have to refinance some 800 billion euros in long-term debt by the end of 2012, and bank borrowing has already suffered a major blow because of sovereign risks – see notes above on deterioration in the credit markets.)

It’s not just the ultimate value of their government bond holdings the banks have to worry about. The deficit reduction and austerity programs much of Europe is embarking on are a step in the right direction but will inevitably kill consumption, investment and growth in the short to medium term. A long and painful deflation and severe recession in the periphery would appear unavoidable. (Defaults down the road are still a likely scenario.)

The fiscal retrenchment under way will see incomes in a number of eurozone countries beginning to fall in nominal terms; this will undermine the ability of households and businesses to service their debts, leading to a surge in private sector loan losses at European banks. Credit growth will also further contract as banks – already burdened with the until recently thought safe government bond holdings – will become even more reluctant to lend to riskier private sector borrowers.

Lack of credit will further reduce investment, job creation and economic growth. Slower growth and lower tax receipts will make it even more difficult for the periphery to get their debts under control. And, slower economic growth will create further problems for the banks, causing higher loan losses as highly indebted eurozone households and companies default on their loans. A vicious feedback loop.

A double dip recession in parts of the eurozone should, on itself, not have a disastrous impact on US and Asian economies, although some industries are companies will be more heavily exposed to diminishing European revenues (Europe is China’s largest export market). However, a potential collapse of the European banking system would undoubtedly have catastrophic consequences for the global financial markets, plunging the world back into recession.

And this time policy makers and central bankers would have little ammunition left to support the economy; interest rates are already at or near zero and there is (for now) little appetite for several more trillions worth of stimuli. That might change, of course, after a severe deflationary period, financial collapse, recession/depression; the Fed, ECB and other central banks and governments would then undoubtedly embark on quantitative easing and stimuli on a never before seen scale.

Deflation followed by hyperinflation, anyone?

Links to interesting articles I have read over the past few days that you might also enjoy…

Fiscal Crises and Imperial Collapse (Niall Ferguson) – video presentation

Barney Frank Proven to Be a Liar and a Fraud!

Using Behavioral Finance to Better Understand the Psychology of Investors

Scientists Create Artificial Life: World First as Craig Venter Makes Designer Microbe from Scratch!

Fantastic Presentation on Human Cognitive Biases

Federal Debt As A Percent Of GDP – By President

Beware the Muni-Bond Bubble

The US Government Is About To Get Hit With ‘The Perfect Storm’ Of Debt

The Road to Serfdom (F. Hayek) – free download & a must read!

After months of optimism and growing complacency last week brought a sudden reversal of market sentiment. Optimism was replaced by worry and fear. Confidence was erased, despite a 110 billion euro EU/IMF bailout package for Greece and good US economic data; fear of a sovereign debt meltdown in Europe contributed to Tuesday’s and Wednesday’s sell-off, culminating in Thursday’s bloodbath. The Dow plunged nearly 1,000 points – the largest intraday decline on record – only to recover much of the loss minutes later. Even so, equities suffered their worst session since February 2009, with all major US indices ending the day down by more than 3%.

Escalating concerns of spreading European sovereign debt crisis, aided by images of murderous riots in Greece (casting further doubt of Greece’s ability to implement proposed austerity measures), provided the catalyst for the panic sell-off. Although some believe a trading error or technical glitch may have helped on the downside, the fact is the market was already very weak before the mid-afternoon plunge. The sell-off was, it appears, driven by good old fear.

More selling on Friday – despite better than expected US nonfarm payrolls report – reinforced the growing sense of panic. Both the Dow and the S&P 500 posted the largest weekly losses since March 2009 (DJIA fell by 5.7%, S&P was down 6.4% and the Nasdaq 8%), erasing all gains for the year. As fear spiked, so did the VIX (Chicago Board Options Exchange Volatility Index); it jumped by 86% – the largest weekly increase ever in its 20 year history. In a flight from risky assets the yen, dollar and gold were the best performers.

The EU/IMF providing just a short-term patch for Greece and no solution for other peripherals, financial markets remained unimpressed. Spreads in European sovereigns continued to blow out; the euro sliding further. There have also been increased concerns about European banks, which (as of end of 2009) hold claims of $193 billion on Greece and more than $1 trillion on Portugal, Ireland and Spain. Libor (the interbank lending rate) rose sharply as banks became increasingly suspicious of each other’s exposure to European peripheral sovereign debt.

The slide in the euro, soaring bond yields and global markets’ reaction to the crisis finally led eurozone governments to lay out a set of measures to safeguard the financial stability of the euro area. Last weekend they vaguely committed to additional fiscal consolidation and reform of the Stability and Growth Pact to ensure fiscal sustainability in the region.

As of Monday morning European leaders agreed on providing a massive rescue package of 750 billion euros ($960 billion) to eurozone countries in an effort to stop the sovereign debt crisis and contagion. Eurozone governments pledged 440 billion euros in new loans and guarantees and 60 billion under an existing lending program, with an additional 250 billion to come from the IMF.

The most dramatic intervention came with the announcement that the ECB (European Central Bank) would buy euro area public and private debt. The dollar swap line with the Fed has also been reactivated.

Yesterday’s rescue package averted an immediate crisis and will likely buy Europe some time to allow real fiscal adjustments to take place. However, while it helps eurozone sovereigns with near term financing, it does not fix the longer term debt and solvency problems.

Ultimately, Greece’s problem is not just one of liquidity but also solvency, so the country will still likely have to resort to debt restructuring (which has now been postponed). Without the option of currency devaluation, Greece must go through severe debt deflation. Incomes and tax revenues will plunge. The vicious circle of falling nominal GDP and rising debt/GDP ratio can only be stopped when growth resumes – which will be difficult without devaluation. Solvency risks will not go away anytime soon.

The euro currency downtrend will most likely continue. We may not be far away from a point when the ECB starts printing and effectively monetizing eurozone debt. Concerns of longer term viability of the single currency will also stay as peripheral economies sink deeper into debt deflation.

European periphery facing severe austerity programs and prolonged recessions will not only kill EU’s growth for the foreseeable future but also impact global demand that will go down just as the cyclical recovery is starting to face headwinds.

Where next for the markets?

Peripheral spreads have rallied spectacularly, retracing 50-75% of their widening since the end of March within just a few hours. However, this extreme narrowing is unlikely to be sustained unless the ECB continues buying peripheral debt. European, US and global equity markets also responded positively with a huge rally yesterday.

Last week’s Greek debt fallout provided a perfect trigger for corrective action – we were certainly due for one after the steep rally off the March 2009 lows. Bullish sentiment had reached levels consistent with short term tops (Investors Intelligence survey of investment advisers – a measure of the crowd’s sentiment – reported last Wednesday that 56% of advisers were bullish – the highest level since the 2007 market peak); equities and commodities were overbought. The amount of cash as a percentage of total assets at equity mutual funds was at a record low. Insider sales were at extremely high levels compared to insider buying.

At the moment it’s premature to say whether the sell-off is over; we could be seeing a relief rally, the correction could reassert itself and last for a few weeks. However, given the strong momentum from the March 2009 lows, decent valuations and good upside breadth the cyclical bull market certainly appears to be intact. The markets are bound to remain volatile for a while though.

The following chart shows the spike and subsequent decline in the VIX – also known as Wall Street’s ‘fear index’. A few weeks ago it was at 18 month lows, indicating high investor confidence (and complacency). As we’ve moved from optimism to fear and dread last week volatility rocketed, only to fall back after Monday’s eurozone bailout news.

(The VIX is a measure of the implied volatility of S&P 500 Index options. A low value indicates expected stability in the markets; a high value means expected turmoil. So the VIX tends to exhibit a strong negative correlation with equity prices.)

Another sentiment indicator, the equity put/call ratio, was also very stretched by the end of April, indicating extreme bullish sentiment. As optimism turned into fear the put/call ratio spiked up.

A look at April breadth measures also signaled an imminent correction as over 90% of S&P500 stocks traded above 50 day moving average. We dropped to oversold territory last week, before bouncing back somewhat.

As risk aversion grows US equities could benefit from a flight of capital from Europe; though it will more likely continue to flow into bonds. Importantly, the US economy is improving on all metrics.

We are now seeing a starting recovery in the labor market, based on the payrolls numbers as well as Household Survey employment data. Last Friday’s US nonfarm payrolls surprised to the upside with 290,000 jobs added in April – much better than the anticipated 180,000, with the March number revised upward to 230,000. However, the unemployment rate increased to 9.9% from 9.7% due to a surge in the workforce. (Also, census hiring added 66,000 jobs to the April number.)

There is no doubt about the strong recovery in US manufacturing, as witnessed by ISM data (at 60.4% as of April). The manufacturing sector expanded for the eighth consecutive month to its highest level since July 2004. The pace of new orders was very strong and employment within the sector continued to grow.

Consumer spending has been rising (albeit at the expense of the savings rate). Retail sales rose above expectations in April, for the fifth time in the last six months.

Despite positive US data investors remain skeptical about the health of the economic expansion. At present the consensus is for subdued economic growth; that might end up proving to be too conservative.

Short term interest rates are at their multi-decade lows. Even if rates were to start rising faster than expected, the environment will stay very stimulative for a long time. Low interest rates provide a subsidy to income, profits and economic growth.

Whereas liquidity has been the main driver of the stock market rally until now, the next phase will likely be spurred by growth and profits, with performance depending on expanding economy. Low rates, strengthening business activity and strong balance sheet conditions will drive earnings growth. (Earnings have been very positive, beating expectations in most cases. Expectations of S&P 500 operating earnings are in the region of $80-84 by the end of 2010.)

If economic growth is decent and rates stay low, profits will likely keep surprising on the upside. Of course better economic growth, employment growth and improving corporate profitability will eventually see a rise in interest rates. That alone is, however, not automatically negative for stocks. It is generally only when interest rates start to exceed the nominal GDP growth that the economy slows down. The yield curve also has to become inverted for a cyclical equity bear market to be triggered. Historically, cyclical bear markets were triggered when the yield curve became inverted at a level that was higher than the nominal GDP growth. We are nowhere near that point.

The cyclical bull market has further to go, although the pace of price gains is likely to be much slower, given the steep rally off the March 2009 lows. Most retail investors have not yet moved into equities and are sitting on the sidelines. Yet there is little reason to believe that they will not do so again once confidence in the rally becomes more widespread. Optimism should increase as evidence accumulates on the strength and durability of the economic expansion.

US fundamentals look good for now: leading indicators of growth remain strong, rates are extremely low, earnings are beating expectations, valuations are reasonable.

Equities are relatively cheap on 1-2 year forward valuations (PE of 14 and 12, respectively). Global equities valuations are also attractive at 12M forward consensus earnings multiple of 13. Emerging markets trade on a 12M forward P/E of 12, although they have, over the last two decades, grown earnings at an annual rate of 22% vs. 12% in developed markets, as well as having lower leverage and higher economic growth. Equities are also cheap relative to bonds (as per dividend yield/bond yield ratio).

Retail investors have been net sellers of equities since March 2009. The total allocation to equities by the US household sector is well below long term average. Global bond funds posted inflows of $83.5 billion this year, equity funds saw inflows of only $7 billion. Since the trough of March 2009 US equity funds inflows came to $40 billion compared to bond funds inflows of $360 billion. Retail investors have so far not participated in the rally – retail equity funds saw net outflows of $82 billion since March 2009 (though in March 2010 retail have been modest net buyers). Institutional equity funds have seen modest net inflows since March 2009. (Data from EPFR Global and Credit Suisse.)

Central banks will likely continue to flood the system with liquidity whenever deemed necessary, and the Fed will keep short term rates in real terms (inflation adjusted) below zero for a very long period of time – all of which is positive for equities. And, as noted, there is plenty of cash available from investors who have missed the rally and are still sitting on the sidelines.

I believe the cyclical bull market (i.e. rally within the secular bear that started in 2000) will go on for a while, so any 10-20% corrections may be seen as a buying opportunity for select equities.

There are of course a number of medium to long term concerns.

The situation in parts of the eurozone will remain precarious. Austerity measures will plunge the periphery into a deep and prolonged recession, while bailouts will come at the expense of the productive European economies, all dragging down demand. Europe will buy less US goods, and with the euro likely close to or at parity to the dollar US companies won’t be able to compete with European exporters. This could well slow down US growth by late 2010 and 2011. (Tax hikes will also kick in next year.)

China is tightening in an attempt to slow down its economy, amidst concerns of overheating and housing bubbles. (The Shanghai Composite Index has broken below its key 200-day moving average – a possible precursor of what’s to come in other markets?) Brazil and India (and much of the rest of the developing world) are raising interest rates to fight inflation.

Concerns also remain about US regulatory changes, including financial reform.

The US housing market is a weak spot that needs monitoring. Although prices are stabilizing, the overall picture remains worrying, in particular due to the massive amount of unsold overhang remaining in the system. On the positive side, house price to income ratio is now close to a 40-year low and yields on low-end properties are, according to Credit Suisse research, over 8% – the highest on record relative to 30-year mortgage rate.

And there are still some $6.5 trillion of excess leverage in the developed economies, which will end up reducing growth. Government bond funding will also become more of a problem in the next few years, and not just in Europe. Economies won’t be able to simply grow their way out of fiscal indebtedness. In order to stabilize government debt to GDP fiscal policy will have to be tightened significantly (in the US, UK, Japan, much of the eurozone), which will be extremely challenging both politically and economically. We are still heading toward sovereign defaults a few years from now.

If we are lucky, we may have another 12-18 months before things start getting ugly again.

I think most Americans would agree taxes are heading higher. Yet, curiously, most may not care. (A Gallup survey shows 45% of Americans are happy with their tax rates and 3% believe them to be too low.) In fact, I suspect a significant portion of the population may welcome the tax increases with hardly concealed joy.

How is that possible, you ask?

The explanation is as simple as it is disturbing. For nearly half of US households taxes are simply somebody else’s problem. Approximately 47% pay no federal income taxes at all! (Data from Tax Policy Center for 2009.)

That’s right: nearly half of Americans qualified for enough credits and deductions to fully eliminate their tax liability, or had too low incomes to start with. (According to Deloitte, credits for low- and middle-income families have risen so much that a family with two children making $50,000 a year will owe no federal income tax.)

Half the country is happy with tax policies… well, they should be if they pay no taxes in the first place! These are the people who, more often than not, support higher marginal tax rates, for that simply means someone else will have to pay for their ever growing entitlements.

It is a sign of our hypocritical era that the cry of making taxes more ‘fair’ – meaning of course robbing higher earners blind so that lower earners need to pay nothing – has now been almost universally accepted.

But how on earth can one talk of fairness?

Consider this: the top 1% of Americans pay 40% of federal income taxes, the top 5% pay over 60%… while the bottom 50% pay less than 3%! (Data from the Congressional Budget Office, latest available tax burden release, 2006.)

Half the population is getting something for nothing, and they call this fairness?

As is always the case with expanding welfare states, generous entitlements are paid for by everyone except the actual beneficiaries.

There is nothing fair about redistributing incomes, much less on such a massive scale. There is no fairness in the government penalizing someone for working harder than others. (Not to mention it is unsustainable over a longer term – you will run out of wealthy people to tax.)

Now can you see the fundamental problem here? 40% of American households paid 86% of total federal tax liabilities. However, when it comes to deciding how the government should spend that money, they are outnumbered by the 60% who paid just 14% of taxes.

Is it any wonder that government spending is out of control and the US is coming close to fully adopting European-style socialism? The majority of voters decide on how to use other people’s money – why would they want any spending cuts?

The Congressional Budget Office data also shows that higher earners are paying a larger share of total federal taxes than ever before (as far back as tax burden data goes, to 1979).  

According to the IRS, in 1987 the top 5% of earners paid 43.26% of all federal income taxes; today, that group pays more than 60% of the tax burden – despite bringing in just 37% of the income. By contrast, the share of taxes paid by the bottom 50% of taxpayers – who bring home 12% of the income – has gradually fallen to less than 3%.

Higher earners have, over time, been forced to fund an increasing share of the federal government and fast growing entitlement programs. Meanwhile, according to the Tax Foundation, 60% of Americans consume more in government services than they pay in taxes, and the benefits extended to this group have been steadily increasing.

And yet the likes of Mr. Obama continue to tell us the wealthy aren’t paying their ‘fair share’!

Hence the $650 billion or so in tax hikes and new taxes that will be imposed on higher earners over the next decade will hardly be of concern to the vast majority of Americans. This is a short-sighted view, but then most people aren’t programmed to think of long term consequences. Given the immediate benefits for oneself, who will spare any thought on the negative impact on the economy and future job creation?

Which of course explains the shift toward statism and socialism at a certain stage of mass democracy. (Not for nothing did John Adams, the 2nd President of the USA, say that “there never was a democracy yet that did not commit suicide”, and did James Madison and other Founding Fathers believe that individual rights must be protected from the “tyranny of the majority”. They understood that without checks and balances the propertyless majority would tyrannically tax away the property of the minority.)

The state has clearly become far too big and in the process has made the majority of the electorate dependent on hand-outs, with the result that voting for the necessary medicine will now be virtually impossible.

The massive deficits, unprecedented debts and out of control entitlement programs (as well as demographic trends) leave few options – drastic spending cuts or significant tax hikes (or a combination of the two).

According to a recent Goldman Sachs study (based on budgetary data for 24 OECD economies covering 35 years from 1975), there is only one effective way to reduce debt and sustain future economic growth: imposing budget expenditure cuts across the board. On the other hand, increasing taxes to compensate for a higher budget has proved very damaging to future growth.

While cutting spending would be of most benefit to the country’s prosperity and future, it simply won’t happen on any meaningful scale. When the majority of the electorate has no interest in giving up their entitlements, political leaders will always take the path of least resistance and penalize those voters who, being a minority, don’t present a sufficient threat to their political careers.

And so, on top of all the existing, technically bankrupt federal programs, the Obama administration created a new health care entitlement, to be paid for, as usual, by everyone except those who will benefit. (Detailed overview of associated taxes further below.)

The problem is the US – along with much of Europe – is on a wholly unsustainable budget path, with unprecedented public spending (largely paid for by borrowing and money printing). In the absence of Americans rejecting the expanding welfare and entitlement state, taxes will have to rise much beyond the scheduled increases. Unless, that is, the administration finds some other – miraculous – way to reduce the enormous amounts of debt it continues to pile up.

A recent study by the nonpartisan Tax Policy Center calculated that to reduce the federal budget deficit to a sustainable 3% of GDP, the government would have to find some $500 billion each year – in new revenue (or spending cuts). To get that amount via tax increases on the top two brackets (families with over $209,000 in taxable income) the rates would have to go from the current 33% and 35% to 72.4% and 76.8%.

You didn’t think socialism comes cheaply, did you?

The truth is, no matter how much marginal income tax rates will rise, they cannot realistically be taken high enough to fill the fiscal hole. A broader based tax or a consumption tax is therefore likely to be on the horizon in the coming years.

Speculation about a value-added-tax (VAT) is already ripe. Former Fed Chairman Paul Volcker, among others, has called for VAT to be considered in light of the massive deficits. VAT is a national sales tax applied at each stage of production and collected by businesses (meaning additional bookkeeping and costs). It’s difficult for anyone to escape the tax since it’s included in the price of products and services you buy. (In Europe VAT rates range from 15-22%.)

VAT, apart from being a convenient way to pay for ObamaCare, has other advantages as well. It would allow (via increasing rates) for funding of a continued expansion of government, and as such would undoubtedly permanently open up the floodgates of public spending.

But while VAT is (for now) just a speculation, the tax increases starting next year are very real. Below you’ll find an overview of tax hikes and new taxes to be imposed on (better-off) Americans in 2011-2018.

2011 – tax hikes (tax cuts expiry) on higher income and capital income

First there is the expiry of the Bush tax cuts at the beginning of next year. The highest tax bracket will move from 35% to 39.6% and the 33% bracket will rise to 36%. The estate tax will also revert to 55%, with an exemption of $1 million (unless Congress reinstates the 2009 rules of 45% federal rate and $3.5 million exemption).

Importantly for investors, the capital gains rate is set to rise to 20%, up from 15% now. Dividends, currently taxed at 15%, will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% (unless Congress enacts a proposal for a top dividend tax rate of 20%).

While most of these increases appear to only target wealthier Americans, they are also damaging to small businesses. (According to IRS data, some 26 million small business employers file under the individual income tax code and so will be subjected to much higher taxation.) This, along with the onerous new health care burdens, will certainly not help small businesses hire more people.

On top of the tax cuts reversal, Obama’s health care ‘reform’ brings a number of new taxes and tax increases (2011-18) aimed at financing part of the new spending. For obvious reasons most of the tax hikes will start in 2013, after the election year. (Some ObamaCare related taxes go into effect in 2011, however, these will affect drug makers and importers.)

2013 – increase in payroll tax + new tax on investment income

From the beginning of 2013 higher-income taxpayers will be hit with a tax increase on wages as well as an entirely new levy on investments.

Medicare payroll tax will rise by 0.9% from 1.45% to 2.35% – a gigantic 62% increase – on wages above $200,000 for individuals and $250,000 for married couples filing jointly.

In addition to that, and for the first time ever, Medicare taxes will be extended to investment income. A brand new 3.8% tax will be imposed on the falsely called ‘unearned’ income – dividends, capital gains, interest, rents and other investment income – for individuals making more than $200,000 a year and couples making more than $250,000.

(A 2.3% excise tax on sale of medical devices also goes into effect in 2013.)

2014 – penalties for lack of insurance

2014 is when the health coverage goes into effect, and the requirement begins for everyone to have health insurance. (The government will provide subsidies for lower and middle income groups.) If you don’t want health insurance, tough; you’ll pay penalties – $695/p.a., further rising in 2016.

Medicaid (the federal-state program for the poor) will expand to all Americans with incomes of up to 133% of federal poverty level; since this could bankrupt the states they might start electing out of Medicaid. (More than a dozen states have already filed lawsuits over the constitutionality of the burden imposed by Obama’s bill.)

Subsidies (tax credits of up to 50% of employer’s contribution) for small businesses (up to 10 employees) will provide for coverage increase. Penalties will be imposed on employers with over 50 employees who don’t provide ‘affordable’ coverage (note – affordable as deemed by government bureaucrats); they will be fined $2,000 a year per employee, excluding the first 30.

(The health insurance industry will also start paying annual fees; $8 billion in 2014, rising in subsequent years.)

2016 – steep rise in penalties for uninsured

Penalties for those who don’t carry coverage will rise to 2.5% of their taxable income or $695/p.a. – whichever is higher.

Not to mention, a mammoth bureaucracy will be created thanks to ObamaCare (see here the astonishing list of all the new boards, commissions and agencies the bill gave birth to). The government will also hire an estimated 16,000 IRS agents to harass and audit individuals and individual businesses to check for compliance. (I suppose Mr. Obama would expect us to applaud this convenient new job creation scheme?!)

2018 – tax on high value plans

An excise tax of 40% will be imposed on health care plans with premiums exceeding $10,200 (individual coverage) and $27,500 (family coverage).

Investors hardest hit

Apart from higher-income taxpayers being disproportionately targeted as a revenue source, policy is now clearly taking the path of increased taxation of passive income. In fact investors and higher earners will bear all the burden of ObamaCare (without getting any of the benefits).

Let’s look again at the massive new taxes Obama assaulted investors with, as well as the likely impact.

Those with income from stocks, real estate or other investments are expected to contribute a giant share of the costs of health care expansion. (I suppose we’re seeing a theme here… from the continuing witch-hunt on the financial sector to the increasingly investor-hostile environment.)

Aside of the income tax and payroll tax hikes detailed above, there are three specific developments penalizing investors: increase in capital gains tax from 15% to 20% (2011), increase in dividend tax (to either 20% or as high as 39.6% – see further below; 2011), and the new additional 3.8% tax on all ‘unearned’ income (2013).

What exactly will be subject to the 3.8% tax? Dividends, interest, annuities, royalties, rents, as well as capital gains (minus deductions properly allocatable to such income). Basically, all income and gains derived from a ‘passive activity’ count as investment income. (Note that income and gains from an investment fund, even if the fund is classified as a ‘trader’ for tax purposes, will be subject to the tax.) Tax-exempt interest income and distributions from tax-qualified retirement plans, including IRAs and Roth IRAs, are not to be included in investment income.

Capital gains, currently taxed at 15%, will therefore be subject to a 23.8% tax (20% after expiry of the Bush tax cuts + 3.8% in new tax).

Dividend income (currently taxed at 15%) will be particularly hard hit. In 2011 dividends will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% from 35%. With the additional 3.8% Medicare tax dividend tax will go as high as 43.4% in 2013. Obama has proposed a top dividend tax rate of 20%; if Congress enacts the proposal, the top tax rate for dividends would rise to ‘only’ 23.8% at the beginning of 2013.

Impact on investment and investors’ behavior

Overall, some $409 billion in additional taxes will be snatched from investors in order to pay for big government socialism. What will be the likely impact on investment?

Essentially, investment income (capital gains, dividends) will be worth less to investors once the tax hikes/new taxes go into force than it is today. It is feasible that it could revalue the entire stock market lower.

Credit Suisse in a recent (April 2010) report estimates that a 10% rise in dividend and capital gains tax in the US would take about 7% off the fair value of the equity markets (assuming that 30% of the market is owned by tax-exempt funds and foreigners and the higher tax rates will apply for 15 years).

The 2011 capital gains tax increase could also prompt investors to liquidate holdings this year, ahead of the increase.

In addition, we may see shifts in investors’ behavior, in particular if dividend tax goes up by nearly 200%. Investors will certainly take that into consideration when making decisions; as a result they could shy away from dividend stocks and focus on those they perceive as having greater potential to appreciate.

More generally, the new taxes will discourage investment, making it more difficult for companies to bounce back after the recession. On top of that, as noted earlier, most small businesses pay the individual income tax, and the rate hike will have a negative impact on expansion and hiring. (Mr. Obama of course sees small business owners not as job and wealth creators but as rich exploiters who must pay yet more onerous taxes so that those who don’t pay any can enjoy still further entitlements.)

Add higher income taxes for the most productive Americans and higher payroll taxes, and it becomes clear that the Obama administration is penalizing those who have worked hard, saved, and invested, while rewarding and indulging the less able, unproductive and lazy. Classic Marxist class warfare… blaming the productive and enterprising for all of society’s ills, which can naturally only be ‘fixed’ by redistribution of unprecedented scale.

We will not need to wait too long to see the outcome. Significant tax increases can only reduce economic growth, for they take away people’s incentives to work, save, and invest. (They also encourage tax avoidance, thereby defeating the purpose of the tax increases.) Capital will be allocated to where it can avoid (some of) the taxes instead of where it would be most productive for the economy.

“When people who earn more than the average have their ‘surplus’ or the greater part of it seized from them in taxes, and when people who earn less than the average have the deficiency, or the greater part of it, turned over to them in hand-outs and doles, the production of all must sharply decline, for the energetic and able lose their incentive to produce more than the average and the slothful and unskilled lose their incentive to improve their condition.”

(Henry Hazlitt)

I will not even take into consideration increases in other taxes at federal, state and city levels, including corporate tax hike proposals, a likely consumption tax on energy (as part of climate change legislation) and possibly a value added tax.

And in the unlikely case you still believe Mr. Obama’s socialist propaganda on how the ‘rich’ aren’t paying their ‘fair share’, please review the statistical data at the beginning of this article. Not only do higher-earners pay a fair share, they are being robbed blind. (Brief recap – the top 5% earn 37% of income yet pay nearly 61% of all federal income taxes, while the lower 50% earn 12% of income and pay less than 3% of taxes. And that is before any of the coming tax hikes on the better-off!)

How did we get to this sorry state?

Consider that in 1913 the top rate of income tax was just 7%! Not only have taxes gotten more progressive and excessive, there has also been a staggering increase in related bureaucracy. The number of pages in the tax code has increased by 16,775% in the past century.

Taxes are, however, only a side issue. What should really concern us is how, within a relatively short period of time, the US went from a limited government, free enterprise, individual liberty valuing regime (of the Founders) to big government statism and finally the progressive socialism of today. The people, once freedom loving and self-reliant, have carelessly traded their liberties and responsibilities for entitlements and handouts.

Government programs and welfare only make people less reliant on themselves and more dependent on the state, which in turn prompts an ever increasing size of government, until one inevitably ends up with socialism.

The dependency mindset is now almost as prevalent among Americans as has long been the case in much of Europe. The productive sector that adds value to society is sucked dry by the parasitic state bureaucracy, the able and hard working are penalized for their success; as a result the whole society ends up much poorer. (Not to mention the terrifying and impoverishing public debt burden left to the next generations.)

Of course all this happens in the name of ‘fairness’ and ‘equality’.

Yet redistribution has nothing to do with fairness and everything to do with envy and theft. Such action gains, thanks to majority rule, a seal of legitimacy, but it really is no better than common robbery.

The fact is today the vast majority of people feel entitled to the property of others. They demand that it be taken away from them through taxation, so that (some of) it can be given to those they deem to be ‘in need’ – i.e. those who have less but of course feel entitled to have more.

Forcibly taking other people’s money would in other circumstances be considered criminal, yet this mass criminality is rationalized on the grounds of democracy, will of the people, political mandates, etc. Progressive taxation appeals to the masses who, more often than not, have a desire to pull down the minority of the most productive, talented, enterprising (and as a result more successful). Progressive policies in general are just a mean to an end; the end being an envy-based redistribution.

Unfortunately once a certain stage of statism or progressive socialism is reached it is nearly impossible to reverse. Once a voting majority pays no income tax and benefits from entitlements, the productive and enterprising minority is doomed. The majority will continue to vote away the rights of others, and call it the will of the people.

This is the tyranny of democracy the Founding Fathers had warned against. They did not intend for the state to guarantee everyone’s well-being and provide support against every possible obstacle. They would be horrified at the idea of divesting some people of their properties for the advancement of others in society. And yet today that is exactly what much of the population expects – to be taken care of by the government, be given something for nothing – all at the expense of those who stand on their own two feet and attain things by hard work.

One can work and produce goods or services that others want to pay for, or one can steal (or give the government a mandate to loot on their behalf). It is human nature to take the path of least resistance, which explains why most believe it is perfectly acceptable to plunder others rather than obtain what they desire by their own efforts and sweat. Naturally they will always find a justification for such action; hence it is deemed a matter of fairness for a minority to subsidize the majority who are perceived as disadvantaged in one way or the other (never less apt, less willing or simply lazy).

This socialist disease has now infected much of the fabric of the society. And it’s not just the liberals who prefer the state to make life-governing decisions for them. According to information from the 2008 American National Election Study about spending priorities, the majority of self-identified conservatives isn’t really in favor of cutting spending on most government programs either.

Of course anyone who disagrees with this entitlement mentality is labeled uncaring, uncharitable, lacking social conscience, or worse. The notion that unless we let the state do everything for us we are ‘bad’ persons is now so prevalent that few dare to mention the choices that must be made. How many in public office take up the cause for limited government and hence severe cuts to welfare and the public sector (including eliminating millions of counterproductive public jobs, bureaucracies, regulations, entitlement programs, etc)?

And yet far from unfair or uncaring, that is the only viable path to safeguarding America’s economic future.

//

//

//

//

//

//

//

//

At the outset it must be said that, regardless of the day to day fluctuations of financial news, we are entering into unprecedented territory. What may be construed as long term planning may well be categorically different than medium term common sense.

The increases in the total federal debt outstanding are off of all known scales that we have a historical measure to compare against. In essence, the catastrophic toxic products that nearly imploded out financial system haven’t exactly vanished, as the chart below will make clear. As in a very large shell game, much of this highly problematic material has been shifted off of private books and on to public books.

One of five possibilities will ensure, or some politically expedient combination of the five.

1.    default on the debt (very low probability)
2.    debase the currency (high probability)
3.    massively curtail public spending (one can only cut so far)
4.    raise taxes (count on this one)
5.    experience such massive technological change that we can innovate our way past it

Chances are excellent that our political class will engineer a mixture of currency debasement/inflation, spending cuts, tax increases, and pray for a technological breakthrough. In other words, as for long term prospects, even if we do have a respectable recovery from the lows, as the folks at the Bank Credit Analyst are predicting, we will remain burdened with exceptional social, fiscal, and taxation problems, riding on top of demographic changes, that cannot be waved away with any known magic wand.

E-Commerce sales remain a relatively small component of the entire US economy, however we feel that they are a worthy leading indicator on one hand, and also a sign of the ways in which the consumer is moving away from the higher overhead brick-and-mortar economy to the more customized, flexible, and more deflationary economy of mobile capital and business structures.

Fascinatingly, real retail and food service sales are only about four times bigger that e-commerce sales at this point, and real storefront sales are quickly being overtaken by internet commerce. The difference obviously remains sufficiently great that one will not displace the other overnight. Having said that, e-commerce has advanced with remarkable alacrity, and the implications cannot be ignored. Soon the competitive dynamic of algorithmic pricing will displace and undercut a significant amount of that traditionally associated with face to face commerce. And that impact is likely to be disinflationary if not deflationary.

The employment cost indices make instructive viewing. Whether we look at the manufacturing, service, or private industry indices YoY, we see punishing deceleration in wage and salary gains, in line with earnings fall-offs through 2009. The great question that faces us on many levels is whether an inflationary surge that might well appear as a result of unsustainable debt will be, or could be, an effective index for private sector wage gains and sustainable retail price gains.

In the inventory to sales ratio we see a similar process of “inventory deleveraging” which is by no means merely a product of the last downturn; this is a structural change that clearly demonstrates the US economy moving closer to a just-in-time, lean run model. The move toward e-commerce suggests that this structural change will also reduce many job descriptions as the relationship between the consumer (don’t forget, this mythical being, in toto, accounts for about 70% of the US economy) and the seller removes one or more traditional layers of distribution and marketing.

So where does the estimable Robert Shiller and his cyclically adjusted price/earnings ratio fit into this picture? We tend to see the CAPE index, as it is sometimes known, as a kind of long term fair value estimator. Shiller ingeniously has taken the average of the previous 10 years of earnings as the denominator (hence the “cyclical” part) and compares his adjusted price to this long term measure of earnings capacity, instead of simply a quarter by quarter comparison of price to earnings.

We have made a minor, but we feel useful adjustment to Dr. Shiller’s calculation by instead computing the rolling ten year median earnings value and then drawing a line one standard deviation above the mean of the CAPE series and another line one standard deviation below the mean. We feel that this is a good estimate of the long term fair value band, or we might say, the not-emotionally-driven-by-panic-or-euphoria band.

We have also included this second chart which shows the long term average on the CAPE value from 1881 to present.

Our conclusion is this: at the moment the US equity markets are reasonably priced against long term trends and there could be an extended period where they perform acceptably. However, they are by no means historically cheap; one could say they are about fairly priced, and the market will be very sensitive to perceived inflation in the unfolding of the story.

As long as inflation remains tamed by disinflationary pressures, money will remain parked in the debt markets, and equities will be vulnerable to blips of bad news. There are no absolute guarantees, however, we do accept that there are vast amounts of capital forced to find a home should the economic landscape suddenly change.

As a final thought, we include this study of trends in federal debt maturities.

One can only rationally conclude that the disinflationary and pro-inflationary crosswinds will sooner or later interact with violent energy. Either large sectors of the US working population will find themselves trapped by an inflation that damages them as a social class, potentially producing an extreme and irrational political response, or there may be some novel form of social irresponsibility as the American governing class tries to finesse its way out of an impossible position.

In the Part I of our ETF Guide we looked at the basics of exchange traded funds, their advantages for investors, the various types of ETF funds as well as the somewhat newer additions to the ETF universe – equally and fundamentally weighted ETFs and actively managed ETFs. (You can read ETF Guide - Part I here.)

Today we look at the benefits and risks of the more complex ETFs that have become increasingly popular in the last few years.
New generation of ETFs – new risks
Although exchange traded funds (ETFs) were first introduced as passive, low-cost, transparent investment vehicles, today investors also have access to a number of highly complex ETFs. While their popularity with traders and experienced investors is growing, it is essential that you fully understand the risks before investing in these more exotic vehicles.

Compared to traditional ETFs, this new generation presents (often significant) additional risks. Read on to learn about leveraged ETFs, inverse (short) ETFs, futures-based commodity ETFs, ETNs and ETCs, and ETFs of ETFs. Finally, we also show you the main risks you will be exposed to with certain types of ETFs. These are frequently misunderstood by investors and could result in a loss of your capital!

Leveraged and inverse ETFs have attracted plenty of criticism. Although they are simple to use, their very complex structure may be difficult for retail investors to understand. While they are undeniably complex and quite different vehicles from the original, transparent funds, they have their place in an informed investor’s arsenal.

Leveraged ETFs

Leveraged ETFs have only been available for a few years and are generally used by traders. They are designed to amplify the returns of an underlying index by using debt and derivatives (usually futures or swaps). The financing provides greater exposure; typically the leverage ratio is 2:1 or 3:1.

So, for example, the daily return (before expenses) of a two-times leveraged ETF should be twice that of the underlying index – that goes both for gain and loss. Since these instruments exaggerate market movements they can be very volatile.

Leveraged ETFs require daily rebalancing to maintain a constant leverage ratio. That, combined with high volatility, can erode gains over time, so they are best used for short term trading.

(While leveraged ETFs deliver a multiple of the index’s daily performance, over long term, due to the compounding effect of leveraged performance, they tend to deviate significantly from the underlying index.)

The constant buying and selling of derivatives result in transaction and interest expenses, on top of the management fee. There are both long and short leveraged ETFs. Due to their high volatility and risk investors should use them with care.

Inverse ETFs

Inverse – or short – ETFs are designed to return (before expenses) the opposite of the benchmark they track. For example if the S&P 500 declines by 2% an inverse S&P ETF would rise by 2%, and vice versa.

Inverse ETFs therefore offer investors an opportunity to benefit from falling markets. They can be used speculatively, to bet on decline of the underlying index, or for hedging purposes.

Buying an inverse ETF provides similar results to short selling the index. However, while short selling exposes a trader to potentially unlimited losses, an inverse ETF exposes him only to the loss of the purchase price.

There are inverse sector ETFs, index ETFs, commodity ETFs, etc. Like leveraged (and other complex) ETFs, inverse funds have higher expense ratios than simple ETFs – though typically still lower than mutual funds.

Short selling

Unlike mutual funds, many ETFs can also be sold short – just like stocks.

Like buying inverse (or short) ETFs, short selling (or shorting, going short) traditional ETFs is used for hedging and speculation. Investors can hedge their portfolios against downside risk in declining markets, reducing losses on their long positions. Short selling also offers an opportunity to profit from betting on falling markets.

Shorting is the process of selling securities that the trader has borrowed (rather than owns). When expecting the price to drop, short sellers sell the borrowed securities at the current (higher) price and hope to buy them back at a lower price at a later date. They then return the securities to the lender and the difference is their profit. If the prices rise instead of decline, short sellers incur a loss.

Futures-based commodity ETFs

Commodity ETFs (tracking the performance of a commodity or basket of commodities) either hold the physical commodity or use futures contracts to gain their commodities exposure.

Commodity ETFs that use futures often diverge significantly from the price of the benchmark they are designed to track. This high tracking error is mainly due to contango and backwardation related to futures, leading to losses from rolling futures contracts in contangoed markets and gains in backwardated markets. (For further explanation read here.)

(For example, the highly popular US Oil Fund ETF (USO) has consistently failed to deliver what it had promised – tracking the price of crude oil – due to these phenomena.)

Futures-based commodity ETFs are taxed differently than most other ETFs, so check carefully before investing. (More information here.)

ETNs (Exchange traded notes) and ETCs

Exchange traded notes – or ETNs – are debt instruments linked to the performance of an index, commodity or currency. They have been around since 2006 and can be bought and sold through a broker, like stocks and ETFs.

ETNs, due to their structure, are very flexible and offer easy access to hard-to-reach assets such as commodities or countries that impose limits on foreign investment.

The main difference between ETNs and ETFs is that, as debt notes, ETNs don’t actually own any assets. Instead, the issuing bank promises to pay the ETN buyer the amount reflected in the index, minus fees.

Commodity ETNs (also ETCs – exchange traded commodities) offer certain advantages over (futures-based) commodity ETFs. Their price closely tracks the underlying commodities index, removing the tracking error often seen in commodity ETFs. So with ETNs investors can generally get what they planned for – the return of the index (minus management fee). They may also offer certain tax advantages (to US investors), compared to futures-based commodity ETFs.

However, investors need to understand that the creditworthiness of the issuer is very important here. ETNs are debt obligations and as such subject to the solvency of the issuing bank. If the issuer’s financial condition deteriorates, it can negatively impact the value of the ETN. If the issuer goes bankrupt, ETN holders may lose their capital. (Investors in ETCs are exposed to the credit risk of the guarantor.)
ETFs of ETFs
One of the newest products in the ever expanding ETF universe are ETFs of ETFs, available since 2008. These funds of funds offer different asset allocation strategies and risk levels to investors. In principle they provide a more diversified portfolio in a single product.

However, there are a few things to keep in mind. ETFs of ETFs can compound fees, since the fund’s expense ratio is applied on top of the expense ratios of the ETFs held by the fund. They can also push ETFs that have not proven popular with investors and are being repackaged in this way by the issuer. Not surprisingly, the fund’s issuer will typically give priority to their own ETFs when constructing the fund.

More innovations – hedge fund ETFs

Last year Deutsche Bank launched the world’s first hedge fund ETF. It tracks the bank’s proprietary db Hedge Fund Index and is linked to the performance of its constituent hedge funds. There are now a few more hedge fund ETFs on the market. While direct investment in hedge funds is out of reach of most investors (due to large minimum investment requirements), the ETFs are accessible to anyone.
ETF benefits for traders
Traditional ETFs have proven popular as basic building blocks in long term investors’ portfolios.

However, thanks to their trading flexibility, liquidity and convenience, ETFs are also widely used by traders to go long or short on indices or specific sectors. Options can also be written against many ETFs, just like with stocks. Double- and triple-leveraged ETFs are a good, low cost tool for day traders who understand how to use them properly.
RISKS: What you need to watch out for when buying ETFs!
When buying ETFs it’s not enough to consider what a particular ETF invests in.  Investors must understand the structure of each ETF before putting in any money. As discussed earlier in this article, there are many variations in structure and execution, and as a result the risks differ vastly.

Below we sum up the most frequently misunderstood risks related to specific ETFs.

1. Tracking errors

While all funds have a certain tracking error (deviation from the underlying benchmark), futures-based commodity ETFs sometimes completely fail to track the underlying commodity (chiefly due to contango and backwardation in futures markets). See section on Futures-based commodity ETFs. Leveraged ETFs track the daily performance of the index but will deviate significantly over longer term (see section on Leveraged ETFs).

2.  Counterparty risk

As with most investments, ETF holders are exposed to market risks related to the securities the funds track. However, with some products, there are additional counterparty risks investors need to be aware of.

ETF holders will remember autumn 2008, when the near demise of AIG resulted in a number of ETCs (exchange traded commodities) – that were guaranteed by the US insurer – being temporarily suspended from trading, due to concerns that AIG wouldn’t be able to meet its contractual obligations. (Trading resumed after the Fed’s bailout of AIG.)

So how concerned should you be about counterparty risk in relation to ETFs? And, which ETFs are at risk?

First of all, it’s important to distinguish between physical or ‘cash-based’ ETFs, swap-based ETFs and ETNs/ETCs.

Cash-based ETFs are very transparent and hold the underlying securities of the index they track. In case of the provider’s failure investors have recourse to the fund’s ring-fenced pool of underlying assets.

(US physical ETFs must hold 100% of the underlying securities, meaning the investor is exposed to no counterparty risk. In Europe they can use derivatives but must hold a minimum of 90% of the fund as collateral, limiting any counterparty risk to a maximum of 10% of the fund’s net asset value.)

Swap-based ETFs invest in derivatives, offered by third parties, to provide exposure to the index. They hold a basket of securities (to which investors have recourse in case of issuer’s failure) and an index swap. In the EU (under UCITS rules) investors’ exposure to the risk of counterparty default is limited to a maximum of 10% of the fund’s NAV per counterparty.

(Note: swap-based ETFs have their advantages; they tend to be more efficient, with lower cost and lower tracking errors than ETFs that hold the underlying index constituents or futures contracts.)

Then there are ETNs (and ETCs). Investors in exchange traded notes are directly exposed to counterparty risk of the note issuer. (See section on ETNs earlier in this article.) ETC investors are exposed to third parties guaranteeing the securities’ performance (AIG in many ETCs).

Risk is sometimes reduced through collateral, but in some cases investors could lose their capital in case of the issuer’s bankruptcy. (Note: A few precious metal ETCs are backed by physical holdings, eliminating counterparty risk.)

While most ETFs are reasonably safe for investors, it would be good to see more disclosure in the industry. For example, many ETF providers don’t disclose who the counterparties are in their funds, what percentage of the fund relies on uncollateralized swaps, how often collateral is rebalanced, etc. This is something investors should have the right to know.

Finally, below are answers to a few frequently asked questions related to ETFs.

What’s the difference between NAV and the market price?

Net Asset Value (NAV) refers to the fund’s total assets minus its liabilities; market price is the quoted price the ETF is trading at. Although large premiums or discounts are rare, NAV and market price will diverge at times.

How liquid are ETFs?

The liquidity of ETFs depends mainly on the liquidity of the underlying securities, rather than the trading volume of the ETF itself.

ETFs allow units to be created or redeemed reflecting supply and demand. Therefore their liquidity comes from the creation/redemption process and/or trading on exchange. ETFs with low trading volumes can still be liquid and traded with ease.

Do ETFs pay dividends?

Yes, depending on the index they track. The dividend income received from underlying stocks or bonds is distributed to ETF shareholders or (if the ETF tracks a Total Return Index) reinvested.

Do ETFs influence asset prices?

Some analysts believe certain ETFs can cause market bubbles. While it is beyond the scope of this article to explore this in depth, it’s worth noting, for example, that the world’s second largest ETF, SPDR Gold Shares ETF (GLD), now holds 1,117 tonnes of gold bullion (more than the central banks of China, India, Russia or the EU). The ease of exposure to gold, at low cost, has resulted in investors and speculators to funnel massive amount of capital into GLD. Due to its size GLD’s trading activity can heavily influence the global gold price.

A year ago, with the world on the brink of a total economic collapse, we were told buy & hold investing was dead, earnings would take years to recover and the economy would languish for years to come. Of course the experts were wrong, and anyone who didn’t listen and bought stocks is sitting on exceptional gains.

The rebound has indeed been stellar. The Dow Jones Industrial Average ended 2009 up 19% (having gained 60% from March lows), S&P 500 is up 24% and the Nasdaq up 43% – the best year for the US markets since 2003.

In the UK the FTSE 100 gained 22% last year (54% since the year’s lows) – its best annual performance since 1997.

Lost decade… for some

Of course, as positive as that is, it’s only half the story. When we look at the performance over the last decade, the picture is quite different. Little wonder the last decade has been labeled the ‘lost decade’. Instead of holding stocks over the last 10 years investors could as well have stuffed the money under a mattress. Or so it seems.

From the end of 1999 through 2009 the Dow has seen its second worst performance on record (down by 9%). The 1930s and the 00’s were also the only decades during which the Dow ended lower than where it started. The S&P has fallen by 24% in the 10 years since the end of 1999 and the Nasdaq by about 44%.

The UK and Europe haven’t fared any better. Investors in the FTSE 100 would have lost 23% over the last decade; the German Dax has fallen by 14% and the French CAC-40 by 34% over the same period. Even accounting for dividends investors would still have lost out. Naturally, when we take into consideration inflation and falling currencies, the decline in asset values has been even sharper.

The awful performance over the decade is of course somewhat skewed as 2000 saw the peak of the dotcom bubble with stock markets at historic highs. The past decade saw not just one but two market crashes. It’s therefore my belief this was an abnormally bad period for equities and the next decade will be much more in line with historic performance.

Great decade for others…

More importantly, when we talk about a ‘lost decade’, we’re forgetting the other parts of the world, outside the US and Europe. Investors in emerging markets have seen rather extraordinary gains over the last 10 years – despite the sharp declines in 2008.

While emerging markets were hit hard by the flight to safety (the Shanghai Composite slumped by 65% in 2008, Russia’s Micex by 67% and Brazil’s Bovespa by 41%), they rebounded just as fast. The Micex index gained 121% in 2009, the Shanghai Composite index rose 80% (and Shenzhen Composite 117%), Bovespa added 83% and India’s Sensex 80%.

Compare the 10-year losses in the main developed markets with the emerging markets performance over the same period. The Shanghai Composite gained 140%, Sensex 30 went up by 249%, Bovespa by 301% and Russia’s Micex has surged a staggering 802% since the end of 1999.

Here’s a chart comparing 10-year returns in emerging vs. developed markets:  See chart.

Emerging markets in 2010 and beyond

I believe the emerging markets will continue to outperform in the long term. Yes, they are highly volatile and there will be plenty of bumps, but the long term trend has been up and I see few reasons to doubt it will continue.

Much of the developing world’s growth in the last decade has been fueled by a reduction in poverty rates, fast expansion of the middle classes and resulting consumption. These trends will continue and support robust economic growth for years to come. While China heavily depends on exports and is therefore linked to the strength of western economies (for now), that is less the case for the likes of Brazil and India.

That’s not to say that the strong rebound of 2009 wasn’t partly due to the massive fiscal stimulus (particularly in China) and speculative money inflows. Just like the cheap money supported the rally in the US and Europe.

According to IMF predictions, in 2010 the developed economies will see a 1.3% GDP growth vs. 5.1% in the emerging markets. In 2011-2014, the IMF estimates average annual growth of 2.5% and 6.4%, respectively.

Over the last two decades developed nations have seen a strong loss of economic influence. The US, Europe and Japan controlled approx 64% of the global economy in 1990; that is now down to 52%. The events of 2008/9 can only help to accelerate this process.

Furthermore, the four BRIC nations now hold approximately 42% of the world’s foreign exchange reserves. The G7 hold 17%, and if we take out Japan they come to a mere 4% of the world’s reserves. Over the last 10 years, while the BRICs accumulated reserves, the West went amassing debts.

For the UK, US and many EU economies ballooning fiscal deficits and spiraling public sector debt will present major problems in 2010 and beyond. Most Asian economies (excl. Japan) do not have the problems of government and household debt that the West has.

Where is the economy heading?

We won’t see a double dip recession, but economic growth in the US is likely to be subdued. Even that could be threatened should interest rates rise too much, too early (which, however, is unlikely to happen). Some analysts expect the US economy to heal more quickly and post stronger than the generally forecast 2.5-3% growth.

The budget deficit is an obvious problem. Huge amounts of private sector debt have been shifted to the government. The bill will eventually come due. The scale of the deficit will place an upward pressure on interest rates.

On top of that, high levels of consumer indebtedness, as well as unemployment, are likely to keep consumer spending weak. Higher taxes, which seem to be a certainty in the US and UK, will also inhibit growth.

The UK is in an even more precarious position. The obvious issue being its enormous deficit, as well as the 2010 general election, which could, in the worst case, see a hung parliament (and resulting uncertainty for the markets and economy). As in the US, recovery will also depend on improvement in employment and the property market.

Importantly, the withdrawal of the stimulus will have an impact on the markets and economy. If done too early it could cause a double dip recession, if too late it is likely to lead to a spike in inflation. Interest rates are likely to stay very low this year as the Bank of England won’t want to risk a relapse into recession.

2010 – A good year for equities?

Despite previous warnings, it seems the 2009 rebound in the markets wasn’t so unusual after all (once it became clear that Armageddon was no longer likely). The markets frequently recover before there is any sign of improvement in the economy or corporate earnings.

After last year’s surge in equity prices, 2010 performance will largely depend on earnings growth, fueled by productivity gains and maybe a return of the consumer. If the expected earnings don’t materialize, stocks could see a significant correction.

Coming out of recessions equities have traditionally performed quite well, and we could well see the markets end 10-15% higher in 2010. The large amount of cash still sitting on the sidelines and waiting to be invested is also likely to help prop up equity prices.

The exit from the monetary and fiscal stimulus that fueled last year’s rally may have a negative impact. A genuine recovery (with self-sustaining growth in jobs, earnings and spending) has to kick in before government stimulus is withdrawn. If private sector demand doesn’t step in by that time, we will see a reduction in output.

It is unlikely that we’ll see significantly higher interest rates in 2010. That’s good for the markets – low rates support earnings as well as steering yield seeking capital into equities. The concern is that if the Fed doesn’t move fast enough on rates, we are going to have excess demand for many goods and commodities, resulting in a rampant inflation. It would, in fact, be surprising if the trillion dollar stimulus didn’t trigger inflation down the road.

What seems certain is that 2010 will be a much more ordinary year for the stock markets, compared to the last two. Investors will have to earn their returns which will stem from individual investments rather than a general market momentum. Even if the markets stay largely flat or range bound, there will be opportunities to outperform.

Should US equities perform well next year, it is likely that many foreign markets (excl. Japan and Western Europe) will do even better amidst stronger economic growth. Given that many S&P (and FTSE) companies now derive a significant part of their revenues overseas, blue chips with strong foreign sales could also benefit from global economic growth.

Emerging markets, in particular Asia and Latin America, will, in my view, continue to outperform in 2010 and over the next decade. Just be prepared for the volatility and short term hiccups.

All that said… nobody knows what exactly will happen in the markets in 2010 (or any other year). The only thing certain is that there will be opportunities for proactive and selective investors to achieve healthy returns. And that’s where investment talent will come in.

3X5KGD7Y5VFY

Starting off our new series on Financial Spread Betting, today we look at what is spread betting, who uses it, for what purpose, and how it actually works in practice.
Understanding OTC Derivatives
Financial spread bets and their close relative Contracts for Difference (CDF) are off-exchange, OTC (over-the-counter) derivatives. That is, financial instruments not traded on exchanges and whose value is derived from underlying securities. They are essentially contracts traded and negotiated directly between the two parties – the spread betting company and you, the client – without going through an exchange.

Financial spread betting offers retail traders easy access to a large number of international markets, ability to take long and short positions and high leverage. It is only suitable for (short-term) trading, not for long-term buy & hold investment.

When spread betting, just like trading CFDs and other derivatives, you are not actually buying or selling any shares. You are simply betting on the price movement of the underlying share (or commodity, index, currency, etc). And, thanks to leverage, you get exposure to the markets at a small percentage of the cost of owning the actual underlying instrument.
Increasing popularity
Spread betting was first offered in 1974 by IG Index in the UK. It has grown rapidly since the late 1990’s thanks to the introduction of online dealing. Once the preserve of City traders, financial spread betting has grown in popularity among ordinary investors in recent years. This is especially true in the UK due to the favourable tax status (spread betting gains are tax-free under UK tax laws). Today there are an estimated 250,000 people in Britain alone that engage in spread betting.

Although most attractive to individual traders, spread betting is also occasionally used by professionals and funds for speculation and hedging risk exposure. Institutions, however, generally favour CFDs for a number of reasons, including higher transparency and cost effectiveness in large transactions. (We will explain the similarities and differences between spread betting and CFDs in another article.)

Financial spread betting is now available in a number of countries, including the UK, Ireland, Canada, Australia, South Africa, much of Europe and parts of the Far East. It is, however, prohibited in the US (along with CFDs) due to SEC restrictions on OTC derivatives. In the UK financial spread betting is regulated by the Financial Services Authority (FSA).
The role of the spread betting company
It is important to understand that the bid and offer prices, although based on the actual market price of the underlying instrument, are set by the spread betting company (the market maker). Therefore, the price you will trade is not the exact price you see in the market. The spread will typically be slightly wider; this is how the provider makes money (instead of charging a commission as in CFDs). The spread betting company also defines the contract terms, margin rates, what underlying instruments you can trade, etc.

The companies are not allowed to give advice – spread betting is always execution-only.
Purpose of financial spread betting
Spread betting is most commonly used for speculation on price movement of equities, indices, commodities, currencies. You make a profit if the price of the underlying security moves in the direction you expected.

However, it can also be used as a hedge for your long term portfolio. (We will look at this aspect next time.)
How does it work?
A financial spread bet is a contract between the customer and the provider to exchange the difference between the opening and closing price of the bet. Your profit or loss is the difference between the opening price and the closing price multiplied by your stake.

So, what exactly is the ‘spread’ and ‘bet’ in spread betting?

‘Spread’ refers to the difference between the bid and offer price quoted by the spread betting company. The higher price (offer price) is what you can buy at, the lower (bid price) is the price you sell.

The ‘bet’ size, or stake, is the (GBP in the UK) amount you choose to bet per point movement. There is no standard contract size; you nominate your own stake. Most spread betting companies allow you to go from £1 per point up to several hundreds (and more) pounds per point.

Example:

The spread betting provider will quote a bid-offer price for the DOW, say 10,546–10,548. You think the price is heading down, so you sell 10,546 at £5 a point. The DOW falls to 10,473, or 10,472-10,474 as in provider’s bid-offer price, and you close the trade (essentially making a buy bet). Your profit will be the difference between the closing price of 10,474 and the opening price of 10,546, times £5. That means 72 X 5 = a profit of £360.

Of course if the DOW starts to rise above the level at which you sold, your trade will instead start incurring a loss.
Dummy account
If you’re new to spread betting, it’s a good idea to practice on a trading simulator (or demo account) first. Many spread betting companies allow you to practice on their platforms without putting real money in. Of course the psychology and emotions are quite different when you trade a dummy account as opposed to having real money at stake. It is a good way to become familiar with the platform and the process though.
So, is spread betting gambling?

No, it isn’t. Unless, of course, you consider all financial trading to be gambling. Perhaps it’s fair to say that it comes down to the way the individual uses the product. Traders who jump into markets without any strategy or risk management and trade on gut instincts are indeed little more than gamblers.

The term ‘betting’ is a bit unfortunate and misleading, which is why many prefer to call it spread trading. However, the tax-free status comes from the fact spread trading is (in the UK) classified as ‘betting’, even though it is regulated by the FSA. For example, CFDs, although very similar to spread bets, are not a tax-free instrument.

Interested in learning how to profit from financial spread betting?

Starting with the basics of financial spread betting, we will be adding more articles and free guides each week, including details of various profitable strategies. Next time you will learn all about the benefits and risks of spread trading and what you need to be a successful trader.

The roller-coaster year that started with the possibility of a financial Armageddon is nearly over and finishing on an upbeat note. After a vigorous nine months rally the markets enter the final days of trading at the highs for the year.

Although the equity markets are still well below the 2007 highs, the rebound came with unexpected speed. Since the beginning of the year the Dow has gained 19.9%, S&P 500 is up by 24.7% and the Nasdaq by a stunning 44.95%.

The last trading days of December are traditionally characterized by low trading volume and positive mood, with prices mostly heading up – a so called Santa Claus rally.

Santa Claus rally?

Um, yes. And it’s not just a myth either. It is an uplift in stock prices that starts around, or a few days before, Christmas and typically ends in the first two or three trading sessions of the new year. Historically, during this week or so of trading, the S&P advanced by an average of about 1.5% (since 1950).

While the year-end rally tends to be quite reliable, it’s worth noting that in the years when the markets registered a loss instead, the next year often saw a bear market. So a lack of a Santa Claus rally can be a warning signal for the coming year. (E.g. a lack of a year-end rally in 1999 was followed by a market fall in 2000. A year-end decline in 2007 preceded a disastrous 2008.)

Yesterday the Dow ended up by 0.5%, closing off the holiday week with a 1.85% gain (to 10,520.10). The Nasdaq rallied 3.35% to 2,285.69 and the S&P gained 2.18% to 1,126.48. Expectations are for further advances until the first days of January.

Generally the last few months to the year end tend to be bullish. December is frequently the best single month and November-January tend to represent the best three-month period for equities. 12 of the last 15 year end periods saw stock prices moving up.

There are also several theories or patterns related to January. It is often said that the first four or five trading days of January set the course for the month and often for the first quarter. A selloff in the first days indicates big money (that tends to be reallocated at the time) withdrawing its support from stocks. However, this pattern doesn’t seem to have much historical validity.

January ending higher does frequently mean a good chance for the year to end higher (‘January barometer’; ‘as January goes, so goes the year’). On the other hand, a down January has proven to have less prediction quality as to where the markets will end the year. Overall, the January barometer has been significantly more accurate in bull markets.

Then there is also the so called January effect - a tendency for small cap stocks to rally during January. (The theory is it is due to investors selling at the end of the year to create tax losses, and re-entering positions in January, resulting in a bounce. The effect is visible in the less liquid small and micro caps.) However, the January effect has been significantly weaker in recent years.

Finally, it is said that when the Dow closes below its December low during the first quarter of the next year, it is often a warning sign of lower levels to follow.

The Santa Claus rally is not unique to the US markets. It has also been observed in the FTSE and a number of other stock markets throughout the world.

To end this post, I wish you all….

Merry Christmas and a Happy & Profitable New Year!