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?

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.

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.

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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!

If you are interested in stock market investing, chances are you have heard of, or even invested in, ETF funds.
What is an ETF?
Exchange traded funds (ETFs) have only been around since 1993, when the first ETF was introduced. That original ETF (SPDR S&P 500 ETF, by State Street Global Advisors) is still one of the most popular today. In recent years ETF funds have become increasingly popular as an alternative to mutual funds.

ETFs are low cost index funds that are listed and trade on major stock exchanges, just like stocks. They are made up of a basket of securities, similarly to mutual funds. However, an ETF has its own ticker symbol and can be bought and sold, during market hours – like an individual stock – through your broker (including discount online brokers). (A standard brokerage commission to buy or sell will apply.)

ETFs track a variety of stock, bond, commodity and currency indices. Some ETFs track the performance of a broad index (e.g. the S&P 500, FTSE 100, etc), others are more narrowly focused on a specific sector, company size, or even a country or region.
Why invest in ETFs?
ETFs have become increasingly popular with both individual and institutional investors, as well as traders and other financial professionals. Despite the jump in money flows into ETFs, they are still small compared to the amount of money invested in mutual funds.

So what are the main advantages of ETFs?

• low expenses
• tax efficiency
• diversification -> reduced risk
• transparency, trading flexibility and  liquidity
• instant, low cost exposure to global markets
• exposure to specific sectors, industries, investing styles, etc
• access to long & short strategies

While mutual fund managers try to beat the benchmark index each year, ETFs aim to mirror it.

Which is not a bad thing considered that a vast majority of fund managers under-perform the market averages, and even top managers rarely sustain their excellent returns over time. Trying to outperform the market – especially after fees – is difficult, and most managers don’t succeed.

Most investors tend to be better off buying an index ETF, which is low cost and will ultimately outperform most active managers.

One of the most important decisions for an investor is the right asset allocation for his portfolio. ETFs are well suited here, allowing active investors to easily adjust their asset allocation as markets (and risks) change, increasing or cutting exposure fast.

Since ETFs trade on exchanges, you have the advantage of the same types of trades (long, short) and orders (incl. limit, stop, stop loss, etc) as with an individual stock. Many ETFs also have the capability for options (puts and calls) to be written against them.

The diversification of most ETFs reduces investment risk. Every individual stock is only part of a basket, hence ETFs are generally less volatile than individual stocks.

Importantly, there is no minimum investment requirement, so you can buy as much or as little as you wish.

Expense ratios

Buying and selling fees:

• ETFs – standard brokerage commission

• Mutual funds – between 0 and 5% (on purchase)

Management fees:

ETFs tend to have a significantly lower expense ratio than mutual funds.

• ETFs – annual fees of 0.1 – 1%

• Mutual funds – 1-3% p.a.

(Expense ratios of ETFs vary, so make sure to check each fund’s prospectus.)

You would not believe how much this saving adds up over the long term!

Often investors don’t realize that costs play a huge role in reducing their returns. Commissions, load fees, advisory fees, management fees, taxes, etc… when added up, they will reduce overall investment returns very significantly.

Tax Advantages

One often overlooked issue is the high amount of taxable transactions in most mutual funds. Actively managed mutual funds have high turnover of their portfolio, and more trades result in not only higher transaction fees but also additional taxation. (The tax is deducted from the investors in the fund, even when they don’t sell their shares.) This, along with all the other costs and fees means a significant reduction in a fund’s return.

ETFs are usually more tax efficient than mutual funds. They are generally designed to track benchmark indices, and as such make fewer trades. The low portfolio turnover reduces the frequency of tax gain distributions.

(In the US, whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the fund must distribute capital gains to its shareholders. These gains are subject to taxes, even if you reinvest the distributions in more shares of the fund. ETF investors, on the other hand, only realize capital gains when they sell their shares in the ETF, when the ETF changes holdings in its underlying index or when stocks are removed from/added to the index.)

So instead of looking at the reported pre-tax returns of actively managed funds, compare after-tax returns of available investments before you decide where to put your cash.

(Note that US taxation of commodity ETFs is more complex and varies depending on their structure. Some commodity ETFs own the physical commodity and are taxed at a long term capital gains rate. Others use futures contracts to gain their commodities exposure; these are taxed every year, even if you don’t sell, at a hybrid rate -60% of your gains are taxed at the long term capital gains rate and 40% are taxed as short term capital gains.)

Please note that this is not meant as tax advice and may not be correct at the time of reading. Speak to your tax advisor before making any investment decision.
Who issues ETFs?
There are a number of companies providing ETFs. Among the best known are Barclays Global Investors, Vanguard, State Street Global Advisors, Fidelity Investments, Credit Suisse, Deutsche Bank, Lyxor, and many others.
Types of ETFs
When doing your research on ETFs, read the prospectus and information found on the issuer’s website. There are many different types of ETFs, depending on what the fund is tracking but also how the securities are weighted, whether there is any additional risk exposure, etc. Make sure you understand what exactly you’re buying before you invest.

ETF types:

Index ETF

The most common type of ETF, an index ETF tracks a specific US or foreign stock index (e.g. NASDAQ 100, FTSE 100, S&P 500, Russell 2000, etc). There is a large variety of index ETFs for investors to choose from.

Sector/industry ETF

These ETFs represent a specific sector (industry group), e.g. technology, energy, materials, industrials, healthcare, financials, utilities, consumer staples, etc. They track the collective performance of that industry. As with most other ETF types, there are US as well as foreign and global sector ETFs.

Size-specific ETF

These ETFs are defined by the market capitalization of the individual stocks within. For example large-cap companies (generally over $10 billion in market cap), mid-cap companies ($2 bil to $10 bil), small-caps ($300 mil to $2 bil), micro-caps ($50 mil – $300 mil).

Country-specific ETF

These ETFs track the performance of the markets of an individual country, or, in some cases, an entire region (e.g. Eastern Europe, Eurozone, Latin America, Asia, etc). There are numerous international ETFs listed both on US and foreign stock exchanges.

Commodity ETF

Commodity ETFs track the performance of a commodity (e.g. oil, natural gas, gold, silver) or a basket of commodities (such as precious metals, base metals, agricultural commodities, etc).

As discussed in the tax section above, you need to make sure you fully understand how the commodity ETF is structured. While some own the actual commodity, others are futures-based. Risks as well as tax implications will therefore vary.

Currency ETF

A currency ETF provides investors the ability to track the performance of various currencies throughout the world, such as the US dollar, Japanese yen, British pound, Euro, etc. (It’s important to note that while FOREX is essentially a 24hr market, currency ETFs are available for trading only during stock market trading hours.)

Fixed income ETF

ETFs that track corporate bond or treasury bond indices.
ETFs by weighting model
Equal-weighted ETF

Most ETFs (and indices) are weighted by market capitalization, meaning that larger companies have much greater representation in the index and greater influence on the price movement. Most of the index’s capitalization is concentrated in the top holdings.

A few providers now offer equal-weighted (index and sector) ETFs, which give a broader representation of the companies within the index. Each stock is initially given an equal weight, allowing you to spread your risk equally among all the stocks in the index. It also means you get more exposure to smaller and midsized companies, which often outperform the larger caps.

The other issue with market cap weighting is that stocks that have quickly risen in price and become overvalued will have higher weighting in the index. (The higher a stock’s valuation, the higher is its market cap.) Equal-weighed ETFs avoid overweighting stocks that trade above their fair value.

To maintain equal weighting, the ETF needs periodic rebalancing (generally done on a quarterly basis).

This means that such ETFs (compared to traditional index ETFs) usually have higher expense ratios, as well as higher bid-ask spreads (since they tend to be more thinly traded). As rebalancing involves selling stocks that have appreciated most, it results in higher transaction fees but also higher tax liability (due to realization of capital gains).

While equal-weighted ETFs are a great addition to the ETF universe, they tend to be slightly more expensive as well as less tax efficient, all of which can result in a lower compound return. Investors need to examine carefully whether these ETFs will benefit their portfolio.

Fundamentally weighted ETF

While traditional indices are market cap weighted, fundamentally weighted ETFs offer an alternative, weighting companies based on fundamental factors (such as book value, earnings, dividends, etc).

Some ETFs are weighted to fit a certain investment style. For example, there is a range of value ETFs which select companies based on combinations of price/earnings, price/book, price/cash flow ratios, dividend yield, etc.

As we have seen with equal weighting, ETFs that are weighted other than by market cap tend to have a higher portfolio turnover (since they have to buy and sell holdings as prices fluctuate). This results in increased transaction costs and lower tax efficiency; both generally apply to fundamentally weighted ETFs as well.
Actively managed ETF
Actively managed ETFs have been around since 2008 and have so far not proved very popular with investors. These ETFs, instead of tracking an index, use a manager to select the securities to be included in the fund.

Actively managed ETFs present similar issues as traditional actively managed mutual funds… the expense ratio and transaction costs are higher, and tax liabilities are higher.

Therefore, the manager has to add up enough value to make up for this. Now, as we can see with most mutual funds, that rarely happens. Since most managers don’t do better than market averages, the benefits of actively managed ETFs may be questionable (at least until we start to see some track record of these funds).
Coming in Part II…
While ETFs were first introduced as passive, low-cost, transparent investment vehicles, today there is also a number of highly complex ETFs. Some of them have proved very popular with traders and experienced investors, but it is essential that you fully understand the risks before investing in these more exotic vehicles.

They include leveraged ETFs, short ETFs, futures-based ETFs, ETNs (exchange traded notes), ETFs of ETFs… And we’ll tell you all about them, including the pros & cons and things to watch out for, next week, in Part II of this ETF guide.

In the meantime, if you have any questions about ETFs (or indeed any investments), simply write it in the comment box below and you’ll get an answer asap. (Alternatively you can always write to info (at) moneyhoneyblog.com.)

With the dramatic falls and high volatility in the stock markets over the last 15 months coupled with economic uncertainty, it is little wonder gold has surged in popularity with investors. The decline of the dollar and threat of strong inflation in the coming years has seen investors flock to gold.

It’s not just retail investors either… fund managers and institutions have also been attracted by the shine. And, for the first time in 22 years, central banks are net buyers of gold.

In the last six months gold has shot up from $880 to today’s record high of $1,226 an ounce. Over 12 months it has surged by over 55%. But how much further can it go? Are we witnessing a gold bubble that is bound to end in tears, or are prices heading further north?

Experts’ opinions are split. While many are calling for $1,500 – $2,000 an ounce (and even as much as $4,000 in a few cases), others urge caution after the recent bull run. The bulls argue that gold is, in inflation adjusted terms, comparatively cheap. In 1980 gold reached $850 an ounce – around $2,200 at today’s prices.

Gold is traditionally seen as a safe haven in uncertain times, as well as a hedge against inflation and the US dollar. (As the dollar weakens, the price of gold rises. And the greenback continues to be under pressure thanks to record low interest rates and the trillions of dollars being pumped into the US economy.)

How can you invest in gold?

First of all… what is bullion? Simple. Bullion is a ‘refined and stamped weight of precious metal’. Therefore, any tradable form of gold that you can buy at the current market price of gold (plus costs) is gold bullion.

Physical gold – bullion bars and coins

When looking at the various forms of physical gold, compare the premium (the percentage over the spot price of gold as quoted on the markets) for each of them.

Bullion bars, especially the larger ones, usually sell at a lower premium, followed by krugerrands and then sovereigns (coins). Bars are somewhat more difficult to dispose of and you will need to sell through a specialist gold dealer.

The majority of retail investors buy krugerrands and sovereigns, whereas bars are preferred by institutions, governments and central banks.

Krugerrands are the most popular type of modern 1 ounce gold coin. They can generally be bought at lower premiums than other bullion coins.

There are also many other, lesser known types of gold coins. Premiums tend to vary, so it’s best to obtain reputable and professional advice before purchasing.

Sovereigns, semi-numismatic gold coins, are sold at a slight extra premium, due to their historic and aesthetic value and smaller size. (Note that in the UK sovereigns are exempt from capital gains tax.)

Bullion coins and bars can either be delivered to you or stored. When stored, consider the solvency and credit rating of the depository, as well as security (and of course any fees). When delivered, you will need to arrange suitable insurance and safekeeping.

The World Gold Council is a great resource with a directory of reputable gold dealers.

Gold certificates

Gold certificates are cost effective, eliminating the need for shipping, storage and insurance. They are also liquid and can be sold easily. As with bars and most coins, your investment is solely determined by the price of gold.

When purchasing certificates, you need to consider the solvency and credit rating of the issuer. The Perth Mint Certificate Programme is the only government backed precious metal certificate programme in the world.

Shares and Funds

Investing in gold mining stocks comes with a greater risk. Unlike physical gold, share prices are influenced by each company’s performance and earnings, hence the price does not always move in accordance with gold price.

Due to the risk and volatility of individual gold mining shares, investors should generally avoid purchasing just one or two stocks. Unless, of course, they have a thorough understanding of the industry and are apt at analyzing individual companies.

Collective investment vehicles such as mutual funds offer exposure to the sector through a portfolio of gold mining stocks. They offer a lower risk and have proved a popular way to invest in the precious metal sector.

There are numerous choices of funds that invest in gold miners, as well as many others that offer a basket of natural resources and energy sectors, including gold and other (precious and industrial) metals.

Exchange Traded Commodities (ETCs)

ETCs track a particular commodity or basket of commodities. Like ETFs (Exchange Traded Funds), they simply mirror a specific index or sector they are tracking.

Gold ETCs track the price of gold and are available from a number of ETF and ETC providers. Some ETCs also allow traders to short (bet on falling prices) or leverage their investments. (Leveraged ETCs multiply the profits or losses incurred.)

As with ETFs, before investing in ETCs, make sure to read and understand the prospectus. They vary in structure and will therefore respond differently to market changes.

ETFs and ETCs are traded on exchanges as regular stocks and can be bought and sold through stockbrokers, including online brokers. As with mutual funds, there is an annual administration fee, albeit lower (typically 0.35 to 0.5% pa).

Trading gold

The above options are suitable for (longer term) investors in gold. Traders tend to use derivatives, incl. futures, options, spread betting, etc. These (high risk) instruments are best suited for short term speculations on price changes, and should not be used for long term investment.

ETFs, while popular with investors, are also often used by traders, hedge funds and institutions speculating on short term movements in the gold price.

Unlike the economy, which is at the early stages of its comeback, with a shaky path ahead, the stock markets have come roaring back. After the strong rally since March, cries of too much too fast have been multiplying. Trouble is, these are much the same voices who have been advising investors to be cautious and wait before returning to stock market investing. It seems very many have now missed the rally… in particular the retail investors, many of whom rushed to sell in the panic of late 2008 and early 2009.

So has the market gone too far and are we in for a big correction? Well, here are two reasons why I disagree:

1. The doom-mongers are forgetting that the (US) stock market has lost more than half of its value between October 2007 and March 2009. So while the market is more than 60% up from its March lows, it is still 30% below the late 2007 highs.

2. Prices are justified by fundamentals: the consensus earnings per share estimate (S&P 500) for 2010 is approx $77. That is less than 15 times valuations, which is lower than the 50 year average of 16.5 and 25 year average of 17.8. So, in my view, fundamentals fit in quite nicely with the price levels.

While it’s true that equities have come a long way in a fairly short time, and current valuations may not be as compelling as a few months ago, I remain bullish from a long term perspective.

Sure, we may – and probably will – see occasional pullbacks, 5% or so would be my guess, but that’s normal market behaviour. Anyone who’s been sitting on their hands waiting for a large correction is, it would seem, well on the way to miss on one of the best investment opportunities of the last few decades.

Of course, if you know what you’re doing, there are still plenty of good companies to be had at extremely attractive valuations. With zero return on cash and continuing uncertainty in global property markets, equities are at present easily the most attractive long term investment.